Disability Insurance Basics

Disabling injuries affect millions of Americans each year. Disability insurance, which complements health insurance, helps replace lost income if an individual is unable to work due to a disability. There are three basic ways to replace income.

1. Employer-Paid Disability Insurance

This is required in most states. Most employers provide some short-term sick leave. Many larger employers provide long-term disability coverage as well, typically with benefits of up to 60 percent of salary lasting for a period of up to five years until the age of 65, and in some cases extended for life.

2. Social Security Disability Benefits

This is paid to workers whose disability is expected to last at least 12 months and is so severe that no gainful employment can be expected.

3. Individual Disability Income Insurance Policies

Other limited replacement income is available for workers under some circumstances from workers compensation (if the injury or illness is job-related), auto insurance (if disability results from an auto accident) and the Department of Veterans Affairs.

For most workers, even those with some employer-paid coverage, an individual disability income policy is the best way to ensure adequate income in the event of disability. Workers who buy a private disability income policy can expect to replace from 50 percent to 70 percent of income.

Disability benefits paid out on individual disability policies are not taxed; benefits from employer-paid policies are subject to income tax.

Types of Disability Insurance

There are two types of disability policies: Short-term disability and Long-term disability. Short-term policies have a waiting period of 0 to 14 days with a maximum benefit period of no longer than two years.

Long-term policies have a waiting period of several weeks to several months with a maximum benefit period ranging from a few years to a lifetime. Disability policies have two different protection features: noncancelable and guaranteed renewable.

Noncancelable means that the policy cannot be canceled by the insurance company, except for nonpayment of premiums. This gives the policyholder the right to renew the policy every year without an increase in the premium or a reduction in benefits.

Guaranteed renewable gives the policyholder the right to renew the policy with the same benefits and not have the policy canceled by the company. However, the insurer has the right to increase premiums as long as it does so for all other policyholders in the same rating class. There are several options and factors to consider when purchasing a disability policy.

Additional Purchase Options, The insurance company gives the policyholder the right to buy additional insurance at a later time.
Coordination of Benefits, The amount of benefits policyholders receive from their insurance companies is dependent on other benefits they receive because of the disability. The policy specifies a target amount the policyholder will receive from all the policies combined and will make up the difference not paid by other policies.
Cost of Living Adjustment (COLA), The COLA increases disability benefits over time based on the increased cost of living measured by the Consumer Price Index. Policyholders will pay a higher premium if they select the COLA.
Residual or Partial Disability Rider, This provision allows workers to return to work part-time, collecting part of their salaries and receiving a partial disability payment if they are still partially disabled.
Return of Premium, This provision requires the insurance company to refund part of the premium if no claims are made for a specific period of time declared in the policy.
Waiver of Premium Provision, This clause means that the policyholder does not have to pay premiums on the policy after he or she is disabled for 90 days.

Factors Affecting the Choice of a Disability Policy

1. Definition of Disability

Some policies pay benefits if workers are unable to perform the customary duties of their own occupation. Others pay only if workers are unable to perform any job suitable for their level of education and experience.

Some policies define disability in terms of workers’ occupations for an initial period of two or three years and then continue to pay benefits only if they are unable to perform any occupation. “Own occupation” policies are more desirable, but more expensive.

2. Benefit Period

The benefit period is the amount of time policyholders will receive monthly benefits during their lifetimes. Experts usually recommend that the policy pay benefits until at least age 65, at which point Social Security disability will take over. Young people may consider buying a policy offering lifetime benefits because it will still be relatively inexpensive.

3. Replacement Percentage

A policy that will replace from 60 percent to 70 percent of total taxable earnings is advisable. A higher replacement percentage, if available, is more expensive. Other sources of income should be evaluated before deciding how much disability coverage is needed.

4. Coverage for Disability Resulting from Either Accidental Injury or Illness

An accident-only policy is less expensive but does not provide adequate protection. Ideally, both accident and illness coverage should be purchased.

5. A Cost-of-Living Increase in Benefits

Policies may not pay benefits for a decade or more and should keep pace with increases in the cost of living. (Some companies also offer “indexed” benefits, keeping pace with inflation after benefit payments begin.)

6. A Policy Paying “Residual” or Partial Benefits

This type of policy is available so that people can work part-time and still receive a benefit making up for lost income. A standard feature in some policies, and added by a rider to others, a residual benefits policy pays partial benefits based on loss of income without an initial period of total disability.

7. Transition Benefits

Offered by some companies, it can offset financial loss during a post-disability period of rebuilding a business or professional practice.

8. Ongoing Coverage

A noncancelable policy will continue in-force as long as the premiums are paid; neither the benefit nor the premium can change. A guaranteed renewable policy keeps the same benefits but may cost more over time since the insurer can increase the premium if it is increased for an entire class of policyholders.