Individual Disability Insurance
for Personal Income Protection
What defines disability?
Individual disability insurance offers choices when it comes to the definition of disability. The basic definition is of the modified "own-occupation" type, where, due to injury or illness, a person is disabled if they are unable to perform material and substantial duties of their own occupation and not working. The not working requirement can be waived, for additional cost, by adding true occupation or residual/partial riders to the policy.
"True" own occupation permits a disabled person - while on claim - to moonlight in a different occupation without disqualifying themselves or reducing benefits, thereby creating a path to full income replacement.
Residual/Partial disability riders allow a person to qualify as disabled even if they are working in their own occupation but not earning as much as before. Under this definition, the amount of the benefit is generally the full amount as long as earnings are below some threshold (25%, for example) of pre-disability earnings. Above that threshold, benefits are proportionate to the loss of income. Residual/Partial riders add a lot of value for high earning professionals who are paid on the basis of performance such as attorneys, consultants, software developers, executives, sales positions. Where earnings and attendance don't move in lockstep, the focus is less about the occupation than the income itself.
It is common for individual policies to have both riders (true own occupation and residual/partial) so that the insured is in a position to take advantage of whichever definition is best at the time of claim.
When do disability benefits start?
Benefits begin after the Elimination Period is satisfied, which is selected at the time of application and is the number of days after disability starts. A typical policy has an Elimination Period of 30 or 90 days.
How long do disability benefits last?
Benefits cannot go past the Benefit Period chosen at application, which is typically to age 65, 67, or 70. Lifetime benefits may be available with some policies in special situations. As a worker approaches this age and continues to work beyond it, most policies renew with a rolling 2 year Benefit Period.
Absolute Benefit Periods like 2 years or 5 years are also available, which can reduce the cost. These are per claim Benefit Periods - not aggregate - meaning the policy can be used multiple times with a fresh Benefit Period. With non-cancellable versions (the most common) the cost does not go up over time regardless of how many times the policy is used.
Some policies have special limitations for psychological claims. This is also referred to as a "psych limit" or "mental/nervous limit", and is commonly defined by what is published in the current version of the Diagnostic and Statistical Manual of Mental Disorders (DSM). Psych limits are typically 24 months which may be either per claim or aggregate depending on the policy.
What is the benefit amount based on?
You may be most familiar with group insurance, where a percentage of earnings is insured. Group insurance defers calculation of the benefit until the time of claim, at which time formulaic reductions are applied such that the actual benefit is usually less than the gross benefit percentage.
Individual disability insurance benefits are pre-determined at front end of the process (application) as a fixed dollar monthly indemnity amount - e.g, $5,000 per month, $10,000 per month, etc. The insurer underwrites the application so that the issued policy is whatever the person applied for, so long as the amount is not too large relative to current earnings.
The issue amount does not change after the policy is issued. As future earnings fluctuate, coverage may go up but it will not go down, at least before age 65. Over the course of a worker's career, increases to the benefit amount are ratcheted up.
Despite insurer's intentions to keep issue amounts modest, 100% income replacement can and does happen due to the inability of the insurer to cancel previously issued layers of coverage. There are four (4) ways this can happen.
(1) A future decline in earnings can result in income replacement ratios exceeding 100%.
(2) The acquisition of group insurance after individual insurance is issued may result in greater than 100% income replacement, because group and individual coverages generally don't integrate with one another, and group insurance does not ask about other coverages at the time of enrollment (whereas individual does).
(3) If (and only if) the policy is of the "true" own occupation sort, it is possible for benefits plus work earnings from a different occupation while disabled from one's own occupation to equal or exceed 100%. Since true own occupation does not penalize a person for moonlighting, any work earnings will supplement benefits.
(4) 100% may be possible right out of the gate by including certain riders designed to achieve this, such as catastrophic riders, group supplement riders, and retirement contribution riders.
Replace 401(k) or other retirement contributions so that you keep saving during a period of disability.
For individuals contributing to a retirement plan.
Is bonus and equity compensation covered?
For purposes of qualifying for a new policy and determining the maximum issue amount, insurers will generally consider incentive compensation and equity compensation as well if it appears on the W-2 and if it is a steady part of a person's compensation.
For purposes of determining the benefit, the issue amount is the benefit amount and the type of compensation is irrelevant. One exception is if a person continues to work (usually in their own occupation) but makes less money for health reasons. If the policy has this feature, the carrier pays based on the loss of earnings; and in order to know that, they need to determine what the person was making before. Pre-disability earnings generally includes bonus compensation and taxed equity compensation.
Will I be able to increase coverage in the future to keep pace with earnings?
Yes, if you build in that option into the policy from the start with the appropriate rider(s).
Carriers offer different types of increase options. Some are automatic and require no action at all - not even financial evidence, but the increases are modest (like 3%). Other options allow for large increases at annual or tri-annual intervals, or upon certain life events such as losing group coverage. Some options put a person on a track where a minimum increase has to be taken, while others leave it up to the insured to wait as long as they want up to a certain age (usually 55 or 60).
In general, future increase options do not require a person to medically qualify for the increases because the policy was underwritten for future increases up front, with the applicable rider attached to the policy. However, increases do require a person to financially qualify at the time each option is exercised.
The cost of adding layers of coverage in the future is not free. There is a charge based on the added volume, and the rate for any given layer is based on the current age when that layer is added. Thus, each layer has a higher unit cost than the one added before it. The favorable price of previously purchased layers is not affected. So the premium for the policy as a whole is actually the sum of each layer of coverage added over the years. While the term "non-cancellable" does mean "the premium can't go up," it refers to each layer independently rather than the policy as a whole. Of course if you never exercise an increase option, the premium for a non-cancellable policy would stay the same.
If you expect your earnings to rise significantly in the future, plan ahead for future increases and be sure to apply for the appropriate rider. There may be a cost for the rider itself.
What if I change occupations after my policy has been issued?
The test for disability would be relative to your new occupation. You don't need to update the carrier and the policy is just as valid as it was before. Insurers take the chance that you may enter a different, high risk occupation after the policy is issued and there is nothing they can do about it.
If you file a claim while unemployed, the test for disability will depend on the policy. Some will base it on your career occupation using a common sense standard, others will use an any-occupation test.