The correct answer is “over insurance.” The monthly benefit for an individual disability income policy is typically limited to a percentage of the insured’s income to prevent over insurance. Over insurance occurs when the policy’s benefits exceed the insured individual’s actual income, which can create several adverse consequences for both the policyholder and the insurance company.

Here’s a detailed explanation of why over insurance is the correct answer and why the other options are not correct:

Over Insurance (Correct Answer):

When the monthly benefit provided by a disability income insurance policy exceeds the insured’s actual income, it results in over insurance. This can lead to several undesirable outcomes. Over insurance creates a moral hazard, as the insured individual might have little incentive to return to work or make a full recovery if they are receiving more income from the policy than they were earning while working.

It can also lead to a situation where individuals purchase disability insurance solely to profit from the policy, rather than to replace their lost income in case of disability, which can be financially unsustainable for insurance companies.

Moreover, over insurance can have implications for the overall stability of the insurance industry. If a large number of policyholders are overinsured, insurance companies might face financial strain, as they would be obligated to pay out significantly more in benefits than they had anticipated. This can affect the financial health of the insurance company and potentially lead to higher premiums for all policyholders.

Now, let’s discuss why the other options are not correct:

a) Claims:

Limiting the monthly benefit is not aimed at avoiding claims, but rather ensuring that claims are reasonable and in line with the insured individual’s actual income. Claims are the primary reason for having disability income insurance, as they provide financial support in the event of a disability preventing the insured from working.

b) The elimination period:

The elimination period is the waiting period before benefits become payable under a disability income insurance policy. It is not related to limiting the monthly benefit. The elimination period is designed to help manage costs for the insurance company and ensure that the policy is intended to cover more extended periods of disability rather than short-term issues.

d) Adverse selection:

Adverse selection refers to the situation where individuals with a higher likelihood of making a claim are more likely to purchase insurance. In the context of disability income insurance, adverse selection would occur if individuals with a higher risk of disability were the primary purchasers of the insurance.

Limiting the monthly benefit is not primarily aimed at avoiding adverse selection but rather at preventing over insurance, as explained earlier. Insurance companies manage adverse selection through underwriting practices, rating, and premium adjustments.

In summary, limiting the monthly benefit for an individual disability income policy to a percentage of the insured’s income is primarily aimed at preventing over insurance. Over insurance can lead to moral hazards, financial instability for insurance companies, and potentially higher premiums for all policyholders.

It is essential to strike a balance between providing meaningful coverage for policyholders while ensuring that benefits do not exceed the insured’s actual income, thereby maintaining the integrity of the insurance system. The correct answer, “over insurance,” accurately reflects the rationale behind this practice.