Insurance functions best when it is used to cover high-cost low-probability risks — things that aren’t likely to occur, but would be devastating if they did. Technically, paying insurance premiums on an ongoing basis has a slightly greater expected loss than just retaining the risk, but the trade-off — converting a potential financial disaster into a manageable ongoing premium — is appealing.

Yet long-term care coverage has a challenge: What was once believed to be a higher-cost, lower-probability event has now turned into a very high-probability event with an increasingly large volume of lower-cost claims. As a result, long-term care insurance has begun to morph from effective insurance into something that looks more like just prepaying long-term care expenses in advance — at a high premium rate and with little insurance leverage.

Perhaps it’s time to reform long-term care insurance policies so that they once again focus on high-impact, low-probability events. For instance, what if elimination periods for long-term care insurance were increased to allow for a two- or three-year deductible, instead of today’s common three-month period? That way individuals could take the significant premium savings and use it to cover their care during that time period.
Could such an increase in deductibles reduce the cost of long-term care insurance coverage enough to make it affordable once again to at least a much larger segment of the general public?

SHIFTING ODDS

For insurance to effectively manage risk, an event should have both low likelihood and relatively high impact.

When insurance covers a small number of high-impact events, the cost of operating the insurance company is very small relative to the amount of premiums and potential claims. When insurance covers low-impact events (with lower-cost claims, but at greater frequency), overhead ends up consuming a larger percentage of the premiums — reducing the implied leverage of the insurance.

In fact, if the risk is inexpensive enough, it would be much cheaper to simply self-insure and avoid the share of premiums that goes to the insurance company’s overhead and profits — especially if the likelihood is so high that the expense can be reasonably anticipated.

Unfortunately, this dynamic of high-cost/low-probability versus low-cost/high-probability events is present in the world of long-term care insurance. When first created, the insurance was intended as a form of coverage to protect against the high-impact but lower-probability risk of needing long-term care assistance at an advanced age; one key study estimated that the risk of needing a nursing home was 27% for men and 44% for women (which isn’t all that low).

Yet with sustained improvements in medicine over the past several decades, life expectancy has increased. Far more adults (and even more affluent planning clients) will reach the advanced age where some type of long-term support is necessary.

In fact, the real risk of a 60-year-old needing long-term care is now estimated to be a whopping 50% (and some research suggests it’s as high as 65% for a 50-year-old female). In other words, on average one out of every two people who are now age 60 will need long-term care at some point during their lifetime. Needing any long-term care has morphed from (somewhat) low probability to increasingly high probability.

In addition, recent research suggests that long-term care may actually be a lower impact event than estimated previously. Industry data from the American Association of Long- Term Care Insurance shows that 45% of nursing home stays last one year or less, and 75% last no more than three years. The probability of a true high-impact event — say, a five-year nursing home stay — is only 12%. (Notably, these probabilities would be a bit higher if you include home care, as well.)

A 2013 study suggests the average nursing home stay could be as short as just over a year. The researchers found that previous studies may have failed to recognize how often people enter facilities but recover and are discharged. This means even those with two to three years’ worth of cumulative stays may be doing it with a series of shorter long-term care events, not one extended high-impact event.

Why does this matter? Because, as noted earlier, if the need for long-term care is actually a rather high-probability but fairly low-impact event — with 50% probability of needing care, but stays averaging little more than a year — then traditional LTC insurance may be little more than prepaying long-term care expenses, and not really functioning as effective insurance.

THE FIX

The solution is to restructure long-term care insurance once again to focus on low-probability, high-impact events.

For traditional types of insurance, this is accomplished by establishing deductibles — a portion of claims that are paid out of pocket — eliminating smaller (and more likely/frequent) claims, and ensuring that the only claims are the truly large and material ones. (Think higher deductibles on homeowner’s or automobile coverage.) Focusing only on the big claims makes the coverage much cheaper, because even though they’re expensive, those big claims have such low probability.

In the context of long-term care insurance, the “deductible” is the elimination period — that period during which the individual is eligible for and receiving care, but paying out of pocket. With long-term care insurance, the deductible can range from 0 to 365 days, but over 90% of long-term care insurance buyers get coverage with a three-month elimination period.

