Are Long-Term Care Insurance Hybrids All They're Cracked Up to Be?

"What about life/long-term care insurance hybrids?"

That question, or some variation of it, began hitting my inbox as I wrote about long-term care insurance earlier this summer. Readers said they liked the "multitasking" nature of these hybrid policies, as they offer either an annuity or life insurance in addition to a long-term care component. That means that the premiums wouldn't go to waste if the purchaser doesn't end up needing long-term care.

Several also noted that the health screening for these types of policies--especially the hybrid annuity/long-term care policies--can be less stringent than is the case with straight long-term care policies. And because these policies typically require a lump-sum premium, hybrid policyholders won't face the same premium increases that traditional long-term care insurance policyholders have confronted over the past several years.

Likely owing to those attractions, sales of the hybrid products have grown by double digits in each of the previous five years, according to LIMRA, which provides research on the insurance industry. Meanwhile, sales of standalone long-term care policies have been declining.

Yet, even as hybrid policies can make sense in certain instances, there can be significant drawbacks, too. As with any product that isn't straight insurance, the various features (and the fees associated with them) can make it difficult to comparison-shop. Perhaps more importantly, purchasing a long-term care policy today may not look like such a savvy move in hindsight, especially if the premiums on standalone long-term care policies stabilize and/or interest rates trend up--both realistic scenarios.

A Range of Outcomes
Long-term care hybrid policies are different from straight long-term care insurance in that they pay out something even if someone doesn't require long-term care.

For example, a hybrid life/long-term care insurance product would provide life insurance, but also include a rider that would cover long-term care costs. If the individual required long-term care during his or her lifetime, the cash value of the life insurance policy would be reduced accordingly.

Similarly, the hybrid annuity/long-term care product functions like an annuity, but the long-term care rider means that it can provide a higher level of monthly income if long-term care is needed. When long-term care coverage is needed, the value of the benefit is subtracted from the value of the annuity.

The flexibility of these policies has intuitive appeal. True, two thirds of individuals over age 65 are projected to need some form of long-term care in their lifetimes, and the costs of extended care can be ruinously high, which is why insuring against that risk is often advisable.

But that means that a third of the population will not require long-term care. The life/long-term care insurance hybrid policyholder who dies at 70 without having used any of the policy's long-term care coverage will still be able to leave a death benefit for his or her beneficiaries. Similarly, the person who purchases a hybrid annuity/long-term care policy but lives to age 95 without touching the long-term care coverage will be able to tap the annuity for income throughout his or her long lifetime.

You Paid How Much for That Insulation?
Another benefit, at least in theory, is that hybrid policyholders will be insulated from the premium hikes that purchasers of long-term care policies have confronted in recent years. The hybrid policies typically require an upfront lump-sum premium, whereas long-term care premiums are usually paid on an ongoing basis, often annually. Thanks to the confluence of very low interest rates (which means insurers can't earn much on policyholders' money), high rates of long-term care usage, and lower-than-expected lapse rates, many insurers have increased premiums in recent years. Policyholders have had to choose between forking over the higher costs, accepting a lower future benefit, or letting their policies lapse.

Those premium increases are likely one of the key reasons that, despite high long-term care usage, demand for the products has actually declined. But Michael Kitces, a partner and director of research for Pinnacle Advisory Group and publisher of the financial-planning industry blog Nerd's Eye View, believes the ability to "lock in" the premium on a hybrid policy may provide a false sense of security.

Yes, the person who buys a hybrid in lieu of a straight long-term care policy may be dodging future premium increases. But, Kitces argues, the worst may already be over in terms of long-term care premium hikes. That's because insurers are pricing policies more realistically, factoring in currently low interest rates, insurers' claims experience, and low lapse rates from existing policyholders. Additionally, insurers will also likely have the tailwind of higher interest rates at some point. That means they'll be able to turn a profit on long-term care policies by investing the premiums; they won't be forced to increase them.

A related issue, which Kitces discussed out in this blog post, is that even as purchasers of hybrid policies can effectively lock in their premiums--because they make their purchases with a lump sum--they still face a potential opportunity cost. By plunking down a lump sum, the purchaser of the hybrid policy effectively cedes the right to earn a higher return on that money in a more favorable yield environment, turning it over to the insurer instead. That's because the insurance company controls the cash value of the policy, and is under no obligation to increase cash value as prevailing yields trend up. Indeed, some of the policies don't promise any growth of principal at all.

"I'm very afraid these products will end up being spectacularly costly for today's buyers," Kitces said. "They're just paying in opportunity cost and the upside of interest rates, rather than hard-dollar cost in the form of a check."

For those reasons, Kitces believes that the right answer for many would-be hybrid purchasers--especially those who think there's a good possibility that rates will trend up--is to buy a long-term care policy and invest the rest. "If you think rates are going to stay low like this forever, buy a hybrid policy. But if you think rates are going to rise, buying a traditional long-term care policy and keeping your cash flexible to reinvest may be far better," he said.

Kitces does allow that the hybrid policies may be appropriate in certain instances. One of the key situations would be if an individual would not otherwise qualify for a pure long-term care policy due to health factors; he or she may in fact be able to qualify for a hybrid policy, especially an annuity/long-term care hybrid. According to the American Association for Long-Term Care Insurance, some policies offer "simplified underwriting," which means that no physical or medical records are required; rather, the applicant may have a telephone interview with a nurse about his or her health.

Kevin Loffredi, an annuity expert and vice president of integrated web tools for Morningstar, says the hybrids can also make sense for individuals who already have annuities but want long-term care insurance as well. "Many investors have assets sitting in fixed annuities not earning much. They can leverage those dollars to purchase this type of policy. From the investor perspective, they are using an asset more efficiently," he said. Such an exchange is possible thanks to the Pension Protection Act of 2006, which altered the Section 1035 rules. Check with a tax advisor before embarking on any such exchange.

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