Protecting Yourself with Insurance

Filed under Personal Finances. Fact checked on May 24, 2012.

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The function of any type of insurance coverage is to insulate you from some or all of the economic impact of a loss. Health, disability and long-term care insurance can enable you and your business to remain financially solvent during personal and familial hardships.

The primary function of any type of insurance to insulate the policyholder (you) from some or all of the economic impact of a loss. You pay a relatively small amount as premiums to your insurance company, and the company promises to compensate you if a covered loss occurs, even if the amount of this loss is many times the amount that you paid as premiums.


Example

On February 24, 2013, Keith Moore paid a yearly homeowner's policy premium of $500 on his $100,000 house. The next day, the house burned down. His insurance company later paid him $100,000 for the damages.

If Keith were a small business owner, it's fairly easy to imagine that his business might well be seriously affected. It may even be a home-based business, with destroyed business records, inventories or machinery. Besides the loss of assets that must be replaced, the owner will feel the pinch in terms of lost personal income.

What might not be as apparent to the would-be or fledgling business owner is that an economic loss falling on the owner, which on its face has nothing to do with the business itself, can still bring the business to its knees.

In the example above, even if Keith's $100,000 loss is completely unrelated to the business, if he didn't have insurance coverage the loss might force him to withdraw needed money from the business. This could reduce the business's ability to build or market its products or services, or at least hinder its potential growth. And even if Keith doesn't take anything out of the business, the loss may mean that banks would no longer be willing to extend credit to the business, viewing Keith's personal financial distress as making his personal guarantee on his business's loans worthless.

Thus, as a business owner, when you think about insurance coverage, keep in mind the fact that what hurts the business hurts you, and what hurts you hurts your business. As a practical matter, this means that you have to insure against the same type of personal risks that the non-business owners of the world must, but you must also insure against the type of risks that are related to the business. It's either this, or be willing to face the consequences when an uninsured loss strikes.

Some types of insurance products, such as life insurance and annuities, may also function as investments as well as asset protectors. See our article on life insurance for a discussion of how to choose the best life insurance policy. 

This article focuses on the following types of insurance:

  • annuities
  • disability
  • health
  • long-term care

Understanding Annuities as "Upside Down" Life Insurance

An annuity is sometimes referred to as an "upside-down life insurance policy." With a traditional life insurance policy, you normally pay a relatively small periodic amount in the present to get a large sum in the future. 

With an annuity, you normally pay a larger amount now in order to get periodic payments (starting immediately or at some point in the future) over an extended period of time. While a life insurance policy primarily protects your beneficiaries against the economic harm of premature death, an annuity is meant to protect you (and your dependents, or children, if you live long enough!) from the economic harm of outliving your life savings and other resources.

Annuities are available in various forms, including the following:

  • Deferred annuity. A deferred annuity is one in which purchase payments are made in a lump sum (single premium) or installments, and annuity payments are to commence some time in the future.
  • Immediate annuity. An immediate annuity is one bought with a lump sum, with the annuity payments to commence immediately.
  • Fixed annuity. A fixed annuity is one designed to assure the buyer of a lifetime (or other fixed period) of payments of a guaranteed fixed amount. The amount of these payments is based on the age of the annuitant (the person whose life the annuity is computed on) at the time the payments are to commence, the sex of the annuitant, and the rate of interest that the insurer will assume will be made from the purchase funds paid by the annuitant.
  • Variable annuity. A variable annuity (also known as a "market value account") is one in which the insurer invests the premiums (less investment charges) in a portfolio of securities. The value of the annuity provided varies with the performance of the portfolio. The purchaser of a variable annuity does so with the hope that the performance of the underlying securities will outstrip the return that would have been possible from a fixed annuity. Although there are never any guarantees, over the long haul, this looks like a sound bet.

Both the amounts that build up within the annuity (during the accumulation phase), and the amounts that are received as annuity payments (during the distribution phase), can qualify for favorable federal income tax treatment. Thus, purchasing an annuity can become a tax-deferred method of saving for retirement, especially for those business owners who don't wish to set up a retirement plan that covers all their employees.

Disability Insurance Works When You Can't

Throughout much of a business owner's life, the chances that he or she will become disabled are greater than the likelihood of early death. However, many more people have life insurance policies than have disability policies.

