Planning around Long-term care need if one cannot (or doesn’t want to) buy LTC insurance
Other than LTC insurance to finance LTC: a potential tax-advantaged solution for mainly the affluent
‘There is more than one way to skin a cat’ can be true for some when planning how to pay for the things (and mainly the services) triggered by a potential long-term care situation. Underwriting difficulties are more frequent than with other kind of applications, still some people who wouldn’t be able to get LTD or CI plans might be able to buy LTCi. One shouldn’t give up too early because the set of criteria scrutinized is not necessarily more difficult but simply different. Problems can be avoided by applying early and by including LTC insurability considerations when buying LTD or CI policies at younger ages. The strength of the rational/calculative argument for buying LTCi varies somewhat according to circumstances, and mainly according to age. Some people who decide against buying LTCi can still benefit from the strategic application of a certain insurance product, namely: select universal life (UL) policies. The advantage is taxational, and this strategy assumes a large asset base to start with, … or an early start so that the large asset base could be created, by investing serious amounts in the policy, by the time the LTC risk becomes significant. Internal Rate of Return (IRR) calculation doesn’t invalidate call for caution regarding investment value of ROP rider.
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Similarly to any other kind of insurance, there is a strange aspect of Long-Term Care insurance (LTCi) as well: when you already need it you cannot get it. Many people stumble over this simple premise, still there is not much to add to it, … you either get it or you don’t. It’s more important to dwell on some aspects of how the insurance company decides if they accept the application or not, and at what price. The process is called underwriting, and it has two main areas: medical and financial. On the financial side, they want to see if the applicant would likely be able to pay the premium, if they are applying for an amount that is commensurate with their circumstances (net worth, earned income, income potential, etc.), and they want to ensure that they are not over insured, that could create incentives for someone to cheat. On the medical side, they are trying to figure out the chances of a claim happening along a time line. They rely on huge statistical data bases and high-level mathematical-statistical number crunching (so called actuarial calculations), as well as judgment by medical professionals. In addition to basic demographic data (age, gender), for the analysis they collect information about current health status (height, weight, blood pressure, medication used, etc.), health history (of own or sometimes of (grand)parents and siblings), and lifestyle (smoking status, driving record, occupation, hobbies, foreign travel, etc.) as well. Various kinds of insurance involve different sub-sets of this big collection of aspects as relevant and important, therefore the questions asked from someone who applies for one kind of insurance is somewhat different from the questions asked if the application is for another kind.
When shopping around for insurance coverage, the price is an important factor, of course, … but it’s not an unproblematic issue, because it is not immediately straightforward. Insurance companies create their ‘rate books’, in which they set their ball-park prices for various risk categories. (They base it on how they asses the risks in those categories, but also on the company’s financial and market situation and strategies, etc.) When an illustration is made for a prospective buyer, these rate-book ball-park numbers are used. Because there are so many factors in the underwriting process, the exact premium cannot be predetermined or promised in advance: it will come from the underwriters. This is the main reason why it’s a mistake to focus too much or exclusively on the price when submitting an application, and this is why showing better-than-regular rates in illustrations is a bad practice: it tends to raise unreasonable expectations. (It’s much better to look at the range of premiums within which the personal rate will likely fall.) While it may sound scary that one is supposed to sign an application when in fact one doesn’t even know what the price will be, actually there is not much to worry about.
- (i) If a policy is seen as a good buy strictly at a certain price and not a penny more, then it was probably a poorly made buying decision in the first place. (I wouldn’t be able to set any clear rules to say what potential increase one should be comfortable with, of course; all I mean is that there always should be some limit within which one is willing to compromise, … especially if the underwriting revealed some risk considerations one had not been aware of.) The official price offer from the company can be a pleasant surprise as well, a deviation to the other direction from the ‘ballpark number’ or illustration price, … but it is never a problem for customers to accept that.
- (ii) Buying insurance is not a single and final/irreversible act for the buyer; they may change their mind during or even after the underwriting process. The process usually takes weeks (sometimes less, sometimes more, … even months occasionally), then the official verdict is delivered as either a decline or an offer by the insurer, including the price. The client has 10 days to accept or not accept this final offer without any immediate financial consequences. (There might be perhaps consequences later, if/when someone who declined an offer would like to apply for another policy, … but let’s not deviate so far from our topic here.) Even if he/she accepts the offer and starts to pay for the policy, the customer can always cancel the whole contract; on the other hand, the insurer is on the hook, … they cannot cancel the contract unilaterally, and with many policies they cannot later increase the premium either.
