Life and Health insurance policies are usually purchased for family or personal purposes, but many are use for business reasons. There is a large market for life insurance for business purposes, but this section will deal with business uses of Disability Income insurance.
The three types of business entities are Proprietorship, Partnerships, and Corporations. These will be described in more detail in respect to using Disability Income insurance for business purposes. The following chart provides a comparison of the three types of business ownership and how they are affected by various factors. The differences are important in determining the type of Disability Income insurance that would be used.
COMPARISONS OF TYPES OF BUSINESS ENTITIES
PROPRIETORSHIP PARTNERSHIP CORPORATION
1. Creation & ownership Voluntary action of individual Voluntary agreement of Authorized by law,
both parties statutory formalities.
2. Relation of owners Person & business are same, Association of owners, Business & stockholders
personal & business assets merged managed by general partners separate entities. Corp.
Business in firm name, is legal unit, owns its own
assets in firm’s name but assets, can act in own best
partners are co-owners. interest. Managed by
directors & officers.
3. Liability of owners for Total liability. Total, but can have firm Limited to capital contribu-
Firm’s debts. assets first applied to firm tions, + unpaid stock sub-
debts w/rights of contribu- scriptions, shareholder can
tion between partners. personally guarantee debt.
4. Limit of Capital No legal requirements, but No legal requirements, but Limited to capital authorized
practically, limited to resources practically, limited to the in Articles of Incorporation,
of individual owner. resources of partners & can be increased or decreased
willingness to contribute. by amendments, limited to
what stockholders wish to
contribute.
5. Profits Profits belong to owner. Shared equally unless Shares through dividends
special agreement. declared by directors out
of profits and apportioned
among outstanding shares.
6. Taxes Taxed as individual owner is Income taxed to partners Taxed as separate entity
taxed. Business income is his. as individuals. w/special license, franchise
fees. Some closed corpora
tions may elect Sub. S and
taxed as partnership.
7. Life of Entity Limited to life of individual Ends with dissolution Perpetual unless limited
owner. on death of any member by terms of charter,by-laws
unless prior agreement. or statute.
(Continued on next page)
8. Effect of death Business becomes part of Business dissolved & Business continues as
owner’s estate & assets. liquidated or reorganized. independent legal entity
unless prior agreement. deceased’s stockholder’s
Deceased partner’s interest shares goes into his estate
passes to his estate. or through it to the heirs.
Disability Income insurance when used for business purposes is used primarily in Key Employee insurance, for continuation of business purposes, and can also be used for nonqualified executive benefits.
Many business, if not most businesses, revolve around the expertise, experience, capital, technical knowledge, or for some other reason have an individual or several individuals, who are valuable assets to the company and are necessary for the continued successful operation of the company. There are many examples, e.g.: a corporation may be very dependent upon an executive whose financial worth provides an important endorsement and can be the basis for the company’s good credit rating.
A manufacturing firm can rely heavily upon the expertise of the engineering knowledge necessary to the success of the company. A programmer or computer engineer can be very important to the research and development of programs, software or hardware. A sales manager can become indispensable with the development of a sales force and marketing techniques that have proven profitable.
In any event, the disability of a Key Employee (formerly called “key employee”) can have huge financial effects on the company. As fire insurance can benefit a company if their building or equipment is destroyed by fire, or their liability can protect them from damaging lawsuits, Disability Income insurance can protect the company from financial loss in case of disability of a Key Employee.
Financial losses and adverse affects due to the disability (or death, but that is another subject) of the Key Employee can be protected against by issuing Disability Income insurance policies on Key Employees and making the business the owner and beneficiary. In case of disability of the Key Employee, the business will receive payments that will aid them in either acquiring another person that can perform the duties, or can assist by stabilizing the company until the Key Employee is able to return to work.
The fact that a business has Key Employee insurance certainly can help stabilize their credit standing, and often influence credit standing positively. If a business applies to a financial institution for funds, the fact that their Key Employees are insured is definitely a plus and often the business can obtain a larger line of credit and on better terms. A Disability Income insurance policy on the life of the Key Employee, particularly if they are a senior executive, may be required by some financial institutions in a business loan or arrangement.
The major question shall always be how much insurance is needed for the business to continue as before. The simplest (and most accurate) answer is that the value of a business is the value of current and present profits. If the company is a corporation, the value of the stock provides the most accurate measurement of the value, but losses will be assumed to be the result of any major operational, property loss or – most importantly in determining the value of a loss – the personnel loss and how it affects the business.
Property loss, business interruption, and other types of insurance, including Key Person insurance, is a method of the business hedging its losses through the medium of insurance.
However, if the stock of a company is not traded (or it is not incorporated) then other methods must be used to determine the value of the business, such as using a multiple of the company’s net worth from its balance sheet. Other systems of estimating the value can be used in some businesses that simply do not lend themselves to the ability of estimating worth. If the value of the business is needed to determine the benefits under a Disability Income insurance policy, the value of the business as used for other insurance purposes – commercial fire and continuation of business policies, for instance – can be used.
From this base, the next step is to determine the actual impact on the finances of the firm in case of disability of the key employee, whether the loss is permanent or temporary, and the discount factor to be used in projections of losses.
CONSUMER APPLICATION
Brothers James and Jack Jesse, with James performing marketing and administrative functions own Jesse’s Auto Body Shop and Jack is the “hands-on” foreman for mechanical, painting and body shop work. The estimated net worth of the business is about $300,000. It nets $200,000 a year on the average on gross income of approximately $2 million, with the profits split evenly between the brothers.
If Jack were disabled, they estimate that the revenue would fall by 50%, which would translate into a loss of total income of $50,000, or a 75% decline in total income to the brothers. Further, they feel that total income between the brothers would fall by 25% the first year ($50,000), but that it would continue to fall until it reached 75% (which would affect key employee life insurance). A replacement would cost $120,000 per year, which is $70,000 more than they are paying Jack now. For Disability Income insurance purposes, $10,000 a month could be considered for 24 months.
If James were to become disabled, the business would suffer about the same loss the first year ($50,000) but it would not decrease as rapidly as they feel that could replace James quicker and probably for less money, as the business reputation was due to the superior work by Jack. However, it would still take at least 24 months before a replacement would be acceptable. A monthly benefit from $8,000 to $10,000 for 1 or 2 years should be considered.
