One of David Colflesh's clients is a widow, age 70, who had most of her liquid assets in CDs."She inquired about long-term-care coverage," recalls Colflesh, who offers investment advisory services through Eagle Strategies in Tarkio, Miss., and is a New York Life agent. "Her tax adviser recommended that she use her savings to pay for long-term care if she needed it. After I reviewed her financial situation with her, she decided to move $100,000 from her CDs to a life insurance policy that also offered LTC benefits of over $230,000." The policy will pay a modest death benefit even if all the LTC benefits already have been paid.
Essentially, this client wound up with a product that's a combination of life and LTC insurance. Such products have been around for a while and have enjoyed some success. This year, however, these so-called combo LTC products, including annuity/LTC as well as life insurance/LTC blends, are likely to become even more popular as some deferred tax breaks take effect and pricing benefits become clearer.
"We certainly need rejuvenation in this market," says Phyllis Shelton, president of LTC Consultants in Hendersonville, Tenn. "Combo products, along with worksite sales, are the two bright spots I see for LTC insurance."
Long-term decline
As Shelton's comments indicate, standalone LTC insurance sales have been in a funk lately. According to LIMRA, "Significant declines in individual LTCI sales continued through the third quarter of 2009, with 28% fewer buyers when compared with the first nine months of 2008 and a 29% decline in new premium." Indeed, 2005, 2006 and 2008 were also down years, while 2007 was flat.
Why have sales of individual LTC insurance been slowing? Many observers cite the "use it or lose it" aspect of LTC policies; consumers might pay premiums for years - even decades - and never file a claim. Some potential buyers may be put off by the idea of "wasting" the money spent on LTC insurance premiums, says Carl Friedrich, a consulting actuary and principal in the Lake Forest, Ill., office of Milliman.
LIMRA puts the average annual premium at about $2,160. Even with some discounts, a married couple might be looking at an outlay of around $4,000 per year to buy coverage. Many individuals and couples probably tell themselves that they have other alternatives (sell a house, tap a portfolio, rely on a relative) to spending so much money to protect against a financial drain that might never occur.
Hence the appeal of combo products. If clients need coverage for long-term care, they have it. If their need for custodial care is modest or nonexistent, the money they spent on life insurance or annuity premiums will provide a payoff for them or their beneficiaries.
This appeal has resulted in significant business already. For 2008, first-year premium on combination plans was estimated at $650 million (primarily single premium), Friedrich says. That exceeded first-year standalone LTC insurance premiums (primarily annual premium) of roughly $600 million. Shelton adds that the $600 million number does not include group sales, which are considerable.
"We have offered a life insurance policy with an LTC rider for a few years," says Steve Roche, vice president of product strategy at the individual life division of Hartford Life. "Recently, 20% to 25% of the people buying that policy are choosing the LTC rider, which exceeded our expectations. That indicates the appeal of a product where you will not lose it if you don't use it."
Long time coming
The totals for combo products can be expected to climb this year because of some provisions of the Pension Protection Act of 2006. That act included some changes in tax law that went into effect in January. Those relating to LTC insurance included:
* Approval of LTC riders on annuity contracts. Formerly, these riders were specifically allowed for life insurance policies but not annuities. Now it's clear that LTC riders can be added to annuities without losing the tax deferral of annuities or some tax-free insurance benefits of most LTC insurance policies.
* Tax-free access to cash values for LTC coverage. Previously, when insurance or annuity cash values were tapped to pay for LTC coverage, the consumer owed tax on the money moved from one side of the combo product to the other, as if a distribution from the insurance policy or the annuity had occurred. Now such internal transactions won't generate income tax.
* LTC insurance eligibility for tax-deferred exchanges. Life insurance policies, annuities and LTC insurance policies can be exchanged for LTC policies under the like-kind exchange rules of Section 1035 of the tax code. Life insurance policies and annuities with LTC coverage are included. Until 2010, Section 1035 didn't extend to LTC insurance.
As might be expected, some strings were attached, and the language can be confusing. Only "qualified" or "tax-qualified" LTC insurance will get the benefits described above. That's generally not a problem because 99% of all LTC insurance sold now contains the product features needed to be tax qualified, according to LIMRA.
However, these new tax breaks are not extended for any "qualified" annuities - those purchased and held within a retirement plan such as a 401(k) or an IRA. Thus, the new tax benefits for combo annuities apply only to those with tax-qualified LTC benefits that are held outside of a qualified retirement plan.