Let’s turn now to the specifics of LTCi underwriting. The perhaps most important special characteristic here is that the process heavily relies on cognitive functioning assessment. Based on scientifically validated and standardized methods, there is a personal interview with the applicant, usually on the phone but sometimes face-to-face, an important part of which is this assessment. Some health history facts, let’s say an earlier heart attack, ‘milder’ type of cancer or high blood pressure kept under control, that would easily exclude someone from some other type of insurance, can be deemed as not that important for LTCi underwriting. Another important difference from other kinds of policies is that there is no distinction made in the premium according to smoking status. Finally, the premiums are fully guaranteed only for the first 5 years, and within certain limits afterward.
All in all, the percentage of decline - that is unwillingness to take the risk by accepting the application and offering a contract - by the insurer is much higher in living benefit insurance than in the area of life insurance, and perhaps the highest in this special field of LTC. One reason for this is probably that people wait for too long, they postpone applying until it’s too late because something happens that ruins their chances. Not only is the likelihood for successful underwriting higher if the application is made at a younger age, but then the premiums are significantly lower as well. Another way to avoid LTC underwriting problems is - not for someone who is around or after retirement, but for younger people - to select disability and critical illness (CI) plans which automatically (that is without new underwriting) transform into LTC coverage around retirement, or CI policies that include ‘Loss of Independence’ as a condition that triggers benefit payment. This latter kind of benefit is of a different character (usually a lump sum, as opposed to the regular income or reimbursement stream coming from LTC plans), but the triggering conditions are the same: inability to perform (usually) two activities of daily living (ADL). This difference can be either good or bad news (depending on the length of the future period when LTC will be needed), it would be hard to tell in advance which one.
In a previous post I’ve analyzed why it is usually sensible to take the risk of ‘wasting premium money’ as opposed to taking the risk of perhaps ending up as needing LTC while uninsured. As I pointed it out there as well, there is no way of doing a perfect analysis on this that everybody without exception would find equally compelling. There are hardly ever ‘you must do it this way’ rules in personal and financial matters anyway. (Related to it is that people are entitled to make mistakes in their own affairs, … however, professionals are not entitled to let it happen without speaking up when they see it, I believe.) If we do the same kind of analysis for a 75 years old, and a 55 years old, e.g., strength of the evidence will be somewhat different for sure. (See in box below.) In other words, especially if we consider various biases against insurance companies by some people (whether warranted or not is beside the point now, but a wide range is evident, from the properly sceptical through the self-delusional to the paranoid, and everything in between, with or without reasons), it cannot be a surprise that there are those who say: I will rather finance my potential LTC need then share the risk with others via and insurance contract. There are situations where the consequences of this self-insurance choice can be really dangerous (when they may completely run out of money while still alive) and there are situations (when there is a very big asset base to start with) where it is perhaps not the smartest decision but at least it’s likely/certainly not potentially catastrophic.
|We are dealing with a 55 years old (on the left) and a 75 years old (on the right) here. In both cases, an initial portfolio of $500,000 is to rather reliably provide an annual income of $25,000 until age 95. (For the 55 years old we assumed 10 more working years during which he would add more to the initial assets.) We assume an LTC period of six years for each, from age 80 to age 85. The annual premium for a policy that would pay (after a 30 day waiting period) $3,000 cash per month (for whole lifetime if needed) would cost every year about $1,600 for the 55 years old and $7,100 for the 75 years old.
These charts are from the updated 2010 version of ORC, the software relying on raw market data of the past century, from retirementoptimizer.com.
