Return of Premium Disability Insurance: The Black Hole
Published in the March/April 2001 issue of the MDDS Articulator
By David Richards - Financial Advisor Park Avenue Securities. Disability Insurance Brokerage Manager and Field Representative (Denver, CO) for The Guardian Life Insurance Company of America, New York, NY.
This narrative will address the key issues to focus on when considering disability insurance with a “Return of Premium” feature vs. a policy without this feature. This article offers my opinion of these types of policies and generally discusses contract features of such “Return of Premium” plans that have been offered over the years by several companies. No example herein is meant to identify any specific insurance agent’s sales tactics in marketing these products.
When making a financial planning decision, like the purchase of disability insurance, it is important to focus on the future financial implications and ramifications of your buying decision. The first and foremost consideration should be the quality of the underlying disability contract. The bottom line is this: the quality of the contract (and of course, the issuing company), will determine if, how, when, and how long you are paid income if you suffer an accident or illness that results in a partial or total disability. Isn’t this why we buy insurance coverage in the first place? Especially for an Optometrist, Dentist or Physician, the quality of the underlying contract is the most important consideration.
The “Return of Premium rider” is an optional feature of a disability income policy that is issued by very few companies. Numerous companies used to offer the product in the 1990’s. Currently, only two companies in the industry offer this option on their disability plans. Several other companies recently announced that they will no longer offer this option on their new policies. Why would so many companies discontinue selling the product? Most insurance buyers simply don’t purchase this option. If it doesn’t sell well, companies discontinue it.
Depending on the company, the “Return of Premium” option on a disability contract basically says that the insurance company agrees to refund 50% to 80% of the total premiums paid into the plan after 5 or 10 years minus any claim dollars paid to the insured. The insurance company charges approximately 40 to 60% extra for this option over and above the basic cost of the insurance. There is no investment vehicle attached to the policy, and no real return on the extra money that is put into the plan. (One current plan offers a 50% refund, but the insured must pay an extra 55% in premium in order to get the refund. It’s a wash at best, regardless of hypothetical equivalent “rate of return” illustrations.)
When the insured enters into one of these “Return of Premium” contracts, they are merely paying about 40 to 60% extra for their coverage in the hopes that they’ll receive a 50% or 80% refund after 5 or 10 years. Any “return” on the investment that is shown by agents selling this coverage is “phantom” return. The insurance company is borrowing your money (in the form of the extra premium), and reducing their risk on the policy because the insured is funding their own short-term disability claim. The insurance company is certainly investing the extra premium dollars for their own account during those 5 or 10 years and is merely giving it back plus a percentage of the basic premium if no claims have been filed. Remember… the “refund” is reduced dollar for dollar for every claim dollar that the insured receives over the 5 or 10-year period. Although agents who choose to sell this optional policy feature often state differently, there’s absolutely no guarantee that you’ll receive 50% or 80% of your money back after 5 or 10 years because there’s no way of knowing whether or not you’ll suffer an accident or illness that results in a claim. A 5 or 10-year period of time is much too long to make such an assumption. It only takes a short-term claim (about three months of benefits) to completely wipe out a “Return of Premium” refund.
In my opinion, the “Return of Premium” option is a poor buy. In my 17 + years of experience in the disability insurance industry, I have never met a true financial planner, accountant, or practice manager that recommended this type of policy. Many of the financial professionals that I have talked with over the years feel very strongly that any extra money that the insured has should be invested outside the disability policy. If the insured becomes disabled anytime during the 10 years of the contract, their investment outside the policy will likely be intact. Inside the policy, the “investment” would be lost. It’s just too risky.
The opportunity cost that is lost with this option is also significant. That extra premium could be at work in a real investment (like an IRA, Mutual Fund, individual stocks or bonds, or your own business!), which is not affected if you file a disability claim.
A few agents who encourage their clients to buy these “Return of Premium” policies play a dangerous game with numbers to make the sale. In their effort to show the phantom “rate of return” soar on these policies, they carelessly encourage their clients to violate IRS tax code regarding the deductibility of insurance premiums and tax treatment of the premium refund, if ever received.
The danger lies in three areas. First, some of these agents encourage their clients who own S Corporations to deduct their full personal disability insurance premium, which is specifically prohibited in the IRS tax code (Section 104). Only owners of C Corporations may deduct personal disability insurance premiums. Secondly, even though the C Corporation can deduct the personal disability coverage premium, if the return of premium is received after five or ten years, then the refund is taxable income in the eyes of the IRS because it was fully deducted. Some agents dangerously encourage their clients to hide this refund and not run it back through their business. They justify this recommendation because there isn’t a 1099 issued by the insurance company for the refund. This activity is still careless and illegal and would be found in an audit…and guess who’s responsible….you are! The third danger is basically the same as the second above, but involves the Overhead Expense policy with the premium refund option. Although the premiums for Overhead coverage are deductible for any type of business entity, the refund after ten years, if received, is taxable because it was deducted as a business expense.