In Key Employee Disability Income insurance, in case of disability, insurance proceeds are paid to the business.
The function of Key Employee Disability Income insurance is to pay a monthly sum (indemnity) to a business entity during the period of time that the Key Employee is disabled. The Key Employee is the named insured under the policy. Benefits commence after the elimination period and continue while he is disabled, for a period of 12 or 24 months.
The amount of monthly benefits is usually high to reflect the value of the employee to the business and generally is issued separately from any limits that the insurance company may have for personal insurance. The policy itself is actually owned by the business that receives all of the benefits. Maximum benefit amounts vary, but can go as high as $15,000 a month.
There are only a few companies that write this type of policy, such as Lloyds of London and there are only a couple of standard commercial companies that will write these policies.
It is a matter of good business and tax practice that there be an “official” written notification of a disability salary continuation plan for Key Employees. This notification can take several forms, but typically a letter is placed in the employment-record files for this purpose. Such a letter should contain key articles.
The document should state the name and employee number (if any) of the Key Employee. The words “Key Employee” may be written in bold letters at the top of the document.
The document should specifically state that a disability salary continuation plan for the employee was approved by the (President or owner if not incorporated, otherwise, by Board of Directors) and the reason thereof – such as a show of gratitude for having served the firm for X number of years, or whatever.
The period of time that the employee would continue on full salary during absence from work due to sickness or injury – usually starting from the first day the employee was absent from work.
Reference then should be made to the Disability Income insurance policy and it should be attached to the document, with a copy kept in the employee’s file. The document should also state the benefits that the employee will receive from the policy in respect to the amount of money (benefits) that will be received, and the period of time that these benefits will be received should be stated. If there is a difference between sickness and injury benefits or benefit period, then this should also be stated. It really is not necessary to go into more detail as to benefits of the policy – such as elimination period, etc., as that, for instance, is covered by the above statement.
Who pays for the premium and how long the policy will remain in force should be stated. For instance, the company may intend (it would be wise not to make a positive period-of-time commitment, unless there is a specific reason to do so) to keep the policy in force as long as the employee continues to work for the company. Generally, the company will pay the premiums on this policy and it should be so stated. Note that if this is a “Split-benefit” type of plan, where the employer pays part of the premium, that would be so stated in this document, which should be noted as a “Split-Benefit Plan” at the top of the document.
Managing the plan and the assets of the policy (if any) is the responsibility of the employer. If there is a fiduciary and administration requirement under ERISA (Employee Retirement Income Security Act of 1974), then for legal reasons this should be stated. It is often also stated that any responsibilities of the insurance company shall be only those stated in the policy. Other statements regarding providing written explanation of its decisions and the right of the employee to review the plan are pertinent also.
A “hold-harmless” type of statement is usually inserted, which states in effect that if benefits are denied, the employee or representative (read attorney) must be the ones to contact the insurance company for details and the insurer must furnish this information to the employee.
A statement as to amending the plan should be included – usually amended only by the authorization of the Board of Directors.
If the plan is an “Endorsed Contributory Plan”, whereby the employer only “endorses” the plan but the employee pays the premiums, usually through payroll deduction the letter is much different. The document should show “Endorsed Contributory Plan” at the top.
A statement regarding payroll deduction and the fact that the employer will deduct the premiums from the salary of the employee and will submit those premiums to the employer is in order, to sort of “clear the air.”
The employer would want to list the advantages of the program, which could be statements such as:
The policy cannot be cancelled until the employee reaches age 66. Only the employee can cancel it. (The employer does not have the right to cancel the policy, and it is so stated.)
Premiums cannot increase until age 66.
A statement as to when the employee will start receiving benefits and the wording of this would depend upon the wording in the policy as to the definition of disability.
A statement as to portability, allowing the employee to take the policy with them if they leave the employer, even if they are not in good health.
Inform the employee of the name of the company administrator in case of questions. It usually is a good idea to attach a copy of a summary of coverage offered by the insurer.
If the employee does not wish to participate in the program, the employee’s signature is required. Usually at the bottom of the document is a statement “I do not wish to participate in the contributory wage continuation plan,” or words to that effect, followed by the signature of the employee and the date.
If a corporation wishes to establish a “formal” Disability Income insurance plan, the documentation is more “formal” and does not generally take the form of a “letter.” The document should, in most cases, be headed “Disability Income Plan For XXXXX Corporation,” and this should appear at the top of the document.
A statement that the company adopts a Disability Income plan for (class of employees, such as “any officer,” but in any event the participants of the plan must be identified). Frequently, the statement “and any Key Employee of the corporation” is added, with definition of Key Employee to follow. This allows the latitude of providing a benefit for a Key Employee who may not be an officer for some reason or other.
A statement defining those participating in the plan, for instance if it is for officers, then a statement to the effect that an officer shall be an Officer of the Corporation as elected by the Board of Directors of the Corporation.
If the plan is to include Key Employees, then a definition of Key Employee should be stated, with caveat that the definition may be changed by action of the Board of Directors.
A statement to the effect that any officer that becomes disabled will continue to receive full salary, reduced by the amount of benefits received under the insurance policy, or some other factor if desired – for instance, 80% of salary reduced by insurance benefits, etc. Generally it is full salary, however.
A Key Employee usually has a limit on the time that they will receive full salary – such as a six-month period after becoming disabled. During this time, the salary will be reduced by the amount of benefits received under the insurance policy. After this period of time, typically, the Key Employee would receive only the benefits of the policy “under the terms of the policy.”
Sometimes a Key Employee is not insurable. In that case, one method would be to pay the employee full salary for a period of time, such as 6 months, and then pay a percentage of his salary for an additional period of time, such as for 12 months. There would be no payments after that time.
Definition of “salary” may be in order – as in some corporations the difference between salary, benefits and bonus is rather murky. A simple statement that “salary” for purposes of this plan would be defined as the salary paid the officer or Key Employee, as of the date they became disabled.
There could be a final statement that the plan could be changed, amended or terminated by the action of the Board of Directors of the corporation at any time.
