Executive Summary
As traditional long-term care (LTC) insurance becomes more and more expensive, and interest rates remain at ultra-low levels, planners and their clients have become increasingly interested in so-called "Hybrid LTC" policies that match together a life insurance or annuity policy with LTC coverage, especially with a more favorable set of tax rules that took effect in 2010. For many, though, the primary appeal of hybrid policies is the simple fact that, unlike their traditional LTC insurance brethren, the premiums really are guaranteed and cannot be increased in the future. Given some of the extraordinarily large premium increases that traditional LTC coverage has experienced in recent years - especially for some of the early policies issued in the 1990s and early 2000s - a cost guarantee is remarkably reassuring.
Yet the reality is that the guarantee of LTC premiums in a hybrid policy may be entirely offset by the fact that the insurance company controls the cash value, and is under no obligation to pay a going rate of return, especially if interest rates rise. In other words, it doesn't really matter that the insurance company can't increase the premiums on the policy by $4,000/year, when the company can simply under-pay on the interest rate by $4,000/year to accomplish the same result! And while the cash value of a hybrid LTC policy generally does remain liquid, taking a withdrawal to reinvest to get better, higher rates would entail surrendering the policy and forfeiting the LTC coverage! In fact, for some types of hybrid LTC policies, the arrangement contractually provides no rate of return to the client at all, and is essentially the equivalent of the client selling a call option on interest rates to the insurance company, where the more rates rise the greater the company wins at the expense of the client!
Given the unique structure of hybrid LTC policies, though, there are still several circumstances where they may be appropriate, despite the concerns about how they may perform in a rising rate environment. In some cases, simplified underwriting provides a way to get coverage for those who otherwise couldn't get any, and in other scenarios, the favorable tax treatment alone can make a hybrid policy compelling as a place to park an existing appreciated annuity. Nonetheless, the bottom line is that in today's environment, consumers must be careful not to engage into hybrid policies that amount to little more than offering the insurance company the unilateral right to profit if/when interest rates rise, when the reality is that simply following a "buy LTC insurance and invest the rest" philosophy would lead to a far better outcome in the long run.
Understanding Hybrid LTC Policies
The basic concept of hybrid long-term care (LTC) policies is fairly straightforward: to pair together life and long-term care insurance (hybrid life/LTC) into a single policy, or alternatively to pair together an annuity and long-term care insurance (hybrid annuity/LTC) into a single policy. Typically funded with a single lump sum premium, the hybrid policy provides the usual benefits/guaranteed associated with its life or annuity policy base, along with the available benefits of a long-term care insurance policy, with all the associated costs deducted directly from the cash value of the policy without current income tax consequences (this treatment was made more favorable for hybrid policies issued after 2009 under the Pension Protection Act of 2006).
Thus, for instance, an individual might put $200,000 into a hybrid life/LTC policy, that will pay a $400,000 death benefit if the client passes away, provide $400,000 of long-term care insurance benefits if he/she gets sick and needs care, and in the meantime the $200,000 of cash value remains invested in the policy and eligible for a modest rate of return (e.g., 1% to 3%). Notably, most/all of the growth in the policy at those interest rates will likely be eroded by the life and long-term care cost-of-insurance charges, but hybrid life/LTC policies typically provide a guarantee that no matter what, the client's original $200,000 remains assured, liquid and available without surrender charges or penalties (though withdrawals would impact available amounts for claims, and claims may affect the amounts available at surrender or death as well). Thus, in essence, the client gets a long-term care benefit if needed, a death benefit if the long-term care claims never manifest, and a guarantee for liquidity in the meantime. In the case of a hybrid annuity/LTC policy, the approach is similar, although the policies typically have a small surrender charge if liquidated early, and pay a lower rate of interest, but also have lower costs (as there is no life insurance death benefit to pay for, and the policy simply pays out its cash value at the time of death).