|They illustrate (in a more condensed way than I was able to show when I used the 2009 version of ORC) the same to-buy-or-not-to-buy dilema that I analyzed at length in the slide presentation on Konrad’s case in the previous post referred above. Once more, ‘Lucky’, ‘Median’, and ‘Unlucky’ are descriptors of the historic period as the retirement unfolds, in terms of investment potential and inflation (real returns). Blue lines show the no-insurance-and-no-LTC-need-either scenario. Green is the line where LTC need occures but its costs are covered by the benefit from an LTCi policy. Red represents the situation when the need for financing crops up, and it has to be done from own assets (the self-insuring scenario). The main message these charts suggest (to me anyway) is that the effect of being uninsured when a LTC need arises is too significant to leave for chances.|
Some people say they wouldn’t spend on living benefit premiums of any kind (or just on LTCi perhaps) because they find the potential loss of that money unacceptable (in case they live without having any successful claim on the policy ever, … that is no benefit money received). I think it’s not the best way of thinking (because it reflects a poor understanding of the fundamental concept of risk-pooling, on which insurance is built), especially if we consider the alternatives, but instead of arguing with emotions (usually a losing battle anyway) I can pinpoint that there are so-called return-of-premium (ROP) riders on policies (LTCi policies as well) that can be purchased. These riders guarantee that all (or a predetermined large portion of all) the premiums paid will be given back to the client or their beneficiary at death or at predetermined (sometimes elective) dates when the coverage is finished. I’m not convinced that these riders always worth the money. Whether they are worthwhile or not can be determined only by doing meticulous calculations, but they’re surely very good to sell for agents/brokers, so there is a potentially strong conflict of interest situation around this issue. The ‘rational/cold’ calculations of expected internal rate of return (IRR) would sometimes support and sometimes not support the claim that premium paid for this rider is money well spent; each situation is different. (IRR calculation is a method not used or even understood by most people, even though it is arguably the best way to account for the time factor in evaluating any investment option. You may learn more about it and even play with a calculator here.) However, if someone simply cannot handle the thought emotionally that he/she pays all those premiums for a long time for nothing tangible in return, the availability of ROP rider may be important: it may help some people to make the right decision they wouldn’t otherwise.
Let’s illustrate how this ROP rider evaluating calculation can (or rather: should) be done. The example used will be of Konrad, introduced in the previous post, … except that in this example the premiums are a bit lower because we use a policy with longer waiting period. Thus it’s the case of a 55 years old man who buys a policy that would pay him (after a 90 day waiting period) $3,000 tax-free cash per month for the period when he needs LTC. The annual premium for this policy (regular premium) is $1,403, payable for life. If he buys the ROP rider, then there is an extra premium for that in the amount of $1,063. What the ROP guarantees is that if he dies while the policy is in force, his beneficiary would get, tax free, all the premiums paid, minus all the insurance benefit he might have received while alive.
As you can see in the summary spreadsheet below, I calculated IRR values for each year, and a summary IRR value. The IRR values for each year show what would be this number for someone who dies in that year, provided there was no benefit received while he was alive. Notice that the value is getting lower and lower as we get to more advanced ages. Since the chance that death happens is very different for each year (this man will probably live for decades more) we cannot just take the average of these annual IRR values because that would give too much weight to the high numbers in the early years when the absolute numbers are lower, when the IRR is extremely high, and when the chance that death occurs is very low. A much more reasonable way of combining all the data into one single IRR number is to calculate first the expected net cash flow of this investment for each year (so that both the likelihood of death for that year and the size of the cash flow would be properly included), and then calculate the IRR for that expected net cash flow stream.
You don’t have to understand all these calculation details; the end result is what you should look at, and it’s not too bad for the first glance. It’s 5.69% per year, and it’s tax free for the beneficiary. This calculation, however, disregarded that some of the people who buy the policy will collect living benefit, therefore the death benefit in those cases will be less than was assumed in the calculation, or none. Also, the small inaccuracy in our calculation with the distribution of death events at various ages probably inflates slightly the calculated number. Finally, one more thing can be brought up cautioning perhaps against this rider. It is that it’s a completely illiquid investment, and there is no possibility even to stop paying into it (without loosing what was already paid in) once it has been started. In other words, he should decide for it only if he is sure that he (or perhaps that beneficiary?) will be able to pay it during his whole life. Once he is all right with this commitment, he could even look at the basic LTC buying decision a little bit differently at the light of this calculation. Namely, in addition to the basic function (creating extra income when needed and whereby protecting assets) the policy also creates a rather good investment opportunity for this man, … provided, again, that he can confidently commit to paying the extra premium as well.
To show that the IRR value is not the same for every situation, let’s change just the age of this man for the sake of another analysis. As you can see in the spreadsheet below, the IRR is higher (7.53%) for a 35 years old that it was for the 55 years old. (Notice how much lower premiums are when the policy is bought at a younger age.) Considering, however, the inflating factors again, but now for this young man (who has more time&chance to use the policy as it was intended, that is to get living benefit from it, … meaning more lost opportunity to get a premium payback, and also that he has 20 more years for which to commit to regular premium payment), it’s still not obvious at all that it would be a good investment idea. At the minimum, it’s not a compelling one, whatever some people like to say.
