Quite the combination: Hybrid products offer more effective safety net for seniors

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By Carl A. Friedrich | 01 November 2009

From 2000 through the first half of 2009, sales of long-term care (LTC) insurance plunged—a phenomenon that would seem to defy demographic trends that show an increasing number of Americans turning 60 each year. Rate hikes, product uncertainties, and an intractable reluctance by consumers have made LTC insurance a difficult sale. But a number of market and regulatory factors have come together to spur innovation in combination products that pair LTC with an annuity or life insurance. Could this next generation of hybrid products be the solution that consumers and insurers have been seeking?

Insurers have long weighed the pros and cons of the LTC market. While enticed by a rapidly growing senior market that currently numbers around 41 million, insurers continue to worry that providing LTC coverage may result in an unmanageable level of risk. Their main concern stems from the fact that LTC product designs are constrained by regulations that—among other restrictions—bar premiums with scheduled increases beyond age 65. In contrast, expected claim costs increase rapidly by age. Thus, insurers are required to develop level premiums that are anticipated to prefund all future claims of an aging pool of policyholders. Consequently, the annual premiums are well in excess of expected annual claims in early years, and eventually drop below expected claims in later years of a policy. As a result, this typically creates the result for LTC that higher lapse rates actually increase insurers' profitability, making the product "lapse supported."

Once purchased, LTC insurance tends to grow in importance in the minds of aging policyholders, who feel that the time when they may have to avail themselves of the coverage is nearing. This policyholder loyalty further magnifies the lapse supported nature of LTC insurance. In addition, the level premium structure with its inherent prefunding of future claims increases the pressure on insurers to meet investment targets. This pricing arrangement works well when interest rates are increasing and in the high single digits, but when investment returns sag, as they have recently, many insurers find that profitability plummets.

Insurers have also overestimated lapse rates, which, as the quality of insurers' products and distribution systems have improved, have decreased from the mid-single digits annually to between 1% and 2%. With larger-than-expected numbers of insured seniors on the books, claims are up and profitability is down.

These disruptive forces have precipitated recent increases in prices for new products being sold today, which in some cases cost as much as 50% more than those issued just five years ago. These higher rate levels, now averaging above $2,000 per year for a typical policy for recent industry sales, have further exacerbated the issue of affordability. Potential buyers have long been leery of the use-it-or-lose-it dilemma inherent in LTC products that by law have no cash value. In addition, a number of companies have had to file for rate increases on in-force policies, making the marketing of new policies more difficult.

Enter combo plans

Some of consumers' concerns may be mitigated by the introduction of combination LTC plans that generally rely on an accelerated payment of life or annuity base plan benefits to cover LTC costs, but still have cash value if LTC isn't needed or benefits aren't exhausted.

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Virtually all combination LTC plans feature an element of self-insurance in that part of the LTC benefit is paid from either the cash value of the contract, as is the case with an annuity, or as a prepayment of both death proceeds and cash values in a life contract. Once the value of the contract is exhausted, independent LTC benefits are typically continued for a specific number of years. This structure lowers the cost of LTC for buyers who are now self-insuring part of the cost of LTC.

Under annuity-LTC plans, which are likely to have greater market appeal, accelerated benefits derived initially from reductions in the account value are used to provide LTC without assessing surrender charges. This payment stream is typically combined with some form of independent LTC benefits that extend beyond the term supported by the contract's cash value. Charges for the LTC insurance are assessed as level percentages expressed in basis points against the account value. As account values grow, new layers of LTC insurance are purchased with new layers of level charges.

The self-insurance component of the plan can greatly increase the affordability of LTC for consumers. But it is only one aspect of the product’s appeal.

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In 2006, Congress passed the Pension Protection Act, which broke new ground in the annuity market by giving LTC benefits that are integrated into a nonqualified annuity tax-free status, even if a portion of the benefits serves to reduce the account values in the underlying annuity. Effective Jan. 1, 2010, this unprecedented change in the annuity tax code will mean that an insured individual will be able to receive the entire account value of the annuity contract—principal as well as gains that had been formerly taxable—on a tax-free basis when proceeds are paid as qualified LTC benefits.

The change in the tax code could not be more timely. According to the Congressional Budget Office, the annual cost of nursing home care averaged $70,000 in 2004, a figure that is expected to double over 20 years, at which point approximately 67 million Americans will be over the age of 65. At present, only 10% of the target population for whom LTC insurance might be suitable have purchased it, according to reliable estimates.

