Disability Income Underwriting and Claims
Disability income coverage is priced and issued on three questions: how risky is the applicant’s work, how much income can the insurer fairly insure, and how long and how soon will the policy pay. Once a claim comes, the answer turns on a few formulas that apply the policy’s own terms. Each formula is worked below, followed by a comparison of individual and group coverage and a look at what workers’ compensation pays for the same absence from work. Names and figures in the examples are invented and are not statutory figures.
Occupation Classes
An individual disability insurer places each applicant in an occupation class. The class reflects how likely a person in that work is to become disabled and how long a disability tends to last. An office-based professional falls in a favorable class, while a roofer or a logger falls in a hazardous one. Insurers use their own scales, so the labels differ by company. What does not differ is how the class acts on the contract.
| What the class changes | Favorable class | Hazardous class |
|---|---|---|
| Premium for the same benefit | Lowest | Highest |
| Definition of total disability offered | Own occupation available, often for the whole benefit period | Own occupation limited in time, or any occupation only |
| Maximum benefit period | Often to age 65 | May be limited to a few years |
| Residual and other riders | Available | May be unavailable |
The class follows the duties of the work, not the job title. A surgeon who spends the day operating and a physician who reviews charts from an office carry different risks, although both are physicians. An underwriter asks what the applicant does in a typical week, how much of it is manual work, whether the applicant works at heights, drives or handles hazardous materials, and whether the work is the applicant’s own business. An applicant who changes to a more hazardous occupation later may find that the insurer reduces benefits in line with the premium paid, a condition of the change of occupation provision in many policies.
The effect on price can be large. Suppose, for illustration, that a favorable class pays $40 a year for each $100 of monthly benefit and a hazardous class pays $110. A $4,000 monthly benefit then costs $1,600 a year in the favorable class and $4,400 in the hazardous one, which is 2.75 times as much for the same benefit.
Own-occupation coverage is worth most to those whose income depends on a narrow skill. The classic case is a dentist who loses a hand and can no longer practice but could do other work. A carrier will sell that definition to a dentist for the whole benefit period, since it prices the risk in the class, and will not sell it to a person whose own occupation is hard to define.
Financial Underwriting and the Limits on Benefits
The insurer does not sell a benefit for whatever the applicant requests. It limits the benefit to a share of earned income, because a benefit near full pay gives a reason to stay on claim. The limit is set before issue. This is financial underwriting.
Two limits matter.
- The issue limit is the most this insurer will issue to this applicant on a new policy.
- The participation limit is the most total disability income the applicant may carry, from all insurers and sources combined, as a share of earned income. The insurer asks about every other individual policy and every group plan. A Michigan policy may also carry a relation of earnings clause that cuts overlapping benefits after issue if the total promised exceeds the insured’s earnings (MCL 500.3444).
The insurer counts earned income, from wages, and for a self-employed applicant from net business income shown on tax returns after business expenses. Investment and rental income do not count, because they continue while an applicant is disabled.
A Worked Issue Limit
Dana Whitcomb earns $96,000 a year as a regional sales manager, which is $8,000 a month. Her insurer’s total limit is 70% of earnings. Her employer already provides group long-term disability that pays 60% of earnings.
- Total limit: 70% of $8,000 is $5,600 a month.
- Existing group coverage: 60% of $8,000 is $4,800 a month.
- Room for an individual policy: $5,600 minus $4,800 is $800 a month.
The insurer will issue Dana no more than $800 a month of new coverage. Policies seldom exceed 70% of gross income, and the figure can be lower because the insurer is looking at what the person would take home. Benefits from a policy whose premiums the insured pays with after-tax money are not taxed. So insuring about 70% of gross income replaces most of net pay.
The insurer also checks that the income is stable. An applicant whose commissions vary widely is measured on an average of the last two years, not the best month, so that a record year does not support a benefit the applicant could not otherwise sustain. A self-employed applicant needs more care. Suppose Ravi’s printing business shows $180,000 of revenue and $120,000 of business expenses on his return. His earned income is the $60,000 net, or $5,000 a month, not the $180,000. At the same 70% limit, he can insure $3,500 a month.
The Elimination Period and Benefit Period
The elimination period works like a deductible, and the benefit period is the cap on duration. Each is a price lever.
