Long Term Care Insurance – Reducing The Implied Leverage of Insurance

risk

By Michael Kitches

Insurance functions best when it is used to cover high-cost low-probability risks — things that aren’t likely to occur, but would be devastating if they did. Technically, paying insurance premiums on an ongoing basis has a slightly greater expected loss than just retaining the risk, but the trade-off — converting a potential financial disaster into a manageable ongoing premium — is appealing.

Yet long-term care coverage has a challenge: What was once believed to be a higher-cost, lower-probability event has now turned into a very high-probability event with an increasingly large volume of lower-cost claims. As a result, long-term care insurance has begun to morph from effective insurance into something that looks more like just prepaying long-term care expenses in advance — at a high premium rate and with little insurance leverage.

Perhaps it’s time to reform long-term care insurance policies so that they once again focus on high-impact, low-probability events. For instance, what if elimination periods for long-term care insurance were increased to allow for a two- or three-year deductible, instead of today’s common three-month period? That way individuals could take the significant premium savings and use it to cover their care during that time period.
Could such an increase in deductibles reduce the cost of long-term care insurance coverage enough to make it affordable once again to at least a much larger segment of the general public?

SHIFTING ODDS

For insurance to effectively manage risk, an event should have both low likelihood and relatively high impact.

When insurance covers a small number of high-impact events, the cost of operating the insurance company is very small relative to the amount of premiums and potential claims. When insurance covers low-impact events (with lower-cost claims, but at greater frequency), overhead ends up consuming a larger percentage of the premiums — reducing the implied leverage of the insurance.

In fact, if the risk is inexpensive enough, it would be much cheaper to simply self-insure and avoid the share of premiums that goes to the insurance company’s overhead and profits — especially if the likelihood is so high that the expense can be reasonably anticipated.

Unfortunately, this dynamic of high-cost/low-probability versus low-cost/high-probability events is present in the world of long-term care insurance. When first created, the insurance was intended as a form of coverage to protect against the high-impact but lower-probability risk of needing long-term care assistance at an advanced age; one key study estimated that the risk of needing a nursing home was 27% for men and 44% for women (which isn’t all that low).

Yet with sustained improvements in medicine over the past several decades, life expectancy has increased. Far more adults (and even more affluent planning clients) will reach the advanced age where some type of long-term support is necessary.

In fact, the real risk of a 60-year-old needing long-term care is now estimated to be a whopping 50% (and some research suggests it’s as high as 65% for a 50-year-old female). In other words, on average one out of every two people who are now age 60 will need long-term care at some point during their lifetime. Needing any long-term care has morphed from (somewhat) low probability to increasingly high probability.

In addition, recent research suggests that long-term care may actually be a lower impact event than estimated previously. Industry data from the American Association of Long- Term Care Insurance shows that 45% of nursing home stays last one year or less, and 75% last no more than three years. The probability of a true high-impact event — say, a five-year nursing home stay — is only 12%. (Notably, these probabilities would be a bit higher if you include home care, as well.)

A 2013 study suggests the average nursing home stay could be as short as just over a year. The researchers found that previous studies may have failed to recognize how often people enter facilities but recover and are discharged. This means even those with two to three years’ worth of cumulative stays may be doing it with a series of shorter long-term care events, not one extended high-impact event.

Why does this matter? Because, as noted earlier, if the need for long-term care is actually a rather high-probability but fairly low-impact event — with 50% probability of needing care, but stays averaging little more than a year — then traditional LTC insurance may be little more than prepaying long-term care expenses, and not really functioning as effective insurance.

THE FIX

The solution is to restructure long-term care insurance once again to focus on low-probability, high-impact events.

Comments (2)
It is good to read what I have been waving my arms about since 2000 when I retired from the Federal system and was subsequently bombarded by LTCI marketing material(Hancock and NY Life, as I recall), fully endorsed by the OPM director. This kind of ‘insurance’ is filled with perverse incentives. Basically, insurers are selling a form of ‘insurance’ that will not be subject to claims for 30 to 40 years and so to maximize current sales these companies are incentivized to use actuarial data making the current premium as low as possible for a given level coverage and delay premium hikes as long as possible so as to delay lapse rates but as future premiums sharply rise, count on those lapse rates to decrease long term liabilities thus increasing the ability to pay future claims. And as Kitces points out, the high projected claims rates makes this less insurance and more a future cost sharing scheme, much as Dental Insurance works.The other topic I challenge Mr. Kitces (or others) to explore are future claims denials. Like some severe forms of disability insurance claims, the claimant will likely be physically and mentally incapacitated and unable to make an insurance claim when they are suffering from advanced dementia or the inability to perform 2 of 6 ADLs. This means family members will likely have to file the claim. How will they respond if the insurer denies the claim? Since Qualified LTCI may not use ‘medical necessity’ to initiate benefits, it will be up to the insurer (actually, their contracted medical team) to determine when an ADL can or cannot be performed. So when the letter denying the claim is received by the family member, what will they do next?How hard a LTC insurer will be to deny claims in 20 to 30 years when most of the QLTCI claims start to roll in will be dependent on their financial health…which I’ve read has improved over the past 2-3 years. This is good, and hope the claims process on these goes well. But the risk here to policyholders is significant, and I encourage anyone considering buying a QLTCI policy to consider other options first.

Posted by Bruce M | Thursday, January 22 2015 at 7:14PM ET
LTC insurance is contributing to more wellness and shorter lengths of stays in skilled care. My clients use their LTC policies to recover at home from surgeries and illness. Over 300 claims have not resulted in even one nursing home placement. Staying home with relatives and intermittent outside assistance helps avoid long facility stays. I shudder to think what a year or two of no help after a major health event would do to families and clients’ well-being. When you can’t walk, you need help with everything! For most retired folks, LTC is a cash flow problem. You use up your savings and can wind up with a long life and no income from depleted investments. Cost of care can be $40,000 to $100,000 a year.
I know it is not a charity, but the insurance industry has done a great job for my clients, and I hope interest rates climb and we can continue to provide this life-saving product at a sustainable profit.
Posted by Barbara H | Thursday, January 22 2015 at 10:55PM ET

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