The Private Insurance Market

I’m currently in the process of buying long-term care insurance—you know, so my daughter won’t have to take care of me when I’m old. I have a good agent who knows all about the market and has answered every question I’ve had. I understand personal finance, opportunity costs, discount rates, and inflation. I know my way around a spreadsheet (one benefit of my years at McKinsey). But I find it’s still hard to figure out what to do.

A bit of background: Long-term care insurance pays for your stay in a nursing home if you become unable to take care of yourself. Depending on the policy, it may also pay for care you receive at home instead of going into a facility. According to the insurer I’m considering, the median annual cost of a semi-private room in a nursing home in my state is $145,000, and the average stay is something like three years. To put that in perspective, in 2009, the median net worth of families where the head of household was of age 65–74 was $205,000 (including real estate assets).

Long term care is not covered by Medicare, except for a short period after each acute event. It is covered by Medicaid, but to be eligible for coverage you have to exhaust all of your assets. Despite that onerous requirement, Medicaid currently covers 40 percent of all spending on long-term care. (2011 Long-Term Budget Outlook, p. 39.) The Affordable Care Act of 2010 included what is known as the CLASS Act, which would have allowed anyone to buy long-term care insurance, with an average benefit of $75 per day, for a monthly premium of $123. The CLASS Act, however, has been suspended because the administration could not certify that it would be deficit-neutral over the long term. So the bottom line is: until you use up all your money, you’re on your own.

Still, shouldn’t you be able to buy protection in the private insurance market? The short answer is: not really.

The first problem is that private long-term care insurance is designed to help you pay for long-term care, but not to insure you against open-ended costs. Most policies have limits on both your maximum daily benefit and your lifetime total benefit, so a typical policy will only cover you for, say, three or five years. Unlimited duration policies do exist, but they are priced to deter people from buying them—because insurance companies don’t want that risk on their books. So an insurance policy will help you pay for long-term care, but won’t take away the tail risk—unless you’re rich enough that you can cover the tail risk yourself.

The second problem is that there’s no way to protect yourself against inflation. The “inflation protection” in the policies I looked at is a simple annual increase in your daily benefit by 3 percent or 5 percent. It isn’t indexed to actual inflation, let alone to actual inflation in the cost of long-term care, which is what you care about. This is important because, if you’re in your forties, you’re buying a policy you will probably need in about thirty years. Again, the insurance companies don’t want that risk, so you get to keep it. So if you buy the maximum, 5-percent protection clause, there is a decent chance that your benefit will keep up with actual costs, but there’s no assurance that it will.

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The third problem is that you can’t protect yourself against your premiums going up in the future. The standard way to pay for long-term care insurance is to pay an annual premium that stays flat in nominal terms for the rest of your life. This means that you’re overpaying (relative to the actuarial cost of the insurance) in the early years and underpaying in the later years. But if the insurance company figures out that it has underpriced long-term care insurance in general, it can file for a rate increase and boost your premium payments down the line. And by that point, you’re stuck. You can’t switch insurers because the new insurer won’t take into account the overpayments you made to the old insurer, so it’s certain to charge you higher premiums.*

In a competitive market, doesn’t that just mean that someone will enter the market with a product that includes real inflation protection and a lifetime premium guarantee? Well, it hasn’t so far. But more importantly, that wouldn’t be real insurance either, because of the fourth problem. With long-term care insurance, you’re buying a product you probably won’t need for decades, at which point the world will have changed considerably. There is a decent chance that your insurer has mispriced the risk (more people will need long-term care than they expect, or long-term care will be more expensive, or medical advances will mean that people are living longer in long-term care)—in which case it will go out of business. And then your insurer won’t be around when you need it.** Insurance companies try to protect themselves by (a) not offering real inflation protection and (b) reserving the right to raise your premiums in the future; if they didn’t, they’d be even more likely to fail. But that still isn’t perfect protection, which means you’re taking on counterparty risk.

Then there’s the fifth problem, which applies to all private insurance without a governmental mandate: adverse selection.

In short, the private market doesn’t provide good long-term care insurance—because it can’t. The insurance you can buy is really just a way of reducing the amount you’ll have to pay for long-term care; it’s a financial planning tool that tightens the distribution of your expected long-term net worth. My spreadsheet says it’s worth it on that basis, so I’m planning to buy it (although I’m not accounting for counterparty risk or the risk of future premium increases). But it isn’t insurance against extreme outcomes.

If we want real long-term care insurance, there’s only one place where we could get it: the federal government. The government can offer unlimited coverage and real inflation protection (benefits based on actual costs at the time you incur them) because it has the ability to absorb long-term financial risks. It can mandate universal coverage, eliminating adverse selection. Because it can raise premiums (or other taxes), it will not go out of business. (Those potential premium increases, however, do mean that it can’t offer a lifetime premium guarantee.)

If this sounds radical, it shouldn’t. We already do virtually the same thing: it’s called Medicare Hospital Insurance, and it’s one of the most popular programs in existence. The Hospital Insurance trust fund is facing a long-term deficit, but that’s not because of its basic structure: it’s because the premiums it charges (payroll taxes) haven’t gone up along with health care inflation, so it’s systematically undercharging for the risk it’s taking on.

A federal long-term care insurance program would pool a major financial risk that most middle-class families today are facing alone. (Arguably, if you don’t have any assets, you don’t face any risk because of Medicaid.) This is exactly what governments are supposed to do: protect ordinary people from risks that they cannot absorb and that private markets do not provide good solutions for. It would probably also help budget deficits in the long term. The government already picks up 40 percent of all long-term care spending through Medicaid, for which it gets nothing; a real long-term care program could pay for itself through payroll taxes, reducing Medicaid spending.

Now I know the last thing that will happen today is a new social insurance program. Instead, middle class people will continue hoping they don’t need long-term care, elderly people will spend all their money on long-term care and then go on Medicaid, and government spending on Medicaid will continue to climb. But that’s a comment on our political environment, not on the proper role of government in society.

* You can accelerate your premium payments by paying the whole thing over ten years, which reduces this risk; but the people who can afford to do that are usually people who can self-insure for long-term care anyway.

** There are state guaranty funds that pick up policies from bankrupt insurers, but their benefits are likely to be less than what you originally paid for.