Disability Insurance 15 – Disability Benefits Under Life Insurance Policies

Two main methods of providing disability income in life insurance policies are: waiver of premium and combination policies.

1. Waiver of Premium

Many life insurance policies offer a ”waiver of premium” provision in the event the policy owner becomes disabled during the term of the policy. A separate premium is payable for this additional coverage or rider. For tax purposes, the adjusted cost basis of the policy does not include any additional premium payable for this benefit. The payment of this type of benefit does not represent a disposition for tax purpose, since it is paying an amount equal to the premium to keep the policy in force.

2. Combination Policies

A policy that is considered exempt allows the cash values in the plan to accumulate on a tax-deferred basis. Recently, some insurers have designed policies that allow the addition of the disability benefits within an exempt life insurance policy.

These policies provide both (i) life insurance protection and (ii) disability income benefits. For example, one type of policy allows the cash values of the insurance policy to fund all or a portion of the disability premium. The cash value can also be used to finance the disability benefits. Therefore, the Elimination Period for the disability benefits can be extended, which has the effect of reducing the costs of the disability plan.

There are several some advantages and disadvantage to these combination products:

Advantages of combination policies

a)The packaging of insurance benefits into one product can simplify the process for the prospective purchaser.

b)The completion of the application and underwriting requirements for the combined policies may be quicker as duplicate questions and medical tests can be avoided.

c)The policyholder can benefit from reduced policy charges under a combined policy.The premiums for disability insurance benefits are normally an after-tax expense.

However, the cash values of the life insurance policy that are growing on a tax-deferred basis can be used to fund the charges under a combined program. The policyholder, therefore, benefits due to their ability to use the tax-deferred investment income under the exempt life insurance policy to fund some or all of the disability premiums.

d) Combining disability insurance and life insurance creates flexibility for premium payments. Generally ”disability only products” require the payment of a level annual premium.

By including disability coverage within an exempt insurance policy, it is possible to build up a cash reserve that can be used to fund future morbidity or disability costs.

2. Disadvantage

a)It can be very difficult for one company to provide the best products in both the life insurance and disability product lines. A policyholder may have to forgo some important product features when dealing with a combination product.

b) A combination product may not be as flexible as separate policies once the policy is in force. A policyholder with separate life and disability policies could make changes to one policy, such as surrender the policy, without affecting benefits under the other policy. This may not be the case with a combination product.

c) As they are relatively new to the marketplace, the tax treatment of these types of plans is still in the process of evolving. Taxation department may disagree with the insurer’s position that the cash values of an insurance policy can be paid out tax-free in the event of disability. As well, the calculation of the adjusted cost basis of the insurance policy could be impacted by taxation department interpretation of the rules and the combination of benefits under an insurance policy could affect its exempt status.

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