PRINT - Chapter 6
Special Coverage Disability Insurance Policies


The important points addressed in this lesson are:

In addition to disability income insurance policies designed to replace the insured's income during disability, other disability policies provide specialty coverage for both business and non-business application

Overhead Expense coverage has particular application for the small business owner or professional with both a personal and business budget

Overhead Expense policies provide benefits on a reimbursement basis to pay the insured's usual and necessary business expenses

Disability Buyout insurance provides benefits on an installment or lump-sum basis to fund the buy out of the business interest of a disabled partner or co-stockholder

Keyperson Disability insurance provides benefits to the employer of a disabled key person to help compensate the business for its loss of the key person's skills and talents

Specialty disability insurance may be purchased, on an individual or group insurance basis, that pays disability benefits only in the case of a non-occupational disability; this coverage is generally used for insureds in high risk occupations

Disability insurance is available, on an individual or group insurance basis, that pays benefits based on the monthly service on outstanding debt


Introduction

Up to this point, we have spent virtually all of our time discussing disability income policies whose intent is to replace the insured's income in the event of his or her disability.  However, not all disability policies have that singular objective.  In fact, other disability policies have objectives that are quite different.  

An employee generally has a single budget.  Whether that budget is large or small, it typically covers items such as mortgage payments, food, clothing and so forth.  The small business owner or professional has two budgets: the same budget that everyone else has for clothing, food and the like -- and a second budget for salaries, rent, dues, professional publications, telephone, office supplies and so forth.  

In precisely the way that the salaried employee needs to provide funds to meet a personal budget during periods of disability, the small business owner must also provide cash to meet this second budget if he or she expects to have a business or practice to return to after suffering a disability.  Providing cash to meet that second budget during disability is done through a special type of disability insurance coverage known as Overhead Expense Insurance.


Business-Related Coverage-Overhead Expense Insurance

Providing funds to pay overhead expenses incurred by the insured during a relatively limited period of disability is the function of Overhead Expense insurance.  This type of coverage is often offered in two versions:

Professional Overhead Expense, and
Business Overhead Expense

Although both versions of the overhead expense policy are designed to reimburse overhead expenses, the Professional Overhead Expense policy generally includes employees' salaries as eligible overhead expenses; the Business Overhead Expense policy does not.

Eligible overhead expenses generally include the expenses for all of the following that are incurred during a period of disability:

Rent
Telephone
Professional Publications
Dues
Office Supplies
Utilities
Accounting


Usually, the cost of inventory is specifically excluded as an allowable expense.

Although the benefit periods under Overhead Expense policies are relatively short, the monthly benefits can be as high as $25,000 per month.  The benefit periods offered by insurers are typically limited to 12 months, 18 months or 24 months.  Overhead Expense elimination periods -- those periods between the onset of disability and the accrual of benefits -- are also short; thirty and 60 day elimination periods are the most common in Overhead Expense policies.  

Insurers, in an effort to provide insureds with an additional incentive to return to work, may provide 100% reimbursement for the first $3,000 - $5,000 of eligible expenses but may not issue larger policies except on an 80% or so reimbursement basis.

Business expenses -- even during a period of disability -- typically vary from one month to the next.  For that reason, one of the important provisions in Overhead Expense policies deals with this reality.  A business with $10,000 per month Overhead Expense coverage may find that eligible expenses are $8,000 in one month but $12,000 in the next.  The more consumer-friendly Overhead Expense policies provide for these varying expenses through their carryover provisions.  

The provisions that address carryover in Overhead Expense policies may deal with:

Expense carryover
Benefit carryover  

Let's return to the business owner with varying levels of business expenses that we just introduced.  If the business owner has a $10,000 overhead expense policy and incurs eligible overhead expenses of $12,000, the policy would pay the maximum monthly benefit of $10,000.  In addition, however, it would carry over the other $2,000 of expenses to be paid in a subsequent month when expenses are less than $10,000.  

Suppose that eligible overhead expenses in the next month are $9,000, the policy would, again, pay $10,000, consisting of the $9,000 just incurred and $1,000 of the $2,000 carried over from the previous month.  The remaining $1,000 of unreimbursed expenses may be paid in a later month.

Accounting for this expense carryover might look as follows for an Overhead Expense policy with a $10,000 maximum monthly benefit:

 Month
Expenses
 Incurred
Benefit
Paid
Expense Balance Carried Over
 1
 $12,000
 $10,000
 $2,000
2
9,000
10,000
1,000
3
8,000
  9,000
0

In every month in which expenses incurred exceed the maximum benefit, the unpaid balance is held in an account for possible payment in a later month.