The Elimination Period Trade-Off
Take a $4,000 monthly benefit, and suppose a disability lasts 120 days. Claims are paid in 30-day months for this example.
| Elimination period | Days of benefit | Benefit paid |
|---|---|---|
| 30 days | 90 | $12,000 |
| 90 days | 30 | $4,000 |
The longer wait removes $8,000 of payments on a short claim. That is why the longer wait costs less. Suppose the illustrative annual premium is $1,980 with the 30-day wait and $1,560 with the 90-day wait, a difference of $420 a year. The saving of $420 a year would take about 19 years ($8,000 divided by $420, which is 19.05) to equal one 120-day claim. A client with savings to carry three months of bills may sensibly choose the 90-day wait. A client who lives paycheck to paycheck should not.
The elimination period should not be longer than the client’s other income sources can last. The client’s sick pay and short-term disability should end where the elimination period ends. That is how short-term and long-term coverage are designed to follow one another: the short-term plan pays through the long-term plan’s wait, and the long-term plan takes over when it ends.
A worked timeline shows the fit. Marcus earns $5,000 a month. His employer’s short-term plan has a 7-day wait and then pays 60% of pay, $3,000 a month, for up to 26 weeks. For the first 7 days he draws sick leave or savings. If his long-term policy has a 6-month elimination period, it takes over just as the short-term plan ends and pays 60%, $3,000 a month. If he had chosen a 12-month elimination period to save premium, six months would fall between the plans, and 6 x $3,000 is $18,000 of income that no policy would replace.
The Benefit Period Trade-Off
The benefit period sets the most the policy can ever pay. For a $4,000 monthly benefit and a claimant disabled at 40 with no recovery:
- A 5-year benefit period pays 60 months of $4,000, or $240,000.
- A benefit period to age 65 pays 25 years, which is 300 months of $4,000, or $1,200,000.
A permanent disability’s cost is lifetime income, and a short benefit period leaves the claimant uninsured in the years of greatest need. The insurer prices long periods higher for a reason: it will pay more of them, and those who claim stay disabled longer at older ages. The client chooses by how long other resources would last.
Partial and Residual Benefits
A policy that pays only for total disability leaves a gap for the claimant who returns to work part time or at lower pay. Two provisions fill it.
A partial disability benefit pays a fixed fraction of the total benefit, commonly 50%, when the insured can do some but not all of the duties of the occupation or can work only part of the time. It usually lasts for a limited period, such as 6 months.
A residual disability benefit pays in proportion to the income lost. The formula is
residual benefit = (income lost divided by prior income) times the total disability benefit.
Prior income is as the policy defines it, commonly a measure of the best earnings in a recent period.
A Worked Residual Claim
Priya earned $6,000 a month before she became disabled, and her total disability benefit is $3,600, which is 60% of income. After treatment she returns to work and earns $3,900 a month.
- Income lost: $6,000 minus $3,900 is $2,100.
- Proportion lost: $2,100 divided by $6,000 is 35%.
- Residual benefit: 35% of $3,600 is $1,260 a month.
Priya receives $3,900 in earnings plus $1,260 in benefits, which is $5,160, or 86% of her prior income. She has not lost the whole benefit by returning to work, which is the purpose of the provision. Many residual provisions require a minimum loss of income, commonly 20% or more, before any benefit is paid. A partial disability benefit would pay her 50% of $3,600, or $1,800, if she met its conditions, for a limited time. The residual benefit is smaller, but it follows her earnings and can continue far longer.
Had she earned $5,000 instead, the proportion lost is $1,000 divided by $6,000, or 16.7%. That is below a 20% threshold, and a policy with such a threshold would pay no residual benefit.
