Financial Underwriting

An important disability insurance underwriting issue -- in fact, one of the key issues -- is financial underwriting.  The principal underwriting concern in the area of financial underwriting is whether the insured will be financially motivated to return to gainful employment after a period of disability.  A central reason why a disabled individual might not be motivated to return to work is if doing so would result in his or her losing income -- sometimes called malingering.  That situation would result if the insured were over-insured.

To avoid the problem of overinsurance, insurers developed charts that indicate the amount of monthly disability insurance they will consider for an applicant.  These charts generally state the insurer's Issue and Participation limits.  

Issue and Participation limits charts usually contain four columns:

Annual
Income
Monthly
Income
Individual-Pay Monthly Benefit Available
Employer-Pay All Monthly Benefit Available
 40% - 65%
 50% - 75%


The benefits that are available to an insured on an individually-purchased disability income insurance policy are not usually a rigid percentage of earned income.  Instead, they range from approximately 65% of earned income at the lower income levels to about 40% of income at income levels above $200,000.  

In the same fashion, the benefits available to an insured on an employer-pay-all disability income policy usually range from about 75% of earned income at the lower income levels to about 50% of income at income levels above $200,000.

Limiting the amount of monthly benefits that are available to no more than a fraction of current earned income gives the insured some financial incentive to return to work.  In most cases, however, the benefit provided is still a meaningful one that will enable insureds to meet basic financial obligations.  

The different income tax treatment afforded the disability income benefits depending on who pays for them is the reason for the difference in percentage of earned income available.  Although we will examine the income tax treatment of benefits and premiums later, it's important to know that disability income benefits are usually income tax free when paid for by the insured.  However, the benefits received by an insured from an employer-paid policy are usually income taxable.  

Since employer-pay-all benefits are subject to income taxation, insurers typically permit such benefits to constitute a greater percentage of earned income -- sometimes up to 75% at more modest earned income levels.

There still exists the possibility that a disability income insured may be overinsured at the time that he or she becomes disabled, despite the care with which issue and participation limits are drawn.  That overinsurance possibility exists because benefits may be paid by Social Security.  

The use of the social insurance benefit riders -- a subject that we discussed earlier -- generally resolves that concern.  These riders are so effective in helping to avoid overinsurance that some insurers require applicants to purchase a certain amount of social insurance benefit rider in order to obtain the maximum monthly disability income benefits for the insured's earned income.  

Regardless of their concern about overinsurance, insurers must deal with the marketing issues of the real world.  For that reason, some insurers that generally impose such social insurance benefit requirements allow applicants in their top occupation class -- often physicians -- the option to purchase the maximum allowable benefit as all base benefit rather than as a combination of base benefit and social insurance benefit rider.

In the process of underwriting a disability income application, existing disability income coverage on the proposed insured needs to be considered.  If a proposed insured has existing disability income insurance that will not be replaced, the amount of that coverage is subtracted from the available maximum to determine the amount that may be purchased.  

In addition to existing disability income coverage, another overinsurance concern is caused by the existence of a large unearned income.  For the purposes of current disability income insurance underwriting, more than $12,000 per year of unearned income will usually reduce the amount of disability income insurance available. The amount of monthly disability income coverage available is usually reduced by $.50 for each $1.00 of monthly unearned income in excess of $1,000 per month.

Suppose that a proposed insured had annual earned income of $120,000 and received an additional $30,000 per year in unearned income.  If the proposed insured could purchase $5,000 of monthly income benefit based on earned income, the amount actually available would be $4,250.  
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Effect of Unearned Income-Calculation

The effect of unearned income on the financial underwriting of a disability income policy is generally a reduction of the amounts otherwise available.  A proposed insured whose earned income would qualify for $5,000 of monthly benefit but who had $30,000 of annual unearned income would be eligible for $4,500 of monthly benefit.  The monthly unearned income would reduce the monthly disability benefit available by 50¢ for every $1 of unearned income over $1,000 per month ($12,000 per year), as shown below:

Available disability income coverage from Issue & Participation limit chart
 $5,000

Annual unearned income
$30,000
Allowable annual unearned income
-12,000
Excess annual unearned income
$18,000

Excess monthly unearned income ($18,000 ÷ 12)

 $1,500
Reduction in available monthly benefit ($1,500 x .50)
$750

Reduced monthly benefit available ($5,000 - 750)

 $4,250