How Coverage Works
An orientation to generic individual disability insurance
What is the definition of disability in individual disability income insurance?
There are four broad definitions of disability used in disability insurance, which are any-occupation, modified own-occupation, true own occupation, and partial (a.k.a. residual).
Any occupation would mean that a person must be unable to work in a different occupation to qualify for a claim. Any occupation is fairly uncommon in individual insurance, but it is normal in group insurance where the definition changes from own occupation to any occupation after being on claim for two years.
A typical base policy definition uses 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 a true occupation rider or residual/partial loss of income rider to the policy, which offer the choice to pivot to an alternate definition based on how the person is working.
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. This definition adds freedom and has a rich tradition among physicians, partly due the availability of specialty definitions which permits the individual to moonlight in a different medical specialty. However, it does not permit a person to work on an incidental basis in their own occupation while on claim.
Partial disability is also known as "Residual" disability or a "Loss of Income" claim. These disability riders offer another path to qualify as disabled if working but not earning as much as before. Crucially, this definition permits a person to work any way they want to - including one's own occupation. The effect of this definition is to get away from questions about whether a person can work in their occupation and put the focus on the earnings itself...which is the entire point, after all.
Residual/partial loss of income disability riders offer the advantage of somewhat greater subjectivity, which can be important for performance-sensitive occupations where earnings are driven by cognitive skill rather than physical capacity. Examples include attorneys, consultants, software developers, executives, and sales positions. In these professions, the ability to work is too crude a test and doesn't mean earnings will follow. In fact the earnings of many sedentary occupations are driven by slight competitive differences in cognition and personality where ability to work is not even going to be in question. If earnings vary widely between individuals in the same occupation, that's a strong indication that a favorably worded residual/partial loss of income rider will add value.
Depending on the recovery provision, loss of income benefits may be payable even though the person is no longer disabled...a helpful feature when compensation is delayed. Professionals who maintain a book of business with long term clients are at risk of losing their client base and may never economically recover after returning to work. A similar "long tail problem" can happen to the extent a worker depends on bonus compensation. Bonuses are paid infrequency and may depend on long sales cycles and murky determination formulas which the worker may have no direct control over. In short, a good loss of income rider can bridge the gap when medical recovery and economic recovery don't move in lockstep.
It is possible to have multiple definitions on the same policy so that the insured is in a position to take advantage of whichever definition suits the nature of the claim.
When do disability benefits start?
Benefits begin after the Elimination Period is satisfied. The Elimination Period is the number of days after disability begins during which benefits do not accrue. A typical comprehensive income protection policy has an Elimination Period of ninety (90) days in order to keep the premium down and avoid overlap with other sources that are commonly available such as state disability benefits, employer-funded salary continuation, and short term disability insurance.
Shorter Elimination Periods (of 30 or 60 days) and standalone short term disability insurance policies are also available.
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 conditionally renew with a rolling 2 year Benefit Period.
Absolute Benefit Periods like 2 years or 5 years are also available, which reduces the cost. Many higher end policies use "per claim" Benefit Periods - as opposed to aggregate - meaning the policy can be used multiple times with a fresh Benefit Period.
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 pegged to?
Individual disability income insurance benefits are pre-determined at the time of policy issue. This is a fixed dollar monthly indemnity amount - e.g, $5,000 per month, $10,000 per month, etc. In practice, the individual always wants more than the insurer is willing to issue, therefore the issue amount ends up being the maximum amount the individually qualifies for at the time of application based on a snapshot of current earnings.
As future earnings fluctuate after the policy is issued, the issue amount remains static unless the policy owner takes action to increase it. Over the course of a worker's career, the issue amount is often ratcheted up, but never down. Therefore, an individual who acquires a policy and then later decides to transition to a less stressful, less well compensated position would still have the security of the original issue amount. The security of a fixed benefit amount regardless of future earnings fluctuations is the hallmark feature of individual disability income insurance.
Is 100% Income Replacement Possible?
100% income replacement is possible in the following situations:
(1) A future decline in earnings can result in income replacement ratios exceeding 100%. Unlike group coverage, individual policies are often issued on a non-cancellable and guaranteed renewable basis, which prevents the insurer from making downward adjustments except at the policyowner's request. From the insurer's standpoint, the risk is that an individual will take advantage of these guarantees by acquiring coverage after a peak earnings year. Insurers cannot prevent this, but they can somewhat reduce the likelihood of it happening by qualifying applicants up front based on historical earnings stability and employment stability.
