What Is Disability Insurance?
As its name suggests, disability insurance is a type of insurance product that provides income in the event that a policyholder is prevented from working and earning an income due to a disability.
KEY TAKEAWAYS
Disability insurance is a type of insurance protecting against loss of income due to disability.
Disability insurance is available through both public and private programs.
Some of the variables affecting the cost of disability insurance include the strictness of requirements for qualifying under the plans; the amount of income to be replaced; the length of time in which benefits are paid; the medical history; and the length of time policyholders must wait before beginning to collect those benefits.
How Disability Insurance Works
Oftentimes, insurance products will protect against a specific loss, such as when a property and casualty insurance plan reimburses the policyholder for the value of stolen property. However, in the case of disability insurance, this compensation relates to the lost income caused by a disability.
For example, if a worker earned $50,000 per year prior to becoming disabled, and if their disability prevents them from continuing to work, their disability insurance would compensate them for a portion of their lost income provided that they qualify. In this sense, disability insurance essentially covers the opportunity cost of the now-disabled worker.
Real-World Example of Disability Insurance
As a rough estimate, disability insurance typically costs about 2% of the annual salary of the person being insured. Of course, the actual amount will depend on the insurance carrier and on policy features such as those discussed above. Different individuals will have different preferences in terms of how much they are willing to pay in exchange for greater or poorer protections from potential disability.
To illustrate, consider two hypothetical workers. Worker A is a professional working in a highly specialized field. It took Worker A ten years of post-secondary education to become qualified in their field, and this has allowed them to generate a relatively large income of $250,000 per year. Worker B, on the other hand, is a high-school graduate who regularly switches between jobs and earns about $30,000 per year.
Worker A knows that, if they become disabled, they may still be able to work in another field, but this would very likely require a significant loss of income. For this reason, they decide to purchase a relatively expensive disability insurance plan that has a flexible definition of disability.
Because of Worker A’s high income, they can easily afford their relatively high premiums. Worker B, on the other hand, decides to opt for a plan with lower premiums even if that plan has a stricter definition of disability. In addition to having fewer resources available to pay for premiums, Worker B is also less reluctant to work in an area outside of their current occupation, since the nature of their work is less specialized.