Calculating disability benefits seems like it should be an easy matter. Yet, determining the amount of disability benefits payable can sometimes be quite complicated. Individual disability benefits are usually easier to calculate than group disability benefits. But the devil is often in the details as the following discussion points out.
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How Are Individual Insurance Disability Benefits Calculated?
When an insurance agent or broker sells an individual disability insurance policy to an insured, the amount of the monthly benefits is stated in the “Declarations” page found at or near the front of the policy. But the benefit amount could be subject to change. For example, if the policy includes a future increase option benefit, benefits may be increased. This is an especially valuable benefit to someone who buys disability insurance at the start of their career and wishes to add additional coverage as their income increases. To obtain the increase, the insured merely needs to show increased earnings and is not required to go through additional medical underwriting to receive a benefit increase.
Some policies also contain riders for cost-of-living increases. Such riders increase the monthly benefits either by a fixed percentage amount or by all or a portion of the consumer price index each year. Another popular rider is a social insurance benefit. This rider pays an additional sum each month if the insured does not receive social insurance such as Social Security disability insurance benefits.
Where things become more complicated is if the insured is only partially disabled, which is typically known as residual disability. Depending on the earnings received while the insured is disabled, benefits may be prorated in proportion to the earnings loss. Calculating earnings loss can be difficult because most policies “index” the insured’s pre-disability earnings. That means the earnings received prior to disability are multiplied annually by the rate of inflation. Insureds should be careful, though, not to mix up indexing with cost-of-living increases in benefits. It has become less common for policies to be sold with a cost-of-living benefit increase. So, unless that benefit is specified in the policy declarations, references in the policy to cost-of-living adjustments usually relate to indexing.
Individual disability policies also often use a formula to calculate pre-disability earnings that can sometimes be confusing. Insureds are often given the choice of using their prior year’s earnings, the best year of earnings over the three years preceding the onset of disability, or an averaging of income from prior years to establish their baseline earnings.
When an insured is residually (partially) disabled, many policies pay at least 50% of the scheduled benefit for a period if the insured has suffered at least a 20% loss of earnings. If the earnings loss is greater than 80% (sometimes 75%), however, the full benefit is typically paid.
Individual disability insurance payments are not reduced by other sources of income such as workers’ compensation, Social Security, pension payments, or payments on account of personal injuries. However, earnings received after the onset of disability can be confusing because some policies include a business owner’s share of the profits of the business even if the insured is no longer working in their business or professional practice.
Some individual policies also contain a “recovery” benefit that will continue payments after the insured returns to work on a full-time basis so long as there is an earnings loss attributable to the disability. Recovery benefits are especially valuable for professionals who need time to rebuild their practices and reestablish client or patient relationships that may have lapsed during disability.
How Are Group Long-Term Disability (LTD) Benefits Calculated?
Group long-term disability benefit calculations can be more complex than individual disability benefit determinations. Benefits are paid at a rate equal to a percentage of the insured’s income, usually with a cap on the maximum amount of benefit payable. Typically, the percentage of earnings paid in benefits is either 50%, 60%, or 66 2/3% depending on how the policy is worded, although short-term disability benefit payments can sometimes be even higher depending on the plan and the employee’s length of service.
Other Factors Considered in the Calculation of LTD Disability Benefits
Determining pre-disability income can be challenging because different policies utilize different formulas and measurements. Some policies base benefits only on the insured’s base salary and do not include commissions or bonuses. Others look at the insured’s rate of pay immediately prior to the onset of disability, while some policies look at a set period such as the prior year’s W-2 or K-1 reported earnings.
Cost-of-living increases in group long-term disability insurance are extremely rare nowadays; and group long-term disability coverage is subject to a host of offsets. Insurers apply a dollar-for-dollar reduction of disability payments for the insured’s Social Security (and usually their dependents’ Social Security) benefits, workers’ compensation, retirement, severance, and personal injury recoveries. If such benefits are paid in a lump sum, determining the offset can be quite complex.
In addition, if the insured is continuing to work while disabled, long-term disability benefits are prorated based on the insured’s earnings loss, although most policies contain a work incentive benefit to encourage employees to return to work. Such benefits allow the insured to receive a combined total of benefits plus income of up to 100% of their pre-disability earnings before benefits are subject to reduction. Typically, work incentive benefits last 12 or 24 months before either a straight proration is applied, or a formula is used such as an offset of 50% of earnings applied against benefits payable.
Long-term disability benefits are also more likely to be subject to income taxes than individual disability benefits. If the insured pays the premiums for the disability coverage with post-tax dollars, benefits are non-taxable. However, if the employer pays all or a portion of the premiums, the benefits are taxable in proportion to the employer’s contribution.
How Buyouts Impact Your Benefits
Although not legally required, insurers sometimes offer to settle claims by paying a lump sum to the insured in exchange for the insured’s relinquishment of their right to receive ongoing payments. Evaluating such offers usually requires input from a financial professional. When lump sum buyout offers are made, the insurance company does not simply multiply the benefit amount by the number of months remaining. Instead, insurers take the insured’s mortality into consideration, i.e., whether the insured’s medical condition reduces their life expectancy. In addition, insurers discount the future payments to present cash value. Present cash value is a mathematical calculation that takes into consideration that a lump sum is being paid immediately rather than over the course of time. To determine present value, insurers plug in a discount rate, which is expressed as a percentage that is used to discount the stream of payments. The higher the discount rate, the lower the payout. However, the discount rate is not simply a straight percentage reduction but is used within the context of a mathematical formula.
The insurance company then takes a third reduction for its profit since even in situations where there is no mortality reduction and any dispute regarding the insured’s disability, the insurance company is seeking a quid pro quo for its willingness to pay benefits earlier than they must. Thus, the final offer may be less than 60% of the value of a claim and is usually not negotiable or may only be incrementally negotiable. If the insured chooses to accept the offer, they are required to release the insurance company from any further obligation to pay benefits.
Insurance companies sometimes make mistakes in their calculation of benefits. Such mistakes more often lead to an underpayment of benefits rather than to an overpayment, but in either situation, the error is correctable. If the insured can prove they were underpaid, they should receive an adjustment and increase in benefits. If the insured has been overpaid, though, the insurance company has significant leverage over the insured since benefits can simply be suspended until the overpayment is recouped. It is very rare that an insurance company is required to continue paying benefits more than what it is contractually required to pay even if the error is the insurance company’s fault.
If you run into issues relating to the calculation of disability benefits, it is important that you seek assistance from an experienced and knowledgeable benefits attorney. While the valuation of a buyout offer is more within a financial planner’s expertise, insurance policies are contracts; and an attorney can help in interpreting the terms of such contracts and how they apply to specific situations.