Of course, the kind of analytical approach advocated here or in my previous (’which is the smaller mistake?’) page is somewhat irrelevant from the point of view of people of more modest means. It is so because in their case the challenge is not about protecting assets from erosion by future LTC expenses but about how to find the money at all to pay those expenses. Since it’s not there, the missing funding has to be ‘created’ through the ‘magic’ of insurance (that is of pooling risks). In these situations, if the missing fund (rather: the income stream that would come from it) is not created when needed then things can get out of control easily, meaning more burden on family, shorter stay in own home, less influence in deciding where or from whom to get the care, etc. Although New Retiree A (NRA) with an inflation indexed $40,000 pension but without significant savings can afford running a larger ongoing budget than New Retiree B (NRB) who has no such pension but has $800,000 invested, still - while NRB has the analytical dilemma discussed in my previous post or in the previous paragraph - NRA has stricter conditions from an LTC funding perspective. NRA simply cannot pay a potential $60,000 per year LTC expense without buying insurance, so his/her dilemma is more existential: more of the ’should it happen, how much do I want to stay at home, in control and not at the mercy of others’ type. Basically the same would be the situation for a NRC who has $20,000 income only, even though all or part of that is from own investments; they could pay for LTC expenses, but quite likely only for a little while, after which they would be penniless and perhaps even without any income, although otherwise perhaps very much alive.
The dividing line between the two dilemmas is not rigid and crystal clear, of course, still it’s a meaningful distinction, I think. In this page and the previous one, the logic and arguments (the ‘rational content’) address mainly the 2nd dilemma of more analytical decision-making and asset-erosion-preventing, although some of the information provided (or linked to) is hopefully useful for those as well who are simply sizing up their situation and prospects, to decide - on a much less analytical basis, but rather out of emotions and values (independence, comfort, love, etc.) - if they want to try getting insured or not against a potential LTC. Those people with the less-analytical dilemma use not mainly the analytical skills of experts but their information provider, and perhaps motivational capabilities before they make the decision. If and when, however, they’ve decided for submitting an LTCi application, they will also need analytical and detail-oriented immediate help form the professional, so that they together can select from the available choices the specific policy and features that is the best fit for their own situation and preferences.
Whatever is the background of and rational to the situation (either voluntary or forced), it’s clear that there will be situations when the question should be changed from the ‘To buy or not to buy LTCi’ to the ‘How can we prepare best for self-insuring against the risk of LTC financing’. It’s a very complicated issue even if we look merely at the financial side of it, with a gamut of threads intertwined (needs/wants, earnings/savings, asset-allocation, product-allocation, liquidity maintenance, etc.) about which you can read on this site and elsewhere; properly considering it certainly necessitates full-blown planning activity.
Here I want to pick out just one technical aspect (tax efficiency) that can be made part of the big-picture approach. I’m talking about a product choice, driven by tax considerations. What I’m referring to is the availability of some investment-linked insurance (the so-called universal life, or UL) policies where the investment assets (that were allowed to grow tax-sheltered) within the policy can be accessed tax-free in a serious health situation. The cost of creating and maintaining such a policy may be rather high though, … or may be not, provided it is a joint last to die type of policy where one of the insured people is the senior, and the other is a child or grandchild. I’m not saying here that this strategy is preferable to simply trying to buy LTCi; allegedly, even Warren Buffett has his own LTCi policy, … obviously not because he needs it but simply out of principle, because risk-spreading and pooling is seen as the proper way. (It might be just a legend, I certainly haven’t seen his policy, … but I find the story completely believable, somewhat relevant, and quite amazing.) Instead, again, I claim that if someone with significant assets - for whatever reason - doesn’t have an LTCi policy, then that person could probably benefit from considering this kind of UL policy in his or her broad plan about addressing the LTC financing risk. For affluent people and their families, an arrangement like this has other advantages as well, but we disregard those at this point.
One might say that ‘Yes, but since I cannot buy LTCi, I would be declined for the UL as well’. Not quite so. It’s much easier to get approved for life insurance in general, and especially for joint last to die coverage, than for any living benefit protection plan. For those who have reservations against insurers because they think that claims are sometimes/often/always(?!) denied without reasons (another thorny issue that could be argued for and against endlessly … still some people would see only their own argument as valid) this is something to consider:
- there is much less room for potential disagreements about the legitimacy of claims with life insurance in general than with living benefit (or at least LTD and LTC) claims (CI being more straightforward again). Simply put: presenting a dead body can be doubted less as real than the presentation of pain or some other health problems where subjectivity and pretension might be claimed to be present. Therefore, the basic character (it’s a life policy) is less problematic.
- the bottom line of the insurer is suffering much less when they release the client’s own money from the tax-sheltered investment account than when they start to pay a ‘real’ living benefit (that is money that has been theirs thus far).