(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. When a person is in the process of acquiring coverage, group insurance does not ask about what other coverages a person has, whereas individual insurers do.
(3) If the policy is of the "true" own occupation sort (discussed above), it is possible to collect full benefits regardless of earnings from a different occupation. The combined total can equal or exceed 100%.
(4) 100% may be possible right out of the gate by including certain riders, such as
group supplement riders
student loan 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 possible issue amount, insurers will include bonus, commission, and equity compensation if it is included in W-2 earnings and is a regular part of a person's compensation.
If a person is not working at all due to disability, the type of pre-disability earnings is irrelevant because the benefit is the policy issue amount, with no calculation necessary. If a person is working but not earning as much as before (i.e. partially disabled), variable compensation is generally included in the calculation of pre-disability earnings, although treatment of equity compensation varies from policy to policy.
Can I increase coverage in the future?
Yes, if that option is built into the policy from the start with the appropriate rider(s), which might cost extra.
Medical underwriting is waived on future increases. This is the entire point, and because this adds to the carrier's risk, the application must be underwritten for future increases up front, with the applicable rider attached to the policy.
Carriers offer different types of increase options.
Automatic increase options require no action at all at the time of the increases - not even financial evidence. These "Automatic" increases offer maximum convenience, but the increases are modest (3% or 4%). The Automatic increase option itself is free, though the additional layers of coverage are not. Each year, the policyholder receives a reminder letter when the benefit and premium are about to increase. This letter includes opt-out instructions which, if acted upon, waives the increase and the premium would remain unchanged.
Larger increases are available through other types of increase options which have different labels such as Future Increase Option, Future Purchase Option, Benefit Update or Benefit Increase Rider. Although medical underwriting is waived, it will still be necessary to financially qualify at the time of the increase. If a person does not financially qualify for an increase, previously issued coverage would remain unaffected. Certain variations of these riders are available for no additional cost, however they don't have the level of guarantees and control that the paid varieties offer.
Future increase options generally stop at age 55 or 60, depending on the policy rider.
Adding layers of coverage in the future is not free. There is a charge based on the added volume, which begins at the time the respective layers of coverage are added. The unit-cost rate for any given layer is based on the age when that layer is added and is independent of other layers. Due to increasing age, each layer has a higher unit cost than the one added before it. The favorable price of previously purchased layers are not affected by additions. Therefore, the premium for the policy as a whole is actually the sum of each layer of coverage added over the years. Of course if you never exercise an increase option, the premium for a non-cancellable policy would remain level.
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. Again, there may be a cost for the rider itself.
What if I change occupations?
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 change occupations 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.
What happens after Age 65?
Most policies change to "conditionally renewable" status at the policy anniversary after reaching age 65, but a few change status at age 67 or age 70. The changes may include:
1. Renewability is conditioned upon full time work.
2. Riders drop off the policy.
3. The Benefit Period is a rolling 2 years.
4. The premium goes up annually.
Renewability is no longer automatic and certain conditions must be satisfied on an annual basis in order for coverage to continue for another year. Fortunately, medically re-qualifying is not involved. Neither is occupational underwriting. The most important condition is that a person must continue to work full time. What defines full time is typically 30 plus hours per week which can be asserted with reasonable flexibility (e.g., in a "typical week") Some policies specify a certain number of months out of the year (e.g., 10 months). Self-employment counts, and it is quite common for pre-retirees to renew on the basis of 1099 work. Carriers don't nick-pick whether a person is actually working full time, but they would definitely contest full time status if your employer was registering you as part-time and you had no other work on the side.
Riders drop off the policy, leaving only the base policy. The implications of this are complex because riders can perform many functions. Regardless, the base policy remains the same amount as it has was prior to age 65 - with no benefit reduction - even if earnings decline.
The Benefit Period becomes a rolling 2 year Benefit Period, meaning that whenever claim starts the benefit would continue for two (2) years from that point. For example, if a claim starts at age 68 benefits may be payable to age 70 (not longer than 2 years). There are a few policies that reduce the Benefit Period based on age when the claim starts, but the standard is a rolling 2 years.
The premium goes up annually, which is different than the pre-65 years when the premium was level. Most people would consider the amounts charged quite reasonable considering the risk.
To learn more about out individual disability income insurance, give the Disability Underwriters team a call today.