Long-term care insurance remains a hot topic for investors in the insurance space. We have compiled a set of key topics that would provide investors with greater insights into this long-tail liability. Below are 10 things that explain our opinion on this risk, the current state of the market, and future risks awaiting insurers' LTC business.

1.) LTC Loss Ratios Are Increasing, Making Reserving Even More Critical For This Product

On an aggregate level, inforce policies are declining, while annual statutory loss ratios are increasing for the LTC insurance block of business (see chart 1 and 2).

After LTC sales peaked in 2000s, a growing number of insurers discontinued LTC sales over the last decade. Today, only a handful of insurers sell stand-alone LTC insurance. As the low amount of new sales is offset by policy lapses (due to death or cancelations) each year, we expect this declining trend of outstanding LTC policies to be the standard for this product line.

At the same time, as policyholders age, we expect increased claims associated with these policies. This is also why reserves are of such importance to long-duration liabilities such as LTC. The probability of claiming LTC benefits increases with age. So, in the early years of a policy, a portion of the premiums are set aside as reserves to prefund future claims. But setting up these reserves, which require multiple assumptions, has proven to be as much of an art as it is a science. The data originally used to set the underlying assumptions is only now becoming credible.

Chart 1

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2.) So, Where Did It All Go Wrong? The Assumptions, Duh!

LTC in its heyday was sold and reserved with assumptions that have ended up being just wrong. For example, assumptions related to lapse rates in the initial years were almost 10 times higher than they are today. Interest rates and investment portfolio yields are meaningfully lower than what they were in the late 1990s or early 2000s. Underlying morbidity and mortality have also changed, as policyholders have lived longer than initially expected and the cost of care has proven to be higher than expected.

Over the last decade, insurers have continued to make updates to their reserve assumptions, leading to negative impacts on their earnings. Despite the changes already made to these reserves, we expect continued fine tuning of LTC reserve assumptions and related reserve increases by U.S. insurers. Any rating actions related to insurers' LTC reserve charges will be based on the size of such charges and our view of the insurers' ability, or lack thereof, to fill the capital hole left from such reserving updates.

3.) Underlying Reserve Assumptions Are Seeing Some Similar Updates, But Differences Still Exist

LTC is a complex product with a multifaceted set of assumptions needed for pricing and reserving. Therefore, it isn't surprising that these assumption differ among insurers. We are seeing some convergence, with similar trends in the updates to assumptions. Lowering of the lapse rate assumption and reducing the morbidity improvement assumptions by some insurers are examples of this trend. However, key assumption differences still remain. In our view, this indicates the potential for further updates as policy experience becomes more credible.

Table 1

4.) Discount Rate Assumptions Will Likely Be Updated Sooner Rather Than Later

In 2019 some insurers, such as MetLife Inc. and CNA Financial Corp., updated their discount rate/interest rate assumptions underlying the LTC reserves. As the lower-for-much longer interest rates sink in, we expect this specific assumption to be updated by other insurers as soon as later this year. The impact of the updates will vary by insurer. Although some insurers have disclosed sensitivities related to this key assumption (see table 2), they aren't easily comparable across insurers. Some have highlighted their reserve discount rate, while others have stated their new money yield assumption. Depending on the actual disclosure, the size of the sensitivity can be meaningfully different.

Table 2

5.) Premium Rate Increases Are A Necessity, Not An Afterthought For Most LTC Blocks

The ghosts of assumptions past still haunt these books. Charging higher premiums is the most obvious way to fix an underpriced liability. Although this type of product was sold as a level-premium product, premium rate increases have now become the unfortunate norm.

We expect premium rate increases to be an ongoing necessity for this block. Insurers have put in double-digit rate increases when possible, while also providing the policyholder with a few other options in lieu of a rate hike. When insurers notify their policyholders of a premium rate increase via a premium hike letter, policyholders usually receive a few options for adjusting their policy (typically with less coverage) if they don't want to pay the higher premiums. Below is an example of options a policyholder may receive in their premium hike letter:

• Premium rate hike: Keep the current policy benefit and pay the increased premium.
• Adjust benefits: Reduce the benefit of the existing policy (e.g. lower the benefit amount, shorten the benefit period, increase the elimination period, reduce the inflation feature, etc.) in return for maintaining the current premium.
• Nonforfeiture option: Don't pay any more premiums, and your future LTC benefit will be based only on the premiums that have been paid to date.

We expect insurers will continue requesting premium rate increases for their inforce LTC book. So far, state regulators have been mostly agreeable to insurers' requests. But there is always the possibility that regulators will stop approving these additional premium increase requests. Consumer pressure of course can have an effect on regulators. But they are in a bit of a Catch-22. One option is to approve the rate increases, which would result in unhappy policyholders. The second option is to deny further rate increases, which could imperil the financial health of some insurers, ultimately resulting in the regulators running the LTC block themselves. Given how long and complicated the Penn Treaty liquidation process was, regulators are currently picking the first option.

6.) Not All LTC Blocks Are Made Equal

It's easy to paint all LTC insurance blocks with a broad brush. Though there is no denying the risks in LTC insurance, some product features are prone to less reserve volatility or claims intensity than others. For example, lifetime benefit policies can have higher claims duration than a limited-period LTC product. Inflation protection riders, where some policies provide for benefit payments to grow at a compounded rate, are another feature that can lead to higher claims intensity. Average attained age of a block shows differences in maturity of the liability and the potential increase in actual claims payment as policyholders age. We look closely at such product features to appreciate the riskiness of different LTC blocks.