Basis battle
Not surprisingly, the tax issues related to the Pension Protection Act and combo LTC products remain unsettled. Beth Ludden, Genworth's senior vice president of LTC insurance product development, says the IRS issued a private letter ruling in 2009 that could affect some product designs. This PLR is potentially important because some articles have indicated that "LTC annuities" will be "tax-free." That may not be strictly the case, by the logic of PLR 200919011.
In PLR 200919011, the IRS responded to three requests from an insurance company regarding an annuity with an LTC rider. First, the company asked that its LTC rider would be a qualified LTC contract. Check. Second, the company asked that LTC benefits would not be taxable income, up to the relevant daily cap ($290 in 2010). Check.
Then the insurer asked the IRS to rule that LTC benefits paid would not reduce the "investment in the contract." Instead, the IRS found that such payments will in fact reduce the investment in the contract.
As Friedrich explains, "investment" in the contract is also referred to as the consumer's "basis" in the contract. Some insurers have taken the position that LTC benefit payouts reduce the annuity's taxable gain, perhaps to zero. If the annuity has no taxable gain, subsequent distributions will be tax-free, and the annuity's investment earnings will never be taxed. The IRS disagreed, Friedrich notes.
To illustrate the different results, Michael Kitces, director of research at Pinnacle Advisory Group in Columbia, Md., provides the example of an investor who puts $100,000 into an annuity/LTC hybrid. The contract grows in value to $103,000; then the investor taps this hybrid for $3,000 in LTC costs. (Typically, deferred fixed annuities are the basic contract to which an LTC rider is added to create an annuity/LTC hybrid.)
A consumer would like the $3,000 to come from gains, leaving him or her with only the original $100,000 investment. In this PLR, the IRS says that the $3,000 comes out of basis, reducing the consumer's basis from $100,000 to $97,000. "The client has a contract that was purchased for $100,000, and is still worth $100,000, but now has a $3,000 ordinary income gain looming that will someday be recognized when withdrawals are taken or the contract is cancelled," Kitces says.
Policy options
As mentioned earlier, Colflesh's 70-year-old widow client bought her life insurance/LTC policy with a $100,000 single premium. Kitces, however, insists that hybrid policies do not have to be single premium, although that is by far the most common design and situation in which they are used. "In the beginning, single premium was all that was available - it was identifying 'lazy money' and switching it over," Shelton says. "Now I'm seeing some 10-pay and lifetime-pay products."
Single-pay hybrids may be especially suitable to plans designed to take advantage of one aspect of the new rules: the ability to execute 1035 exchanges for LTC hybrids and standalone LTC policies.
Sometimes, new clients come to financial planners with existing life insurance policies or deferred annuities that are not ideal. Assuming surrender charges are not a significant drawback, such holdings could be exchanged for an LTC policy or an LTC hybrid, using the existing product's value as the single premium. In its fourth-quarter 2009 retirement edition of Cerulli Edge, the Boston-based consulting firm says that "as the Pension Protection Act provides for tax-free exchanges into combination products," it "expects to see many new sales coming in this manner, rather than from fresh cash."
Price points
An LTC hybrid will work best for clients whose financial plans call for life insurance or an annuity in addition to LTC coverage. If that's the case, are such clients better off buying a standalone LTC policy plus the life insurance or the annuity, rather than an LTC hybrid? The answer may depend on how the costs compare.
Friedrich says life insurance LTC riders tend to be priced using different charge structures than those for annuities. "Because death may occur many years after LTC utilization, there is a cost to insurance companies in providing this benefit for life insurance. Therefore, life acceleration riders typically cost 5% to 20% of a life insurance premium."
If that's the case for life insurance with LTC riders, what are the costs for LTC benefits packaged with deferred annuities? Friedrich provides a hypothetical example of a 60-year-old investor who puts $100,000 into a deferred annuity that earns 4% a year for 20 years. If that investor chooses an LTC rider that pays out up to 200% of account value, the cost of that rider might be 65 basis points (0.65%) a year. That annual cost would reduce the account value from $219,000 to $193,000, in this example, but could result in much greater benefits if extensive LTC costs are incurred.
Comparing the cost of a combo plan versus a standalone LTC product, the cost of the LTC portion of a combo plan is often 35% to 50% of that of a standalone LTC product, according to Friedrich. The primary reason is that a portion of the combo coverage is, in a sense, self-insurance. That is, the LTC coverage is relatively inexpensive because payments for long-term care are an acceleration of benefits that eventually would be available to the insured individual as a surrender payout or to the insured's beneficiaries as a death benefit.
Friedrich adds that deferred annuities coupled with LTC riders should have much more favorable persistency than standalone annuities. "That would enhance profits for insurers and may allow for attractive pricing of those combo plans."
Korn is a senior editor at Financial Planning magazine, a SourceMedia publication.
