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Another Insurance Product On The Menu

stethoscope and pen resting on top of paper medical forms

Across corporate America, employees are selecting benefits under their company’s cafeteria plans. Some of their options are more familiar than others.

One of the less widely known is critical illness insurance, a product I had not run across until recently myself. Critical illness insurance, also sometimes called catastrophic illness insurance or “dread disease” insurance, is designed to supplement traditional health insurance if you develop certain serious illnesses or health conditions, such as cancer, a heart attack or a stroke. It is not brand-new, but it has recently gained popularity in the U.S. as a supplement to health insurance, a substitute for disability insurance or both.

The idea of critical illness insurance originally came from Marius Barnard, a South African surgeon who was concerned about his patients’ inability to handle their medical bills, especially after heart surgery. In 1985, Barnard proposed a form of insurance specifically meant for heart attacks, coronary bypass surgery, stroke and cancer. By keeping the insurance’s scope narrow, insurers could keep premiums relatively low. By the mid-1990s, the concept caught on with American insurers, who observed that even people with health insurance could face burdensome medical bills after experiencing a major medical emergency or receiving a serious diagnosis.

These days many people opt for high-deductible health plans in order to try to keep a handle on sharply rising premium costs. This means that people enrolled in such plans may be responsible for a large proportion of their medical bills, even when their insurance works exactly as designed. The Affordable Care Act limits the overall out-of-pocket expenses a plan can impose ($7,350 for an individual and $14,700 for a family in 2018), so in a perfect world, Americans would have enough resources in their emergency funds, health savings accounts or other accounts to cover these costs in a worst-case scenario. In reality, many Americans have no emergency savings at all, and many more have less than three months’ worth of expenses set aside.

Critical illness insurance typically provides a lump sum payout to those who experience a covered condition or disease. Some plans may also offer regular benefits in periodic installments. Benefits can help the individual pay for medical services that insurance doesn’t cover, but also a variety of other expenses, including household bills, child care, transportation to and from treatment, or modifications to homes or vehicles if the patient faces long-term mobility issues. Plans vary, but beneficiaries may receive anywhere from a few thousand dollars up to $100,000.

Premiums for critical illness insurance tend to be modest compared to health or disability insurance. This is because insurers narrowly define the type of illness that qualifies for a payout. While today many plans cover much more than the four conditions Barnard originally specified, they still restrict which illnesses they cover. Chronic illnesses, such as Type 2 diabetes, are frequently exempted; some specific types of cancer or a cancer diagnosis that is not life-threatening may not be covered, either. Plans that cover more illnesses generally entail higher premiums. Critical illness policies also typically restrict benefits, or sometimes cancel the policy outright, after the insured reaches a certain age (often 75). And many plans require that the insured survive a certain period of time after diagnosis before he or she is eligible for benefits.

I view this sort of insurance as a lottery ticket, much like accidental death and dismemberment insurance. In both instances, you can get a generous payout in return for a modest premium, but only if you suffer a particular loss in a relatively unusual way. Accidental death and dismemberment coverage, as the name suggests, pays benefits if an accident kills or dismembers the covered individual. But the policy only applies if the incident is proven to be an accident and not covered by one of many exceptions, such as accidents caused by mental or physical illness. Disability insurance compensates you if you can no longer work for any broadly defined reason, and life insurance compensates your heirs for death from most causes. But accidental death and dismemberment coverage is cheaper, because it narrows the probability that any given insured will collect benefits.

Like lotteries, some critics argue, critical illness insurance may benefit from a cognitive bias that means buyers overestimate the chances of something they have heard a lot about but which is actually relatively unlikely. Cancer is a frightening prospect, and sadly more common than a major lottery payout. But there are many less deadly, but still serious and costly illnesses that could put a strain on your finances and make it hard or impossible to work full- or even part-time. If you become seriously ill with something other than the narrow list of covered illnesses, critical illness insurance won’t help you.

As a practical matter, I suspect most people use critical illness insurance as a low-cost substitute for disability insurance. Actuarially, it is more like a life insurance product whose death benefit is contractually payable in advance in limited circumstances, and which is designed to automatically lapse at 75 or earlier.

While there may be some instances where critical illness insurance makes sense, most people would do better to consider alternatives. Disability insurance provides income if you cannot work for medical reasons, without the narrow limits of critical illness insurance. Individuals who are mainly concerned about high health insurance deductibles could instead contribute to a health savings account or flexible spending account, which can offer tax savings and may be used to pay for a wide variety of medical expenses. It is also good idea to fund a separate emergency savings account, which can help cover nonmedical costs connected to illness, and which still will be available to you if you are lucky enough not to need it for that reason.

If you decide to pursue critical illness insurance, either on its own or as a rider to your life insurance policy, you should take care to read the fine print and understand exactly what you’re buying. These policies are cheap for the same reason a lottery ticket is cheap. But buying lottery tickets does not constitute financial planning, and this financial planner doesn’t buy them.

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