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