People often misunderstand the worth of disability income insurance. I don’t think it is because insurers and their agents disguise it, but rather because it involves a little arithmetic to be clear.
Value depends on several factors:
- The amount of the monthly benefit
- The duration of the possible payout
- The time the disability occurs
- Age at issue
- Investment returns
- Incidental benefits
It is obvious that a $5,000 per month payout is worth twice the value of $2,500. A payout to age 65 is worth more than a payout that lasts two years.
Age at issue matters because someone who is 25 is less likely to have a claim soon than is an older person. Insurance premiums rely on the cost of the claim and the probability of it occurring. Same thing with gender. Females are more likely than males to have a claim. The idea that “Maleness is a birth defect” only applies to life insurance. Maybe routine disabilities kill males easier and stop the payments sooner.
Benefits like options to buy more coverage, return of premium, accidental death are incidental. I will ignore them here. You can assess their value independent from the rest of the policy.
What we want to know is the present value of the future payout? How much financial asset replaces the required income? If you have the asset.
If you have a spreadsheet program and know the formula for creating the net present value of a series, it is straightforward. E-mail me if you don’t have the formula and would like to experiment. Please include a return email address.
Suppose I have a young (age 30) male professional who earns a good living, but has little wealth accumulated. (HENRY. High earnings not rich yet.) Current after tax income is $7,000 per month and he needs it all to carry on as he wishes. He thinks he could invest safely at 5% in a world where inflation is 2%. We will use taxes at 30% of investment income.
The policy will be for the best rated occupational class. There will be options for “own occupation” and cost of living indexing. Benefits payable to age 65. Start date is after 90 days of disability.
With these assumptions and assuming the client becomes disabled tomorrow, the policy is worth $2,330,445. Even if the client waits 10 years to have a claim, the remaining payments are worth about $1.8 million.
The premium will be less than $2,000 annually. For a female about 60% more. Think about it this way. For a male, a premium of one 1100th of the capital value creates the asset. For a female around one 800th.
But maybe they won’t become disabled. Exactly, and that is why it is affordable. Most insurers think they will pay claims of roughly 50% of the premiums received. That does not mean that the benefit is worth 50% of the $2.3 million. That is likely true for the entire population, but for each individual you become disabled or you do not. 100% or 0%. If it turns out that you become disabled, the capital value will be vast and unaffordable. If you turn out to be not disabled, the lost premiums are affordable. People would arrange the insurance if they understood it.
Suppose I could offer a policy for a premium of $2,000 per year. It guarantees that the person will not become disabled during their working life. I’ll bet I could sell a lot of them. From a financial perspective, that is what the ordinary disability income policy does.
The confusion is the advisor’s fault. Most people think a $2,000 premium for a potential $7,000 benefit is crazy expensive. Wrong baseline! It is $2,000 for a coverage of $2.3 million.
Always be sure you control the baseline. People make better decisions then.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772