F NOTE: The above descriptions of these letters are for informational purposes only, and since they are legal documents, they must be written by or approved by legal counsel.
Without being repetitious as much as possible, the Key Person Disability Income Policy has many provisions that are constant in other Disability Income policies, but there are some differences. These differences are discussed below.
The principal distinguishing characteristic of the key employee policy cover page is the notation at the top of the page that this is a “Key Person (or Key Employee)Disability Income policy.” It contains the name of the insured, date of issue, policy number, policy date, a description of coverage, the right to continue coverage, and the required 10-day “free look.”
As with other Disability Income policies, the Policy Schedule contains premiums by mode, and “Specifications,” such as the First Benefit Day, the Monthly Benefit for Total Disability, and the Maximum Benefit Period.
If there are additional benefits, such as Replacement Expense Benefit, it is stated on the Schedule page. Any discounts, such as non-smokers in some policies, would be listed here.
With some Disability Income insurance policies, the following provisions would occur at the end of the policy. At least one Key Person policy, written by a major writer of this coverage, lists these provisions on the first page of the policy, which is then referred to as “Your Contract With Us” or the “Contract Page.”
As in other Disability Income policies (and other insurance policies) this is a statement that the policy is a contract between the insurer and the insured, etc. The authority to make changes is still with the insurer and it is so outlined here.
The policy effective date is typically defined as the date of issue. Note that there is usually a separate “Policy Date” which is used to calculate premiums, etc.
Typically, this is the “own occupation” definition, or so stated that the insured is protected in his “regular” occupation. The word “business” may also be defined generally as the organization named in the application (or successor).
The Waiver of Premium is rather standard; i.e., premiums waived after 90 days of total disability and premiums paid during this period are refunded.
Most policies state that the insured will not incur another elimination period for related disabilities occurring within 6 months of a previous disability.
The claims provisions are standard with most other Disability Income insurance policies, except for the Payment of Claims provision. In a Key Person policy, benefits are paid directly to the business.
The right of the insured to exchange the policy for another disability income policy is stated, along with conditions of exchange (to avoid anti-selection), but the exchange can be made without evidence of insurability. Many companies allow the premiums for the new policy to be priced according to the original issue age and rate classification.
This Rider is commonly used with Key Person Disability Income policies and is used to cover the cost of replacing the insured. Basically, the Rider will pay up to 80% of the expenses incurred by the business for hiring a person to replace the disabled insured.
There is a list of covered expenses on the form, such as the basic monthly salary paid to the replacement during the first (three months typically) with caveats that limit the amount paid to the average basic salary of the insured, with definition of “basic monthly salary, etc. Such things as employment agency fees, fees for executive search organizations, advertising in publications, and other hiring fees are covered. Travel expenses, food, lodging and moving of household goods and personal effects of the replacement are also covered.
A salary continuation plan is offered to the employees as a fringe benefit by the employer, and typically does not involve deferring current compensation to the employee. The plan, simply put, provides for an employee’s salary to continue in case of disability (death and retirement also). The employer, who can take tax credit for these contributions, makes contributions to the salary continuation plan, and they are subject to the same income tax rules as deferred compensation plans.
These plans may be “qualified” or “non-qualified” which determine the tax treatment of the premiums and benefits. Non-qualified plans are usually discriminatory, i.e., the employer can pick-and-choose as to who participates, and the tax consequences are more severe than with qualified plans. However, many employers prefer the non-qualified plan for that very reason, when determining benefits for Key Employees.
A qualified plan meets certain Internal Revenue Code requirements for favorable tax treatment. Employer contributions to a disability plan are held by an insurance company for distributions in the future to employee participants (see discussions on “Reserves” in this text).
In any respect, it is very advantageous for a business to have a formal salary continuation plan because if it does not, it can have serious tax implications. The IRS requires that a “bona-fide” sick-pay plan must be in place before a disability – otherwise the salary paid to a disabled employee will not be tax deductible.
If the disabled employee is also a shareholder in the firm, in the absence of a formal sick-pay plan, any payments made to a disabled employee will be treated as taxable dividends in the year received. There is an additional problem in that without a formal plan, a disabled employee may be prevented from receiving Social Security disability benefits. This may be hard to believe or understand, but the IRS would not consider the person as “disabled.” but as a pure “consultant” for the business, so any tax-free disability benefits that should belong to the employee, are lost!
CONSUMER APPLICATION
Cynthia is an architect and is a Key Employee of Buildum, Inc. She was involved in an accident when skiing with her boyfriend at Vail, breaking a leg and a collarbone. She recovered after 4 months and her employer paid her salary while she was recovering. After returning to work, it was discovered that her collarbone had not healed properly as she discovered when she spent some time over a drafting table. It was determined that she would have to be off work for an additional 12 months to allow the collarbone to heal property.
Coincidentally, the switchboard operator at Cynthia’s firm was injured when she slipped on ice in front of her home and suffered an injury that will keep her from work for 3 weeks.
The problem would arise if Cynthia’s secretary were to not receive full wages during her disability, which would indicate discrimination and there would be tax consequences to the firm. Also, how is the longer period of disability of Cynthia to be treated?
This points up the necessity for the company to have a formal, written sick-pay plan.
There are several precedents for penalizing a company that does not have a proper plan. For instance, in the case of Chesapeake Manufacturing Company, Inc., v. Comm. TCM 1864-214, the court held that if there is no evidence that the reason for a payment to a disabled employee was the disability, the employer might lose a deduction. Chesapeake had been carrying shareholder-employees withdrawals as employee advances, and when one shareholder became disabled and started receiving sick pay, the court ruled these were not sick pay, but were “informal dividends.” This was because the corporation did not specifically earmark the funds paid as disability payments, and there had been little, if any, corporate history of the corporation making disability payments to other employees, nor was there any evidence that the corporation had ever established or considered establishing, any type of disability payment program. Therefore, the payments were not considered as being made because of disability, and were not deductible.
Courts have disallowed deductions for payments made by a corporation when there is no formal plan on several cases, including one case where a president of a Close Corporation started receiving $100 a week while disabled for 5 years since there was no written plan – even though other employees received sick pay on a couple of occasions. Therefore, in this case, the payments were considered as dividends as no employee other than family members (Close Corporation) ever saw a copy of the plan and that the benefits paid to other employees were for only 2 weeks.
