Sarah, a longtime financial planning client, recently called me with a conundrum. Like thousands of other retired and soon-to-be retired Americans, she’d received an unwelcome letter regarding her long-term care insurance policy she’d purchased decades back from a long-gone agent. The letter served as an introduction from a new agent who presented himself as a long-time expert in the field, with a resume that bounced him from salesperson to home office support and now back into the hurly-burly of independent insurance sales. She called him and he informed her that her premium would skyrocket at renewal, with more such bursts likely in the future. He had new options that might be of interest to her and welcomed a chance to discuss them.
Sarah asked for my opinion. I counseled her to go ahead with the discussion, but to beware that incentives matter and that this agent would get compensated for his time only if she made a move to a new product. By doing some math, she could make a good if difficult decision.
Risk Number One for Middle-Class Americans
Funding long-term custodial care expenses is a real risk for many Americans. In fact, I figure it’s the only risk that can turn a middle-class millionaire into a ward of the state, wiping out a lifetime of accumulation in a miserable process. Nary a month passes when I don’t send out large checks from client account to fund essential care not reimbursed by health insurers or Medicare. I call it paying rent in the wrong kind of hotel.
The insurance industry boldly stepped up to meet the challenge with the first insurance products for this risk in the 1970s. In 1996, the Health Insurance Portability and Accountability Act (HIPAA) standardized them and gave them tax preference like health insurance. Although these policies have never been cheap, prudent people in their 50 and early 60s could once address this risk for a few hundred dollars in monthly premiums.
We could customize policies. People concerned about wasting the premium dollars could elect return-of-premium riders that made the policies both lose/win and win/win in the best sense.
If they lost and needed the coverage, the plan paid out big time. A win.
If they died without using it, again, a win considering the alternatives. A win.
In some cases, every dollar of premiums paid was refunded to a stated beneficiary. Spouses could share benefits. Policies could be paid up all at once or over a decade.
These were incredibly useful planning tools for protecting people’s wealth.
Reality Bites
Then the new reality struck. Years of low interest rates and higher than projected usage put the squeeze on the carriers. Companies can increase the premiums on these policies if their state regulators agree it’s necessary. The rate increases started coming in the new millennium. I often run the numbers for clients and report that even at the elevated premium, the policy is worth keeping. In these cases, the new premiums are still less than a third of what premiums on similar new policies would be. The regulators often approve lower increases than the carrier’s request.
In other cases, the higher premiums make keeping the policy prohibitive. However, carriers always offer options to downsize the policy and reduce the premium by adjusting such variables as inflation protection, how long the benefit will pay, the amount of benefit, and the waiting period before collecting benefits.
Sarah’s Case
Back to Sarah’s question. She is now financially secure, although this wasn’t always the case. She started a business in her 50s and she was in the building process when she purchased this policy from a leading company in the field. Today, she is fortunate to be able to self-fund care if necessary.
Her policy is robust by any standard, poised to pay a daily benefit of just over $450, growing at 5 percent compound. Today, she is approaching 70 and the three-year benefit is worth roughly $500,000. It’s quite a bargain by contemporary standards at its current annual premium of $6,000.
Enter the dreaded letter informing her that the new premium will be roughly $1,000 a month, with more boosts likely in the future. The good old days are indeed gone for this insurance. The good news is that she has not needed it. The bad news is that she has a difficult choice of whether to keep it.
Option One: Pay the New Price
One option is certainly to pay the new premium. For people with assets and free cash flow—the only ones who should consider purchasing these policies—I believe in beginning with rate of return analysis. In other words, knowing for sure what the maximum potential benefit is at each age and what the minimum premium is going forward, we can perform a best-case rate of return on the policy. We can also compare to alternatives, such as investing the money that would have gone to pay premiums.
In this case, the current policy, even at the new premium, provides substantial potential value. At age 80, its potential value (if needed) is $815,000 of tax-free money—a 40 percent rate of return on the new premium invested. This compares with a sum of $170,000 for that premium if invested and earning her historical average of 8 percent per year.
Jump ten years to age 90, and the maximum policy payout increases to $1.3 million. The cost, however, is the $500,000 to which the premiums could have grown at 8 percent.
The Math of Misery
This policy, typical of its genre, pays out on month at a time after a 90-day waiting period. The big lose/win benefits only materialize if the care is needed for three years. According to a survey of actuaries conducted by the American Association of Actuaries, one in three policy holders will need a policy long enough to outlast the waiting period. Another study by an insurance carrier found a 5 percent chance of using a policy’s entire benefit.
Simple math multiplies the potential benefit by the likelihood of using it to find one way to look at expected value of insurance. With this adjustment, the insurance, if needed for the entire three years, is a good deal at age 80. By age 90, the investment bests it.
