Understanding Disability Insurance Policies

When it comes to investing, one of the principles investors should abide by is to have their risks covered before they begin or continue investing. That means having an adequate amount of cash stored away for emergencies as well as having the proper insurance coverage in place to protect you from financial ruin during a financially catastrophic event. The most common deficiency is the lack of proper disability coverage.

Data regarding the probability of becoming disabled during your working years is all over the map, however, one point the data is clear about it is that you are much more likely to become disabled than you are to die prematurely. Yet it is much more common for people to have life insurance than it is to have disability insurance (granted, depending on the disability, the financial impact of a premature death is much more substantial than becoming disabled).

In any case, disability policies are intricate and sometimes confusing, which may be one reason why many people don’t have them. Ensuring you get the correct policy for you and your unique situation is extremely important. In this article, we’ll simplify the intricacies of disability insurance and hopefully provide some clarity on which type of policy is right for you.

Disability Insurance Policy Types

Long-term disability insurance usually comes in two different types, own occupation or any occupation.

Own-Occupation

An own-occupation disability policy pays out a benefit if the insured is unable to perform the material and substantial duties of their own particular occupation. An example of this would be a surgeon who becomes completely blind. In no circumstance would this surgeon be able to perform the “material and substantial” duties of performing surgery, which means he would be eligible to receive his disability benefit.

Any-Occupation

An any-occupation disability policy only pays out a benefit if the insured is unable to perform duties of any gainful occupation the insured is reasonably suited for based on their education and experience. Using the example above, with this type of policy the surgeon is not entitled to benefits just because he can’t perform his job in the medical industry. The surgeon will only be entitled to benefits if he can’t work in any gainful position. That means if the surgeon is able to work at a fast-food restaurant or toll booth, he isn’t entitled to his disability benefit.

Many employer-sponsored plans offer a hybrid of own-occupation and any-occupation. Usually, it will be structured so the first two years after your disability the benefit is paid out on the own-occupation clause. After two years, the benefit will be paid out on the any-occupation clause. Statistics show the average disability benefit is paid out two to four years before the the insured is able to return back to work. In this case, the hybrid policy would be beneficial. For example, let’s assume the surgeon owned a policy that only paid out a benefit under own-occupation for two years then switched to any-occupation. The first two years he would be eligible for his $15,000 monthly benefit, after which the benefit would stop since he could perform a variety of other occupations, even though they may be out of his scope of education and experience and pay much lower. (For related reading, see: Choosing the Best Disability Insurance.)

Non-cancelable and Renewable

In addition to the two general types of disability policies, you’ll want to keep an eye out for these terms:

  • Non-cancelable: A non-cancelable policy is a policy the insurance company cannot cancel, increase the premiums on or reduce the benefits, as long as the insured pays their premiums. This is important for a few reasons. If you go from a very low-risk job, like working in an office, to a very high-risk job, like a construction worker, your premiums cannot be increased. In addition, if you go from a higher-paying job to a lower-paying job, your benefit cannot be decreased.
  • Guaranteed renewable: A guaranteed renewable policy is a policy the insurance company cannot cancel if the insured continues to pay their premiums. However, the insurance company does have the right to increase premiums based on the filing of a claim or a higher risk occupation. (For related reading, see: Top 6 Features of a Great Disability Policy.)
  • Conditionally renewable: A conditionally renewable policy basically gives all the power to the insurance company. They have the right to cancel the policy at any time if certain conditions are met (such as moving from a low-risk job to a higher-risk job), even if the insured has paid their premiums. They also have the right to raise premiums and/or lower the benefit amount.

Just like most things, you get what you pay for. An own-occupation policy will be more expensive than an any-occupation policy. And a non-cancelable, guaranteed renewable policy will be more expensive than a conditionally renewable policy. However, the last thing you want to deal with after becoming disabled is fighting with an insurance company or not getting your benefit at all.

Length of Benefits and Elimination Period

The benefit period for disability insurance is categorized generally as either short-term or long-term. Both short-term and long-term policies include an elimination period, which is a set amount of time before the policy will begin to pay your benefit. The elimination period works similar to a deductible in a health insurance policy. It requires you to have some “skin-in-the game” and cover your own expenses for a period of time before the benefit kicks in.

Short-Term Benefit Period

Short-term disability policies usually pay benefits up to 6 months; however, some policies will offer benefits up to two years. Short-term disability policies usually have a 14-day elimination period. Unless your employer offers short-term disability insurance at no cost or substantially subsidized, most people should forgo short-term disability insurance. One of the purposes of having an emergency fund of three to six months of expenses is to cover you in case of a short-term disabling injury.

Long-Term Benefit Period

Long-term disability policies pay benefits anywhere from two years up until retirement. The most common and cost-effective elimination period of a long-term disability policy is 90 days but can range anywhere from 30 to 720 days.

Benefit Amount and Taxation

Most long-term disability policies cover 50% to 60% of your income but can go up to 80%. If the premiums on your policy are paid by your employer, the benefits will be taxable. If you purchase the policy privately and pay the premiums yourself, the benefits will be tax-free. While having a benefit of only 50% to 60% of your income may not seem like enough to cover your expenses, it usually is.

Consider someone who was making $100,000 before becoming disabled and owned an individual disability policy. Between payroll (7.65%), federal (12%) and state (5%), they’re most likely paying around 25% in taxes. Add in an additional 10% for their 401(k) contributions and their take-home pay is around 65% of their gross income. If the insured is able to work another job that is less physically demanding, and the policy is non-cancelable, guaranteed renewable, the insured may very well make up what they were earning pre-disability. (For related reading, see: Taxation of Premiums and Benefits.)

If your disability is serious enough to qualify for Social Security disability benefits, the benefit you receive from your disability policy (or workers' compensation if the injury happened while at work) could be reduced. The most generous policies do not include a provision that reduces your disability benefit, but some policies offset your disability benefit by the amount you receive from Social Security dollar-for-dollar. The most common policy caps your total disability benefits at 80% of your pre-disability income.

Cost of Disability Insurance

As you’ve probably gathered, the cost of disability insurance can vary greatly depending on the following factors:

  • Policy type (own-occupation versus any-occupation)
  • Terms (non-cancelable, guaranteed renewable, conditionally renewable)
  • Length of benefits
  • Length of elimination period
  • Benefit amount
  • Group versus individual policy
  • Subsidized by your employer or not
  • Age, health, where you live and occupation

Most individual policies end up costing 1% to 3% of your income depending on the factors above. Make sure you shop around with different brokers and get multiple quotes you can compare side-by-side.

Bottom Line

Disability insurance is an often overlooked part of an individual or family’s financial plan. Whether you have coverage through your employer or individually, make sure you understand the ins and outs of the policy (ask for a summary plan description) so you can know what to expect if you ever become disabled.

(For more from this author, see: How Timing Impacts Your Retirement Portfolio Longevity.)