Module 4 - Managing Long-Term Disability Benefits

Question 1

Identify key characteristics of long-term disability (LTD) plans. (4)

Answer 1

(a) Benefits are payable only after an elimination period during which income is usually provided through short-term income replacement plans (such as sick leave, salary continuance or weekly indemnity/short-term disability (WI/STD) plans) or government-sponsored programs (such as Workers’ Compensation (WC), Employment Insurance (EI) or, less frequently, Canada Pension Plan/Quebec Pension Plan (CPP/QPP)).

(b) The definition of disability relates to the plan member’s ability to perform their own occupation or any occupation.

(c) The monthly benefit is usually a percentage of the plan member’s predisability earnings.

(d) The benefit period usually ends at the earliest of the plan member’s recovery, retirement or attainment of age 65.

Question 2

Explain how the length of the elimination period for LTD benefits impacts premiums charged by insurers.

Answer 2

The length of the elimination period, also called the qualifying period, has a direct impact on the premiums charged by insurers. The longer the elimination period for LTD benefits, the greater the probability that the disabled plan member will return to work before becoming eligible for LTD benefits. Because the insurer’s risk is lower, the LTD premium rate tends to be lower.

Question 3

Compare the own occupation (“own occ”) and any occupation (“any occ”) definitions of disability used in LTD plans.

Answer 3

The two basic definitions of disability are own occupation (“own occ”) and any occupation (“any occ”).

Own occupation links directly to the plan member’s ability to perform their regular occupation. Typical “own occ” policy wording considers plan members to be totally disabled if a medically determinable physical or mental impairment due to injury or illness prevents them from performing the regular duties of their own occupation.

Any occupation refers to whether the plan member’s disability renders them unable to perform any occupation (i.e., not just their usual occupation). Typical “any occ” policy wording considers plan members to be totally disabled if a medically determinable physical or mental impairment due to injury or illness prevents them from performing the regular duties of any occupation for which they are, or may reasonably become, suited to perform based on education, training or experience. This definition is more common in the manufacturing sector and often appears in collective bargaining agreements.

The “own occ” period of total disability most frequently applies to the first two years plan members receive LTD benefits. After that, plan members must satisfy the “any occ” definition of disability to continue to receive LTD benefits until they reach the maximum LTD benefit period.

Question 4

Explain the significance of the LTD benefit formula.

Answer 4

An LTD benefit typically replaces 50% to 75% of gross earnings and is subject to a maximum monthly dollar amount. The benefit formula the plan sponsor selects is significant because it affects the benefit amount plan members receive and the cost to the plan sponsor (or the plan members if they are paying premiums).

Question 5

List factors a plan sponsor considers when setting its LTD benefit formula.

Answer 5

Factors considered by the plan sponsor when setting its benefit formula are:

(a) Level of desired income replacement relative to the STD benefit level

(b) Tax implications

(c) Taxable vs. nontaxable plan

(d) Definition of earnings

(e) Net income replacement ratio

(f) Benefit maximums

(g) Direct and indirect offsets

(h) All source maximum

(i) Recurrent disability provision

(j) Cost-of-living adjustments (COLA)

(k) Partial disability and residual disability provisions.

Question 6

Describe the tax implications when a plan sponsor pays all LTD plan premiums.

Answer 6

An LTD plan is defined as a wage loss replacement plan in paragraph 6(1)(f) of the Income Tax Act (ITA). According to the Canada Revenue Agency (CRA) Interpretation Bulletin IT-428, benefits that disabled employees receive are not taxable if the plan is considered an employee-pay-all plan, which means that employees enrolled in the plan pay the entire premium as the plan’s terms require or that an employer pays the premium on behalf of employees and accounts for these premiums as wages or salary (with the amount of the paid premium reported as taxable income to the employees).

If plan members contribute only a portion of the premiums, the taxable portion of the benefit is equal to the total benefit received from the plan less the sum of the contributions the plan member made since December 31, 1967, and for which deductions were not previously taken.

LTD benefits payable from a self-funded plan (self-insured with an administrative services only (ASO) arrangement) are subject to plan sponsor and plan member Canada Pension Plan/Quebec Pension Plan (CPP/QPP) contributions and Employment Insurance (EI) premium withholding and remittance if the plan sponsor funds any part of the plan, exercises a degree of control over the terms of the plan and determines the eligibility for benefits.

