The Market for Long-Term Care Insurance

The Market for Long-Term Care InsuranceExpenditures on long-term care services in the U.S. are high and growing - they reached $135 Billion in 2004, or 1.2 percent of GDP, and are projected to triple in real terms by 2040 as the U.S. population ages and health care costs continue to rise.

Long-term care expenditures represent a significant financial risk for the elderly. A 65-year-old woman has a 44 percent chance of entering a nursing home during her lifetime and, upon entering, faces an average stay of two years. Long-term care is extremely expensive - the average rate for a semi-private room in a nursing home was over $50,000 per year in 2002.

Economic theory suggests that individuals should find it valuable to protect themselves against the risk of these large expenses by purchasing private long-term care insurance. Yet the market for such insurance is quite small. Only 10 percent of the elderly have a private long-term care insurance plan, and because coverage under these plans is often limited, only 4 percent of long-term care expenditures are paid by private insurance, while fully one-third of expenditures are paid out-of-pocket.

NBER researchers Jeffrey Brown and Amy Finkelstein explore possible explanations for the scarcity of private long-term care insurance in a pair of new papers. As the authors point out, the limited size of the market may be due to factors that limit the demand for private insurance, such as the existence of the government Medicaid program or limited awareness on the part of consumers, or to supply side market failures, such as a lack of competition in the private insurance market, problems of adverse selection or moral hazard, or the inability of the industry to insure against aggregate risks like rising health care costs.

In Supply or Demand: Why Is the Market for Long-Term Care Insurance So Small? (NBER Working Paper 10782), the authors provide the first empirical evidence on the pricing and benefit structure of long-term care policies. They note that if significant supply side market failures exist, private insurance plans may be priced significantly above the actuarially fair level, so that premiums exceed expected benefits. In addition, insurers may only offer plans that provide incomplete coverage.

The authors find that the typical policy purchased by a 65-year-old and held until death pays out 82 cents in benefits for every dollar of premium. That 18 percent load factor is significantly higher than the 6 to 10 percent load usually found on private health insurance plans. The typical purchased policy is also not very comprehensive, as it covers only one-third of expected expenditures.

However, the authors point to evidence suggesting that high prices and limited benefits are not the primary cause of the small size of the market. They find very large differences in pricing by gender - the typical load factor is 44 percent for men and negative 4 percent for women, so that expected benefits actually exceed premiums for them - yet the rate of purchase of private insurance is very similar for men and women. They also find that insurance companies offer plans that cover 90 percent of expected benefits. The authors conclude that although supply side market failures exist in the private long-term care insurance market, they are not sufficient to explain its limited size.

The authors explore one particular demand side factor in The Interaction of Public and Private Insurance: Medicaid and the Long-Term Care Insurance Market (NBER Working Paper 10989). Medicaid is the payer of last resort; the program covers long-term care expenditures after an individual has used any private insurance benefits for which he is eligible and exhausted most of his financial resources paying for his care out-of-pocket. Medicaid is thus an incomplete but free substitute for private long-term care insurance and its existence may discourage individuals from purchasing private insurance.

The authors develop a model of a forward-looking 65-year-old individual who makes decisions about his present and future consumption and about whether to buy long-term care insu ance in the presence of uncertainty about long-term care expenditures. The authors use the model to calculate the effect of Medicaid on the individual's willingness to pay for private insurance.

The authors find that Medicaid is critical in explaining the absence of private insurance. Even if supply side market failures could be eliminated so that individuals could purchase comprehensive private insurance with a zero load factor, they estimate that at least two-thirds and as much as 90 percent of the population would still not want to buy because of the existence of Medicaid.

They show that one important reason for this result is that the design of Medicaid imposes a high "implicit tax" on private insurance benefits - for a median wealth individual, 60 to 75 percent of premiums go to pay for benefits that Medicaid would otherwise have provided. They also find that recently enacted state Medicaid reforms and federal and state tax subsidies to private insurance are unlikely to have a big effect on this implicit tax, or therefore on the demand for private insurance.

Finally, they note that because Medicaid requires individuals to spend most of their assets before becoming eligible for benefits, it is a poor substitute for private insurance. Medicaid does not effectively protect financial assets or allow individuals to smooth their consumption over time.

As Brown and Finkelstein write, "policy changes that substantially reduce or eliminate Medicaid's implicit tax are necessary conditions for stimulating the private market."

The authors gratefully acknowledge financial support for this research from the Robert Wood Johnson Foundation, TIAA-CREF, the National Institute on Aging, and the Campus Research Board at the University of Illinois at Urbana-Champaign.