What is Disability Insurance and How Does It Work?

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Do you need disability insurance?

In many cases, yes: Since disability coverage could directly impact your ability to pay the bills, a policy may be a must. In other cases, coverage may not be necessary.

Let’s dig a little deeper to see whether you should shop for a disability insurance policy.

disability insurance

What Is Disability Insurance?

If I worked in the marketing department of an insurance company, I’d probably recommend an image makeover for disability insurance.

A better name for these policies would be income insurance.

Why? Because disability insurance protects part of your income in case an injury or illness puts you out of work for a few weeks (or a few years).

Rather than going without income while you’re recovering, your disability insurance could provide some steady money. Your policy wouldn’t replace all your income, but at least you wouldn’t have to make do without any.

Who Needs Disability Insurance?

Let’s get this out of the way right now: If you don’t depend on wages from work as your main source of income, you may not need disability coverage.

If you’re a successful investor — in securities or real estate — or you’re single, or a freelance online gig pays the bills, disability insurance doesn’t have much to offer you.

Do You Need Disability Insurance?

If you’re still with me, you probably aren’t sure whether you should buy a disability policy.

Very few workers — and even fewer millennial-age workers — expect to get injured or become disabled, but the statistics tell a different story.

The Social Security Administration estimates 1 in 4 Americans entering the workforce this year will miss extended work time at some point during their careers because of a disability.

So people who depend on income from work for most or all their living expenses should consider buying disability insurance.

If an injury or illness prevented you from working, the policy could kick-in to keep you floating for a while.

What Is Disability Insurance Used For?

Policyholders use their disability insurance to replace their income from work if an injury or a diagnosis prevents them from working.

A typical disability insurance policy would cover up to 60 percent of your income, which means most people would still have to make adjustments. But at least you wouldn’t have to face the stress of suddenly having no paycheck along with the stress of dealing with an injury or some other disability.

Other Forms of Disability Protection

Other forms of protection can help you, but only within their inherent limitations:

Work-Provided Short-Term Disability: This is a common benefit, but it may help for only a few months. You’d still need a long-term disability policy to address your extended needs.
Social Security Benefits: The Social Security Administration can pay long-term disability benefits, but getting approved takes a lot of time and red tape, and the payouts have grown more austere. Last year, for example, the average disability benefit was about $1,150 a month.
Workers’ Compensation: The law requires this coverage if you’re injured and become disabled while performing your at-work duties. If your disability happens away from work Workers’ Comp won’t help.
State-Funded Programs: A few more progressive states — California, Hawaii, New Jersey, New York, and Rhode Island, for example — offer short-term disability coverage for state residents. These benefits usually last only 90 days.

These programs have their purposes, but your own well-chosen, privately funded disability insurance policy will give you the most control.

Types of Disability Insurance

When you start shopping for disability insurance, you’ll notice companies provide two different kinds of policies:

  1. Short-Term Disability: Replaces income for up to 90 days, though some companies offer up to six months of coverage.
  2. Long-Term Disability: Can replace income for months, years, or possibly even decades.

I recommend millennials buy only long-term disability policies and skip the short-term policies. Both kinds of insurance cost about the same, but a long-term policy can provide a lot more in return.

Rather than buying a short-term policy, you should save up three months’ worth of expenses and insure yourself.

If your employer offers an affordable short-term disability policy as a benefit, that’s another matter, especially if you’re not paying any of the premiums. You may as well opt-in.

These policies have a lot of different rules and exemptions. After all, we are talking about insurance. So let’s dig even deeper.

Limitations of Disability Insurance

Very few kinds of insurance come with no rules or limitations for their use. Before buying disability insurance, make sure you know how the policy you’re considering will work.

The following factors, specifically, can determine how useful and valuable your policy would be. They can also help set the cost of your premiums.

Elimination Periods

When you’re first injured or disabled, your disability insurance won’t pay your claim right away, even if the disability is clearly qualified for coverage.

Instead, you’d complete a waiting period which the insurance industry calls an elimination period.

  • Short-Term Elimination Period: Most short-term policies require at least a two-week wait before a policyholder can begin receiving funds.
  • Long-Term Elimination Period: Long-term policies’ elimination periods vary. You can find 30-day to 365-day elimination periods.

Shorter elimination periods lead to higher premiums. So put some thought into this decision: If you have enough savings to pay for three months’ living expenses, you won’t need a 30- or 60-day waiting period. A 90-day period would suffice.

Just another example of how having extra funds in the bank can save you a lot of money and give you more control over your financial freedom.

Own-Occupation and Any-Occupation Coverage

Naturally, disabilities come in many different forms. Careers come in many different varieties, too.

A back injury could keep a roofing contractor from climbing ladders and navigating sloped roofs, making it impossible for him or her to work in roofing. But the very same injury may not prevent the contractor from getting a job in retail sales.

