The Disability Insurance Trap

Christina Bates -

One out of every four Americans will miss at least 90 consecutive days of work because of an injury or illness between the ages of 35 and 65. Disability insurance can prevent these medical disasters from becoming financial disasters.

However, most disability insurance is obtained through deeply flawed group policies offered by employers. Employees with such group coverage often aren't adequately protected.

In representing clients, I have seen what can go wrong with employer-sponsored disability policies. Here's what to watch out for and bow to get the best coverage…

Problems With Employer Plans

Employer-sponsored disability policies-in which all or part of the premiums are paid by the employer—typically claim to replace 60% or 70% of an employee's income when he/she is disabled beyond the typical 90- or 180-day elimination (waiting) period. However, these promises are empty and deceptive. Insurers are allowed to reduce the benefits they pay dollar for dollar for any benefits the disabled employee receives from his state worker's compensation program... Social Security disability program... the state's disability program...and even cash settlements received for pain and suffering if the employee was injured in an accident that caused his disability.

Even worse: Any money these insurers pay out to group disability policyholders is taxed. Beneficiaries end up with only a small fraction of what they thought they were insured for.

Other drawbacks…

  • An employer might eliminate its disability plan at any time.
  • An employee may not be able to take this disability policy with him if he quits or is fired
  • If a claim is ultimately denied, an employee in the group plan must appeal the denial in a timely manner, then sue in federal court to recover only his past-due benefits, some interest and attorney fees if the court allows. The horror of group disability litigation is that there is no trial by jury, no recovery for emotional distress and no opportunity to seek punitive damages under the Employee Retirement Income Security Act (ERISA). The carrier is required to pay only what it owed—in my opinion, this is like robbing a bank and returning the money years later without any penalty or jail time.

Advantages Of Individual Coverage

It's best to purchase your own individual disability coverage through an insurance agent, whether or not you are covered through an employer's group plan. You will receive the maximum benefit you're owed-tax free-even if you get other forms of compensation for your injury...you, not your employer, have control over the coverage...and if necessary, you can take the insurer to court, get a trial by jury and seek not only the benefits owed but also punitive damages if your state allows.

The downside is cost. A 55-year-old man in good health might spend $280 per month for a well-designed disability policy that replaces 60% of wages up to $4,000 a month after a 90day waiting period. A 55-year-old woman might spend around $325 (women are more likely to become disabled, so their coverage costs more). For a 45-year-old man, the cost might be $199 a month. For a woman, it might be $281 a month.

Two ways to cut the cost of your coverage...

*There are some employer plans that allow workers to pay all or part of the premiums with after-tax dollars so that payouts aren't taxed.

  • Increase your waiting period from 90 to 180 days. This should reduce premiums by about 20% compared with a 90-day wait-but this strategy makes sense only if you can afford to live half a year without income. With a six-month waiting period, you begin to accrue payable benefits in the seventh month and would get a check at the 225th-day (seven-and-a-half-month) mark.
  • Women should ask their insurance agents to check whether unisex policies are available. These might cost 10% to 20% less.

Must-Have Features

Expect insurers to offer coverage for up to two-thirds of your current wages, not to exceed $15,000 per month.

Three provisions that you also should insist on…

  • "Own occupation" protection. Without this provision, your insurer could reduce benefits by the amount you're capable of earning-even in a line of work that doesn't appeal to you.

Example: A stroke makes it impossible for a woman to continue her career as a surgeon. Without "own occupation" protection, her disability insurer might argue that she still could work as a janitor and then reduce her benefits by the $2,000 a month she could earn in that job. With own occupation protection, the woman receives her full benefit for as long as she can't perform surgery.

  • Non-cancelable and guaranteed renewable to age 65. With this clause in the contract, your insurance company can't terminate your coverage until you turn 65, even if your health deteriorates. Guaranteed renewable policies also have fixed premiums.
  • Total disability and partial disability coverage. Some individual policies provide for both total and partial disability benefits.

Example: A woman has a heart attack but still can work 20 hours a week. If her policy covers only total disability, her insurer won't owe her a dime. With total and partial coverage, she will be compensated based on the percentage of her income that she has lost.

  • Cost-of-living adjustment. This feature increases your monthly benefits after disability strikes to keep pace with inflation. It's highly recommended for those younger than 40 but not vital for those over 50—inflation won't have as much time to deplete the value of their benefits. Expect a policy that provides an annual 3% to 6% increase in benefits to cost 8% to 12% more than one that does not provide such an increase.
  • Future increase option. It makes sense to add more disability coverage over the course of your career to keep pace with your rising wages. A future increase option gives you the right to buy more coverage at the initial contract rate, even if your health declines. This provision typically isn't available past age 50.

What To Avoid

  • "Except fraud" provision. If an "except fraud" clause is written into your contract, your insurance company can attempt to take away your policy at any time by claiming that you materially misstated your medical, financial or occupational status when you applied for coverage. Insurance companies sometimes use this clause to deny benefits to honest policyholders when they find the slightest hint of an error on the application

Better: Ask for a "two-year contestability policy" instead. After your contract has been in force for two years, the insurance company cannot contest any statements in your application.

Buying Disability Coverage

Ask trusted financial professionals or friends to recommend disability insurance agents...or call the top insurers to find agents in your area. Make sure an agent is licensed by your state.

There are four major individual disability insurance companies in the US…

  • Guardian (866-425-4542, www guardianlife.com).
  • Mass Mutual (800-272-2216, www.massmutual.com).
  • Northwestern Mutual (414-271-1444, www.nmfn.com).
  • UNUM (877-322-7222, www.unum.com).

Helpful: If the agent you speak with can't get you a quote from each of these insurers, call other agents until you can compare quotes from all four companies. There's nothing wrong with checking the rates offered by smaller insurers as well, but the best deals usually come from the big four.