As with other types of employee benefit plans, the Internal Revenue Service has five requirements:
An example of a Salary Continuation Agreement follows.
ACME SALARY CONTINUATION AGREEMENT
The Acme Corporation recognizes that there is incalculable risk of disability to its employees and consequently, to the Corporation. Therefore, Acme Corporation provides a salary continuation plan for its employees that provide the disability benefits as listed herein.
1. Total Disability Benefits:
A. All employees, who become totally disabled, will receive full salary for a period of (90 days), such benefit to be offset by any workers’ compensation benefits, or any state, federal or municipal benefit.
B. Class A employees will receive full salary for the following 275 days, fully offset by benefits as stated in “A” above, as well as benefits provided under Long-term disability insurance contract for which the premium is paid for all, or in part, by the Acme Corp.
C. Class B employees will not receive benefits under this plan after the first 90 days of salary continuation, except that if they elect to participate in the employer-sponsored disability insurance plan, they may receive benefits under that insurance plan. The employer will contribute X% of the cost of such insurance for those employees who wish to participate.
2. Residual Disability Benefits
A. Residual disability benefits are available to Class A employees who qualify, and to those Class B employees who qualify because of income and occupation.
B. Residual disability is the period after a period of 90 days or longer, during which period the employee has a 20% or greater loss of income because of disability.
C. Acme Corporation will not provide residual disability benefits to its employees under this or any other salary continuation agreement. Employees may qualify for residual benefits to be added to their disability insurance contract and the employees are responsible for premium payment for this benefit through a salary savings plan at Acme Corporation.
D. When the employee pays premiums for disability income protection, monthly disability benefits attributable to those payments by the employee will be received on a tax-free basis.
3. Amount of Disability Benefits
The monthly disability insurance benefit amount to the employee will be determined by the current issue and participation tables of the XXXX Insurance Company at the time of the employee’s application.
4. Total and Residual Disability Defined
The definition of Total and Residual Disability, as well as other provisions of the insurance contract, will be guided by the provisions of the disability insurance policies issued by the XXXX Insurance Company of Evanston, Virginia, USA.
Note: Reference to (90 days) can be 30, 60, 90 or 180 days as elected by the employer.
90-days referred to in 1B. depends upon the elimination period selected.
Note: Earnings level for different employee classes must be identified in corporate minutes.
Sometimes, after a Salary Continuation Agreement has been drawn up, the employer will decide that they want to self-insure the plan. This can happen if a company is large enough to set up its own claims reserves and/or has a large amount of unearned income from which to subsidize this plan. This is, of course, perfectly legal, however there are disadvantages to self-insuring.
Most non-insurance firms have no idea as how to budget for potential claims, unknown and unpredictable. If the company is large enough and self-insures or self-funds other programs, such as its medical benefits program for the employee, they may have access to accountants or actuaries who can assist them in determining these amounts. However, reserving is more complex for Disability Income than for many other benefits. Typically, a company will decide that it is too complicated and too expensive to administer.
There is also the problem of liability that could face the company if for any reason it would not be able to meet its future disability costs. With the fluctuations of the economy in recent months, many companies are not so sure of their availability of funds, and if there were more than usual or more than expected disability claims, the company could find itself in trouble. Most companies would much rather shift this liability over to an insurance company as the insurance premium will remain relatively stable as the experience of all of the insurer’s disability income insurance policies helps to stabilize the experience, particularly if the insurer reinsures some of its policies to spread the risk.
A Disability Income insurance policy that is specifically used for salary continuation plans is discussed below. Many provisions will appear and will apply in other types of Disability Income insurance policies but some are specifically designed for this purpose. Policy wording will vary from company to company, but the provisions as shown in this discussion are typical as to intent and meaning. Also, provisions and wording may vary in certain states.
The provisions as discussed below are in the order of that used by a prominent Disability Income insurance provider but the information contained within the provision and under the provision heading will appear in all Disability Income insurance policies in some fashion. Also note that the wording used as an example of policy wording, will use the typical “we,” “us,” “ours” to refer to the insurance company. “You,” “your” refer to the insured.
Typical of other insurance policies, the cover page will list the name of the insured, the policy number, the date of the policy and effective date. This is followed by a description of the type of contract involved, usually a Guaranteed Renewable Noncancellable contract. The wording would be similar to the following:
“DISABILITY INCOME POLICY: This policy is noncancellable to age 65 at guaranteed premium rate thereafter until age 75, renewable on each policy anniversary on which the insured is employed at least 30 hours per week. After age 65, the premiums rate is based on the insured’s age on each renewal date.”
There is a period of 20-days after the policy is delivered when the individual may cancel the policy for any reason whatsoever. The procedure is outlined, usually by mailing the policy to the company or to its representative. All premiums paid will be refunded. This right is standard in all states, but the period of time or requirements for refusal may vary by state.
Renewal requirements are shown. In a typical policy used for a salary continuation plan, the policyholder may renew on each policy anniversary until the insured reaches age 65. Provisions for coverage after this date, if allowed, vary, but using the type as shown above, this policy would state that the insured may renew to age 75 by paying the premium on the premium due date on which he is employed in a regular occupation at least 30 hours a week.
The policy schedule page contains the name of the insured, policy number, policy date and effective date.
The beginning premium (premium to age 65 in this case) will be shown by mode of payment: annual, semiannual, quarterly (and if applicable, monthly). The premium under this type of policy is guaranteed to age 65. Thereafter the premium will be the attained age premium, which will be shown as of Jan. 1 of the year in which the insured has reached age 75.
This summary includes such items as:
Form Number
Annual Premium
Maximum Total Disability Benefit
Elimination Period
Maximum Benefit Period
OPTIONAL BENEFITS, if any are shown by
Rider Form
Description (such as Overhead Expense Coverage, Cost of Living Adjustment,
Retirement Benefit, College Benefit, etc.
Premiums for the riders are included in the summary of premium.
