IIDI Income Analysis

Individual disability insurance policies for small business owners, often called “IDI” policies, are designed to provide financial protection in the event that the owner is unable to work due to a disability. Generally the income protection is determined in one of two ways – either the policy provides a flat monthly benefit agreed upon in the contract, possibly with a cost of living increase built in, or the income protection is based on the insured’s actual income at the time of disability.

The calculation of income for IDI policies is crucial as it determines the benefit amount the policyholder is entitled to receive. The process involves several key factors and considerations:

1. Definition of Income: Insurers define “income” in various ways, but typically it refers to the net income of the business after expenses but before taxes. This can include salary, bonuses, and other compensation that the owner receives from the business.
2. Owner’s Role and Compensation: The calculation takes into account the owner’s role within the business and their direct compensation. This includes salary, dividends, and other distributions the owner might take from the business. It’s important to differentiate between the owner’s personal income from the business and the overall business revenue.
3. Financial Documentation: Insurers require financial documentation to verify income. This may include tax returns, profit and loss statements, and other business financial records. The documentation helps insurers understand the business’s financial health and the owner’s actual take-home income.
4. Average Income Consideration: Insurers often look at an average of the business owner’s income over a certain period, such as the last two or three years, to accommodate for fluctuations in business income. This average helps in arriving at a more stable income figure for determining benefits.
5. Benefit Calculation: The benefit amount is usually a percentage of the owner’s monthly income, subject to a policy cap. This percentage can vary but typically ranges between 50% and 70%. The aim is to replace a portion of the owner’s income to help maintain their standard of living during the disability period.
6. Policy Specifics and Riders: The specifics of how income is calculated can also depend on the terms of the individual policy and any riders (additional benefits) attached to it. For example, some policies may include bonuses or other variable compensation in the income calculation, while others may not.
7. Business Overhead Expense (BOE) Disability Insurance: For small business owners, another aspect to consider is BOE disability insurance, which covers the ongoing expenses of running the business, such as rent, utilities, and employee salaries, in case the owner is disabled. The calculation of income for BOE policies focuses on the business’s operational expenses rather than the owner’s personal income.
8. Adjustments for Business Growth or Decline: Insurers may also consider recent trends in the business’s income, making adjustments if the business has been growing or declining. This ensures the income calculation reflects the current state of the business more accurately.
9. Non-monetary Compensation: In some cases, non-monetary compensation, such as the use of a company car or housing, may be considered part of the income calculation, depending on the policy terms and the insurer.
10. Legal and Tax Implications: The structure of the business (e.g., sole proprietorship, partnership, corporation) and the local legal and tax environment can influence how income is calculated and benefits are taxed.

It is generally less expensive for business owners to obtain insurance tied to their actual income, and not an established dollar amount.  The reason is simple – the insurance company knows that business owners attempt to minimize income listed on corporate tax returns, relying on business deductions to lower that amount. Therefore, it is financially advantageous to them to rely on tax returns instead of an agreed- upon dollar amount.

If you are in the process of purchasing an individual disability policy, consider which option best suits your needs.  If you are reading this, however, you likely already have purchased a policy and have made a claim under it.  You may now be realizing the extent to which the insurance company seeks to limit your income. Now is the time to consult with experts about how your income will be calculated, and what documentation you can submit to support the amounts closer to what you actually earn annually.