Wade Pfau, Ph.D., CFA, RICP®

Hybrid Long-Term Care Insurance Policies

Click here to download Wade’s “Pros and Cons of Long-Term Care Funding Options” sheet.

Attempts to combat concerns about traditional long-term care insurance have resulted in combination or hybrid products using an asset-based approach to fund long-term care. These new approaches generally combine long-term care funding with life insurance or an annuity.

For instance, one asset-based strategy involves the purchase of a long-term care insurance policy bundled with a whole life insurance policy. This strategy may be done with a single upfront premium, a set of premiums for a fixed term, or ongoing premiums. The cash value is invested and liquid after surrender charges, and the policies generally will provide a fixed interest rate for cash value growth.

Long-term care expenses are first subtracted from cash value before an insurance company must actually cover care expenses with other resources, which allows these policies to be viewed as high-deductible policies. These policies generally provide a death benefit for a fixed amount, less any long-term care claims. To be clear, there are additional charges for the life insurance benefit. The death benefit is spent first, and an optional continuation of benefit rider for the policy could allow for long-term care benefits to continue being paid even after the death benefit has been spent.

For large upfront premiums, these policies may provide an outlet for funds that would have been invested in short-term fixed income assets anyway, so the opportunity costs from potential lost investment growth are less. When compared to low-yielding short-term fixed income assets, a competitive return is provided by the death benefit in the event of a long-life and unused long-term care benefits. The internal rate of return, however, could be significantly higher if the long-term care benefits or death benefit are used earlier in retirement.

Funds sourced to support the asset-based long-term care protection are generally drawn from low-return, low-volatility resources such as cash, CDs, and money market accounts. Conceptually, households may view these funds as part of their emergency or contingency fund, and the long-term care asset can be treated as part of the contingency fund.

A policy might support an internal rate of return guaranteed to be about 1.5% for the death benefit, net of all insurance expenses and taxes. The internal rate of return would be the lowest for couples who enjoy long retirements and do not experience long-term care events. Because the death benefit and care proceeds are received tax free, this advantage must be taken into consideration when compared with other options. Internal rates of return may be much higher, to the extent that both members of the couple experience costly long-term care events and/or the estate receives the death benefit earlier in retirement.

Assets for funding long-term care should generally be viewed as coming from the contingency part of the retirement portfolio, rather than the upside part. And for low-risk and liquid contingency options, a worst-case (which really means best-case in terms of life quality) return of 1.5% net-of-fees and taxes may be entirely reasonable. This return is compared to what might be earned after taxes in investments like CDs or a savings account.

To consider a basic example for how these policies may be structured, consider the example of a one-time $70,000 premium placed into a life insurance contract that provides a death benefit of $125,000. The death benefit can be spent down in advance at a set rate for qualified long-term care expenses, and the unused cash value of the contract remains liquid (after surrender charges) while growing at a modest rate similar to short-term fixed income investments after deducting insurance charges. Tapping the cash value for non-qualified expenses would negate the value of the insurance, though.

Of importance is that those insurance charges were guaranteed in advance as part of the policy and cannot be increased, unlike the case with traditional long-term care insurance. The nature of this long-term care benefit makes the policy behave more like a high-deductible policy, since the cash value is spent first for long-term care expenses and the insurer is only on the hook to pay expenses once the cash value has been depleted. Meanwhile, for those who make it through retirement without long-term care expenses, the death benefit remains.

These newer approaches have sought to eliminate a number of the perceived disadvantages of traditional long-term care insurance, such as premium hikes, finite benefit periods, fears about not making it through the underwriting process, and the general use-it-or-lose-it nature of insurance products. The death benefit is provided when the assets are not used for long-term care expenses. Premium increases can be avoided by paying with a single premium or with a guaranteed set of premiums for a finite period of time. Versions are available that lock costs in at the start, which alleviates the problem of those holding traditional long-term care insurance allowing their policies to lapse in the period leading up to needing care, either because financial constraints left them unable to pay or because cognitive decline led them to either forget about the policy or to think it is no longer needed.

A continuation of benefit rider may be added, which can allow for lifetime benefits after the maximum benefit period for the base policy has been reached. Underwriting is generally more basic, often with a simple phone interview or basic health questionnaire and no medical exam. Simplified underwriting makes this option available to those who may not otherwise qualify for traditional long-term care insurance. Some policies are also issued jointly for spouses to share, with the death benefit provided at the last death.

Michael Kitces has noted a downside for these sorts of upfront paid-up policies at his blog, though, which is that if interest rates rise, the interest paid by these policies may fail to keep up with higher subsequent market rates. Insurers do not have to raise the interest rates paid on the policy’s underlying cash value. This leaves the initial lump-sum put into the contract stuck within a lower-yielding environment than otherwise possible.

Kitces suggests to ‘buy traditional long-term care insurance and invest the rest’ as an analog to the popular refrain about buying term-life insurance. Rising rates could serve as a de facto premium increase of sorts because of the lost interest-earning potential of the policy, though the case still remains that the policy has been paid up and cannot lapse. In this regard, the concern is somewhat mitigated, similar to how a retiree holding an individual bond to maturity knows what they will receive even if a rise in interest rates lowers the marketable price of the bond during the interim.

Nonetheless, Kitces notes that those seeking insurance might be better off setting aside a large enough portfolio of bonds so that the bond interest can pay the insurance premiums on a traditional policy. Assuming interest rates increase, high-future interest from these bonds could offset any subsequent premium increases from the policy. At the same time, rising rates would reduce the odds that premiums have to increase; part of the explanation for rate increases with traditional policies is that interest rates have remained at unexpectedly low levels for a long period of time, reducing the growth for the insurer’s asset pool.

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