Eye on the Entrepreneur - Forgotten risk

admin//July 16, 2002//

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As a business owner, when you think of insuring against risk, what comes to mind? Fire or flood damage? A nasty lawsuit? My guess is that these are the things that you think of first. Once you’ve taken care of these risks, you probably start to think about health insurance and then life insurance. However, there is one risk that many times is ignored, or at least only partially covered: This is the risk of a disability striking you or one of your key employees.What are the odds of something like this happening? According to a booklet published in 1999 by the National Underwriter called “Why Disability?” the odds are one in three that someone under the age of 35 will suffer a disability lasting six months or longer during the course of their career. The author also cites the fact that there are, on the average, 16 mortgage foreclosures caused by disability for every one caused by death. According to the 1985 Society of Actuaries Experience Table, there is a 33 percent chance that one of two business owners will suffer a disability before retirement. The odds increase to 50-50 when there are three owners. Here are some other alarming statistics. According to the National Safety Council report in 1997, approximately 51,000 were killed in car accidents while approximately 2 million people were disabled.The Journal of the American Society of CLU reported in 1996 that the chance of filing a claim with homeowner’s insurance is 1 in 88, while the chances of filing a claim with your auto insurance carrier is about 1 in 47. As you can see, the odds of a disability striking are much greater than you might think.Other than what is provided through group benefits, other types of disability insurance are largely ignored. Many times life and health insurance agents focus on the sale of life insurance and ignore the problem of disability.Since the possibility of a disability striking is so great, what should a business owner look out for?From a business standpoint, there are disability insurance policies to fund business buy-sell agreements. There is even disability insurance to protect a company against the disability of a key employee. For disability buyout insurance, there are companies that will insure up to $1 million to enable a company to buy back a disabled business owner’s interest. Typically, these policies have waiting periods of one to two years. Key employee disability insurance can be purchased with a much shorter waiting period and can reimburse a company for periods ranging from six months to a year for the loss of an employee’s services. For professionals, there are policies that will pay business expenses when the practitioner is disabled. These coverages are issued above and beyond the normal limits available for personal disability income protection. What are some of the things you should know about disability income insurance? Here are some issues to consider:

If you bought a disability income policy before 1990, hang on to it. In the 1970s and 1980s, insurance companies vied with each other to provide the most liberal benefits. Policies were developed that had very broad definitions of disability, and as business owners’ income increased, the insurance companies increased their limits also. This was especially true in the medical profession where monthly benefits of up to $30,000 were not uncommon. Tough times came for the disability insurance industry in the late ’80s and early ’90s. All the liberal definitions came home to roost. I was at a meeting in 1993 that was sponsored by a major disability carrier. One of their senior vice presidents told us that they had one claim for $30,000 per month paid to a physician who was suffering “acute midlife crisis.” On top of that, he had a lifetime benefit!It became inevitable that the insurance companies would begin to tighten up their contracts as losses increased. Benefits on newer policies are much more restrictive and will probably become more restrictive still.So, if you bought that old non-cancelable policy that has that liberal definition of your “own occupation,” hang on to it. If you have group long-term disability coverage in addition to your non-cancelable policy, you may find that if you have a claim, both contracts will pay. Individual policies cannot offset benefits paid under a group contract.

If you have taken a group long-term disability plan for your employees, check out the limits of coverage. It is quite possible that the limits of your group policy may be fine for your employees but inadequate for you. If you’re making significantly more than your employees, you may be grossly underinsured. For example, a policy paying 60 percent of earnings up to $5,000 per month may be fine for someone earning $75,000 per year, but if you earn $125,000 per year, your maximum benefit will be only 48 percent of your pre-disability earnings. If this is the case, consider buying an individual policy to supplement your group coverage.

Pay income taxes on the premiums you pay for your disability insurance. Under current law when premiums are paid with after-tax dollars, benefits are income-tax-free. Consider this: Most long-term policies pay up to 60 percent of your income. Even if the limits of your policy are high enough, that means that you will still take a 40 percent hit to your income if you become disabled. On top of that, the benefits could be taxable as ordinary income and subject to FICA withholding. You might wind up getting less than 50 percent of your pre-disability earnings. Some insurance companies will re-rate your group long-term disability plans if you advise them that you will bonus out the premiums to the employees. They may charge a slightly higher rate, but if you factor in the fact that benefits are now income-tax-free, you are really getting more bank for your disability insurance dollar.

Make sure your disability coverage has a “residual” benefit. This type of benefit will continue to pay if you go back to work at a reduced income.

What if I own the company and become disabled? Can’t I just continue to pay myself a salary? You’d better check with your accountant first. If you own a C-corporation, the Internal Revenue Service could take the position that income paid to you by your corporation during disability is dividend income and therefore not deductible to your company. Furthermore, most business owners are also the key employees. Their ingenuity and skills drive the company and bring in the revenue. If this describes you, your company may not be able to afford to pay you if you become disabled. These are just a few of the issues you should consider when insuring your income (or your ownership interests) against the possibility that you may become disabled. You should definitely check with your accounting, legal and financial advisors to make sure that this serious risk is adequately managed.

Neil R.G. Young, CLU, ChFC, is president of Young & Co., a financial planning firm in Lutherville. If you have any comments or questions, you can send him an e-mail at [email protected] or call at 410-494-7766. The Web site is www.yco.com.