To address these sorts of variables, insurance companies offer own-occupation and any-occupation coverage:

  • Own-Occupation: Will replace part of your income if your disability prevents you from working in your specific field even if you could find work in another field.
  • Any-Occupation: Will replace part of your income only if your disability prevents you from finding any work in any field.

As you could guess, own-occupation coverage costs more than any-occupation coverage.

Benefit Periods

Usually, a policy with a longer benefit period will cost more than a policy with a shorter period.

Short-term disability policies tend to cap out at 90 days, so benefit periods apply more directly when you’re buying long-term coverage.

You could find a long-term policy to replace your income until you reach retirement age, but the premiums would cost a lot more.

This choice depends a lot on how you’d use the policy:

  • Shorter Benefit Period: People who become disabled and need cash flow while they make other, long-term arrangements for income (such as investing in real estate or liquifying other assets) may want only a 2- or 3-year benefit period.
  • Longer Benefit Period: Someone who depends almost exclusively on income from work may need a longer benefit period, though the premiums can become cost-prohibitive.

Payout Amounts

A policy paying 60 percent of your base income at the time of your disability would cost more than a policy paying only 40 percent of your base income.

Again, assess your individual needs when making this decision. Yes, having more money coming in would be nice, but the resulting higher premiums could prevent you from building more financial freedom by saving and investing.

Balance is the key.

Exclusions from Coverage

Even the best disability insurance policies will not pay if your disability is excluded from the policy. Read your policy very carefully to find out what the fine print excludes.

Common exclusions include injuries sustained from:

  • Dangerous hobbies, such as skydiving or scuba diving.
  • Injuries sustained during wars, protests, or riots.
  • On-the-job injuries (Workers’ Comp should help instead).
  • Suicide attempts or other intentional harm.
  • Pregnancy and normal childbirth.
  • Alcohol or illegal drug-related injuries.

Disability insurance may not pay — or you may be denied coverage — if your disability results from a medical condition you already had when you bought the policy (pre-existing condition).

How Much Does Disability Insurance Cost?

Disability insurance costs about 1 to 3 percent of your annual income. If you earn $200,000 a year, you may pay between $2,000 and $6,000 a year in premiums.

That’s a pretty broad price range. To customize your quote, remember to consider your policy’s details:

Most Expensive Premiums: Policies with longer benefit periods, shorter elimination periods, higher payouts, and fewer exclusions cost more.
Less Expensive Premiums: You can save with shorter benefit periods, longer elimination periods, lower payouts, and more exclusions.

Other Factors Impacting Your Premiums

Along with your policy’s features, details of your life will impact your premiums just like they would with life insurance. You can’t always control these factors:

  • Health: Healthier people will be less likely to file a claim and can get lower premiums.
  • Age: Younger people, statistically, get sick less often and can get cheaper insurance premiums.
  • Sex: Men file more claims than women, so women can get more affordable premiums.
  • Income: The more you make, the more income you have to protect, so expect higher premiums.
  • Tobacco: Smokers and people who use other forms of tobacco pay more because they’re more likely to get seriously ill.
  • Your job: Deep-sea anglers, miners, and skydiving instructors — people in more dangerous jobs — tend to pay higher premiums.
  • Pre-existing conditions: Unlike with current medical insurance, disability insurance can charge more or disqualify you for having a pre-existing condition.

These factors — along with your policy features — will work together to determine your premium.

What Conditions Automatically Qualify You For Disability?

Federal law regulates Social Security disability benefits and sets automatically qualifying disabilities.

The Social Security Administration publishes its “Blue Book” which includes a long list of health conditions that could qualify for disability benefits.

A private disability insurance policy will not follow these regulations. Instead, the insurance policy itself will spell out the specifics.

You should never buy insurance without reading every word of the policy first.

How to Find a Good Disability Insurance Policy

As with any insurance policy, shopping around and comparing quotes should be your first step.

Consider factors such as:

  • Ratings: Insurance companies get graded by independent analysts such as A.M. Best and Moody’s. Better grades (A+, A++, AAA, etc., instead of Bs or worse) mean the company has more financial stability and should be in a better position to pay your claim if needed.
  • Reviews: Sites like TrustPilot can tell you about other customers’ experiences with an insurer. As with any online reviews, look for trends and don’t fixate on isolated occurrences.
  • Available Options: If you know you want an own-occupation, long-term disability policy, for example, make sure the company you like offers this option.

Insurance Can Help Protect What’s Important

Being an adult has a way of showing you how vulnerable you are. Insurance can help shield us from some of our financial vulnerabilities.

On the list of necessary insurance policies — life, auto, homeowners, pet, dental, etc. — long-term disability insurance rates near the top for me.

After all, your ability to earn an income is an incredible asset for you and your family. A just-in-place plan to replace part of it makes a lot of sense.

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