In my opinion, the bottom line is this: you don’t have to rely on gimmicks and tax tricks to realize a good return on your money. Simply buy the best coverage that you can for the protection it affords, and then take the savings and invest it in a real investment vehicle outside the disability policies. The few policies that still offer this “Return of Premium” option are not the strongest contractually for a dentist or dental specialist, and carrying less than adequate disability coverage is like playing with fire. Some agents are masterful in their sales presentations of these products and show attractive “rate of return” illustrations for such – which are erroneous and don’t contain proper footnotes showing the calculations and risks to the client. You’ll likely notice that no identifying information for the agent can be found on these illustrations showing 17-20% “returns.” The selling companies wouldn’t allow such illustrations to be used as they’re not “compliant” with the company.
As I mentioned at the beginning of this article, quality of contract is our most important consideration when making an insurance or financial planning decision. Especially with disability insurance, having the best contract provisions available is what matters most. Why do we buy insurance coverage in the first place? To protect ourselves and reduce our risk! Unfortunately, in the insurance industry, some agents choose to sell gimmicks rather than the best quality policy. It can be compared to buying a car in some respects. Although it may look good on the outside, it could be a “lemon” mechanically. Think of it in terms of your own dental practice as well. Do you have to offer gimmicks to gain clients? Are you the cheapest dentist in town or do your simply offer your patients the highest-quality dentistry at a price that’s fair considering the quality of your work?
The important features to look for in a quality disability contract are:
1) A True “Own Occupation” definition of total disability. This definition essentially says that if you can’t perform the material and substantial duties of your regular occupation, you will be considered totally disabled, even if you can work in some other capacity. What this means is if you become totally disabled in your occupation (as an Optometrist) and are entitled to benefits, you will receive your full disability benefit even if you choose to work in another occupation because of the disability.
2) Most of the companies that sell the “Return of Premium” option, although all fine companies, do not offer the true Own Occupation definition described above. Some sell a modified version of the definition including a “transitional” definition or a Loss of Earnings policy where total disability is never even defined in the contract. Such contracts will reduce the disabled professionals’ benefits if they are disabled in their regular occupation and return to work in another and earn at least 20% of their pre-disability income. Once their income in their new occupation reaches 75% of their prior income, their disability benefits go away completely. DI policies never replace 100% of income anyway, so you need the full benefit, regardless of other earned income in a new profession.
This true “Own Occupation” feature is, in my opinion, especially important for younger professionals, who if totally disabled in their regular occupation, would likely work in another as soon as physically possible. This is the “heart” of your plan.
3) The Future Increase Option* is another vital feature of a quality disability contract. This feature allows you, on each policy anniversary (until a certain age), to apply to increase your monthly benefits without any medical underwriting. You only have to prove financially that you qualify for the increased coverage. The best FIO options allow the insured to buy as much additional coverage as they qualify for financially each year (until a certain age). The companies listed in the introduction all have more limited increase options on their plans. This can leave the insured exposed with inadequate coverage if they have an increase in income from year to year, which is most often the case.
4) Other optional features to look for include compound Cost of Living Adjustments, Residual or partial benefits that pay to age 65, a Graded Lifetime Indemnity for total disability and recovery benefits that pay until age 65 if you return to work after suffering a disability and continue to have at least a 15% loss of income.
Conclusion
I am of the opinion that the “Return of Premium” option is dangerous for two reasons. First, the chances of disability over a five or ten-year period of time for the general population are significant (on average about one in three). For professionals who work in specialty occupations like dentists and physicians, the risk is even greater. If you become disabled during the five or ten-year period in which the refund is based, you lose a significant amount of money. The entire refund would be gone with about three months of total disability benefits or six months of partial disability benefits. Secondly, the quality of the policies that this option are attached to are often not the best available for dentists and specialists. Although the companies mentioned are strong companies (which is important), the quality of the contract determines if and how you get paid. Isn’t this why we’re buying the coverage in the first place – for the protection it provides?
Be sure to ask you own accountant or financial advisor their opinion on this “Return of Premium” contract. Most will tell you to buy the best quality policy that you can and take any extra money that you have and invest it outside the policy. You can get real growth out of your money and won’t lose your investment because you have to file a disability claim.
If you’re really considering this policy, ask yourself this question: “do I really want to lend an insurance company several thousand dollars over the next ten years and receive no interest on the loan…and if I suffer an accident or illness that results in a claim that’s paid for a period as short as three months, they keep the money I’ve lent them?”
This publication is offered for the purposes of education and information only and should not be considered tax or legal advice. For information on your specific situation, please consult your legal or tax advisor.
* Restrictions and limitations apply. While medical information is not required when exercising a future increase option, applications to exercise such will be financially underwritten taking into consideration both the applicant's then current income, as well as all disability insurance which is in force, or for which the insured has applied or is eligible to receive.