This provision discusses the Grace Period and the effect of premium payments on that period. Also, since this policy is actually a two-part policy – to age 65 and from that age to age 75, the effect of the Grace Period and the premium for the second part must also be discussed.
The wording of this section may be stated similar to the following:
“All premiums except the first premium are due on or before the due date.
Each premium will keep this policy in effect and continue coverage for the term as shown.
If all premiums are paid before the end of their Grace Period, we will not increase the premium rate for this policy prior to the policy anniversary when your age is 65. On and after the -policy anniversary date when your age is 65, the premium is the rate then in effect for your age on each policy anniversary.
The Grace Period is the 31 consecutive days that begin with the day a premium is due. We will keep this policy in effect and continue coverage during that time. If the premium is not paid during those 31 days, this policy and all coverage under this policy will terminate.
If we accept premium after the policy anniversary when your is 65, we will keep this policy in effect and continue coverage until the end of the period for which we accept it.
If any premium is paid beyond the month in which you die or this policy terminates for some other reason, we will refund the amount of the unearned premium paid.
Premiums must be paid in United States dollars.”
If the policy lapses or terminates because of non-payment of premium, there are provisions that outline the procedure for reinstating the policy. Often insureds that accidentally lapse a policy may feel that the requirements to reinstate are strict, but obviously the insurance company is concerned about anti-selection. They just want to make sure that the insured is not reinstating the policy because they were made aware of a condition during the period that they can reinstate, that could create a claim. The two requirements as described below in the sample wording are not at all unusual.
“If this policy terminates because a premium is not paid by the end of the Grace Period, you may apply to reinstate this policy at any time until the first unpaid premium is six months overdue.
In order to reinstate this policy, you must meet the following two requirements:
1. a reinstatement application must be completed (to complete a reinstatement application means you submit the reinstatement application with evidence of your insurability and the full amount of overdue premium); and
2. we approve the reinstatement application.
A reinstatement application must be prepaid, and we will issue a prepayment agreement. The date of the prepayment agreement will be the date the reinstatement application has been completed.
If we approve the reinstatement application, this policy will be reinstated on the approval date. If the overdue premium is paid without submitting a reinstatement application and we keep the premium without requesting a reinstatement application within a reasonable time, this policy will be reinstated the date we receive the premium. If we issue a prepayment agreement and do not approve or disapprove the reinstatement application within 45 days from the date of the prepayment agreement, this policy will be reinstated on that 45th day.
[Note: The policy can be reinstated as of the Effective Date ONLY if the insurance company does not require a reinstatement application to be filed, which would normally only be if the insured submits the renewal premium immediately, or more probably, the insurer simply let one “fall through the cracks.” Otherwise, the quickest the policy can be reinstated is the date of approval, which means that the application for reinstatement must have been received in the home office and approved which is usually the case. There is another “failsafe” provision that if the insurer allows the reinstatement application to “fall through the cracks,” the policy will automatically be reinstated on the 45th day.]
“If this policy is reinstated, it will only cover:
1. injury that occurs on or after the date this policy is reinstated; or
2. sickness, which is first diagnosed or is first treated more than 10 days after this policy is reinstated.”
[Note: This is typical of disability policies. Immediate cover is allowed on injuries as the insured (theoretically) has no control over injuries so the anti-selection involved in reinstatement is limited, whereas with sickness, a sick period of 10 days is provided so that the insured can not reinstate for the reason that they are quite ill and are aware of it.]
It WILL NOT cover:
1. any injury or sickness which is excluded by name or description; and
2. any preexisting condition excluded by the reinstatement application.
Typical definitions have been discussed earlier, however the following definitions are more applicable to Salary Continuation plans and should be reviewed in that context.
This provision protects the current income at times by increasing the coverage as the insured’s income increases. The increase is determined annually by changes in the CPI-U - typically minimum of 4% and a maximum of 8%.
“On each policy anniversary until the policy anniversary when your age is 55, except during the time that you are disabled, you will automatically have the opportunity to increase the Maximum Disability Benefit by the Indexed Amount, as provided below:
1. On every fifth year that the policy is in force and on the policy anniversary, you must submit evidence and we must agree that your total coverage then in effect does not exceed our issue and participation limits for the income which you are then earning: and
2. you have not refused the opportunity to increase your coverage in two consecutive years.
If you cannot automatically increase the Maximum Disability Benefit because you did not satisfy provision (1) above, you still may increase the Maximum Disability Benefit by the Indexed Amount on any subsequent policy anniversary, until the policy anniversary when your age is 55, except during the period of time in which you are disabled, if on that date the income which you are then earning qualifies you for the increase.
When the opportunity is made available, you may increase your Maximum Disability Benefit by paying the premium for the increased amount based on your age on that policy anniversary and the premium rate then in effect for this plan. The Maximum Benefit Period, Elimination Period and plan will be the same as for the coverage which is indexed.”
The “indexed amount” as referred to in the previous definition, may be defined as:
“The increase available each year will be the percent change in the CPI-U between November 30 in the previous calendar year and November 30 of the two-year previous calendar year or 8% [or similar percentage], whichever is smaller, times the current Maximum Disability Benefit for the policy. If the change in the CPI-U is less than 4%, the increase available will be 4% of the current Maximum Disability Benefit.”
As discussed earlier, this is a relatively new benefit provision and basically it covers organ transplants by treating them as “sickness.”
“Disability which results from the transplant of a part of the Insured's body to another person's body will be considered caused by a sickness”.
Paying for rehabilitation benefits can vary by company. As discussed earlier in this text, for the principal insurers that offer Disability Income insurance, only four companies do not offer rehabilitation and those that do offer it, offer it on an optional basis except for one company where rehabilitation is required. Where it is offered, the wording may be similar to the following:
“While you are receiving the Disability Benefit, you may request or we may suggest participation in a rehabilitation program designed to help you return to work. If we determine that such a program is appropriate, we may pay reasonable expenses for such items as tuition, books, training programs, or additional living expenses. Actual expenses covered and the terms of the plan will be subject to mutual agreement. Our agreement will be outlined in a written plan of rehabilitation. Benefits will continue as provided by this policy except if they are modified by the plan of rehabilitation.”
[Note: This is a very flexible rehabilitation provision.]
