Long Term Care – Hybrid Life Insurance To The Rescue?

Take-Away: There is a renewed interest in long-term care insurance policies now that insurance companies have become more creative, especially with their introduction of hybrid life policies. Some existing life insurance policies, even those held in an irrevocable life insurance trust (ILIT) might be appropriate to be exchanged for a hybrid life insurance policy.

Background: Long-term care insurance has had a somewhat ‘choppy’ history. Sales for these policies peaked in 2002 when 750,000 long term care policies were sold. By 2018 the number of long-term care policies sold dropped to 60,000. The primary reason for the number of long-term care policy sales to drop so dramatically was the ever-increasing policy premiums, which have made the cost of this type of insurance prohibitive for most American families.

Expensive Premiums: The reasons why the cost of long-term care premiums have skyrocketed over the years include: (i) insurance company actuaries, who provided the underwriting projections to initially set the policy premiums, over-estimated how many policyholders would actually permit their policies to lapse (not very many); (ii) the record-low interest rates over the past 20 years have decimated insurance company balance sheets, (thus forcing more funds into required reserves, in turn dragging down company profitability); and (iii) ever-improving mortality rates, (which means that policyholders are living longer and thus able to claim benefits under their long-term care policies, but they are not necessarily living independently.)

Types of Long-Term Care Policies: Generally there are two types of long-term care insurance policies.

Indemnity: An indemnity arrangement pays a specified amount directly to the policy owner if the insured is eligible to receive benefits under the policy. The amount paid could be different than the actual expenses that are incurred for the long-term care of the insured. In short, policy benefits can be paid even if no expenses are actually incurred, e.g. a spouse provides their insured spouse care in their home, albeit at no cost.

Reimbursement: A reimbursement arrangement pays only for the actual costs incurred up to a maximum dollar amount provided for under the policy. Generally, indemnity policies are more expensive than reimbursement policies.

Hybrid-Life Insurance Policies To the Rescue?: One of the obvious draw-backs to the purchase of a long-term care insurance policy is the ‘use-it-or-lose-it’ principle, which does not make the purchase of a long-term care policy very attractive to a consumer. If the long-term care insurance benefits go unused, all premium payments are, with the blessing of hindsight, wasted.

Mixed Use Policy: In response to the use-it-or-lose-it feature of long-term insurance care policies, over 40 life insurance companies now offer a hybrid life insurance policy, which appears to have been a smart move when you consider that in 2018 there were over 460,000 hybrid life insurance policies sold.  The salient feature behind these hybrid policies is that if policy benefits are paid in the form of long-term care lifetime benefits, those lifetime payments simply reduce the contractual death benefit that would otherwise have been paid under the life insurance contract. If the hybrid policy is never used to pay lifetime long-term care insurance benefits, then the full death benefit is paid to the insured’s beneficiares.

Hybrid-Options: Hybrid policy features differ among insurers and the products that they sell. The emphasis could be on either the size of the death benefit, or the long-term care benefit, either of which will impact the size of the policy premium. For example, a hybrid life insurance policy that focuses on long-term care benefits can also have a continuation of benefits rider to maintain monthly long-term care benefits even after the initial death benefit has been exhausted. Similarly, the hybrid policy can be designed with inflation protection rider, which is critical in light of the ever-increasing cost of long-term care. Some companies will offer a rider which permits the long-term care benefits to be accelerated if family members, rather than certified care givers, are hired to provide the care.

Policy Exchange to Mitigate Cost:  While most often hybrid policy purchases are with a single premium payment, it is important to remember that existing life insurance policies can be exchanged, tax-free, into new life insurance policies, including hybrid policies. [IRC 1035.] Accordingly, existing cash value life insurance can be repositioned into a hybrid policy as a tax-efficient way to pay for future long-term care benefits if that is a risk that needs to be managed.

Taxation of Long-Term Care Benefits and Premiums: The purchase of a traditional long-term care policy is considered a medical expense for income tax purposes. Consequently, the long-term care premiums are deductible to the extent that they exceed 10% of the policy owner’s adjusted gross income, which is tied to the policy owner’s age at the end of the year.