Unlike a life insurance policy, which is primarily designed to provide a lump sum payment in the event of death, a disability policy provides income to an individual who becomes disabled because of an accident or illness. There are many kinds of disability policies, which differ on how liberally or restrictively they define disability, how much periodic income they pay, how long you have to wait (called the "elimination period") for payments to begin, and how long payments will go on.

Deciding if Disability Insurance is Right for You

How you should plan to meet the threat of disability depends on how you answer the following question: If you become disabled (whether permanently or not), could family members or others keep the business running, even at reduced profits, until you return?

If the answer is yes. Because you believe that your business can be continued by others after your disability, chances are that the business does not require your constant personal supervision or specialized skills or knowledge that only you possess. However, it's unlikely that whoever runs it for you in the interim will be able to turn the same profit you did. Income from a disability policy could help make up the difference for you.

Because you foresee the business continuing during your disability, another type of disability policy could be a good idea—disability overhead insurance. Upon the owner's disability, such a policy pays out a portion of the business's fixed (overhead) expenses. In this way, the business may have a better chance to survive a period of decreased profits until the owner returns.

If the answer is no. If you believe that your business can't be operated by family members or others while you are disabled, it's probably true that your business depends on your constant supervision or specialized skills and knowledge that only you have. 

Because this is true, there's no need for disability overhead insurance, which upon the owner's disability, pays out a portion of the business's fixed (overhead) expenses. But the fact that you don't expect your business to survive the period of your disability means that you probably have a greater need for disability insurance than if the business continued.

Common Disability Policy Provisions

If you are considering the purchase of a disability policy, you should note that such policies may differ in several different ways:

  • When do the benefits start? Do benefits begin at the onset of disability or is there a waiting period? Common elimination periods include 30, 90 or 180 days. A lengthy waiting period gives no protection for short-term disability.

  • How is disability defined? Older policies paid full benefits for the inability to perform the exact duties performed before the disability, but no benefits if the disability permitted some gainful employment. Newer policies may grade benefits with the job function permitted by the disability.

  • Is there a monetary limitation on payments? State law may impose such a limit. No matter what the owner earns or how the policy is phrased, an insurance company may not pay out more than the maximum permitted by law. For example, a business owner who earns $150,000 per year has a policy that promises to pay 80 percent of the pre-disability salary in the event of permanent and total disability. If state law sets a $100,000 limit on such payments, that is all that will be paid to the owner, even though it appears that the policy will pay $120,000 ($150,000 x 80 percent). In such instances, the owner has "overpaid" premiums, since he or she did not receive the full amount contracted for under the policy. (A good insurance agent will alert you to this possibility regarding your own state, but if you move to a new state, check with a local agent to see whether your existing policy will conflict with your new state's laws.)

  • Will multiple policies generate multiple benefits? State law may also affect whether benefits are cumulative. If they are, there's no use in carrying multiple policies. For instance, an owner has three separate disability policies, each one providing a benefit of $100,000. If state law requires that benefits be cumulative and if there is a $100,000 limit, each insurer will contribute 1/3 of the $100,000. Thus, even though the owner paid for three separate $100,000 policies, he or she actually gets the benefits as if only one of these policies was purchased.

Of course, all this only pertains to you. Be sure to read more about disability insurance in the context of employee benefits if you have employees .

Health Insurance Protects You When You Are Ill

Just as you may be put out of business by a large legal judgment against you if you don't have adequate liability coverage, the same thing could happen because of a prolonged hospital stay or medical treatment if you lack sufficient health insurance coverage.

Comparing Policies

Besides the differences in premiums to be paid and yearly deductibles to be met, there are many ways that health insurance policies can differ. You should consider the following factors when comparing policies:

  • Maximum lifetime benefit. The higher, the better. Some policies have unlimited benefits, while others provide limits (such as $250,000, $500,000 or $1,000,000) on the total amount of benefits that will be paid in a lifetime.

  • Co-payment. The co-payment amount is the percentage of covered expenses that you must pay. If the policy provides for a 10 percent co-payment, you will be reimbursed for 90 percent of your covered expenses. If it provides for a 20 percent co-payment, you will be reimbursed for 80 percent of your covered expenses.