The definition of total and residual disability has been discussed earlier. In a Salary Continuation Disability Income policy, the following wording would be typical:
As discussed earlier, the elimination period is the waiting period before benefits are payable. In a Salary Continuation plan, the following definition can be used:
“Elimination Period means the number of days preceding the date benefits becomes payable (other than the Loss of Use Benefit), during which you are impaired by injury or sickness.
The Elimination Period begins on the first day that you are impaired.
Different Elimination Periods may apply to different coverages under this policy. The Elimination Period for each coverage is described (on the Cover page).
If the impairment ceases before you satisfy the Elimination Period and you become impaired again from the same cause within 6 months, we will combine those impairments to determine when benefits begin.”
It is particularly necessary to define “net income” in business policies. A typical provision could be worded as follows:
“Net income means gross revenue minus your share of the usual and customary business expenses which you or your company incurs on a regular basis and is essential to your established business operation.”
[Since the term “usual and customary business expenses are used, a separate definition of this term is necessary:] “{Expenses which are not usual and customary business expenses include salaries, drawing accounts, profits, benefits and other forms of remuneration which are payable to you or any member of your immediate family who was not a full-time paid employee of the business during the last 60 days before disability began.”
[There are different methods for determining the “prior net income. A flexible definition could show as many as three separate methods for calculation.] “Prior net income means the largest of: (1) the Insured's average monthly net income for the last 12 months before the Elimination Period began; (2) the Insured's average monthly net income for the 12-month period immediately before those 12 months; or (3) the highest average monthly net income for any two consecutive years of the last 5 years before the Elimination Period began. On each anniversary of the first day of a period of disability, we will calculate a CPI-U Factor. We will multiply the prior net income by that Factor and that amount will be used to calculate the Maximum Disability Benefit.”
[The loss of net income also must be defined for business purpose policies:]
The maximum disability benefit will be paid if the insured is totally disabled in his regular occupation, regardless of any “gross revenue” the insured may receive.
“Gross revenue means any income received by you or your business for personal services performed by you in your regular occupation. All revenue will be accounted for on a cash basis. While you are totally disabled as defined above, income accrued but not received before the Elimination Period began will be excluded from gross revenue during disability.”
Typically the policy does not pay benefits which are “based on injury or sickness caused by war or an act of war, whether declared or undeclared.” [Note: Some insurance policies are not treating the present “war on terrorism” as a war or act of war, particularly in case of property damage at the World Trade Center. It will be interesting to see if the insurers apply this provision if someone claims disability because of a terrorist act. There are times when public interest supercedes policy wording or claims practices.]
As discussed earlier, preexisting condition limitations vary, but the following wording is typical:
“This policy does not pay benefits, which are based on a preexisting condition if:
1. the preexisting condition is not disclosed or is misrepresented in the application; and
2. the preexisting condition impairs the Insured or causes a loss of use or other loss during the first two years after the effective date of the coverage. Benefits will not be paid if they are based on impairment or loss of use or other loss that began before the effective date of the coverage.
3. you are receiving medical care from someone other than yourself or a family member which is appropriate for the injury or sickness; and
4. benefits under the Disability Benefit, the Recovery Benefit and the Loss of Use Benefit combined have not been paid for the Maximum Benefit Period.
After disability ceases, resumption of this Disability Benefit is subject to the preceding requirements and those stated in the Successive Disabilities provision.”
Generally, a full monthly benefit is paid if the insured is either (1) totally disabled, or (2) has a loss of net income in his regular occupation of 75% or more. He would be allowed to work part time and benefits would then be based on his loss of net income in regular occupation, but there are no time or duties testing required.
“If you are totally disabled or if your loss of net income is 75% or more, we will pay the Maximum Disability Benefit for that month. Whenever the loss of net income is less than 75% but at least 20%, the amount payable will be determined by the following formula:
Loss of net income x Maximum Disability
Prior net income Benefit
During the first six months that we pay the Disability Benefit, we will pay one-half of the Maximum Disability Benefit rather than the amount due under the formula if your loss of net income is from 20%, to 50%.”
The Salary Continuation Plan takes into consideration the fact that an owner or professional would lose their client base and referrals during a period of disability. Therefore, the insured will need to rebuild their client base and their referrals. The Recovery Benefit would provide benefits for the rest of the benefit period if the insured shows at least a 20% loss of the income he enjoyed prior to disability, and if he is fully recovered and working full time in his own occupation. The policy wording would be similar to the following:
“We will pay the monthly benefit amount in any month after you have satisfied the Elimination Period that:
1. you are not entitled to the Disability Benefit but presently experience a 20% loss of net income in your regular occupation as a result of the past injury or sickness which caused you to satisfy the Elimination Period;
2. benefits under the Disability Benefit, Recovery Benefit and Loss of Use Benefit combined have not been paid for the Maximum Benefit Period; and
3. you are at work full time in your regular occupation.
After disability ceases, resumption of this Recovery Benefit is subject to the preceding requirements and those stated in the Successive Disabilities provision.”
Usually the policy will provide for benefits to be paid even though the insured may be working in his regular profession and is suffering no loss of income.
“Limited by the Maximum Benefit Period, we will pay the Maximum Disability Benefit monthly while an injury or sickness causes you the total loss of use of:
1. speech, hearing in both ears, or sight in both eyes; or
2. one hand and one foot; or
3. both hands; or
4. both feet.
We will pay this benefit from the date of loss. After disability ceases, resumption of this Loss of Use Benefit is subject to the preceding requirements and those stated in the Successive Disabilities provision.”
The important feature of this provision is that any disability that reoccurs within a 6-month period of disability that follows a past period of disability will not be considered as a separate disability unless it is the result of a different cause than the original disability.
“A period of disability, which follows a past period of disability, will be considered a separate period of disability only if the subsequent period of disability is:
1. caused by a different injury or sickness than the one which caused the past period of disability; or
2. separated from the past period of disability by at least six months during which you are able to return to work full time in your regular occupation.
Any such separate period of disability will be considered a new disability; it will be subject to its own Elimination Period and Maximum Benefit Period. Any other subsequent period of disability will be considered an extension of the past period of disability.”
