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Is the Market for Private Long-Term Care Insurance in Danger?

Robin Lumsdaine is Crown Prince of Bahrain Professor of International Finance at Kogod and a senior fellow at the Center for Financial Stability. Below she explains the fiscal state of the private long-term care insurance market, in the wake of MetLife's decision to discontinue its program.

Why is the private Long-Term Care (LTC) insurance market under serious threat?  

People are living longer and health care costs are rising. As a result, the costs of providing LTC insurance are expected to dramatically increase, rendering it too expensive for insurance companies to offer. MetLife is an important example; the company decided to discontinue enrollment in its LTC insurance program just as consumer demand for the product was projected to grow. If others follow suit, this could deal a de-stabilizing blow to the vitality of a critical market.

Can you sum up the reasons why you think MetLife chose to leave the LTCI market in January 2011? 

MetLife cited "the financial challenges facing the LTCI industry in the current environment" as the reason for its exit. There is tremendous uncertainty regarding claims and escalating costs far into the future, some of which is the result of new capital requirements and regulations established after the financial crisis.

How so?  

Medical care costs have far outpaced overall consumer price inflation and average wages for over three decades. As a result, LTC insurance providers face, and are expected to continue to face, an increasing need for inflation protection, well in excess of overall CPI.  

In other words, their liabilities are growing in real terms, outpacing overall price growth. One of the ways companies would normally hedge such growing risk is through leverage, which in turn means an increasing reliance on derivatives. Unfortunately, the reduction in leverage that occurred during the recent financial crisis also created an environment that is less amenable to derivatives.

Why is the LTCI business not sustainable without the ability to spread the risk of medical inflation over a broad range of investors?  

Nearly all forms of insurance are based on the concepts of risk-pooling and pay-as-you-go. Risk-pooling describes the need for a large body of individuals that pay into a pool that provides benefits to the few unlucky individuals that need to file a claim. The lower the chances of a claim, the lower everyone’s premiums are. 

Pay-as-you-go is the term used to characterize the insurance model where the proceeds from current premiums are used to pay the claims of current beneficiaries. With the aging of the Baby Boom population and escalating costs, there will be fewer people paying premiums and hence those premiums will need to rise dramatically. But rising premiums also reduce the incentive to purchase the insurance. And eventually it becomes unsustainable.

How do capital regulations enter into the equation? 

During the recent financial crisis, many insurance companies attained Bank Holding Company (BHC) status in order to have access to the Fed’s lending facilities. MetLife was a BHC well before the onset of the crisis, but it is in fact the seventh-largest BHC. By virtue of its size, it may qualify for some of the most advanced and stringent capital requirements (e.g., Basel II/III) and could be considered to be of systemic importance under the Dodd-Frank Wall Street Reform and Consumer Protection Act, although decisions on these issues are not yet finalized. It is likely that other insurance companies will be similarly affected. 

Derivatives contracts are facing tougher capital requirements under Basel II/III. What is the goal of these requirements, and what are the concerns from the perspective of the company subject to them? 

The goal of Basel II, and its successor, Basel III, has been to make minimum regulatory capital requirements more risk-sensitive; that is, requiring higher levels of required minimum regulatory capital for the riskiest exposures. This is an important and noteworthy goal, aimed at securing the stability of the financial sector. 

In many cases, derivatives exposures do pose a significant amount of risk to an organization, as we saw during the recent financial crisis. In others, such as with LTC insurance providers, derivatives may be a useful hedging tool that helps a firm to mitigate risk, such as inflation risk. The challenge in implementing the capital rules is in distinguishing between these two uses. For a firm, excessive capital requirements inhibit their ability to conduct business.

What will be the impact on consumers and the system if critical institutions continue to exit the LTCI market? 

The escalating medical costs that LTCI will face suggest significant demand in the use of derivatives for hedging purposes to mitigate risk. For those insurers that are also BHCs, such as MetLife, more derivatives on the balance sheet means increasing capital requirements to keep capital ratios above regulatory minimums. In other words, required capital would go up, rather than down, when a provider hedges future LTCI liabilities – putting an additional demand on their business operations. 

The American population is aging, long term care costs and needs are rising, and even the largest insurance companies are facing difficulty pricing and hedging risks. These additional challenges will probably drive some providers to exit or cut back their involvement in this market.

Will new government programs such as the new Community Living Assistance Services and Supports (CLASS) program help to address the problem?  

Partially, but not fully. [HHS] Secretary Sebelius delivered remarks on this topic to the Kaiser Family Foundation last week and gave a pretty frank assessment of both the pros and cons. The challenges the CLASS program faces echo those facing private insurers – for example, ensuring a broad-base of enrollees, structuring premiums to ensure future solvency. Yet the program is still, at its core, a pay-as-you-go system, where benefits need to be funded by the premiums paid in. Just as the private insurance market will struggle with escalating costs and a need to hedge the risk associated with long-dated liabilities, so will any public-sector program.