As a quick reminder, disability insurance will pay you monthly income in the case that you become disabled and are unable to work. In other words, it’s insurance against the loss of income due to poor health.
And as we said in last week’s post, if there’s anyone that relies on your income, including you, then there’s a need to insure the ability to earn that income.
There are a lot of variables to consider when looking at disability insurance, and with all of the different terms it can quickly get confusing. Today I’d like to explain some of the most common and important characteristics of a disability insurance policy so that you can make a more informed decision when evaluating your options.
Definition of disability
They way the policy defines disability is incredibly important, as it determines the circumstances under which you’ll be able to collect benefits. At the highest level, there are basically three ways to define it:
- Own occupation: You are unable to do the work of your current job.
- Modified own occupation: You are unable to do the work of any job for which you are reasonably suited based on experience, education and training. (Yes, this is very vague.)
- Any occupation: You are unable to do any kind of work. (This is Social Security’s definition.)
The “own occupation” definition is the most beneficial to the person buying the insurance, since it covers them under the most situations. It’s also the most expensive. But remember that this is one of the building blocks of our financial security, so while price should matter it shouldn’t be the primary factor.
Also keep in mind that even within these broad definitions, the language will vary from policy to policy and the specific language is very important. Make sure to get some help understanding the specific language of the policy you’re looking at before making any final decisions.
Personally, I decided to purchase a policy with an “own occupation” definition for myself because I didn’t want to have to fight the insurance company on the very vague language of the “modified own occupation” definition, and I definitely didn’t want to only qualify if I was completely unable to work.
Some policies will exclude certain conditions from coverage, either because of a pre-existing condition or because it’s something they just don’t cover. Mental health conditions like depression and anxiety are common examples of things that many policies simply won’t cover.
If you have a pre-existing condition, it will probably be difficult to find coverage for it. Though I’m not an expert on that area so it may be worth looking around to see if there are any reasonable options.
But it is worth your while to compare different companies against each other for more general exclusions. There’s no need to go with a company that excludes certain conditions if there’s another option that includes them.
At the very least, your policy should be what’s called “guaranteed renewable”. This simply means that as long as you continue to pay the premium on time, your policy cannot be cancelled by the insurance company. However, the insurance company CAN raise the premiums, but only if they do so across ALL policies for people with a similar type of occupation. In other words, they can’t simply decide to increase your individual premiums. It has to be a company-wide decision across a broad population of similar people.
One step up from that is a policy that is additionally “non-cancelable”. This simply means that all the same terms as above apply, but in addition your premiums are guaranteed for as long as the policy is in force. This will come at an additional cost.
The benefit is the monthly amount you would receive in the event of disability. This may be expressed as a percentage of your income if you have a group policy (through your employer) or it may be a specific amount if you have an individual policy.
In either case, you likely won’t be able to have more than 60-70% of your income covered. The reason for this is that the insurance company wants to make sure you have an incentive to return to work.
I’ll talk about this more next week when I compare group policies to individual policies, but it’s important to understand whether your benefits will be taxed. If you have a group policy, the benefits you receive would likely be taxed, which means the money you actually get in your pocket will be less than the benefit amount. With an individual policy the benefits will likely be tax-free. This distinction can make a big difference in determining whether you have enough protection.
This is the maximum length of time that benefits will pay out. A typical policy will pay either only pay out for a set number of years or will pay until age 65, no matter when your disability starts.
My recommendation would be to make sure the benefits will last for as long as you currently plan on working. After all, the insurance is meant to protect you from lost income, so the protection should last as long as you expect to earn income. For most people this will probably mean that a policy that pays until age 65 is the best option.
Also called the “waiting period”, this is the amount of time from the start of disability before you would start receiving benefits. You will have some choice here, but typically the most cost-effective option is 90 days, meaning that benefits wouldn’t start paying out until you had been disabled for 90 days.
This is a very similar concept to a deductible with other types of insurance. It’s a cost-effective tool for you because it lets you insure the big loss (long-term disability) while handling the smaller losses on your own. This is one place where a good emergency fund can be incredibly helpful. If you have the cash available to handle the first few months, you can save a lot of money on premiums.
Some policies may offer what’s called a “residual benefit” which will pay you partial benefits if you return to work at a lower salary than you previously had. This can be a valuable benefit and you should understand the terms under which this does or does not apply in your policy.
Cost-of-living adjustment (COLA)
The cost-of-living adjustment (COLA) will allow your benefit to increase over time by some specific percentage so that it can (hopefully) keep up with inflation. This feature will likely come at a small extra cost.
Future purchase option
You can also choose to have the option to purchase additional benefits later on without any review of your medical condition. This can be a valuable benefit if you expect your income to increase over time and therefore think you may need more insurance in the future. It basically allows you to lock in your current medical condition, removing the risk of developing an issue that would make it either more expensive or impossible to get more coverage in the future.
Keep in mind that this only locks in your current health, not your current age. So if you want to purchase more later the premium might be higher simply because your older.
Strength of the insurer
Finally, you should understand the the financial strength of the insurer. The best coverage in the world won’t help you if the insurer is bankrupt when you need it. The easiest way to check this from my own experience is to simply go to the insurer’s website and they’ll either have their financial ratings on the front page or you’ll be able to find it somewhere in their menus.
There’s a lot to consider here, and it certainly doesn’t make for an easy decision. If you’re looking for an individual policy (outside of anything offered by your employer), it probably makes sense to work with a broker who can pull quotes from multiple companies and help you understand the differences.
In next week’s follow-up, we’ll talk about the difference between an individual policy and a group policy, and why you might want an individual policy even if you already have coverage through your job.