Some policies require that the disability period before qualification of the waiver of premium, must be “consecutive” days of disability – 90 days is typical. While disabled, the premium for the policy is waived and any premium that was paid during the qualifying period (90 days, for example) will be refunded.
“After the disability has lasted for ninety days while this policy is in effect, we will waive the premium as long as you are unable to return to work full time in your regular occupation as a result of the injury or sickness which causes the disability. We will refund premium already paid for that period on a pro rata basis.”
Typically, the insurer will pay the Monthly Benefit Amount in any month after the insured has satisfied the Elimination Period that:
1. he is totally disabled or experiences at least a 20% loss of net income in his regular occupation as a result of a present injury or sickness;
2. the injury or sickness, which causes the loss of net income, is the one which caused the Insured to satisfy the Elimination Period.
If the insured misstated his age, the benefit will be adjusted to reflect the correct age, however, for the protection of the insurance company, if the policy had been issued for an incorrect age and if the policy cannot be issued to a person of that age, then the insurer simply returns the premium.
CONSUMER APPLICATION
Marie has always taken good care of herself and looks much younger than her actual age. She had told her boyfriend that she was 55, and he was present when the agent took the application. She had told so many people that she was 55, that everyone believed that.
Marie slipped on the steps in her condo and broke her hip, causing her to lose several weeks of work. She filed a claim with the insurer who performed a routine inspection report and discovered that according to medical records, she was actually 65 and was not eligible for the coverage as the company did not issue this policy over age 64.
The insurance company returned the premium that Marie had paid and she had no coverage.
“If your age has been misstated, any benefit payable will be changed to the amount which the premium paid would have bought for the correct age.
If we accept premium for a coverage, which we would not have issued, or which would have ceased according to the correct age, our only liability is to refund the premium for the period not covered.”
For legal and tax purposes, especially with a salary continuation plan, it is important to know who owns the policy. Typical wording would spell it out quite clearly:
“You own this policy. You have all of the rights and privileges granted by this policy while it is in effect. Some of your ownership rights are:
1. the right to continue or terminate this policy;
2. the right to name someone else (a Loss Payee) to receive the benefits of this policy;
3. the right to suspend this policy while the you are in military service; and
4. the right to assign any or all rights under this policy.
You may reduce the Maximum Disability Benefit at any time. Premium will be recomputed for the reduced amount based on your age and premium class on the effective dates of the coverages. The reduction will be effective on the date we receive your written request at our Home Office.”
The “loss payee” provision is used when someone other than the insured is to receive benefit payments, for instance a creditor and would be addressed as follows:
“If you decide to have someone else receive policy benefits, you must notify us in writing on a form satisfactory to us. The notice will be effective when we receive it at our Home Office.”
This is usually another business or third party use of a Disability Income insurance policy. Whereas the Loss Payee provision allows another to receive benefits, the assignment actually transfers ownership of the policy to another party and the Loss Payee, if any, does not change (unless it is specifically requested.)
“You may assign any or all ownership rights to someone else. The assignment must be in writing and must specify the rights which are assigned and for how long. The Loss Payee is not changed by an assignment unless the assignment specifically names a new Loss Payee.
No assignment is binding on us until the original or an acceptable copy is received at our Home Office. We are not responsible for the validity or effect of any assignment.”
For several reasons, but usually for business purposes, there may be an occasion when the insured or the business may wish to continue coverage on another policy form. The insurer allows this to happen as otherwise the policy might be terminated and the coverage obtained from another insurer. However, certain stipulations are made to help avoid anti-selection.
“This policy may be exchanged for any other disability income policy issued by us when the exchange is made, subject to underwriting guidelines then in effect, provided:
1. you are not disabled;
2. you are able to work full time in your regular occupation and are doing so; and
3. the request is made before the policy anniversary when your age is 55.
The Insured amount, Maximum Benefit Period and Elimination Period will be the same as for this policy. Any rider attached to this policy when you exchange it may be continued on the new policy if it is available with that policy. The new policy will exclude any condition excluded by this policy.
The premium for the new policy will be based on your premium class and age on the effective dates of the coverages exchanged and your regular occupation on the date the exchange is effective.
If your request is approved, the new policy will be effective as of the date we receive the request to exchange policies.”
As with any contract, there is a stipulation that eliminates any “side” contracts and makes certain that only the stipulations contained in the contract are effective.
“This policy represents the entire contract between you and us. Statements by agents or brokers are not part of our contract. Only an executive officer of this Company can approve a change in this policy. The approval must be in writing and be endorsed on or attached to this policy. No one else can change this policy or waive any of its conditions.
Unless we tell you something else, years, months and anniversaries that we refer to are calculated from the Policy Date.”
Stipulated by law, this provision in effect states that if the insured is disabled within a two year period after the policy is issued, then the policy may be contested but only up to either one year beyond the 2-year period of contestability, or the length of the disability (whichever is the shorter). After three years, the company cannot cancel for any reason. The procedure is generally to send a letter to the insured notifying them of the contesting of the coverage and returning the premium. If the insurer is not successful in contesting the claim, the insured will be obligated to repay the premiums to keep the policy in force.
“We will not contest a coverage provided under this policy based on information given in the application for that coverage after that coverage has been in effect during your lifetime for two years from the effective date of that coverage, excluding any period during which you are impaired or suffers a loss of use or other loss. In no event, will we contest a coverage more than three years from the effective date of that coverage.
If impairment or loss of use or other loss begins after a coverage has been in effect during the Insured's lifetime for two years from the effective date of that coverage, we will not reduce or deny a claim which is based on that impairment or loss of use or other loss because of a preexisting condition unless the condition is excluded from coverage by name or description.
“Contest” means that we question the validity of coverage under this policy by letter to you. This contest is effective on the date we mail the letter and refund the premium to you.”
If any provision of this policy conflicts with the statutes of the state where the insured resides on the effective date of that provision, it is amended to conform to the minimum requirements of those statutes. [Boilerplate wording for insurance policies that conform to those state laws prevails.]
In order to allow the insurer to start an investigation after a claim is filed, the policy gives the insurer a cushion of 60 days after the insurer receives the proof of loss, and it also provides for a 3-year period during which claims must be filed (similar to a Statute of Limitation).
