Many Americans who begin exploring long-term care insurance options are initially surprised by the price tag associated with premiums. Premiums for long-term care insurance can cost almost as much as premiums for health insurance, and are way more expensive than other types of insurance that many people are familiar with (like home or auto insurance).
While the sticker price may be surprising, there are good reasons that the premiums are so expensive and in this blog post I will dig into the economics of the insurance industry, why LTCI itself is so pricy, and why high prices help to ensure coverage under many uncertain scenarios.
What is insurance, really?
Insurance is a product that allows you to purchase certainty.
It’s important to recognize that, on average, most people will pay more insurance than they will receive in benefits over the course of their lives. Most people will not have their houses burn down, but yet they will pay their homeowner’s insurance every year — and they will be happy that they never had to use their insurance! What they purchase, when they buy the insurance, is a limitation on their downside risk when the worst happens. Rather than having to save enough money to rebuild their house if it burns down in a fire, they buy the certainty of insurance so they know that if the worst happens they will not be out on the street. By purchasing certainty, homeowners can use the money that they would have had to save in case their house burned down for other things (like buying a boat or paying for a kid’s college).
How do insurance companies set premiums?
Insurance companies set premiums by estimating the risk of an event happening (and the total loss that might come along with such an event) and then setting premiums high enough to cover that expected loss. So when you purchase homeowners insurance, the insurance company will assess the value of your house, how frequently fires occur in your area, and the age of your house (which may impact the likelihood of having faulty wiring or older construction method that can cause or worsen fires). The insurance company creates a statistical risk model by pulling together a ton of data on the relative risk of fires from similar homes in similar areas and then will use that estimate of risk to set your premiums.
For a product like homeowner’s insurance, it is relatively straightforward for the insurance companies to build an accurate model of risk. Sometimes they will under-estimate the risk of fire within a given year, and so the next year they’ll raise premiums after they have to pay out more in claims than they made in premiums. Similarly, if their premiums were set too high and they did not have to pay out as much money as their models expected, the following year they will lower premiums to acquire more customers.
Insurance companies make money when the total amount of premiums they receive is greater than the total amount of claims they pay out. You may be wondering “what keeps the insurance company from overcharging for insurance and making a boatload of profit?”. Because the market for insurance is competitive, insurance companies are in competition with each other to acquire customers — if one insurance company charges more in premiums than their competitors, they will lose customers and will quickly go out of business. In general, this competition keeps premiums in-check across the market so that all of the insurance companies are able to make some (but not too much) profit.
What’s different for long-term care insurance?
Long-term care insurance is more difficult to price than other forms of insurance for a number of reasons:
- The claim period generally comes many years after the policy is initiated (often 10+ years)
- The risk of needing long-term care has been increasing dramatically as life expectancy has increased and life-prolonging medical care has improved
- The cost of providing long-term care has been increasing as medical-care costs have risen generally
The first point is the most important. Long-term care insurance companies must set a price today based on their estimate of the expected loss that could happen 10-20 years from now. This is especially difficult because they have to predict what might happen to longevity and the costs of medical care in 2035! If you believe that longevity will increase 5 years between now and then the implications for the correct long-term care insurance premium is very different than if you believe longevity will increase by 10 years by then.
In fact, in the 2000s, many long-term care insurance companies realized that they had dramatically under-priced the policies that they had sold and faced two unappealing options:
- Go out of business and default on the claim obligations
- Raise premiums for the existing customer base dramatically
Many policyholders were (understandably!) upset when insurance companies raised their premiums in order to be able to cover their looming losses. In response to these changes, many people lost faith in the long-term care insurance industry and similarly many companies simply stopped selling this insurance because they felt it was too risky.
Today, insurance companies that are still writing long-term care policies have adjusted their prices to better incorporate this uncertainty. Because, after learning some hard lessons over the past few decades, they have realized that they need to build in a lot of uncertainty into their models to cover what could happen in the unforeseeable future. This is the main reason why long-term care insurance premiums seem so expensive — the insurance companies have to account for a lot of uncertainty in what might happen in the next 20 years so that they will have enough money to cover their costs.
So is long-term care insurance a bad deal?
Not necessarily. One of the great things about insurance is that it allows people to pool their risks together. If the insurance company is worried about how much the risk of needing long-term care might increase in the next twenty years and how much the costs of providing that care might increase over the period, then you probably should be concerned about that as well!
Purchasing certainty around the economics of long-term care for your family may come at a large cost, but many individuals do find this extra layer of protection is well worth it. At Bolster, we are passionate about helping families build their savings, planning, and coverage to see their retirement through the long-haul (including the possibility of long-term care). Ready to take the first step to make your retirement plans more robust in the event of a long-term care scenario? Sign up with Bolster now, and we’ll give you monthly updates on our retirement and LTC planning resources.