Perhaps one of the most popular features of hybrid LTC policies, though, is the fact that their costs are typically guaranteed, including and especially the cost of long-term care insurance charges that come out of the policy. This is a notable distinction from "traditional" long-term care insurance, where premiums are not guaranteed against future increases (and in fact for older LTC policies, significant premium increases have occurred in recent years for older policies that were underpriced when originally issued long ago, in addition to other changes in policy pricing and structuring).
The "Risk" Of Hybrid LTC Policies
The conceptual framing for hybrid policies is fantastic - to aggregate together offsetting risks (dying sooner reduces likelihood of big long-term care claims, living longer pushes out how soon life insurance claims are paid), and perhaps gain a little more scale for policy administration as well. However, it's hard to be excited about the actual product selection that’s out there, and the way they’re typically constructed at this point.
The primary issue, as I've discussed previously on this blog, is that those buying hybrid life/LTC or annuity/LTC policies are at risk to losing out on significant long-term returns, because if/when rates ultimately rise, there's no guarantee that hybrid policies will pay competitive fixed income rates of return. In other words, if a client puts $200,000 into a hybrid LTC policy, and interest rates rise to 5%, the hybrid policy might only pay out 3%, and the client "loses" $4,000/year of return as an indirect "cost" of holding the policy. In fact, the whole reason hybrid LTC policies can guarantee the LTC insurance costs is BECAUSE they are NOT guaranteeing to pay fair market returns when rates rise! Of course the company can guarantee that the LTC costs in your hybrid policy won't be increased by $4,000/year (or at all), when the company can simply under-pay on the return by $4,000/year to get the same result with impunity, because they control the money!
This is not to say that insurance companies are necessarily nefarious or that there's any particular reason to expect them to underpay on policies in the future; the point is simply that they can, that it is a risk, and that this risk entirely offsets the value of having the costs "guaranteed." Sure, if the hybrid LTC company isn't paying a competitive rate, the investor can take the money out and reinvest it - the principal generally does remain liquid - but then the client loses the LTC insurance, and might not be able to buy replacement coverage at that point! In other words, just as with traditional LTC coverage, if the policy "costs" increase (by underpaying on the return with a hybrid policy, or increasing the premium charges on a traditional policy), the policyowner is still faced with the choice to keep the coverage at the higher (direct or indirect) cost, or walk away and forfeit the policy and its benefits.
Even worse, though, the reality in today's marketplace is that some hybrid policies explicitly pay NO rate of return, they just provide a death benefit and a long-term care benefit (and a liquid return-of-premium cash value guarantee). While many clients don't care in an environment where cash pays "hardly nothing" anyway, the insurance companies certainly know that rates will eventually rise... and when it does, the returns from those rising rates is all money the insurance company keeps. The more rates rise, the more the insurance company makes, since it is contractually agreed upon for the company to not pay any interest rate to the investor at all! In other words, with the hybrid policies that pay no rate of return, this is basically the equivalent of selling a call option on interest rates to the insurance company, where the insurance company wins (and the investor loses) when rates rise... and if the investor wants out and chooses to reinvest, he/she has to forfeit the long-term care insurance policy just to reinvest the money elsewhere!
Accordingly, it seems that over the long run, investors in such circumstances (with hybrid policies that pay little or no return in today's environment) would end out with more money simply by investing the money themselves in bonds (or more aggressively if they wish), buying long-term care insurance with the bond interest (or other growth), and keeping the rest invested on their own (where the assets stay liquid simply because the client keeps control of it in the first place!). Of course, the bond interest might not quite be enough to cover the traditional LTC premiums right now (and therefore deplete principal slightly), but it will be more than enough once rates rise, which again seems like a reasonable "bet" for someone who still has a 10-20+ year time horizon for long-term care and retirement needs (and over that time horizon, the client could have generated an amount equal to the hybrid life/LTC death benefit just with normal growth!).
In other words, just as permanent insurance is often not competitive to "buy term and invest the rest", today's hybrid long-term care insurance is often even LESS competitive to "buy LTC and invest the rest" as soon as rates rise. Which means, in essence, many of today's hybrid LTC solution only "win" if rates stay unexpectedly low for an unexpectedly long period of time (and do you and your client really want to make a bet where you only win if rates DO NOT rise from here for the next 10-20+ years the client might be alive?).