Taxation of Long-Term Care Benefits: The benefits paid from a long-term care policy (or under a hybrid policy) are normally received tax-free if they are used for long-term care expenses. The insurance company files with the IRS an annual Form 1099-LTC which reports the benefits that were paid. There are, however, IRS limitations to the amount of benefits that may be received by the long-term care recipient tax-free annually- the HIPAA daily amount that is established for each day of a long-term care claim, which in 2020 is $380.00 a day, or the actual qualifying costs incurred for the long-term benefit, if higher.

Individual Long-term Care Premium Deduction: What follows are the long-term care insurance premium income tax deduction limits for 2020: (i) age 40 or less, $430.00; (ii) ages between 41 and 50, $810.00; (iii) between ages 51 and 60, $1,630.00; (iv) between ages 61 and 70, $4,350.00; and (v) more than age 70, $5,430.00

HSA and HRAs: Funds held in a health savings account or an employer funded health reimbursement account can be removed income tax-free to pay for tax-qualified long term care insurance premiums, up to the premium deduction amounts noted above.

Employer Sponsored Long-Term Care Policies: Self-employed taxpayers have a slightly more generous income tax deduction for premiums paid than the amounts noted above for the payment of long-term care insurance premiums by individuals.

Partnerships , LLC’s and S Corporation’s: Partners of a partnership, members of an LLC, or shareholders of more than 2% of an S corporation can have the entity pay for and deduct as a business expense the cost of their long-term care premium. While the taxpayer (partner, member or S shareholder) is required to include the premium cost to their adjusted gross income, they can deduct up to the maximum dollar amount based on their age (noted above) without having to meet the 10% of adjusted gross income threshold.

C Corporations: By far the best result from a tax-saving perspective is a C corporation, which can purchase long-term care insurance on its employees, as well as their spouses and dependents, and take a 100% income tax deduction as a business expense on the total premiums paid, with no age-based dollar limits. Moreover, the C corporation can discriminate by limiting this long-term care insurance benefit to a specific class of employees. Accordingly, the tax deduction to the C corporation is unlimited and the benefit paid is non-taxable to the employee within the individual dollar limits described earlier.

Hybrid Life Insurance Policies: If premiums are paid for a hybrid life insurance contract, generally the premium paid will not be tax deductible. However, some life insurance companies that are now selling hybrid policies will delineate how much of the premium is going to provide the long-term care benefits, and if that is the case, then the owner of the hybrid policy will be able to take a partial income tax deduction.

Planning Considerations: A discussion about the need for long-term care insurance should be a part of every estate plan. If the client is strongly motivated to leave a legacy to family members, it does not make much sense to blissfully ignore the possiblility that most of their wealth that was intended to satisfy that legacy objective will be diverted to pay for their long-term care expenses. Only the extremely wealthy can expect to comfortably pay for their long-term care from their own financial resources. For the rest of us, consider the following:

1. Life Insurance Policy Exchange: If an individual already owns a cash surrender value life insurance policy, he/she might want to consider using an IRC 1035 policy exchange and acquire a hybrid life insurance policy in order to obtain access to long-term care benefits.
2. Annuity Policy Exchange: If a client owns a tax-deferred annuity, some insurance companies will provide similar benefits under a hybridannuity policy, again using a policy exchange under IRC 1035.  Like the life insurance premium, there would be no income tax deduction for premiums paid for a hybrid annuity contract, but like with the life insurance contract, a hybrid annuity policy may allow a potentially taxable investment to provide tax-free long-term care benefits to the annuitant.
3. ILIT: Even a policy held in an irrevocable life insurance trust (ILIT) would be eligible for an IRC 1035 policy exchange so that the trustee then held a hybrid life policy. Consider the typical ILIT where the insured is the husband, with his spouse and children are the lifetime ILIT beneficiaries. The surviving spouse might someday need long-term care benefits, and the children might consider the acquisition of that hybrid life insurance policy as a good hedge to preserve their inheritance even if their surviving parent endures years of long-term care.

Conclusion: Conventional long-term care insurance might be too expensive for most of us to consider. But with hybrid life insurance now available, there appears to be a new, and much stronger, market. Certain that should be the case if an individual already owns cash surrender value life insurance and is considering the purchase of a long-term care policy.