Wednesday, December 5. 2012
How Long-Term Care Insurance Rate Increases Work
As a starting point, it's important to understand how long-term care insurance rate increases really work.
Qualified long-term care insurance (eligible for tax-free benefits under the Internal Revenue Code) must be "guaranteed renewable" - which means as long as premiums continue to be paid, the insurance company must continue the client's coverage, and they cannot single the client out to either cancel his/her coverage or raise the premiums.
However, rates on insurance that is guaranteed renewable can be increased by going to a state's Department of Insurance and requesting a premium increase for an entire "class" of policies, such as "all policies issued to people age 55-64 in the year 1998" - and if your client falls into that group of policyowners from that age bracket and that year in that state, the client's rates can be increased.
Given that state insurance departments have to agree to premium increases - which aren't exactly popular - why do they ever approve at all? Because in situations where the premiums are too far below anticipated claims, there's a risk that the insurance company could be rendered insolvent and unable to fully pay all claims to all policyowners. At the end of the day, it's better to have a rate increase that ensures policyowners get all their benefits, than keep premiums in place at the risk of rendering the policies partially or entirely defunct.
Notably, though, what premium increases do not allow is for companies to make up the prior losses that they've had, nor to increase the premiums so far that the insurance company can make a big profit going forward. Premium increases tend to merely be enough to ensure that the company remains solvent and capable of fully paying all claims for all policyowners. Of course, there is some uncertainty to the projections, so it's conceivable that the insurance department may approve a rate increase large enough that the insurance company will enjoy some extra profits.
However, in practice the opposite seems to be the case; the insurance departments have been so unwilling to push through premium increases unless it's absolutely necessary that often the increases are huge when they do occur (because it's been so many years that the insurance company has been undercharging), and some companies have ultimately had to go back later and ask for another premium increase because it ultimately turned out that the first increase was so conservative for existing policyowners that it still wasn't enough to ensure solvency (much less any profits) for the insurance company.
Decisions To Make When The Premium Increase Occurs
So given all the steps involved for an insurance company to get a premium increase approved, what should clients do when the notification arrives?
The good news and the bad news is that there are usually more choices than just "pay the new premium, or get rid of the policy." To give policyowners flexibility in how to handle a rate increase, insurance companies usually offer several options, including:1) Keep the policy as-is and just pay the new premium
2) Keep the current premium and reduce the policy's daily benefit amount to the extent necessary to bring benefits in line with cost (e.g., from $250/day down to $200/day)
3) Keep the current premium and reduce the policy's benefit period to the extent necessary to bring benefits in line with cost (e.g., from a 5-year benefit period down to 4 years)
4) Keep the current premium and reduce the policy's benefits inflation rate (if the policy included an inflation rider) to the extent necessary to bring benefits in line with cost (e.g., from a 5% inflation rider down to a 3.5% inflation rider)
5) Cancel the policy
The bad news, of course, is that more choices make the decision more complex. Although not every insurance company and premium increase situation will include all five options - the requirements for what is made available vary by state and some insurance companies offer more flexibility than others - most companies will offer at least one or two of the options in the middle, in addition to the first and last.
Making A Decision To Handle A Premium Increase
Given the choices, which are most appealing? There are a number of factors to consider...
1) Keep the policy as-is and just pay the new premium
In general, this is the most appealing option, if it's affordable. For instance, think of the situation in another context, as though the cable company came forward one day and said:
"Our apologies. We just discovered an error in our billing. It turns out that although you currently receive the 187 premium channel cable service, we have actually been billing you for the 114 channel basic service. Having discovered our error, we unfortunately need to raise your rates to charge you for the 187 premium channel service you are actually receiving. Alternatively, if you wish, you can drop your service down to the 114 channel basic service that you have actually been paying for all along, and we'll continue to charge you the same amount. Either way, though, we will not charge you anything for all the years we accidentally gave you the premium service for the basic cost."
If you want the 187 premium channel cable service, and can afford it, you should go ahead and pay for it even after the price is "corrected". While it is frustrating that you can't get the same features for the original cost, the reality is that the original pricing was wrong, and the new pricing is correct. The new pricing can still be good value for the benefits you receive.
And notably, this is especially true in the long-term care insurance context, because policies getting premium increases are generally still much less expensive than the coverage would cost new today! For instance, a policy for $200/day with lifetime benefits that might have cost $2,000/year if purchased back in 2001 might get a premium increase notification of 50% - which means the premium is jumping up to $3,000. Yet a comparable policy today for the same benefits for the same age could easily cost upwards of $4,000 (and in fact, lifetime benefits aren't even available anymore!). In other words, even after the premium increase, most older policies are still cheaper than equivalent new policies today. And of course, if the client actually bought the policy 11 years ago, then the daily benefit would not be $200/day but would be up to about $350/day with inflation adjustments; getting that policy new in today's marketplace could cost nearly $7,000!
So by comparison, while a surprise premium increase from $2,000 to $3,000 may be a very unpleasant shock, it still represents a fantastic deal for the coverage going forward from here. In turn, this means that if the policy is still affordable, it virtually always still is a good financial decision to keep the coverage at the new rates (assuming, of course, that the coverage is still needed in the first place).