Decisions, Decisions
I’m fond of saying that when it comes to insurance, you shouldn’t focus on analyzing premium and benefits; actuaries have already done so and in a competitive market they will be fair. Ask what happens if you need the policy but you don’t have it. In other words, focus on the error of needing the policy but not having it, rather than the risk of having it but not needing it. What will the former mean to you and your loved ones?
Given these numbers, if there was a return of premium rider on the policy, or if the policy was funding a special needs trust or otherwise protecting assets for a critical financial need, keeping it would be attractive if not crucial. In this case, however, Sarah’s financial circumstances have changed for the better and she can easily self-finance more years of care than she’ll likely ever use.
What Else is Out There?
As you’ve just seen, the question of how to address the current policy is not easy. Different people could easily form different conclusions depending on their risk tolerance for health events, their expected investment returns, and their preferences for shifting financial risks versus retaining them.
As you will see, the same can’t be said for the new options presented to Sarah. These ranged from useless to dreadful considering her situation. It really can’t be any other way, as every insurer must construct every insurance product with the same raw materials—interest rates, morbidity estimates, and mortality expectations. Given today’s low interest rates and the high rates of usage of this important protection, I’d expect any new policy to offer less, not more, financial value for the insured.
Restructure the Current Policy
Option one is to restructure the policy with the existing carrier. If the carrier is considered sound, this can be a good option. The 5 percent compound may no longer be needed, for example. Or a benefit can be reduced and a larger share of the risk retained. If the carrier is considered weak, however, this may be throwing good money after bad, as the future will just bring more difficult choices.
The new agent presented a reduction of the benefit by 56 percent to $200 a day. The change was linear and the relative payoffs remained the same as for the existing plan. This would be a real option with a sound carrier, but not here.
Acquire a New Plan from a Sound Carrier
The next option presented involved a traditional plan with a sound carrier. Here the benefit is reduced to $100 a day. The annual premium is $2,780. This could be a useful amount for some home care in our market. That said, this is not a meaningful amount for Sarah, given her investments. Still, dollar for dollar, this plan potentially adds real value in the first 18 years if it is needed and completely used. If we apply the 35 percent probability of using it, the value is extinguished in less than a decade.
Bet on a Sure Loser
As conditions have deteriorated for traditional long-term care insurance, the industry has developed hybrid plans that combine life insurance and long-term care insurance. These come in many forms and have evolved over the years as interest rates remained low.
These innovative plans can provide some excellent protection in the right product for the right plan for the right client. In some cases, they accelerate the life insurance death benefit, free of income tax, at 2 percent a month. A $250,000 policy, for example, pays $5,000 a month until the policy is exhausted. In other designs, the long-term care benefit is substantially larger than the life insurance benefit. These policies are popular, representing 85 percent of all long-term care policies sold in 2018 and one in four life insurance policies.
Given the proposal sent to Sarah, she won’t likely be adding to these numbers. She was presented a hybrid plan based on a $75,000 whole life policy that, at best, pays $150,000 of long-term care benefit at $3,000 a month.
It’s easy to understand the pitch. If you need care, the policy provides $3,000 a month for just over 4 years. If you get lucky and don’t need it, you get the benefits of non-participating whole life of $75,000 death benefit. If you need the money in the meantime, you have some cash surrender value, since it’s whole life.
Given the right set of facts, this could work. It could even work well. The agent presented a one-time premium of roughly $69,000 and then suggested that IRA money could be used to capture all the benefits of a whole life plan as well as the attached long-term care protection.
Taxing Times
Sarah’s combined marginal income tax rate (federal and state) is 30 percent. She’d be taking roughly $100,000 out of an IRA to fund a policy with a death benefit of $75,000, a cash surrender value that never exceeds $70,000, and a long-term care benefit that an investment of greater than 4 percent would beat in the first ten years.
If not funded with an IRA, these numbers get a bit better. Still, it seems more like a test of diminished mental capacity than a serious proposal. These numbers simply don’t crunch.
Keeping Current with the Times
Considering the choices, I believe that Sarah will eventually relieve herself of her long-term care premium, thereby relieving the carrier of the risk of paying a potential claim. Although not the ideal or intended outcome for either party as they entered their relationship, this result stems from the truism that sunk costs are sunk and as the world changes we must change with it.
Sarah’s increased wealth rendered the protection afforded by the insurance less valuable. For the carrier, the unpredicted collapse of interest rates and increase in longevity made keeping its intended promise at the premiums it initially wrote impossible. Logical thinking tells us that a decision may have been sound at the time it was made, even though its results didn’t turn out as expected.
That’s the case here. Sarah’s original choice to protect her family from the financial ravages of paying for long-term care was smart at the time. Now it’s smart for her and the carrier to part ways as friends.
Michael Lynch CFP is a financial planner with the Barnum Financial Group in Shelton CT and the author of Keep It Simple, Make It Big: Money Management for a Meaningful Life, October 2020. He can be reached at mlynch@barnumfg.com or 203-513-6032. His articles can be enjoyed at www.michaelwlynch.com.
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