By affixing LTC to the chassis of an annuity contract, insurers are able to fulfill the dual need of preserving income for individuals who fear they may outlive their assets, or potentially protecting them from the debilitating costs of a long confinement.

At the same time, insurers can enjoy pricing synergies that exist between annuities, whose earnings increase with lower lapse rates, and lapse-supported LTC, the importance of which tends to grow in the minds of insured individuals as they age. By adding the LTC rider, insurers have gained a natural hedge against lapses in their annuity products that typically occur soon after the surrender-charge period ends.

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A ready market

The potential market is enormous. If only 1% of the 95 million Americans between the ages of 45 and 70 were to invest $50,000 in a combination LTC-annuity product, the market would be some $47.5 billion. A higher penetration rate of 3% of the targeted population with an investment of $100,000 would create a $285 billion market. These numbers may seem fabulous in some respects, but considering the fact that some $750 billion is already invested in nonqualified annuities that could serve as a source of funding for combination LTC-annuity products if the appropriate mechanism were to be developed, these off-the-cuff estimates may not seem unreasonable.

These asset-based combination products are not without their challenges, however.

The regulations that govern LTC and annuity products have grown up separately, and tend to address each product individually. State regulators have at times found it difficult to determine how some of these innovative products will fit within current insurance regulations.

Insurers will also need to resolve the strategic differences between LTC underwriting, which requires extensive medical information, and annuities underwriting, which requires answers to only a few financial questions. Finding a common approach that satisfies an insurer's underwriting needs while still accommodating a sales force's need to issue policies quickly and efficiently may be tricky, but it's not impossible. For instance, insurers may be able to guard against antiselection by adopting a moderate standard of underwriting that relies on a set of questions related to preexisting conditions, complemented by noninvasive techniques such as telephonic interviews with tests for cognitive abilities and prescription drug database reviews, all of which can be administered within short timeframes.

This streamlined approach, however, does not address the seldom-discussed issue of gender bias, which may pose an even greater challenge to the alignment of risk with LTC pricing. LTC rates traditionally have been developed on a unisex basis, not because of any regulatory requirement but rather as a matter of marketing. The present approach favors females whose claim costs over the life of a book of business are much higher than those for males. This cost difference stems partly from the fact that females typically live longer, which increases the likelihood that they will reach an age where LTC is needed, and partly from their higher utilization rates at some ages.

But even here, there are techniques that can address this pricing risk. For example, substantial spousal discounts could promote a 50-50 spread of males and females, and mitigate the risk of underpricing associated with insuring a higher proportion of females. A large spousal discount—perhaps in the range of 25% to 30% or more—would also make sense because the presence of a mate could potentially delay the need for formal LTC.

Finally, for insurers that have not developed a strong expertise in LTC, the prospect of taking on a risk whose costs are closely tied to healthcare can seem somewhat daunting. Healthcare costs, with their potentially high volatility, raise the possibility of incurring substantial liabilities that stem from the promise to pay for LTC costs at some indeterminate time far into the future.

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But experience shows that LTC claim costs per policy in force, year by year, have generally been in line with pricing assumptions, because virtually all standalone and hybrid LTC products cap benefits at a daily or monthly limit. If the rate of inflation for LTC services per day or month unexpectedly jumps, the increase would not have a material impact on insurers' results.

Still, insurers cannot go blindly into the LTC arena. It is important to have a firm handle on the components of cost. Milliman has recently updated its LTC claims cost database, which now includes more than $6 billion in industry claims, and those familiar with this data can provide knowledgeable perspectives regarding cost differentials.

Financial modeling can help insurers understand what happens under various scenarios. How are insurer returns affected by a 20% increase in claim costs? What would be the impact of a 10% decrease in lapse rates or a long-term decrease in interest rates? Past experience has shown that LTC insurers' results suffered more from a drop in interest rates and higher-than expected persistency than from rising healthcare costs.

Combination LTC-annuity contracts are indeed complicated products that will require training of a distribution force that can clearly and accurately communicate the benefits and limitations of these products. They will also call for the development of underwriting systems that reduce risk without sacrificing speed or inhibiting the introduction of new product designs geared to the needs of a demanding market. If ever there was a time for innovation in asset-backed products, it is now. With the right direction, such products can be a boon to both insurers and consumers.

Carl Friedrich is a principal and consulting actuary with the Chicago office of Milliman. He specializes in the design and pricing of life insurance, long-term care, and annuity insurance products, with an emphasis on emerging combination multi-line products. He also advises clients on reinsurance, mortality, and financial management issues.