Yet with an average length of stay significantly longer than this, the deductible isn’t actually achieving its purpose of carving out high-frequency small claims. (Remember that in the long-term care world, a year or two is a small claim, whereas a large claim might be five-plus years of care.)

What would a more effective, higher-deductible LTC policy look like? Imagine a policy that has a five- or 10-year (or even a lifetime) benefit period, but a two- to three-year elimination period to go along with it.

LONGER ELIMINATION PERIODS

With an elimination period that high, even the average stay in a nursing home will fall within the deductible period; the actual probability of ever having a material claim against the long-term care insurance would fall dramatically. That’s good, as it means the cost of coverage could fall significantly, while policies could simultaneously have richer benefits (after the elimination period) and do a better job of insuring against extreme events when they occur.

Currently, long-term care insurance has become so expensive that more than two-thirds of all policies sold have a benefit period of just four years or less — meaning that clients are effectively insuring the early years of care and self-insuring the later years. Longer elimination periods would allow consumers to self-insure the shorter early period instead, and then have less expensive insurance coverage for the rest.

This would shift long-term care insurance back to a traditional insurance model, covering the high-impact, low-probability catastrophic events.

Of course, this still means many (even most) people will need to save and create reserves to handle that elimination period — but on the plus side, they should be able to cover much of it with all the long-term care insurance premiums they are no longer paying.

Why hasn’t this approach already been put into practice? In an effort to protect consumers, most states actually require all long-term care insurance sold in the state to have an elimination period of no more than 365 days. These are remnants of consumer protection laws passed several decades ago when long-term care insurance was cheap and ultralong elimination periods were not considered necessary.

Yet as long-term care needs and insurance have evolved, these state laws still require elimination periods so short they render LTC insurance unaffordable for many. This drives up premiums, limits the pool of participants and forces industry consolidation. Imagine how expensive automobile insurance would get if state laws prevented anyone from buying automobile insurance with a more-than-$50 deductible, and you have an understanding of how these laws, despite good intentions, have hampered the market for long-term care insurance.

Of course, the whole purpose of laws limiting elimination periods was to ensure that people don’t go bankrupt waiting to be able to make a claim. Policies with longer elimination periods may need additional financial underwriting, or some other process that will reduce the risk that consumers might buy untenably long elimination periods.

Yet any such solution may still be an improvement over the current state of affairs, in which so many people don’t buy any coverage because the short elimination period is outright unaffordable.
Another incentive for states is that by having policies with longer elimination periods but longer subsequent benefit periods, there’s a potential reduction in future state Medicaid claims as more people buy coverage.

That would be an improvement from the way things stand now, when so many can’t afford coverage — and many others buy policies short enough to cover a limited period of claims, then gift away assets to qualify for Medicaid.

HYBRID POLICIES

Notably, while traditional LTC policies can’t offer it, there actually is one current form of high-deductible LTC coverage: most of today’s hybrid annuity- or life-insurance-based LTC policies, an indirect result of their cash-value-based claims structure. These policies aren’t subject to the existing state laws limiting elimination periods on traditional long-term care insurance.

In fact, hybrid policies may be increasing in popularity simply because they offer a form of high-deductible LTC coverage that is in demand and can’t be purchased elsewhere.

Unfortunately, though, hybrid long-term care policies ultimately risk being dramatically more expensive for consumers in the long run, if (or when) interest rates eventually rise and the cost guarantee turns out to be a mirage.

At a minimum, consumers should have the choice of a high-deductible traditional long-term care policy or a hybrid policy, and decide whether they wish to keep control of their cash value and how it is invested.

The bottom line is that the nature of our long-term care needs continues to change with advances in medicine and increases in longevity — our LTC insurance needs to adapt, as well. By restructuring elimination periods, the coverage can be adapted back to its primary purpose — to insure against an extended, financially devastating long-term care event — and in the process bring down the cost and make the insurance accessible to more people who want and need it.

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., and publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

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