In practice, LTD benefits are rarely self-insured, and LTD premiums are rarely cost-shared.

Question 7

Outline how predisability earnings are defined for the purpose of calculating LTD benefits.

Answer 7

The LTD benefit amount is calculated based on the plan member’s gross earnings immediately before the date of disability, regardless of the tax status of the benefit.

Gross earnings are regular earnings received from the employer and can include bonuses, commissions and overtime pay when earned on a regular basis. If included, commissions are usually based on the average commissions received in the preceding 24-month period. For plan members with less than 24 months of employment, commissions are based on the average commissions received for the duration of employment. Net earnings are gross earnings less income tax.

Question 8

Identify factors a plan sponsor considers when deciding whether to implement a taxable or a nontaxable LTD plan.

Answer 8

Factors considered by a plan sponsor when deciding whether to implement a taxable or nontaxable LTD plan are:

(a) In a nontaxable plan, plan members pay 100% of the LTD premium, which can free up a significant amount of plan sponsor funds. This is often the primary consideration for plan sponsors.

(b) In a nontaxable plan, plan members make premium contributions with after-tax dollars (i.e., they pay premiums from net income or “take-home pay” after taxes have been deducted; premiums are not deductible against taxable income). In a taxable plan, plan members pay taxes only if/when they receive benefits from the plan. Because the majority of plan members will never receive benefits from the plan, a taxable plan is preferable since they will never have to pay tax on this benefit.

(c) In a nontaxable plan with a fixed percentage of salary benefits schedule, the net income replacement ratio increases as salary levels increase (up to the all source maximum). This can lead to misunderstanding among higher paid plan members, who may expect a higher level of benefits than they will actually receive, since the all source maximum may limit the benefit to less the amount defined by the benefit formula.

(d) In a nontaxable plan, plan members may want a role in the design of the plan because they are paying for it.

(e) In a nontaxable plan, plan members may want to opt out of coverage. However, in Canada, LTD coverage is overwhelmingly mandatory, regardless of who pays the premium.

(f) In a nontaxable plan, plan members may feel more entitled to receive benefits because they are paying for the plan. However, thorough claims adjudication by the insurer can limit this impact by declining claims that are not legitimate.

(g) In a taxable plan (unlike a nontaxable plan), LTD benefits qualify as earned income for registered retirement savings plan (RRSP) contribution purposes.

Question 9

Compare the benefits schedules for nontaxable and taxable LTD plans.

Answer 9

Where benefits are nontaxable (i.e., the plan members pay the entire premium), the benefit schedule is typically between 55% and 67% of gross monthly earnings. A lower benefit percentage may apply to gross earnings above a specified amount in order to avoid a situation where the net income replacement ratio increases as income increases (as a result of progressive personal income tax rates). This type of graded or tiered benefit schedule provides a more consistent net income replacement ratio across a wide range of salary levels.

An LTD plan that is taxable should be based on a higher percentage of predisability gross earnings than a plan that is nontaxable, to provide a comparable level of after-tax income replacement. The benefits schedule is typically between 60% and 75% of gross monthly earnings. Since the benefits are taxable, there is no need to introduce a graded or tiered benefit schedule.

Question 10

Describe the nonevidence maximum (NEM) and the overall maximum (OM) that apply to LTD plans.

Answer 10

The NEM is the amount of insurance an insurer will provide without requiring plan members to submit medical evidence of good health either at the time of enrolment in the plan or when their earnings increase. When a plan member’s earnings increase to a level at which they are entitled to coverage in excess of the NEM (i.e., based on their earnings and the benefit schedule), plan members must submit medical evidence to the insurer for review by its underwriting staff. If the insurer determines that the medical evidence indicates a poorer-than-normal risk, it can decline to provide the additional coverage above the NEM.

OM is the maximum insurance amount the insurer will provide and is outlined in the benefit schedule.

Question 11

Explain the basis for calculating benefit maximums in LTD plans.

Answer 11

The calculation of benefit maximums usually takes into account the number of insured persons, the total volume of coverage and the average amount of insurance per person. It also considers the nature of the plan sponsor’s business and, if applicable, the insurer’s reinsurance arrangement. Each insurer uses its own formula to determine LTD maximums, though the results tend to fall within a fairly narrow range.