“No one may start legal action to recover on this policy until 60 days after written Proof of Loss has been given to us. Legal action must be started within three years after the written Proof of Loss is required to be furnished.”
It is possible that a combination of benefits could exceed the Maximum Disability Benefit on the policy. This provision caps the amount payable.
“The Disability Benefit, Recovery Benefit or Loss of Use Benefit payable in any month shall not exceed the Maximum Disability Benefit. In any month that the Loss of Use Benefit is paid, no Disability Benefit or Recovery Benefit will be paid.”
The instructions as to how to file a claim for disability benefits are very typical of policies of this type and are outlined in detail. Laws and regulations stipulate most of these procedures. Rather than duplicate the wording here and in the Chapter on Claims, suffice it to say that in addition to filing the proper and required claim forms, the insured may be required to undergo a physical (medical) examination and/or a personal interview. The insurer may require this examination/interview at various times. In any event, the insurer not only dictates when such are required, but also will pay for such procedures.
The general rule regarding taxability of premiums and benefits is simply that taxes have to be paid either on the premiums or on the benefits. There are methods of postponing the payment of taxes – such as the use of annuities in estate and financial planning – but in the end, Uncle Sam will get his share. This is a problem facing business prospects for Disability Income insurance – the idea of a tax deduction as a business expense currently is attractive, however, asking an employee to pay taxes on benefits is often not so very attractive.
The employer who is unincorporated (sole proprietor or partnership) does not have this problem as they pay the premium in after-tax dollars and benefits are received tax-free. However, the corporation can make choices by establishing either a qualified or a non-qualified salary continuation plan and therefore, they must make the choice as to whether to deduct disability premiums.
If the principals of a small and closely held corporation look at their tax returns, it is possible that they may each may be in a higher tax bracket than their company. Therefore, if this is the situation, and they purchase individual (noncancellable) policies and pay the premiums with after-tax dollars, then the benefits that they would receive in case of disability are income tax free.
On the other hand, if the premiums for a qualified plan are paid by the business, and if the corporation deducts the premiums, then the benefits that would be paid to the individuals are taxable.
In order to put this in the proper prospective, under current tax law, the tax rate for corporations are as follows:
Taxable Tax
Corporate Income Rate
$0 to $50,000 15%
$50,001 to $74,999 25%
$75,001 to $100,000 34%
$100,001 to $335,000 34%(*)
$$335,001 and above 34%
* When corporate taxable income is between $100,001 to $335,000, an additional 5% is added, creating
a 39% maximum rate. When the corporation’s taxable income is above $335,000, the 5% is dropped and
the effective rate returns to 34%
Contrast these tax brackets to the individual tax brackets:
PERSONAL TAXABLE INCOME
Single Taxpayer Joint Return Rate .
$0 to $20,350 $0 to $34,000 15%
$20,350 to $49,300 $34,000 to $82,150 28%
Above $49,300 Above $82,150 31%
Prior to 1986, many employers deducted the premiums as the tax rate was 50%, so they would be paying only 50 cents on each dollar of premium. Obviously, the corporate deduction is worth less today. There is an offsetting situation, however: since insurance companies will issue larger benefits for employer-paid policies (as the risk of anti-selection is much less than if the individual applied for and paid for the policy), the increased benefit can help the insured to pay the income tax that would be due on the benefits if the insured becomes disabled.
STUDY QUESTIONS
1. There are three types of business entities, which does NOT include
A. Proprietorship.
B. Corporation.
C. Minority Ownership.
D. Partnership.
2. A person who is important to a business because of expertise, experience, capital, technical knowledge, or who are otherwise valuable assets to a company, are called
A. business owners.
B. corporate sponsors.
C. Key Employee.
D. union representative.
3. In determining the value of a business, the simple answer is
A. the surplus.
B. the assets.
C. the sales price.
D. the value of current and present profits.
4. In an “Endorsed Contributory” plan,
A. the employer only endorses the plan, but the employee pays the premiums.
B. the employer always pays the premiums.
C. the plan is a true group plan and the employer pays half the premiums.
D. the state Department of Insurance endorses certain insurers.
5. A plan offered by an employer which assures the employee(s) that in case of disability, their salary(s) would still be paid, is called
A. a Buy-Sell agreement.
B. a corporate endorsement plan.
C. salary continuation plan.
D. an Entity agreement
6. A corporation is large and self-insures its employee health benefits. They are now considering insuring a disability income program for the employees.
A. This would be advisable as they have the expertise already.
B. Reserving is more complex for disability plans, plus the problem of liability if the company were not able to meet future disability costs, so they may wish to reconsider self-insuring.
C. In most states, employers, regardless of how large they are, are not allowed to self-insure.
D. This would be a good move as the plan would automatically be reinsured by the Federal government under ERISA.
7. In a Disability Income insurance policy for a salary continuance plan, CPI-U means
A. Certified Premium for the Insurance, Un-rated.
B. the insured Can Purchase additional Insurance, for an Unlimited amount.
C. Consumer Price Index for All Urban Consumers.
D. that it is a salary Continuation, Personal Insurance, Unregulated.
8. Under a business Disability Income insurance policy, “net income” is necessarily defined as
A. gross income minus the insured’s share of the usual and customary business expenses.
B. the amount of income the insured receives from non-salary sources.
C. the adjusted gross income as it appears on the last federal income tax form of the insured.
D. gross income plus usual and customary business expenses.
9. A business Disability Income insurance policy takes into consideration the fact that the owner of the business would lose customer base and referrals during a period of disability. This is called
A. a Recovery Benefit.
B. a Gross income loss.
C. tough luck.
D. Base Retrieval Benefit.
10. There may be an occasion wherein the insured or a business may wish to continue coverage on another Disability Income insurance policy form. This is usually allowed if
A. the business is in the entertainment industry.
B. the agent forfeits his commissions.
C. the insured agrees by posting bond, never to cancel the policy.
D. the insured is not disabled, able to work full time in his regular occupation, and the request is made before the insured is age 55.
ANSWERS TO STUDY QUESTIONS
1C 2C 3D 4A 5C 6B 7C 8A 9A 10D