New "Hybrid" Policies Combine Long-Term Care and Life Insurance -- Tax Free

August 5, 2010
the staff of Modera Wealth Management

New "hybrid" long-term care insurance policies offer the benefits normally associated with an annuity or life insurance, plus protection against long-term care expenses. Even better: Funds distributed from these policies are now tax-free.

Long-term care insurance has long been the primary means by which individuals could transfer the risk of paying for expensive long-term care to a third party. Statistics show that the average person has a 70 percent chance of needing long-term care due to either advanced age or debilitating illness. The average stay in a long-term care facility is three years, and the out-of-pocket cost could be staggering -- around $300 a day, which is more than $100,000 a year.

For a fraction of that cost annually, a relatively young person can obtain long-term care insurance that would pay for up to the entire cost of nursing-home care, adult day-care services or assisted-living care. Buyers usually have a choice of daily benefits ranging from $50 to $300 per day, with options for inflation protection and length-of-coverage once long-term care is needed. Of course, this insurance is still not cheap and, unless you were wealthy enough to self-insure — or pay the full cost of long-term care yourself -- it was one of the only insurance choices available.

Premiums Rise as Rates Decline

One obvious drawback is that if you never need long-term care, you just paid an awful lot of money over an awful lot of years for nothing (unless you count peace-of-mind). That’s why many people purchase both a long-term care insurance policy and a life-insurance policy. This way, regardless of whether the insured ends up needing long-term care, the life-insurance policy would pay for the cost of the long-term care insurance premiums and unreimbursed medical expenses upon the insured’s passing. It would also protect the insured’s assets so that a surviving spouse and other heirs wouldn’t be faced with a significantly smaller inheritance.

Over the past few years, the long-term care market has experienced dramatic changes, some bad, some good for consumers. Let’s take the bad first: Over the past few years, insurance premiums have risen around 18 percent to 25 percent, primarily for policyholders under the age of 65. For a long time, rates were kept steady, aided by the fact that insurers can’t simply raise rates when they please; insurance providers need to apply to the states in which they operate for a rate increase. Yet, over the years, as every American knows, the cost of providing health-related services has risen dramatically. Consider that healthcare inflation has significantly exceeded the Consumer Price Index for the past 10 or 15 years. When long-term care insurance carriers initially priced their policies, they didn’t assume such a large inflation rate on the cost of services.

Another cause for the rate hikes is that insurers typically invest premiums in safe, low-yield investments, such as bonds or cash equivalents. As we all know, rates on these instruments have fallen significantly over the past few years, so insurers can no longer make enough money in their investment portfolios to cover the expense of their policies. So, now they need to raise premiums.

The Tax Advantages of “Hybrid” Policies

Fortunately, the good news for consumers is that the Pension Protection Act of 2006 (which took effect this past January) has encouraged the creation of a new, tax-advantaged long-term care option. They are called “hybrid” policies that offer the benefits normally associated with an annuity or life insurance, plus protection against long-term care expenses. Before this year, a person who bought an annuity or life-insurance policy with long-term care benefits was taxed on any payouts. Now, thanks to the new law, that money is distributed free of taxes.

Typically, these hybrid policies are funded with a large, lump-sum payment of $75,000 to $100,000, or more. Here’s how they work: Should you purchase such a policy and die, the policy would typically pay you up to two-times your lump-sum payment, tax-free. In the event you require long-term care, the policy would typically provide you with a pool of capital of up to four-times your lump-sum payment. Moreover, the hybrid policy gives you the flexibility to withdraw some of your lump-sum payment for other uses, although this would proportionally impact your level of coverage.

If this concept sounds appealing, but you already have an existing life insurance policy or annuity, there’s more good news. You can make a tax-free exchange of the cash value of your life insurance or annuity policy and transfer it to a hybrid long-term care policy. So, if you are thinking about your future long-term care needs, the new hybrid policies offer significant benefits.