Question 12

Outline the benefits that are usually included as a direct offset in LTD plans.

Answer 12

Offsets are other sources of income that plan members receive while disabled that reduce the benefits payable under the LTD plan. Direct offsets generally include benefits payable under government-sponsored benefit programs, including primary (plan member only) CPP/QPP disability pension and WC benefits. They may also include benefits payable from automobile insurance (where permitted by law). When plan members receive these other sources of income, the insurer takes the position of second payer and reduces the amount it pays from the LTD plan accordingly.

Question 13

Identify sources of income that may be included as indirect offsets in LTD plans.

Answer 13

Indirect offsets limit income from all named sources to a specified percentage of predisability earnings, known as the “all source maximum.” These offsets reduce the LTD benefit amount only if the total income from the LTD benefit and all named sources exceeds the all source maximum. All named sources typically include the direct offsets (i.e., primary/plan member only CPP/QPP disability pension, WC benefits, benefits payable from automobile insurance where permitted by law) plus indirect offsets:

(a) Benefits payable under an association or other group disability program

(b) Any income as a result of any job or business for remuneration or profit, including severance or vacation pay

(c) CPP/QPP disability pension benefits payable to the plan member’s dependents as a result of the plan member’s disability (some insurers no longer include this as an indirect offset)

(d) Retirement benefits related to any employment, (e.g., employer-sponsored retirement plan, multi-employer pension plans, etc.).

Question 14

Explain the purpose of including an all source maximum in an LTD plan and how it is applied in taxable and nontaxable plans.

Answer 14

The purpose of the all source maximum in an LTD plan is to prevent the disabled plan member’s total income from becoming so close to their predisability earnings that there is no financial incentive to return to work. If plan members receive more income than the all source maximum, the insurer reduces their LTD benefit by the excess amount. If the LTD benefit is taxable, the all source maximum is based on a percentage of predisability gross earnings, up to 80% or 85%. If the LTD benefit is nontaxable, the all source maximum is based on a percentage of predisability net income (again, up to 80% or 85%), where “net income” is income after deductions for provincial and federal income taxes.

Question 15

Explain the recurrent disability provision and identify circumstances under which insurers will waive recommencement of the elimination period for LTD benefits under the recurrent disability provision.

Answer 15

The recurrent disability provision considers plan members who attempt to return to work but who cannot perform their regular occupation due to a recurrence of the disability.

Insurers will waive recommencement of the elimination period for these plan members if:

(a) Plan members return to work on a full-time basis during the elimination period and become totally disabled within 14 to 30 days due to the same or a related disability. The plan members are then considered to have been continuously disabled for the purposes of the elimination period. The elimination period is typically extended by the number of days worked.

(b) Plan members return to work on a full-time basis following a period of total disability for which benefits were payable (i.e., they satisfied the elimination period) and become totally disabled within six months due to the same or a related cause. The plan members are then considered to have been continuously disabled for the purposes of the elimination period.

Question 16

Explain the purpose of the cost-of-living adjustment (COLA) provision in LTD plans.

Answer 16

For disabilities lasting for several years, the impact of inflation can effectively diminish the value of disability benefits. LTD plans can address this issue by including a COLA provision.

A COLA provision typically provides for the indexing of the disability payment based on any adjustment in the Consumer Price Index (CPI), not to exceed a stated maximum (usually 3% or 5%). The adjustment to a plan member’s monthly benefit occurs on an annual basis, typically on January 1, provided the plan member has been receiving benefit payments for a minimum of 12 months.

In practice, COLA provisions are rare, with less than 10% of LTD plans including this feature.

Question 17

Describe the key differences between partial and residual disability provisions in LTD plans.

Answer 17

Partial disability benefits provide protection for plan members who are able to work at a limited capacity while receiving LTD benefits. The partial disability provision in the LTD contract typically specifies that the total income the plan member receives from all sources cannot exceed 100% of their predisability earnings. Eligibility for partial disability benefits links directly to the definition of total disability in the LTD contract. Partial disability provisions vary widely among insurers.

