Could legacy long-term care (LTC) blocks be the next wave of M&A deals?

Long-term care (LTC) has been considered one of the last remaining vestiges of the legacy challenges impacting a number of U.S.-domiciled life/annuity/health insurers. Approximately 15 years ago in the United States, we witnessed the beginning of a wave of asset management firms and private equity companies acquiring, via their insurance subsidiaries, legacy/challenged blocks of business from traditional insurers. These acquisitions typically began with more simple blocks such as fixed deferred annuities (FDAs) to allow for the new entrants to better digest and understand the nature of insurance risks and the overall operating environment, given that many of them had not operated in the highly regulated U.S. insurance market. FDA blocks, especially those with high guaranteed crediting rates, were apt targets given the low interest rate environment in the 2010s along with the asset management expertise of the new acquiring companies.

As more private equity and asset managers entered the space, it led, and continues to lead, to a congested market for simple liability blocks, with a large number of buyers (e.g., greater than 10) often bidding for the same opportunity. While a highly competitive auction process is attractive for any seller, buyers need to carefully gauge their competitiveness in order to make efficient use of their time. Further, as more deferred annuity blocks have been involved in transactions, it has led to a shrinking pool of blocks available for potential buyers, which inevitably leads traditional insurers to focus on other types of legacy blocks.

We have recently seen heightened mergers and acquisitions (M&A) activity related to blocks of universal life with secondary guarantees (ULSG). Principal Financial Group, Lincoln Financial Group, and Prudential Financial have each announced the de-risking of their balance sheets with regard to ULSG blocks.

ULSG blocks are materially more complex compared to FDAs, given the material relevance of mortality risk and the potential for policyholder behavior risk (lapse, premium payment, use of secondary guarantee, etc.). We have noted that among the new entrants bidding on blocks of legacy business, there is a smaller pool of players with interest in ULSG due to the complex risks involved. The smaller number of potential acquiring companies in this type of transaction is attractive in itself, as it increases the probability of winning an auction process.

We expect continued activity for ULSG blocks given the following combination of factors:

1. Increasing interest rate environment
2. Better and more credible data on various key ULSG assumptions (especially for lapses)
3. Buyer interest in ”asset-intensive” blocks
4. A number of blocks with material size

This same combination of factors could also be applicable to legacy LTC blocks (with the additional consideration of morbidity risk—frequency and severity of claims), which some may find attractive from a diversification perspective. So is it time for new entrants targeting U.S. legacy insurance blocks to turn their focus toward LTC? Before answering that, let’s first briefly review what went wrong with legacy LTC business.

What went wrong in the LTC market?

The height of the LTC market was in the late 1990s and early 2000s and included over 100 carriers issuing standalone LTC insurance. However, deteriorating experience compared to original pricing assumptions resulted in LTC blocks becoming unprofitable, and many carriers exited the LTC market. Most of these legacy LTC blocks have not issued new policies in 15 or more years, have already encountered various problems, and still have substantial remaining future liabilities. The following summarizes the challenges faced by legacy LTC blocks:

Lower lapse rates

• Carriers originally priced LTC insurance assuming ultimate lapse rates in the low to mid-single digits (e.g., 3% to 5%).
• Actual ultimate lapse rates have proven to be much lower and are around 1.0% or less for most blocks.
• Lower lapse rates lead to more policies persisting to later ages, where claims are more prevalent, and thus results in higher claims.

Lower mortality rates and higher mortality improvement

• Mortality rates have been lower and improved more than carriers originally assumed.
• Similar to lapse, people living longer leads to more policies persisting to later ages and thus higher claims.

Higher morbidity

• Morbidity assumptions have increased since legacy LTC products were originally priced, which has led to higher claims than anticipated in pricing.
• Longer claim length has been a driving force behind changes to morbidity, but higher incidence (the rate at which policies go on claim) has also been a driver. The morbidity curve has been steeper by attained age (i.e., higher for older ages) compared to original pricing expectations. The impact of this is exaggerated by the lower lapse and mortality that has been observed.
• The Milliman Long-Term Care Guidelines (Guidelines) provide industry benchmarks related to LTC morbidity that are utilized by many LTC carriers. The experience that makes up the Guidelines has shown an increasing trend in morbidity over time, especially in regard to longer claim lengths. See sidebar for additional information regarding the Guidelines.