Benefit carryover clauses are not as common.  When they are included in an Overhead Expense policy, they work similarly to expense carryover provisions.  Let's return to our business owner and look at how unused benefits can be carried over.  If the eligible overhead expenses in a month are less than the maximum monthly benefit, the policy will pay the amount of the expenses and carry over the remaining unused benefits for use in a later month when eligible overhead expenses exceed the monthly policy maximum.  To see how this would work, let's extend our earlier accounting a few more months during which the policyowner's expenses become less than the maximum monthly benefit.

The more complete accounting might look as follows:

 Month
Expenses Incurred
Benefit
Paid
Expense Balance Carried Over
Credit Balance Carried Over
 1
 $12,000
 $10,000
$2,000
$0
2
9,000
10,000
1,000
0
3
8,000
9,000
0
1,000
4
6,000
6,000
0
5,000
5
15,000
15,000
0
0
 Total
$50,000
$50,000
0
0


Business-Related Coverage-Disability Buyout Insurance

Another important business-related disability policy is the one used to fund a buy-sell agreement.  Too often, business owners overlook the significant disability risk when putting together their plans for buying out their business partners' interest at death.  An easy way for an agent to lose a good client is to have another agent show the business owner that his or her buy-sell agreement has a missing page -- the page that deals with a partner's incapacity due to disability.

We noted earlier that, at most ages, disability is 3 or 4 times more likely to occur than death.  Despite that greater probability, many buy-sell agreements fail to address this risk.  Since the risk is so great, and people can more easily see themselves becoming disabled, many prospects will be willing to discuss disability and its effect on their business succession plans.

Disability buyout policies have an elimination period as do other disability policies.  Rather than 30 or 60 days, however, the elimination period in buyout policies is usually 12 to 24 months.  Another difference is the method of benefit payment.  Although benefits may be paid in installments, the most common disability buyout benefit payment is a lump sum.

The amount of disability buyout benefit, the elimination period and the benefit payment option selected are determined by the buy-sell agreement it is intended to fund. Depending upon whether the agreement is an entity plan (or stock redemption) or a cross purchase plan, the policy may be owned by business or by the other partners or stockholders.

Another important difference between disability buyout policies and other disability insurance policies relates to the insured's disability.  As we know, a critical requirement for an insured to receive a disability insurance benefit in a disability income or Overhead Expense policy is his or her continued disability.  That is not the case in a disability buyout policy.  

The disability buyout insured must be disabled for the elimination period in order to trigger the benefit.  However, once the elimination period is ended, there is no need for insured's continued disability.  Even if the insured miraculously recovers after the disability buyout elimination period, the lump-sum or installment benefit will be paid.

Applying for a disability buyout policy the purchase of a life insurance policy designed to fund the agreement in the event of death.  In the case of the life insurance purchase, the insured usually applies for the life insurance before the buy-sell agreement is drawn.  

Applying for a disability buyout policy usually means that all of the buy-sell documentation is completed since insurers generally require that it be furnished to them before they will issue the disability buyout policy.  

When a business owner completes a buy-sell agreement by adding a provision for business succession in the case of disability and funding it with a disability buyout policy, he or she accomplishes two important things:

Business succession is planned for in the event of disability, and funds are provided to meet the disability buy-sell obligation created by the agreement

Determination of the partner's disability lies in the hands of the insurance company rather than in those of the remaining partners

These are distinct benefits recognized by most business owners.


Business-Related Coverage-Keyperson Disability Insurance

Now that we have considered Overhead Expense and disability buyout insurance, let's turn our attention to an equally important application of disability insurance: insuring the key person.

Keyperson disability insurance is designed to function in an identical manner to keyperson life insurance.  It replaces the value that is lost to the employer as a result of the loss of the employee through disability.  The benefits provided by the keyperson disability coverage are usually of fairly short duration but are normally very large.  

When Keyperson disability insurance is purchased, the insured employee has no direct interest in the policy -- other than being the insured.  The employer is the policy:

Owner
Beneficiary
Premium payor  

Valuing the key person is one of the most difficult issues with regard to key person disability insurance.  Although there are a number of approaches that may be used to assign a value, none of them is particularly precise.  We will briefly examine four methods that are often relied upon to point to a keyperson value including:

One Year's Profits
Contribution to Earnings
Excess Salary
Present Value of Lost Earnings

One of the simplest and, probably, least accurate methods of valuing a keyperson is the one year's profits method.  The average annual business profit for the most recent 3 to 5 year period is simply divided by 12.  The result is the amount of monthly keyperson disability insurance purchased.  In addition to being simple, this approach buys the business a year to find and train a replacement for the disabled key person.

