Investing Specialists

Could Your Long-Term Care Premiums Be Hiding in Plain Sight?

Christine Benz

Among the investor groups that I speak to, there's one topic that seems to create more angst than any other. No, it's not the threat of a stock market correction, or what an interest-rate shock could mean for bonds, or inflation. Rather, people tell me that they're worried about paying for long-term care and its possible implications for the rest of their plans.

No matter what decision investors have made about long-term care expenses, they see risks--and I do, too. If they've purchased long-term care insurance or plan to, they naturally worry that premiums could go higher, that the insurer won't be able to make good on its claims, or that they'll end up fighting with the insurance company over what type of care is covered. If they've foregone insurance with an eye toward self-funding long-term care costs, they wonder how much to set aside. What if their situation is an outlier and they require years and years of costly care that loots their portfolio? And finally, if they've decided that relying on Medicaid-provided long-term care is the only way they'll be able to pay for long-term care (and Medicaid covers upward of 60% of long-term care costs in the U.S.) they worry about what type of care they'll receive and where.

Given all of those concerns--and the inherent gloominess of long-term care in general--it's probably no wonder that many investors don't give long-term care expenses much more than an anxious thought or two (probably in the middle of the night). But my take is the current long-term care crisis--and no, I don't think that's hyperbole--is that it's time to get creative with the options for paying it.

Last week I wrote about the role that health savings accounts can play in paying for long-term care; HSA owners can use their accounts to pay the premiums or to cover eventual costs out of pocket. (There are pros and cons to either strategy.)

There's another potential avenue, too, albeit a more complicated one. People with existing annuities or whole-life insurance policies can take advantage of what's called a 1035 exchange to swap into long-term care insurance--either a standalone long-term care insurance policy or a hybrid life-insurance/long-term care or annuity/long-term care product. Such an exchange allows the investor to obtain a product that better fits their current needs and it can also be incredibly tax-efficient, assuming it's carried out correctly.

An intuitive aspect of the strategy--especially in relation to life insurance--is that it neatly trades off one type of risk protection for another, often at a life stage when it makes sense to do so. While a young accumulator with dependent children and/or a nonearning spouse should buy life insurance to provide income in case of premature death, his or her need for life insurance generally declines over time as the children grow into adults, the working years ebb away, and the investment portfolio gains in value. Of course, there are other reasons to hold life insurance beyond income replacement for dependents--estate planning considerations, for example--and that's a key selling point for whole life insurance policies versus term. But for many earners, the risk of not being able to provide income after a premature death becomes overshadowed with a concern over paying for long-term care. By the time a person is in his or her 50s, he or she may no longer have dependents and is also at a good age to begin contemplating long-term care insurance. (Wait too long and the coverage could be cost-prohibitive or out of reach altogether due to a pre-existing condition.)

A New(ish) Kind of 1035
A 1035 exchange allows an insured person to exchange one financial product for another of like kind (meaning same owner, same insured party) without having the transaction count as a sale and be subject to taxes. (Any surrender charges on the original policy would still apply, however.)

Whereas 1035 exchanges have been available for life insurance and annuities for years, the Pension Protection Act of 2006 opened the floodgates for exchanges from life insurance and annuity products into hybrid life/long-term care and annuity/long-term care products or pure long-term care products. Financial planning guru Michael Kitces delves into the history in this article; the provision that allows for annuity/life insurance exchanges into long-term care product went into effect beginning in 2010. Another benefit of conducting a 1035 exchange into a long-term care product is that even if the original product had an embedded gain, the ability to take tax-free withdrawals from the long-term care policy provides a tax-advantaged way to obtain long-term care insurance. Only qualified long-term care insurance policies (all of them on the market today) are eligible for a 1035 exchange. Meanwhile, as Kitces notes, the annuity must be nonqualified, meaning it was purchased with aftertax dollars rather than inside the confines of a retirement plan.

Needless to say, deciding whether a 1035 exchange is a good fit for you, and making sure that you're thinking through the key variables, is a complicated exercise. That underscores the value of seeking qualified, objective advice before proceeding. But for people whose life insurance or annuity products have outlived their usefulness, it's an approach worth considering. 

1035 Exchange Into a Hybrid Product
Because hybrid life/long-term care and annuity/long-term care products are purchased with a lump sum, the process of exchanging a life insurance policy or annuity for such a product is relatively seamless. As noted above, the owner and insured party with the initial product (whether annuity or life insurance policy) needs to remain the same as the insured with long-term care. In terms of execution, the major hitch for the transaction to qualify as a 1035 exchange is that the insured person can't receive a check for the product he or she is swapping out of; the money must go directly into the new policy.

At first blush, the hybrid products have a lot to recommend them. The most intuitively appealing aspect is that the insured receives a payout under multiple scenarios--in contrast to purchasers of pure long-term care insurance, who only "recoup" their payments if they end up needing long-term care. If a purchaser of a life/long-term care hybrid dies without needing long-term care, the full death benefit would be paid out to his or her heirs. On the other hand, if the insured has a long-term care need, funding such care would reduce the cash value of the policy accordingly. Annuity/long-term care hybrids, while less common, work similarly: If a long-term care need arises, those expenses reduce the amount of any eventual annuity payout.

Additionally--and this is a particularly big consideration for people who are north of age 55 or so--the underwriting standards for hybrids are less stringent than is the case for a pure long-term care policy. And because the hybrid policies are usually purchased with a lump sum rather than as a series of premiums, the purchaser effectively can sidestep the premium increases that have bedeviled purchasers of long-term care.

Yet the hybrids aren't perfect. As a general rule of thumb in the insurance marketplace, the more your policy covers you against a range of outcomes, the more you're apt to pay for it relative to a single-outcome policy like pure long-term care insurance. (It's obvious that a homeowner's policy that includes protection against fires, floods, and theft should cost more than one that protects against theft alone.)

And while the ability to buy such a policy with a lump sum effectively insulates the insured individual against direct premium increases, the buyer 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. Because the insurance company controls the cash value of the policy, it 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. The hybrid products are also more complicated than pure long-term care products, making it difficult to comparison-shop among insurers.

1035 Exchange Into Standalone Long-Term Care Insurance
Things get more complicated when swapping an annuity or life-insurance policy for a pure, standalone long-term care policy. For one thing, the number of available long-term care policies has shrunk dramatically over the past decade and a half, owing to a poor claims experience on the part of the insurers. There were more than 125 insurance companies selling policies in 2000, but that number had shriveled to 15 by 2014. Not only are would-be buyers of pure long-term care policies shopping in a shallower pool (so insurers have less incentive to be competitive), but it's impossible to find long-term care insurance that's available with a single premium. (Insurers realized that the single premium arrangement locked them into lower premiums than would actually be needed to satisfy claims.)

That has a couple of implications. First, today's purchasers of pure long-term care policies are subject to the threat further premium increases; in the most recent example, Genworth received approval from state regulators to hike premiums by 58% on existing policies. There are also logistical challenges to purchasing long-term care insurance because single-premium products are no longer available. In order to exchange into such a product from a life insurance contract or annuity, the policyholder must conduct a series of 1035 exchanges to complete the "buy," as Kitces discusses here. That may be fine for those who have a trusted financial advisor who can carry out the staged transactions, but is cumbersome for people who are managing the transactions on their own.