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Graded vs. level premium disability insurance: Which is better & why?

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Nobody likes to have their insurance premiums increase. It usually indicates that you’re getting older (like when your term life insurance rates increase) or that you’ve had a fender bender (when your auto insurance rates go up).

However, in some instances, like in the case of buying disability income insurance, some people prefer purchasing a policy with premiums that are going to increase, known as graded disability insurance premiums, as opposed to buying a policy with level premiums that will remain the same for the life of the policy.

Why would someone prefer a policy with graded premiums over one with level premiums? Let’s look at each, then apply that knowledge to your situation and see which is better.

Let's dig in.

Level premium disability insurance, explained

Level premiums for long-term disability insurance are similar to those for permanent life insurance, like whole life insurance or universal life insurance. They remain constant for the life of the policy.

Level premiums may, at first glance, seem like an obvious choice compared to graded premiums that increase over time, but the actual cost of level premiums should be considered. In reality, and actuarily, insurers overcharge in the early years of a disability insurance policy with level premiums.

When determining premiums for disability income policies, insurers have actuaries determine the risk of insuring policyholders throughout the entire coverage period, then calculate a level premium that will be high enough to cover the more significant risks and higher costs associated with advancing age.

This means that a younger policyholder will pay more than they should, based on their risk level, in the policy's early years. It also means the insured will need to keep the policy until the maximum coverage age to receive the full value of selecting the level premium approach.

While level premiums are appealing to people who want to be sure their annual costs never increase, it should also be noted that their rates will never decrease. Any savings from a policy’s higher premiums and lower claims in the early years is kept by the insurance company, not the policyholders who are paying a higher premium for certainty and predictability.

Can level disability insurance premiums ever increase?

It seems like an oxymoron, but in some cases, level premiums can increase, proving the need to always carefully read any insurance policy when it’s delivered to you, or preferably read a sample policy in advance.

In some individual long-term disability insurance policies (contracts), there is a clause that allows the insurance company to raise the rates of all individuals within a specific class. For example, an insurer might elect to raise the premiums of all policyholders with an occupational class rating of 3A in the state of California.

However, your level premium cannot be increased if you have a non-cancellable policy. Though insurers may try to raise rates because the number of claims filed for a particular occupational class was higher than anticipated, policyholders with non-cancellable policies will be immune to these proposed rate hikes, which must receive regulatory approval.

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Graded premium disability insurance, explained

Disability insurance policies that have graded premiums, on the other hand, begin with a lower premium that gradually increases over time, with most policies having a step-up in rates every five years. The longer you keep the policy in force, the more likely you’ll file a claim, and insurers raise rates accordingly as you get older.

Graded premiums typically change based on 5-year age bands — under 30, 30-34, 35-39, 40-44, etc. The rates reflect each age group’s actual risk, meaning premiums aren’t inflated during the early years of a policy.

Most policies with graded premiums allow the policyholder the option to switch to a level premium on the policy’s anniversary date. This will enable you to lock in your rate at your attained age, which is your age at the time of the change.

Which is better for you — level or graded premiums?

While graded premiums will eventually cost you more than level premiums if you keep the policy for many years, young professionals often benefit from a graded premium structure early in their careers when they’re paying off student loans and building their practice.

By the time the premiums increase in later years, your income will likely increase, and your overall financial situation will be more stable, making it easier for you to afford higher premium payments.

Depending on your policy, the breakeven age between fixed and graded premium policies is usually in your early 50s. As such, if you’re planning on keeping your policy well into your 50s or 60s, a level premium may make more sense financially.

Consider a level premium policy with a future increase option

If you prefer knowing what your fixed expenses are going to be but want the assurance you can increase your monthly benefit at a later date even if your health has declined, a policy with level premiums and a future increase option rider may be the best policy for you.

This rider allows you to periodically increase your monthly benefit amount without going through medical underwriting. However, you will need to provide financial evidence of insurability, and your total benefit can’t exceed the total allowable level based on the insurance company’s guidelines.

How much should you pay for disability insurance?

There are two rules of thumb when it comes to evaluating the cost of your disability insurance:

  • The cost should be within the range of 1-4% of your annual income; and
  • It shouldn’t exceed 2-6% of the policy’s monthly benefit amount

The best way to minimize your monthly premium is to buy disability insurance when you’re young and in good health.

Learn More: How Much Does Disability Insurance Cost?

When should you buy disability insurance?

The best time to buy disability insurance is, frankly, today. Everyone is at risk of becoming disabled. In fact, the Social Security Administration has found that one out of every four Americans will experience a disability in their career before retirement from either an illness or injury.

If you become disabled and your income stops, your disability insurance policy may be the only thing that allows you and your family to stay in your home, maintain the standard of living to which you’re accustomed, and pay for future needs, like your children’s education.

Talk with a licensed insurance professional today and put this critical piece of your financial plan in place. The peace of mind that comes from securing your family’s financial future is well worth the monthly premium — level or graded.

The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.

— Published March 21, 2022
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