This approach has greater validity in the small closely held company, especially if there is a single key person.  In the event there are two or more key individuals, some assignment of the responsibility for profit should be made.

The contribution to earnings approach is somewhat more complex but is likely to provide a more valid estimation of a key person's value. Its method estimates management's contribution to the company's earnings by recognizing that earnings are generally due to two factors:

invested assets, and
management's talents and skill   

The contribution to earnings calculation involves four steps:

Multiplying the company's book value by a reasonable percentage rate that represents the return that could be achieved if those assets were invested.  Suppose that a business has a book value of $1 million and that a reasonable rate of return is 10%.  Those assets could produce annual interest of $100,000.

Subtract the assumed earnings attributable to assets from the company's average annual income over the previous 5 years.  If that average annual business income is $300,000, the value added each year to the bottom line by management's skill is the difference -- $200,000.

Divide the value added by the number of key persons.  If the business has 4 key persons, the contribution to profits made by each of them might be estimated at $50,000.

In the final step, the $50,000 in annual profits attributable to the key person is multiplied by the number of years it would take to locate, recruit and train a replacement manager to the level of the disabled key person.  If it is estimated that it would take 2 years to find, recruit and fully train a replacement, the total disability benefit should be $100,000, paid over a 1 or 2 year period.

The excess salary method to estimate a key person's value seeks to divide the key person's salary into two segments:

The amount earned by the individual because of his or her performance of  routine job duties

The amount earned by the individual that is attributable to his or her special expertise -- the expertise that makes him or her a key person

In the excess salary approach, the estimated amount of salary that would be required to hire a replacement to perform the disabled employee's routine duties is subtracted from the key person's total compensation.  The balance is the excess salary paid to the key person.

The excess salary thus determined is multiplied by the number of years it would take to replace the disabled key person.  This is the amount of keyperson disability needed.

The present value of lost earnings approach to valuing a key person requires that some reasonable discount rate be applied to the lost earnings caused by the disability of the key person for as long as those earnings can be expected to affect earnings.  The resulting present value is the value of the key person and the amount of required disability insurance.

It should be abundantly clear that none of these methods for valuing a key person comes close to scientific precision.  However, they provide a reasonable basis for assisting the chief executive in deciding how much each of his or her executives is worth to the organization.

Usually, a conditionally renewable policy is used in connection with key person disability coverage.  Clearly, the condition that must be maintained to renew the policy is the insured's continued employment.  Although a noncancellable, guaranteed renewable policy may be used instead, this may lead to problems.  Specifically, if a noncancellable, guaranteed renewable policy is used, it will, generally, reduce the amount of personal disability income the insured may purchase and will limit the amount of keyperson disability coverage available.

The definition of disability normally used in keyperson disability insurance is a pure own occupation definition.  If the key person is unable to perform the substantial and material duties of the job, he or she is not functioning as a key person, and a benefit should be paid.


Non-Business-Related Coverage-Non-Occupational Policies

Two special disability policies are used in non-business related situations:

Non occupational policies, and
Debt protection policies

Non-occupational disability coverage is more common in group insurance than in individual insurance.  However, the coverage exists in both individual and group insurance forms.  The principal feature of the non-occupational policy is that it pays disability income benefits only if the disability is caused by a sickness or injury that is not related to the insured's occupation.   

The individual policy version providing non-occupational coverage is often used to supplement Workers Compensation benefits.  While certainly not as comprehensive as traditional disability coverage, it may be the only form of coverage available to workers in certain high-risk occupations.   


Non-Business-Related Coverage-Debt Protection

Debt protection disability policies are, also, more frequently issued on a group rather than an individual basis.  Just as in the case of non-occupational coverage, however, debt protection coverage exists in both forms.  

When debt protection disability coverage is issued on a group insurance basis, the beneficiary is usually the lending institution.  Group debt protection disability coverage is often used with mortgage debt.  In individual disability policies that provide debt protection disability payments, the beneficiary is almost always the debtor, not the creditor.


Summary

Special coverage disability policies are available for both business and non-business application.  Business application of specialty disability policies provide benefits to pay a business owner's overhead expenses, fund a disability buy-sell agreement and compensation an employer for the loss of a key person's services as a result of disability.

Non-business disability insurance may be used to provide non-occupational coverage, especially for individuals in high-risk occupations.  In addition, disability insurance is often used to provide debt protection -- especially in the case of a home mortgage.