When Are Hybrid LTC Policies Worth Considering?
Notwithstanding these concerns about the exposure to foregone income and growth if interest rates rise, there are a few situations where hybrid contracts are appealing right now are:
- Using a hybrid annuity with simplified underwriting (a unique offering from a few of today's annuity/LTC hybrids, that allow for coverage after only a very limited amount of underwriting) for a client who can’t get traditional long-term care coverage in the first place. If the client is in poor health and is high risk, and it's possible to get ANY coverage, such as from a hybrid annuity/LTC policy, that’s often a good deal. And the time horizon is likely short enough that the risk of foregone growth from future rising interest rates is greatly diminished anyway. In practice, we've already seen some very poor health clients get an offer from the insurance company to issue a hybrid LTC/annuity coverage (in part because the insurance company knows the overwhelming likelihood is still that the client will pass away before meeting what is often a 3-year self-insurance deductible period). Notably, it's generally only hybrid LTC/annuity policies that have simplified underwriting options, not hybrid LTC/life policies.
- Parking an existing appreciated annuity in a hybrid product, as a way to liquidate the gains for future LTC needs on a tax-preferenced basis. After all, under the standard treatment for annuities, withdrawals from an appreciated annuity are taxable, and often can only partially be offset by medical expense deductions when spent on long-term care insurance needs. However, claims paid directly from an (appreciated) hybrid LTC/annuity are 100% tax free under the changes that took effect in 2010 from the Pension Protection Act. Thus, if the goal is to earmark the funds from an appreciated annuity for long-term care needs anyway, a hybrid policy may be a more appealing way to execute the strategy (and at worst, the annuity will still pay out its cash value as a death benefit to beneficiaries, as it would have anyway). The caveat to this tactic, though, is that it has to make sense from an investment perspective, too, which isn’t always the case given how low the returns are on many fixed hybrid annuity/LTC policies. The approach must also be weighed against simply doing ongoing partial 1035 exchanges of the appreciated annuity to fund a traditional long-term care insurance policy directly on a tax-preferenced basis.
- Using a hybrid life/LTC policy for a portion of money that was specifically going to be allocated to lower-return bonds anyway AND is not anticipated to ever be needed. While the net return on the cash value of the life/LTC policy (especially after life and LTC insurance costs) may be mediocre, the internal rate of return (IRR) for the policy if held to death is often at least competitive with today’s bond rates (which is also why clients should be cautious about surrendering existing permanent pure life insurance policies in today's environment) and is guaranteed under the terms of the policy. With this strategy, the client gets a reasonably competitive fixed rate of return by holding the hybrid policy until death, and still gets significant potential upside if there’s a long-term care event. Notably, this is specifically for hybrid LTC/life policies, not hybrid LTC/annuity policies, as a key part of the value is the assuredness of the death benefit boost. On the other hand, if rates rise enough, the client might still have had more by simply keeping their investments liquid and buying traditional long-term care insurance separately.
The bottom line is that in today's marketplace, there are some opportunities to effectively use hybrid life/LTC and annuity/LTC policies, but the evaluation is more complex and nuanced than to simply focus on the guaranteed LTC costs, guaranteed liquidity of the policy, and potential to get a death benefit (at least for life/LTC policies). While those features may be appealing, as long as the insurance company gets to control the money, and the rate of return it pays, the guarantee on costs alone is meaningless, and clients must be cognizant than in a rising interest rate environment they may finish with far less money than simply buying traditional LTC insurance and investing the rest. This is especially true since, if interest rates rise, the risk of traditional LTC policies having premium increases is further diminished and it becomes more and more likely that today's LTC policies will experience no future increases; in other words, clients should be cautious not to run away from traditional LTC policies and towards potentially-low-return hybrid policies at the exact moment that traditional LTC premium increases are slowing and interest rates are near the bottom of a long-term cycle! Nonetheless, if a client's needs perfectly match one of the scenarios where a hybrid policy is appropriate, it's difficult to beat the cost/benefit trade-offs in today's environment!