2/3/4) Keep the current premium and reduce the policy's daily benefit amount, or benefit period, or inflation rate, to the extent necessary to bring benefits in line with cost
Where the premiums are not affordable after an increase, the next choice is to select one of the options that will decrease (but not cancel) coverage, to bring benefits down to the point where they are aligned with the original premium.
Given the options about what to reduce, the first choice in most cases should be the benefit period, especially if it is 5+ years in duration. The reason is simple: the average long-term care insurance claim is only about 2.8 years (1040 days). The median claim is even shorter, as the average is distorted by a small number of extremely long claims. While it's true that there is some risk that your client could be the next ultra-long claim, the odds are that that will not happen, and that owning a long benefit period will simply mean paying for a lot of coverage duration that will never be used. In a scenario where the premiums are unaffordable - which means something has to change - paying for coverage for an unlikely claim duration should be the first thing to go.
The next option to consider reducing in most scenarios is the inflation rate on the policy. The reason for this again is simple: if the client has already had the policy for about 10 years or more (as that's often how long it takes before premium increases begin), the client has already gotten a lot of leverage out of the inflation rider, and is older and unfortunately closer to the point where he/she may either make a claim sooner or pass away sooner, which limits the value of the inflation rider going forward. This is contingent on age, though: the older the client currently is, the more appropriate it is to consider reducing the rate on the inflation rider. Clients in their 70s and especially 80s might consider a reduction in the inflation rate; clients in their 60s should be cautious about reducing the inflation rate; clients in their 50s or younger (although premium increases on such policies are rare in the first place) should not reduce their inflation rate as the impact could be severe over a multi-decade period (it would be better to just reduce the daily benefit amount and let it compound back up with a full inflation rate).
The option of last resort for most clients (except perhaps those who bought very young) would be to reduce the daily benefit amount. This is because in most situations, clients only buy enough coverage to, at best, meet the average cost of care in their area. In other words, unlike the benefit period, which is usually above-average in length (implying some room to cut), the daily benefit amount is typically barely enough to cover costs at the time of claim in the first place, so it should be last on the list for cutting. You can verify whether your client's coverage is still in line with typical costs in the area by checking out the Genworth Cost of Care data (be certain to look at the client's current inflation-adjusted benefits and not the original benefit amount!), but what you'll likely find is that there's more room to cut elsewhere first, especially since all else being equal a short-fat policy (shorter benefit period, larger daily benefit amount) offers more flexibility than a long-thin one.
5) Cancel the policy
As a true choice of last resort, if the coverage is unaffordable it can simply be cancelled. Given the ways that coverage can be reduced to stay level with current premiums, though, this should generally only be selected if there really has been a change in needs, such that the coverage is simply no longer necessary (e.g., wealth has increased to the point that the client can afford to self-insure and has chosen to do so).
The Bottom Line
In the end, getting a notice of a premium increase on a long-term care insurance policy is certainly not pleasant. Regardless of the fact that it essentially means the company has been underbilling the client for years, and is only asking to fix the pricing going forward (without recapturing all the prior years' mistakes), it's still a shock when the premium increase comes, especially since it only occurs when the situation is serious... which unfortunately means the magnitude of the increase is usually somewhere between "large" and "very large" when it arrives!
Nonetheless, the fact remains that even after premium increases, an older long-term care insurance is still typically much less expensive than what a comparable new policy would cost in today's marketplace, and still represents a tremendously leveraged way to pay for long-term care insurance. After all, if the client ultimately makes a claim of $250,000, $500,000, or more for benefits, the financial benefits will be fantastic regardless of whether the coverage cost $2,000/year or $3,000/year. Which means if possible, the best deal when a premium increase occurs is to just go ahead and keep paying the (new) premiums.
To the extent a premium increase is unaffordable, though, something must be done. The first choice should be cutting the benefit period, which for most policies is far longer than what is necessary to satisfy the typical claim. The second choice should be to cut the inflation option, if the client is older and the remaining years of compounding is limited. The last choice should be to cut the daily benefit amount, for the simple reason that most clients barely have enough benefit to cover the cost of care in the first place.
In any scenario, though, it's important to first be certain that the client understands why the premium increase has occurred to begin with, and to explain what it does do (keeps the company solvent to pay policyowners going forward) and does not do (help the company make up for lost profits). On the plus side, though, because new policies today are even more expensive than old policies with premium increases, the risk of future rate increases on today's newly purchased long-term care insurance is the lowest it's even been - which means that while rate increases are an unfortunate reality for those who purchased coverage in the early years that the insurance was first offered, it will soon be a thing of the past.
(Editor's Note: This blog post was featured in the Carnival of Personal Finance #391 on The Dividend Guy blog, and also the Carnival of Retirement on the Investing Money blog.)
The series of choices has become common more recently as both the frequency and the magnitude of rate increases has itself risen. I believe some state insurance departments (although not all) actually require choices to be provided now.