  • Limitation on yearly per-person outlay. This represents the maximum amount of unreimbursed expenses (such as $2,000) that you would have to pay for each covered individual in any one year. It includes the amount of your deductible and a portion of the co-payments made by you during the year.

  • Coverage for type of care. Policies often apply different co-payment amounts and length-of-stay limits to the following: hospital rooms and doctor fees, surgical procedures, dental procedures, mental health services and out-patient care.

Understanding the Tax Treatment of Premium Payments

Corporations generally can deduct the full cost of health insurance premiums paid with respect to their employees. In recent years, self-employed individuals, partners, and S corporation shareholders, have also been able to fully deduct their health insurance premiums.

Obtaining Health Insurance as a Small Business Owner

Before you run out to purchase your own health policy, make sure that you haven't overlooked alternatives that may be close at hand: coverage under your working spouse's employer-provided plan, or your former employer's COBRA coverage.

If you can get coverage under your spouse's employer-provided plan through a larger payroll deduction from his or her paycheck, this probably will be your least expensive option.

Continuing medical coverage (known as COBRA coverage) that a former employer must, by federal law, make available to you for a period of time following your separation from employment may be more expensive than some policies available through other sources. However, COBRA coverage definitely makes sense in these two instances:

  1. if you are uninsurable because of poor health
  2. if your coverage is almost expired and you don't know if you can get new coverage before the old coverage lapses

In most cases, COBRA coverage lasts for 18 months after your separation from employment.

Coverage Via Professional, Business and Trade Associations

You may be a member of, or be eligible to join, an association that offers health insurance. If so, take a look at the coverage available. It may or may not be a good deal.

Example

The National Association for the Self-Employed offers health care benefits and options to its members, as do the National Association of Professional Women and the National Restaurant Association. Search for your industry's leading trade organizations and you may be surprised about the insurance options available.

If an association that you don't belong to offers good coverage at a reasonable premium, it may be reason enough to join.

Considering Health Maintenance Organizations

Health maintenance organizations (HMOs) are managed care organizations that you may be eligible to join. They aim to offer health care services at affordable premiums, but to do so they markedly decrease your choice of doctors and hospitals that you can use.

Because HMOs typically require rather minimal payments for preventive and routine care provided at a member doctor's office, the HMO co-payment provisions are usually not very significant other than for "out of the ordinary" medical expenses or procedures. Provided you follow the certification rules of your plan, most of your major medical expenses will be completely covered.

Weigh the Cost of Preferred Provider Organizations and Individual Plans

Preferred provider organizations (PPOs) are also managed care organizations. If you are a member, you can go to any doctor or hospital for any covered care, but the amount that the PPO will reimburse you will be lower if you choose a doctor or hospital that is within the PPO's preferred providers network.

Individual Health Insurance Policies

This is usually the most expensive insurance option and, generally speaking, should be considered after other options have been carefully explored and can't meet your needs. 

Whether, and at what cost, you can obtain an individual health policy from an insurance company will depend on your age, health, lifestyle and family history. More flexibility may be available with the purchase of your own policy, but that will usually come at a much steeper cost.

You may be able to significantly lower your premiums if you will agree to a high annual deductible amount, such as $1,000 or $2,000 per person. Although the prospect of having to pay the first $1,000 or $2,000 of medical expenses before even qualifying for any coverage may seem unreasonable, it may be a sensible alternative. 

If you could weather the worst-case situation of having to pay the full deductible amount for all the covered individuals in your family within the year, this high deductible may be for you. At a significantly lower premium than a comparable policy with lower deductibles, the high deductible plan would give you the assurance of coverage for catastrophic health care costs that could otherwise cause you to lose your house and business. Plus, you can offset a portion of the costs of a high-deductible health plan by opting to establish a Health Savings Account, discussed below.

Using Health Savings Accounts to Pay Costs with Pre-Tax Dollars

A health savings account (HSA) is a tax-exempt account that you set up with a qualified HSA trustee (such as a bank) to pay or reimburse certain medical expenses you incur. You must be an "eligible individual" to take advantage of an HSA. Although you don't need IRS permission or authorization to set up an HSA, you do need to with a trustee, such as a bank or an insurance company.

To be an eligible individual and qualify for an HSA, you must meet the following requirements.