Lower interest earnings

• Carriers originally priced LTC insurance assuming interest rates of up to 5% to 8%.
• For many years the interest rate environment was unfavorable compared to the original pricing expectations. Because of the long-tailed nature of LTC liabilities and the substantial reserves associated with the liabilities, the interest rate assumption is more impactful on LTC compared to many other health insurance products.
• More recently, the interest rate environment has been climbing, which can have varying impacts for LTC blocks, depending on asset mix, duration, and investment strategy.

Mix of business

• A large portion of policies issued elected very rich benefits, such as lifetime benefit periods and compound inflation protection. These richer benefit designs deepened some of the problems listed above as larger pools of benefits were available to policyholders.

Not all LTC blocks are the same. Most of the interest we have observed regarding LTC transactions involves these legacy LTC blocks. In contrast, products issued more recently (2010 and later) have not seen as many financial problems as earlier blocks and carriers have been less motivated to seek out risk transfer options on these newer blocks.

How to consider an LTC M&A deal

For a seller

Given the nascent nature of the LTC block transaction environment, an insurer looking to de-risk its LTC portfolio may begin by analyzing segments of its LTC block that are ”stable” and ”bite-sized”:

• By ”stable,” we mean portions of an LTC block that have higher certainty to cash flows (e.g., insureds have started utilizing their benefits, or segments with smaller proportions of policies with lifetime benefits or an inflation protection rider).
• By ”bite-sized,” we mean LTC blocks that are, for example, between ~$1 billion and ~$3 billion as measured by statutory reserves, instead of the larger, $10 billion-plus deals recently seen for ULSG and/or annuity blocks. For buyers new to the LTC insurance market, smaller blocks that have higher cash flow certainty enable new entrants to better digest complex and novel liabilities that many of them are encountering for the very first time.

Finally, a seller should consider ”packaging” an LTC block segment it picks to sell with a block with simpler liabilities (e.g., FDA). That affords two benefits: first, the potential for an increased deal size, which can create more interest among various buyers who have raised material capital for insurance opportunities; second, it can serve as a potential offset or pad against the volatile economics that could be generated by a purchased LTC block.

For a buyer

We have seen a number of interested parties begin to educate themselves about the LTC market. That often begins with:

• Reviewing basics of the product features
• Understanding the different key actuarial assumptions
• Analyzing actuarial projections for a sample LTC block
• Understanding synergies or natural hedges with other blocks in their portfolio
• Reviewing the implications of varying asset strategies for a sample LTC block
• Scoping the potential for any offshore reinsurance benefits

While each of the tasks in the bullets above can be pursued during an actual deal process, currently the small number of LTC block processes limits buyers to either work with their in-house actuaries on these steps or with third-party actuarial consultants. Unlike FDA, which is primarily spread-based, complex LTC block economics are rooted in spread, mortality, morbidity, policyholder behavior, and premium rate increase evaluations. These factors all result in a longer education lead time for any buyer or new entrant compared to M&A deals involving FDA blocks around 15 years ago. Given our view that LTC blocks are the next wave, we would encourage potential buyers to start the education process now.

Finally, with regard to premium rate increases, a buyer may consider reinsurance structuring that could help consider how to manage that critical risk. For example, a transaction price could be based on the view that limited to no future rate increases would be achieved. To the extent rate increases are approved, a buyer (reinsurer) could share in the upside with the seller via a larger expense allowance for an agreed-upon period. That said, companies have been fairly successful in achieving rate increases and some states may become more open to approving rate increases. For example, the New York State Department of Financial Services recently recognized that its historical rate approval decisions likely have been too conservative, potentially foreshadowing the state being open to approving larger rate increases in the future.¹

So is it time for LTC block deals?

Given the convergence of LTC blocks with growing credible experience data, pressure on insurers around legacy blocks (especially insurers that are publicly traded), and buyers considering the next area of focus, we would certainly say it is time for a closer value evaluation of LTC blocks by sellers and buyers in preparation for transactions in the very near future.

¹ New York State Department of Financial Services (June 7, 2023). Long-Term Care Insurance: Looking Back and Thinking Ahead. Retrieved August 29, 2023, from https://www.dfs.ny.gov/system/files/documents/2023/06/dfs_ltc_report_20230607.pdf.