What it means
Disability insurance replaces part of a person's income if illness or injury prevents them from working. To decide how much to pay, the insurer needs a starting figure for what the person was earning before the problem arose.
That figure is the pre-disability earnings. The policy defines exactly how the figure is calculated.
Some use the basic salary at the time of disability, while others take an average of the best few years or the last 12 months of pay. Whether bonuses, commissions and overtime count varies, so people with variable pay should read the definition carefully.
The benefit is then a percentage of that figure. Many plans pay in the range of 50% to 70% of pre-disability earnings, because insurers want to leave some incentive to return to work.
Benefits may be reduced by other income, such as state support or part-time earnings. For employers, the figure matters when choosing group cover for staff.
A plan that defines earnings narrowly may leave highly paid or commission-based employees with benefits much lower than they expect. Finance and human resources teams should check that the definition matches the way staff are actually paid.
Self-employed people need particular care, since their income often changes from year to year. Insurers may ask for tax returns and accounts to prove earnings, and they may base the benefit on net profit after expenses.
Reviewing the cover each year as income grows helps to avoid being under-insured. Timing can also catch people out.
If pay fell shortly before the claim, because someone moved to part-time work while unwell, the insurer may use a lower figure unless the policy looks back at the best earlier period. Employees with a worsening condition should check how the policy treats such changes before they reduce their hours.
In practice
Real-world examples.
Example
A software engineer with a salary of $96,000 has a policy paying 65% of earnings. Her annual benefit is $96,000 x 0.65 = $62,400, which is $5,200 a month. She chose the plan because the benefit is large enough to cover her mortgage.
Example
A salesman earns a base salary of $50,000 and commission of $40,000 a year. His employer's plan defines earnings as base salary only, so his benefit is based on $50,000 and not on the full $90,000. At 60% he would receive $30,000 a year, compared with the $54,000 he might have expected.
Example
A freelance designer insures 60% of her average net profit over the last two years. When illness stops her working, the insurer verifies her earnings using tax returns and begins monthly payments. She keeps copies of her accounts so any later review runs smoothly.
Formula
Calculation
Monthly benefit = Pre-disability monthly earnings x Replacement percentage
An employee earned $6,000 a month before becoming disabled, and her policy replaces 60% of earnings.
Monthly benefit = $6,000 x 0.60 = $3,600.
If she also receives $500 a month from another qualifying source that reduces the benefit, the insurer pays $3,600 - $500 = $3,100 a month, so her total income is $3,600 a month, or 60% of her earlier pay.Case study
Seen in the real world.
Brookside Engineering is a fictional firm that bought a group disability plan for its staff. The plan paid 60% of basic salary, and the firm assumed this was a generous cover.
When a senior engineer whose pay included large bonuses became disabled, the benefit was far lower than he expected. In this illustrative case, the company reviewed the plan with its broker, added a supplementary policy that included bonuses in the definition of earnings and told staff exactly how benefits were calculated.
The human resources director noted that the cost of the change was small compared with the confusion avoided. She added a plain-English explanation of the earnings definition to the staff handbook. The firm also held a short briefing for staff with large bonuses so that each person could decide whether to buy a top-up policy. Several of them did, and the take-up showed that most had never seen how their benefit was worked out.
Watch out
Common mistakes.
- Assuming bonuses and commissions are automatically included in the earnings figure.
- Expecting the benefit to equal full pay, when most plans replace only part of it so that the person has a reason to return to work.
- Forgetting that other income can reduce the benefit.
Questions
People also ask.
Who decides the earnings figure?
The insurance contract does, and it will define the calculation, including which payments count and over what period.
Are disability benefits taxable?
That depends on local tax law and on who paid the premiums, so it is worth checking before relying on the figures. A benefit that is taxed will leave less income than the headline percentage suggests.
Should I update my cover when pay rises?
Yes, because many policies are fixed at the time of purchase and could leave you under-insured.
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