  • You must be covered under a high deductible health plan (HDHP), described later on the first day of the month.
  • You have no other health coverage except:
    • coverage for liabilities incurred under workers' compensation laws, tort liabilities or liabilities related to ownership or use of property
    • coverage for a specific disease or illness
    • coverage that pays a fixed amount per day (or other period) of hospitalization
    • coverage for accidents, disability, dental care, vision care and long-term care
  • You are not enrolled in Medicare.
  • You cannot be claimed as a dependent on someone else's most recent tax return.

High Deductible Health Plans (HDHP)

A high deductible health plan is exactly what the name implies: It is a medical insurance plan that has a deductible that is significantly higher than the average health insurance deductible. However, it also sets a maximum amount that you must pay each year.

This maximum is the limit on the sum of the annual deductible and out-of-pocket medical expenses that you must pay for covered expenses. Out-of-pocket expenses include co-payments and other amounts but do not include premiums. These amounts are set by law and are adjusted annually if warranted by inflation.

Tip

An HDHP may provide preventive care benefits without a deductible or with a deductible below the minimum annual deductible. Some examples of preventive care are annual physicals, including routine tests, routine prenatal and well-child care, child and adult immunizations, smoking cessation and weight loss programs and screenings for cancer, heart disease, mental health conditions, substance abuse and other routine screenings.

The following table shows the minimum annual deductible and maximum annual deductible and other out-of-pocket expenses for HDHPs for 2012.

Limitation Self-only coverage Family coverage
Minimum annual deductible $3,100 $6,250
Maximum annual deductible and other out-of-pocket expenses $6,050 $12,100

Contributions to HSAs and MSAs made by self-employed individuals will be deductible in computing their adjusted gross income. Money in these accounts can then be used to pay for qualified medical expenses, including the insurance deductible and co-payments. Any money left over at the end of the year can be saved for future years, unlike Flexible Spending Accounts (FSAs) which are "use it or lose it."

If you have employees, be certain to consider health insurance in the context of employee benefits.

Long-Term Care Insurance Covers Custodial Care

Long-term health care contracts are relatively new arrangements designed to provide insurance that will meet your health care needs should you become chronically ill or disabled after reaching a specified age, such as 50. 

As is apparent from the name, long-term care policies greatly expand the time period over which benefits will be paid out, when compared to standard accident and health policies. Another advantage is that, unlike Medicare coverage, long-term care contracts will cover the cost of custodial care, as well as skilled nursing care. These two advantages often make long-term care contracts a preferred way of pre-funding nursing home care for the elderly.

Should You Consider Long-Term Care?

Although federal government estimates states that 70% of Americans living today will need long-term care before their death and the average cost of "custodial care" (which is not covered by Medicare) can easily exceed $80,000/year at current prices, whether you need to add long-care insurance to your insurance portfolio depends upon a number of factors. 

Clearly, the more assets that you will have available to provide for your long-term care, the less likely you will need additional insurance. On the other hand, if you have a family history of degenerative disease or long-life with increasing frailty, you may want to spare your family the burden of providing care and prevent all of your assets from going to the Medicare spend-down necessary to qualify for care in a public aid facility.

Tip

The cost of long-term care premiums increase with your age when the policy is purchased, so it is never too early to start investigating your options. The National Clearinghouse for Long-Term Care Insurance, part of the federal Department of Health and Human Services, can provide objective information to help you start evaluating your situation.

Long-Term Care May Be Taxed As Health Care

If certain specified requirements are met, long-term care insurance contracts will generally receive the same income tax treatment as accident and health policies. That means that amounts received under a long-term care insurance contract are excluded as amounts received for personal injuries and sickness. This exclusion is capped on per diem contracts by the IRS.

Company-paid premiums for long-term care can be excludable from income tax for the employee. If you purchase the policy as an individual, rather than through your company, the premiums count as deductible medical expenses within certain limits.

For 2013, the limits are:

  • Age 40 or under = $360
  • Age 41 to 50 - $680
  • Age 51 to 60 - $1,360
  • Age 61 to 70 - $3,640
  • Age 71 or over - $4,550

Employer-provided long-term care insurance premiums are not excludable from an employee's income if provided through a cafeteria or other flexible spending arrangement. Premiums paid on long-term care contracts by self-employed persons qualify for a full deduction for health insurance expenses.

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