Long Term Care Insurance: A Lesson For All Actuaries

1. Long Term Care Insurance: A Lesson For All Actuaries Middle Atlantic Actuarial Club 2008 Meeting September 18, 2008 John Wilkin Actuarial Research Corporation (ARC)

2. What is Long Term Care Insurance (LTCI) • LTCI pays for nursing home care or home health care when the policyholder becomes frail. • LTCI is guaranteed renewable and financed with a level premium that varies by issue age.

3. LTCI: Elements of Health, Disability, and Life Insurance • Benefits like health insurance: • Nursing home • Home health care • Benefit Trigger like disability insurance: • Unable to perform Activities of Daily Living (which is similar to unable to work) • Cognitive impairment (Alzheimer’s) • Financing like whole life insurance • Level premium for benefits paid near the end of life

4. How Should LTCI be Regulated? • It is a unique product that should have its own regulations • When policies were first issued in the 1980s, there were no regulations specific to LTCI • Based on historical development (stemming from policies covering short-term nursing home stays after a hospitalization), state insurance departments applied health insurance regulations to LTCI

5. Focus on Financing and Setting Premiums • Health insurance uses the concept of a “loss ratio” • The “loss” is the benefit payments • The denominator is the premiums • The concept is that premiums must not be too HIGH; they must be LOW enough so that benefits are commensurate with premiums • In health insurance, loss ratios are generally applied to yearly renewable term insurance • For LTCI, initial yearly loss ratios are low and then become very high • In order to calculate a loss ratio that would apply over the life of the product, the later high benefit payments are discounted by mortality, interest, and lapse • Thus, a high lapse rate produces a low premium • Life insurance uses the concept of adequate reserves • In life insurance, the concept is that premiums must not be too LOW; they must be HIGH enough to fund adequate reserves

6. Ramifications of a Level Premium Used to Finance an Increasing Risk • Initially, premiums are greater than needed to finance current risk. • Eventually, premiums are not sufficient to finance current risk. • Insurers must create an active life reserve from excess early premiums that can be drawn down to finance benefits later when premiums are insufficient.

7. Active Life Reserves:So You Thought That It Was Your Money • By overpaying the initial risk, each policyholder has a stake in the active life reserves of the insurer • How is this stake protected, if at all? • What happens if the policy is terminated? Who gets the active life reserve? • What are the conditions under which the policy can be terminated? Can you be forced to terminate and lose all of your investment?

8. What happens to the Active Life Reserve on Policy Termination? • Four Options: • Profit • Lower Initial Premium (LTCI) • Give to continuing policyholders as dividends (a Tontine Scheme popular until the early 1900s) • Give back to lapsing policyholder (nonforfeiture benefit) • For LTCI with no nonforfeiture benefit, the only method by which a policyholder can preserve his stake in the active life reserves is to hold on to the policy.

9. Release of Reserves Under LTCI • For the most part, LTC insurers used estimated release of reserves from lapsing policyholders to reduce initial premiums • If actual lapses were greater than assumed, then there would be more profit • If actual lapses were less than assumed, then premiums may have to be increased

10. Renewability Options • Five Renewability options: • Cancelable • Can be terminated or premiums increased at anytime on selected individuals or a class. (Auto insurance) • Optionally Renewable • Can be terminated on specified date (usually renewal date) and premiums may be increased for a class, but not on specific insureds • Conditionally Renewable • Insurer can terminate only in the event of conditions stated in the contract (usually attaining a specified age or losing employment). Premiums may be increased on a class. • Guaranteed Renewable • Requires policy renewal as long as premiums are paid, but premiums may be increased on a class (LTCI) • Noncancelable • Policy cannot be terminated as long as premiums are paid and premiums cannot be increased (whole life insurance)

11. LTC Insurers Argued That the Right to Increase Premiums AND the Lack of Nonforfeiture Benefits Were Essential • The risk of frailty was unknown in an insured environment. • The cost of adding nonforfeiture benefits would increase the premium to unaffordable levels.

12. Premiums By Assumed Lapse RateNo Nonforfeiture Benefit Note: Premiums (to the nearest $10) for 65 year old $100/day comprehensive policy.

13. Limits On Rate Increases? • State regulators applied the same loss ratio test to rate increase filings as they did to initial rate filings – a minimum 60% loss ratio over the life of the policy. • This meant that the later corrective action was taken, the greater the increase necessary to reach a 60% loss ratio. • This also meant that if benefits were greater than expected (i.e., the 60% of the premium), then the 40% “load” (for commissions, expenses, and profit) also got the same increase.

14. LTCI Rate Increases:Hobson’s Choice or Morton’s Fork • Hobson’s Choice is actually choice regarding one option – “take it or leave it” • Morton’s Fork is a choice between two equally unpleasant alternatives – “between a rock and a hard place” • A LTCI rate increase would be a Hobson’s Choice if you could drop the policy with no bad consequences. • However, once you terminate, you lose all of the value of your active life reserve and you cannot buy a policy from a different company at a comparable rate (if you are still insurable) because you have a higher issue age. • Therefore, a LTCI rate increase is more like a Morton’s Fork.

15. LTCI: Who Bears the Risk? • If premiums can be increased and, if increased premiums induce more lapses, where is the risk? (Note: Much of it is on the policyholders.) • What happens with a rate increase? • If a policyholder continues, the increased premiums means higher revenue. • If the policyholder lapses, the release of reserves means higher revenue. • However, this could lead to a loss of good will and reduced future sales.

