Disability Insurance

April 13, 2006

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Throughout much of a business operator's life, the chances that he or she will become disabled are greater than the likelihood of death. However, many more people have life insurance policies than have disability policies.

Unlike a life insurance policy, which is primarily designed to provide a lump sum payment in the even of death, a disability policy provides income to an individual who becomes disabled because of an accident or illness. There are many kinds of disability policies, which differ on how liberally or restrictively they define disability, how much periodic income they pay, how long you have to wait (called the "elimination period") for payments to begin, and how long payments will go on.

How you should plan to meet the threat of disability depends on how you answer the following question: If you become disabled (whether permanently or not), could family members or others keep the business running (even at reduced profits) until you return?

If the answer is yes. Since you believe that your business can be continued by others after your disability, chances are that the business does not require your constant personal supervision or specialized skills or knowledge that only you possess. However, it's unlikely that whoever runs it for you in the interim will be able to turn the same profit you did. Income from a disability policy could help make up the difference for you.

Because you foresee the business continuing during your disability, another type of disability policy could be a good idea — disability overhead insurance. Upon the owner's disability, such a policy pays out a portion of the business's fixed (overhead) expenses. In this way, the business may have a better chance to survive a period of decreased profits until the owner returns.

If the answer is no. If you believe that your business can't be operated by family members or others while you are disabled, it's probably true that your business depends on your constant supervision, or specialized skills or knowledge that only you have. Because this is true, there's no need for disability overhead insurance, which upon the owner's disability, pays out a portion of the business's fixed (overhead) expenses. But the fact that you don't expect your business to survive the period of your disability means that you probably have a greater need for disability insurance than if the business continued.

Disability policy provisions. If you are considering the purchase of a disability policy, you should note that such policies may differ in several different ways:

When do the benefits start? Do benefits begin at the onset of disability or is there a waiting period? Common elimination periods include 30, 90, or 180 days. A lengthy waiting period gives no protection for short-term disability.
How is disability defined? Older policies paid full benefits for the inability to perform the exact duties performed before the disability, but no benefits if the disability permitted some gainful employment. Newer policies may grade benefits with the job function permitted by the disability.
Is there a monetary limitation on payments? State law may impose such a limit. No matter what the owner earns or how the policy is phrased, an insurance company may not pay out more than the maximum permitted by law. For example, a business owner who earns $150,000 per year has a policy that promises to pay 80 percent of the pre-disability salary in the event of permanent and total disability. If state law sets a $100,000 limit on such payments, that is all that will be paid to the owner, even though it appears that the policy will pay $120,000 ($150,000 x 80 percent). In such instances, the owner has "overpaid" premiums, since he or she did not receive the full amount contracted for under the policy. (A good insurance agent will alert you to this possibility regarding your own state, but if you move to a new state, check with a local agent to see whether your existing policy will conflict with your new state's laws.)
Will multiple policies generate multiple benefits? State law may also affect whether benefits are cumulative. If they are, there's no use in carrying multiple policies. For instance, an owner has three separate disability policies, each one providing a benefit of $100,000. If state law requires that benefits be cumulative and if there is a $100,000 limit, each insurer will contribute 1/3 of the $100,000. Thus, even though the owner paid for three separate $100,000 policies, he or she actually gets the benefits as if only one of these policies was purchased.

For more information, see our discussion of disability insurance in the context of employee benefits.