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Behavioral Finance and Long-Term Care Insurance

Long-term care insurance is a thorny, multifaceted issue.

Justin A. Reckers and Robert A. Simon, 03/17/2011

Last month we touched the subject of behavioral finance in life insurance decisions and saw quite a bit of feedback from the readership. Some was good, some was bad, some was indifferent. Many readers took the discussion of sales tactics pretty hard and felt the need to defend the insurance-sales industry. We want to stress again the underlying concept of the article was far from being a definitive answer to the perennial question of whether investors should buy term and invest the difference. It was certainly not aimed at impugning the sales tactics of the life insurance industry. Rather, we seek to uncover the relationship between emotion and economic theory at the point of financial decision-making. Make observations about the drive of each power and help others understand how these observations can be used in practice to help everyone make better financial decisions through applied behavioral finance.

This article focuses on long-term care insurance. We will look at the product itself, the emotional aversion or motivation to its use as well as how and why state and federal governments have gotten involved to help promote the economic "rationality" of the product.

Unlike life insurance, long-term care does not have an easily quantifiable probability of paying benefits. In order to receive benefits under a long-term care policy an insured must be considered chronically ill and unable to perform certain activities of daily living. Very few consumers understand what this means before meeting with an insurance agent. The ones that do will have been in a position to provide the necessary care for a loved one at some point in their lives. Those who have been in the caregivers role in the past will understand the two main reasons for most people to purchase long-term care insurance 1) protect against the potentially devastating effect of the cost on other financial goals and plans and 2) insulate the caregiver from the negative physical and financial affects of their role.

The first step in uncovering the emotional component of this step in the planning process lies in the client's ability to comprehend the emotional cost of long-term care. Many will not immediately consider the emotional cost to their loved ones of providing care on a day to day basis. Many people will have a more visceral aversion to accepting care in a nursing home or other facility and completely avoid the conversation about long-term care. This may be rooted in an aversion to change or bias towards the status quo or a lack of understanding around the options they have for their care.

We believe that concern for caregivers is one of the greatest components of the underlying need for long-term care insurance. Helping clients connect the concern they have for the well-being of their spouse and children with the possibility that they may be the exact people charged with their daily care should help develop an emotional connection and motivation towards considering long-term care insurance.

Once the emotional connection is made the client should be more open to understanding the availability of in-home care versus nursing home care and all of the other truly valuable terms of current long-term care insurance products. Working through these policy provisions and concentrating on the options available for minimizing change should help remove the status quo bias of many clients who believe long-term care is only for nursing homes.

State and federal governments believe long-term care insurance is economically "rational," at least from their perspective, and have thrown their support behind it in the last fifteen years.

The federal government most recently got involved in promoting long-term care insurance through a provision in the Deficit Reduction Act of 2005. The DRA created a national long-term care partnership program allowing each state to set up their own programs combining private long term care insurance as the primary payer of benefits with Medicaid as the secondary payer once the private policy benefits have been exhausted. Individuals are then allowed to protect a portion of their assets instead of spending them down to qualify for Medicaid coverage. The beauty the program is two-fold. Individuals are rewarded for planning ahead and purchasing long-term care policies while state budgets are preserved by requiring that the benefits of those qualifying insurance policies be paid before Medicaid benefits can be accessed.

Many states have followed the Fed's lead and developed long-term care partnership programs over the years. The states want individuals to provide for at least a portion of their own care. In order to facilitate this they have developed plans that mandate certain provisions and guarantee asset protection strategies under Medicaid law. The details of each state program differ but the underlying idea is one rooted in behavioral finance. The states want citizens to buy long-term care insurance because Medicaid will be next in line to pay the costs if individuals do not plan for it themselves. More individual long-term care insurance means less drain upon state Medicaid budgets. Richard Thaler might call this "libertarian paternalism."

The evolution of long-term care insurance products as well as state and federal government encouragement of their use has led to a tremendous increase in its use as a financial planning tool. So does it make economic sense? Clearly the state and federal powers that be have decided long-term care insurance makes economic sense and have chosen to throw their weight behind it via partnership programs and tax-qualified plans. They believe, from an actuarial perspective, an increase in individual coverage will help reduce state expenditures through Medicaid and bolster state budgets.

Economic "rationality" from the consumer side is complicated by the myriad of options and choices available in the market place today. Different options make economic sense for some and do not for others. A partnership policy makes little sense for a high-net-worth individual since the Medicaid asset protection likely has no value. We care more about getting to the bottom of the emotional motivation for clients in this case to help facilitate "rational" decision-making. The state and federal government support is just another great example of government involvement in our everyday financial decision-making.

We will continue our applied behavioral finance series next month with observations and applications in estate planning and probate.

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