16. A Booming Market • With little risk, over 100 companies moved into the LTCI market in the 1990s. • LTCI was not an easy sale. • Competition drove (initial) premiums down and commissions up. • You are the actuary of company ABC. What would you do? Producing high premiums could lead to a company replacing you with a more cooperative actuary. An even greater consequence is that a premium may not sell, and that company may have to give up the LTC market completely. • Why low premiums and high commissions increase sales.

17. Guidance to Pricing Actuaries • From the Actuarial Standards of Practice No 18 – 1999: • Actuarial assumptions in combination should reflect the actuary’s professional judgment of future events affecting the incidence and cost of LTC benefits. In setting actuarial assumptions, the actuary should consider available experience data and reasonably foreseeable future changes in experience over the term of the benefit promises. Appropriate provisions for adverse deviation should be considered.

18. ASOP LTC #18 Continued • Voluntary Termination (Lapse) Assumptions are critical to the estimation of costs and to the evaluation of liabilities, because for most plans, higher lapse rates will produce lower expected costs. The actuary should select appropriate lapse assumptions, taking into consideration the method of marketing, policyholders expected to be covered, product and premium competitiveness, premium mode, premium payment method, nonforfeiture benefit, and the service of the entity providing the benefits. At the time any rate change is determined, the effect on voluntary lapses should be considered.

19. A Period of Adjustment • By the late 1990s, rate increases became fairly common. • Policyholders reacted by bringing class action law suits against companies that increased rates excessively. • Many companies sold their LTC business and got out of the market.

20. Class Action Law Suits • Companies argue that their right to increase premiums was stated in the policy. • Policyholders argue that rate increases were far beyond reasonable, that they would not have bought their policies if they knew the rate increases were coming, and that they cannot go back to the situation at the time they bought and select another company.

21. Actuaries In Class Actions • Pricing actuaries had to explain how they arrived at their assumptions • Actuaries need to be prepared to explain assumption setting based on actuarial principles and ASOPs • Actuaries do not want to have to say “My boss told me to lower the premiums”

22. NAIC Reforms -- 2000 • Loss Ratios no longer required for initial premium filings • Insurance companies had the responsibility to make initial premiums adequate • Actuary must certify that premiums are sufficient to cover anticipated costs under “moderately adverse” experience • Rate increases are still possible based on a weighted average loss ratio of 58% of initial premium and 85% of the increase

23. NAIC Reforms – 2000 Continued • Increases above a specified amount require the offer of a contingent nonforfeiture benefit or continuation of the same premium with reduced benefits. • Disclosure of past rate increases to potential buyers

24. LTCI After 2000 • Fewer companies selling • Initial premiums are higher and less likely to be increased. Any increases are likely to be much smaller. • Lapse rate assumptions typically 2% or lower • Still little provision for nonforfeiture benefit, even though the additional cost is now small • Nonforfeiture benefit can be reduced by offering after specified policy duration (3, 4, etc.) and offering less than asset share.

25. Life Insurance 1759: The beginning • The first life insurance corporation in the U.S. was created in 1759 by the Presbyterian Synods in Philadelphia and New York as the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. • Between 1787 and 1837 more than two dozen life insurance companies were started, but fewer than half a dozen survived. • No one worried about the reserve, so it reverted back to the insurance company. • Thus, life insurance become one of the first “lapse-supported” insurance products.

26. Life Insurance Growth 1840’s – 1860’s • New York Life started in 1845 • Equitable Life Insurance Assurance Society started in 1859. Its lavish expenses (including a coming out party for the niece of company vice president James Hyde) was one of the companies whose actions brought about the Armstrong Commission of 1905. Later it developed a social conscience starting a job-training program for drop outs and investing heavily in Columbia, Maryland. • Mutual Life Insurance Company of New York started in 1843 • Metropolitan Life started in 1863 (originally chartered to insure union soldiers during the Civil War). It took the name Metropolitan in 1868.

27. Life Insurance: 1895 • From “Semi-Centennial History: New York Life Insurance Company, 1845-1895”, • “The reserve fund, created by contributions from the early premiums and by interest, was to make up the deficiency of the later years. When a policy was discontinued, its reserve fund was no longer needed for the purpose for which it was accumulated; but it was not the practice of the early companies to return this fund to the discontinuing policy-holder. The theory required it, but various pretexts were found for retaining it: — the company did not agree to do it; the insured had broken his contract; those who discontinued were the best risks, hence the mortality among those remaining would be higher than the average; Life Insurance was yet in its infancy, and no one could tell whether the theory was entirely safe or not, when applied to the particular class of lives insured.” – John A. McCall, President New York Life

28. Armstrong Commission of 1905 • Prohibited deferred dividends and tontine policies, requiring annual distribution of dividends • Limited the amount of new business in a year • Limited costs and sales commissions (eliminating rebates) • Increased reporting requirements to state insurance departments • Lessened competitive forces

29. Industrial Insurance • Metropolitan and Prudential (the 4th and 5th largest companies) came out of the Armstrong Hearings in better shape than the big three. • Mostly because they sold industrial insurance and paid some dividends to policyholders even though not required to • However, the commission did question the high expenses and high lapse rates associated with industrial insurance, issues that also apply to LTCI

30. The First Nonforfeiture Laws • Elizur Wright, Commissioner of Insurance of Massachusetts in the 1850s, required the conversion of the policy to a term policy that could be bought with the reserve reduced by 20%. • Standard Nonforfeiture Law became effective in 1948 – almost two centuries after the first life insurance policy