A residual disability provision allows disabled plan members to work in a limited capacity during the elimination period and still have those days count toward satisfying the elimination period. This provision can lower plan sponsor expenses by keeping plan members working in a reduced capacity, lowering replacement costs and minimizing workplace disruptions. It also allows plan members to feel a greater sense of self-worth, which often results in higher morale and a more rapid return to full-time work. In practice, residual disability provisions are not common, and adjudication practices vary widely among insurers. When offered, some insurers look at whether the plan members’ monthly earnings fall below a certain percentage threshold (e.g., 20% or more loss in monthly earnings due to the sickness or injury) while other insurers do not set a specific earnings test.

Question 18

Explain the purpose of a preexisting condition provision in an LTD plan, and identify the most common provision.

Answer 18

A preexisting condition provision protects against the negative cost impact of high claims that could result when plan members with preexisting conditions join the benefits plan. The provision excludes coverage for any medical condition that existed and for which plan members received treatment during a specific period before becoming eligible for benefit coverage (these periods vary).

The most common limitation is 3/12, which means benefits are not payable for a total disability that starts during the first 12 months of coverage if the disability results from any sickness or injury for which plan members were treated or attended by a physician or for which plan members took prescribed drugs within three months before the effective date of the plan member’s insurance.

Question 19

Identify standard exclusions and limitations in LTD plans.

Answer 19

Standard exclusions and limitations, i.e., circumstances under which LTD benefits will not be paid, include:

(a) Any period during which the plan member is not under the appropriate care of a licensed physician

(b) If the plan member engages in any occupation for remuneration or profit, except as approved by the insurer under the partial disability benefit or approved rehabilitation program

(c) Any period during which the claimant is receiving Employment Insurance (EI) maternity or parental benefits

(d) If the plan member refuses or fails to participate in an approved modified work or rehabilitation program as required by the insurer

(e) If the plan member is outside of Canada, either permanently or temporarily, and this absence is not previously approved by the insurer

(f) For any injury sustained while operating a motor vehicle under the influence of any intoxicant or with a blood alcohol level in excess of 80mg per 100 milliliters of blood

(g) An intentionally self-inflicted injury, unless related to a mental health illness

(h) War, insurrection or participation in a civil commotion or riot

(i) Participation in the commission of, or attempt to commit, any criminal offence.

Benefits are also not usually payable during strikes, leaves of absence or temporary layoffs if the disability commences after the beginning of the strike/leave of absence or announcement of the layoff. However, the elimination period can be satisfied during these periods.

Question 20

Outline circumstances under which LTD benefits terminate.

Answer 20

LTD benefits terminate on the earliest of the date the plan member recovers, dies, retires, attains the maximum age under the contract or does not adhere to specific insurer requirements, such as:

(a) Fails to submit required proof of ongoing disability

(b) Refuses or fails to comply with the third-party subrogation provision

(c) Fails to report for a medical examination required by the insurer

(d) Ceases to receive appropriate professional treatment for the condition being treated and, where required, treatment by a relevant and certified specialist

(e) Participates in any occupation for remuneration or profit other than an approved modified work or rehabilitation program

(f) Refuses to participate in a modified work or approved rehabilitation program

(g) Is confined in prison or other similar institution.

Question 21

Identify criteria disabled plan members must meet to continue receiving insured LTD benefits if the plan sponsor cancels the group insurance contract or changes the plan design after benefit payments have started.

Answer 21

If a plan sponsor alters or terminates a group LTD contract, disabled plan members continue to receive LTD benefits as long as:

(a) The coverage was in force and the plan members were eligible at the time the disability started

(b) The plan members continue to meet the definition of disability in the contract.

Question 22

Identify when an insurer is not required to continue paying LTD benefits if the plan sponsor cancels the group insurance contract or changes the plan design after benefit payments have started.

Answer 22

Insurers do not have to continue payments if benefits are provided on an administrative services only (ASO) basis. In this circumstance, the plan sponsor is responsible for continuing to make benefit payments.

Question 23

Describe the purpose of a waiver-of-premium provision in LTD plans and explain how this provision differs for LTD and life insurance.

Answer 23

Under the waiver-of-premium feature, the insurer waives the LTD premiums payable for disabled plan members who are receiving LTD benefits. Waiver of premium for LTD is similar to waiver of premium in a group life insurance plan. However, in some cases, the definition of disability that triggers the waiver under group life insurance is different (e.g., if LTD coverage is based on “own occ” and life insurance coverage is based on “any occ”). This could result in disabled plan members qualifying for the premium waiver under their LTD plan, but not under their group life insurance plan. For this reason, many contracts automatically approve the premium waiver under life insurance once LTD benefits are approved.

