CFP - Risk Management and Insurance Planning (11% of the exam) - Section C.20

Disability income insurance (individual and group)

Definitions of disability (own occupation, any occupation, modified), elimination and benefit periods, benefit amounts and taxation depending on who paid the premium, riders such as residual and cost-of-living, and how group coverage and Social Security disability interact with an individual policy.

Disability income insurance

Practice question for this objective

Free sampleRisk Management and Insurance Planningmedium

Marisol, aged 38, is an architect with an individual disability income policy paying a full monthly benefit of 8,000 dollars. The contract includes a residual disability benefit that, once the elimination period has been satisfied, pays the percentage of monthly earned income lost multiplied by the full monthly benefit, provided the loss exceeds 20 per cent. Her pre-disability monthly earned income was 12,000 dollars. After recovering from a back injury she returns to her practice on reduced hours and earns 7,200 dollars a month. What monthly residual benefit does the policy pay?

A4,800 dollars a month, being the shortfall between her pre-disability monthly earned income and the amount she now earns in her practice.
B8,000 dollars a month, because a residual claim continues to pay the full contract benefit for as long as the insured remains under a doctor's care.
CNothing, because returning to work in her own occupation on reduced hours ends a claim under the residual disability provision of the contract.
D3,200 dollars a month, being the 40 per cent loss of monthly earned income applied to the full monthly benefit of 8,000 dollars. Correct

A residual disability benefit pays the percentage of pre-disability earned income lost applied to the full monthly benefit, not the raw income shortfall. Work the residual formula in two steps. First find the percentage of earned income lost: 12,000 dollars less 7,200 dollars is a 4,800 dollar shortfall, and 4,800 divided by 12,000 is 40 per cent, which clears the 20 per cent threshold stated in the contract. Second, apply that percentage to the full monthly benefit: 40 per cent of 8,000 dollars is 3,200 dollars. The benefit is bounded by the contract amount rather than by the income lost, which is why a client whose full benefit replaces only part of her income sees the residual payment fall short of the raw shortfall.

Why A is wrong: This pays the raw income shortfall, which is a common error, because the residual formula applies the percentage of income lost to the contract benefit rather than reimbursing the lost dollars themselves.

Why B is wrong: The full benefit is payable during total disability, and some contracts pay it in full for a short recovery period, but a partial return to work at 60 per cent of prior income puts this claim on the residual formula.

Why C is wrong: This confuses the residual benefit with a modified own-occupation definition, since the residual provision exists to keep paying a proportional benefit after the insured goes back to work at a reduced income.

Why D is correct: Correct, because the 4,800 dollar shortfall is 40 per cent of the 12,000 dollar pre-disability income, and 40 per cent of the 8,000 dollar full benefit is 3,200 dollars.

See more CFP practice questions, answers explained.

Exam traps in Risk Management and Insurance Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The full 5,000 dollars a month is taxable income, because benefits from an employer-sponsored group disability plan are taxable to the employee.
Why it is wrong: This is tempting because the plan is a group plan bought through the employer, but the tax treatment follows who paid the premium rather than who sponsored the plan, so the share Priya funded with after-tax dollars stays tax free.
An any-occupation definition, under which he is disabled while he cannot perform the duties of any occupation for which he is reasonably suited by education, training and experience.
Why it is wrong: This is the cheapest definition and is common in group plans, but a surgeon able to teach and consult would be judged capable of a suitable occupation, so the claim would be denied at the point he most wants it paid.

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