Group and Individual Disability Compared
| Feature | Group disability | Individual disability |
|---|---|---|
| Issue | Underwritten on the group, usually without individual medical evidence up to a limit | Underwritten on the applicant, with medical and financial evidence |
| Who owns it | The employer holds the master policy, and the employee holds a certificate | The insured owns the policy |
| After a job change | Coverage ends with employment or is converted if the plan allows | Stays with the insured |
| Renewability | Terms can change at the master policy’s renewal | May be noncancelable or guaranteed renewable |
| Definition of disability | Often own occupation for a first period, such as 24 months, then any occupation | Own occupation can run for the whole benefit period |
| Offsets | Commonly reduced by Social Security and workers’ compensation | Usually paid in full, unless a Social Security rider applies |
| Tax on benefits | Taxable to the extent the employer paid the premium (26 U.S.C. 105(a)) | Not taxable if the insured paid the premium with after-tax money |
A worked comparison shows the offset. Dana’s group plan pays $4,800 a month, as above. She is awarded $2,000 a month from Social Security. If the group plan reduces its benefit by the Social Security award, it pays $4,800 minus $2,000, or $2,800 a month, and her total from both sources is still $4,800. An individual policy of $800 on top of that is paid in full, bringing her to $5,600, which matches the total limit. The offset in the group plan keeps the group from paying twice.
A group plan also depends on the employer. If the employer drops the plan or the employee changes jobs, the coverage goes, and an employee who has become uninsurable in the meantime cannot replace it. A group plan fits a person with a stable employer and ordinary risks. An individual policy fits a person whose group benefits are capped below their income, a self-employed person, or anyone who wants coverage that survives a job change. A young professional with a group plan commonly buys an individual supplement.
Workers’ Compensation
A disability policy answers off-the-job losses, and workers’ compensation answers losses from work. In Michigan the Worker’s Disability Compensation Act makes the employer liable, without regard to fault, for a personal injury arising out of and in the course of employment. Benefits fall into four kinds.
- Medical care. The employer furnishes reasonable medical, surgical and hospital services and medicines when needed (MCL 418.315(1)).
- Wage loss. For total incapacity, the weekly benefit is 80% of the employee’s after-tax average weekly wage, but not more than the maximum weekly rate (MCL 418.351(1)). For partial disability with wage loss, it is 80% of the difference between the after-tax average weekly wage before the injury and the wage earning capacity after it, subject to the same maximum (MCL 418.301(8)).
- Rehabilitation. The employee is entitled to prompt medical rehabilitation and, when the injury prevents the work for which the employee was trained, to vocational rehabilitation including retraining and job placement. It generally does not extend beyond 52 weeks (MCL 418.319(1)).
- Death benefits. Dependents who were wholly dependent on the employee’s earnings receive a weekly payment of 80% of the after-tax average weekly wage, within the act’s maximum and minimum rates, for 500 weeks from the date of death (MCL 418.321). The employer also pays the reasonable expense of the last sickness, funeral and burial, and the funeral and burial part may not exceed $6,000 or the actual cost, whichever is less (MCL 418.345).
Take an employee whose after-tax average weekly wage is $900, an example figure and below any maximum. Total incapacity pays 80% of $900, or $720 a week. If she returns to lighter work with a wage earning capacity of $500 a week, partial wage loss pays 80% of ($900 minus $500), which is $320 a week.
There is a waiting rule. No compensation is paid for an injury that does not incapacitate the employee from earning full wages for at least 1 week. If incapacity goes beyond 1 week, compensation begins on the eighth day, and if it lasts 2 weeks or longer, it is computed from the date of injury (MCL 418.311). An employee off work 10 days is paid for days 8 through 10 only. An employee off work 3 weeks is paid from the injury date.
The act makes these benefits the employee’s exclusive remedy against the employer, with an exception for an intentional tort (MCL 418.131(1)). Most health policies exclude work-related injury, because workers’ compensation is meant to cover it. A claimant injured at work looks first to workers’ compensation, and an individual disability policy with a Social Security or workers’ compensation offset pays less when that benefit is paid.
Lesson summary
- An insurer assigns each applicant to an occupation class based on duties, and the class affects premium, the definition of disability, the benefit period and the available riders.
- Financial underwriting limits total disability coverage to a share of earned income, with the issue limit for one insurer and the participation limit for all coverage combined. A self-employed applicant is measured by net business income.
- A longer elimination period lowers the premium by removing short claims, and a longer benefit period raises it by promising more months of payment.
- A residual benefit equals the share of income lost times the total benefit, while a partial benefit is a fixed fraction paid for a limited time.
- Group and individual coverage differ in underwriting, ownership, portability, definition of disability, offsets and tax treatment.
- Michigan workers’ compensation pays medical care, wage loss at 80% of after-tax average weekly wage, rehabilitation and death benefits, and its benefits are the employee’s exclusive remedy against the employer.