Question 24

Describe and provide an example of third-party subrogation of claims.

Answer 24

A subrogation clause requires plan members to reimburse the insurer for any amount they receive as lost earnings from a third party that is responsible for their injury. This is referred to as third-party subrogation of claims.

For example, assume a plan member (a passenger) is disabled in a car accident in which the driver is at fault, and that driver’s insurer makes a settlement payment to the disabled plan member. If the plan member also received benefits under their LTD plan, the plan’s insurer can recover the part of the settlement that covers loss of earnings, where permitted by law.

Question 25

Describe approaches used for funding LTD plans.

Answer 25

Plan funding options depend on many factors, including the size of the plan, the volume of premiums, the type of benefit, current regulatory requirements, the degree of risk the plan sponsor is prepared to assume and the insurer’s willingness to underwrite the arrangement. Funding arrangements can include insured nonrefund, insured refund and self-insured.

In practice, the most common LTD funding method is insured nonrefund (also called “nonrefund accounting”) because it limits the plan sponsor’s risk to premiums due. If using the insured refund arrangement (also called refund accounting), plan sponsors can choose to purchase pooling protection to limit their risk (either duration pooling or large-amount pooling). With duration pooling, the insurer sets aside a portion of the LTD premium that represents the expected LTD claim payments beyond a specified period of time. In return, both the claim payments and disabled life reserves are fully insured in respect of claims charges past the duration limit. Duration pooling limits are typically established for two- to five-year periods. With large-amount pooling (“individual high-limit pooling”), the plan sponsor pays a pool charge for protection with respect to claims on any one insured individual in excess of the pooling limit or pooling threshold.

However, refund accounting can be problematic for employee-pay-all plans since current plan members bear the burden of any deficit recovery margins resulting from the experience of past plan members. It can also be difficult to return surpluses to employees. The surplus may exist in part because of premiums paid by members who are no longer insured under the plan.

Self-insurance is generally not feasible where there are fewer than 1,000 plan members because of the increased risk this presents to plan sponsors, and it is prohibited in certain jurisdictions.

Question 26

List the advantages to plan sponsors of funding LTD plans through an insured arrangement vs. a self-insured arrangement.

Answer 26

Advantages to plan sponsors of funding LTD plans through an insured arrangement are:

(a) It may reduce the plan sponsor’s exposure to changes in claims levels from year to year

(b) It puts the plan sponsor and plan members at arm’s length in cases of disputed claims

(c) It relieves the plan sponsor of plan administration duties

(d) It may reassure plan members that benefits are actually available and the plan will continue to cover claims

(e) It does not require the plan sponsor to set aside disabled life reserves to ensure claim payments in the future (the insurer holds these reserves)

(f) It is not subject to payment of the payroll taxes that apply to self-insured plans with administrative services only (ASO) arrangements.

Question 27

Outline the accounting requirements that apply to LTD plans.

Answer 27

Postemployment benefits, including LTD plans, are subject to accounting requirements set out in Section 3462 and Section 3463–Employee Future Benefits of the Chartered Professional Accountants (CPA) Canada Handbook or the requirements in International Accounting Standard (IAS) 19 Employee Benefits for publicly traded companies.

If any benefits from these plans are not service-related (which is the norm for LTD plans), it is necessary to recognize a liability equal to the present value of the expected future payments at the plan sponsor’s measurement date if there are plan members receiving the benefits, unless the significant risks of the plan have been transferred to an insurer through an insurance arrangement. If the significant risks have been transferred, the liability is limited to any outstanding premiums at that time.

If the significant risks have not been transferred (i.e., it is a self-insured plan), the plan sponsor’s financial statements must include a liability if any disability benefits were being paid at that time (i.e., at the end of the financial statements’ accounting period). The liability is the present value of all future expected disability payments for plan members disabled on or before the measurement date (usually referred to as a “disabled lives reserve”). The expense is the benefits payable during the accounting period plus the change in the disabled lives reserve.

If any benefits from these plans are service-related (rare for LTD plans), the accounting standards require accrual of the liability over the plan member’s service with the plan sponsor. If the significant risks were transferred to an insurer, the liability is limited to any outstanding premiums at that time (if they were being paid over time).