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Table 3

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Although having LTC insurance risk can constrain credit quality, we evaluate several other factors such as riskiness of the LTC benefits, size of the LTC block compared with the insurers' other liabilities, recent reserving updates, capital buffers, and of course our view of insurers' ability to manage this risk. As a matter of fact, we recently took two positive rating actions on insurers that hold LTC liabilities. One was CNO Financial Group Inc., which meaningfully reduced its exposure by reinsuring a portion of their LTC block. The other was CNA Financial. We recognized CNA's underwriting performance, earnings stability, and market presence of its core businesses, as well as the insurer's proactive claims and inforce management of its run-off LTC block.

7.) Not All Insurers Are In Loss Recognition For Their LTC Book Of Business

U.S. insurers usually undertake an annual process to test the adequacy of their active life reserves for their U.S. GAAP reporting. During the annual loss reserve testing (LRT) process, insurers test the adequacy of their active life LTC reserves. Gross premium valuation (GPV) is a common test conducted by U.S. insurers. As part of this test, insurers calculate GPV reserves based on current experience, which may differ from the assumptions backing their base reserves that are on the balance sheet. If the GPV reserves are higher than the base reserves (net of deferred acquisition cost [DAC]), then insurers are in loss recognition. This means they will need to increase their balance-sheet reserves (or at least write down the associated DAC) until base reserves are equal to the GPV reserve. This is usually when insurers report reserve charges on their financial statements.

Some insurers currently are not in loss recognition and maintain a reserve margin. We view this favorably, because it indicates they have a cushion to absorb some of the volatility from future GPV assumption updates.

Table 4

8.) Reinsurance Or Sale Of LTC Blocks Will Occur, Despite The Near-Term Costs To The Seller

Recently, we saw a couple of LTC transactions. In 2018, CNO Financial announced an agreement to reinsure $2.7 billion of its legacy LTC reserves to Wilton Reassurance Co., and Humana Inc. completed the sale of its subsidiary that held LTC policies to HC2 Holdings Inc.

We believe that there is a potential for more transactions in the future. The buyer/reinsurer, most likely a private entity, could be willing to take over a LTC block from a publicly-traded insurer looking to exit this risk. But, as is often the case, the block will need to be sold at a discount. The buyer will want to be covered for this long-tailed risk, and the seller will need to take a near-term hit on the sale.

There is a long-term benefit for the seller to exit such a capital-intensive business, which requires regulatory approvals for premium increases, reserve updates as it matures, and has a potential negative overhang for investors. But at what cost is an exit appropriate? With rates where they are today, valuations based on current levels may seem a costly proposition for the sellers. But we do expect some more LTC transactions and reinsurance deals to happen, as the cost of running the business longer term, as well as the negative investor sentiment that may put pressure on share prices of some publicly traded insurers, will outweigh the near-term concerns for the sellers.

9.) Changes To Reserves Are Likely After The Upcoming FASB Update

The Financial Accounting Standards Board (FASB) has announced a change to the accounting standards used under U.S. generally accepted accounting principles (GAAP) for certain long-duration insurance contracts. The implementation of these long-duration targeted improvements (LDTI) starts on Jan. 1, 2022, for most public insurers.

The change that will likely have the biggest effect on GAAP LTC reserves is the update to how liability for future policy benefits is calculated:

• Under the new standard, for products, like LTC, assumptions related to mortality and morbidity need to be updated annually based on current claims experience, along with a discount rate that reflects current market conditions. Without the "unlocking" methodology that insurers currently use, which only updates reserves when loss-recognition testing demands it, we expect reserves to be more volatile, year over year. However, we also anticipate "cliff-type" reserve events (whereby reserves remain stable for a long period and then increase sharply) to become much rarer.
• Insurers currently use a discount rate to calculate reserves, which is often based on their expected investment yields. Discount rates vary by insurer since investment yields differ based on portfolio allocations. Under the new standard, insurers will need to use a discount rate based on upper-medium grade (low-credit-risk) fixed-income instrument yield. Assuming upper-medium-grade corresponds to the 'A' level, the current discount rate used by most LTC insurers is higher than what they will need to use after the FASB change.

As part of this update, the FASB is also requiring increased disclosures of liability for future benefits. We have always encouraged greater disclosure in financial statements and support any increase in transparency that would provide additional details to reserving. (For our more detailed views on FASB LTDI, read our "Credit FAQ: GAAP Accounting Standard Changes Could Propel Long-Term Shifts In Life Insurers' Strategies," published Oct. 28, 2019.)

10.) Life-LTC Or Annuity-LTC Combo Products Will See Growth

In 2018, barely 120,000 stand-alone LTC policies were sold by U.S. insurers. That is about 2% of LTC policies inforce currently on insurers balance sheet. Despite the dearth of new LTC insurance policies, the need for LTC insurance isn't going away. As the U.S. population ages, the need for LTC will only increase.

Currently, the government program Medicaid is the largest provider of LTC benefits in the country. However, since Medicaid eligibility is need-based, individuals often need to spend down a significant portion of their assets before they can receive LTC benefits from Medicaid.

So, is there a private market solution? Currently, a combination LTC product, which includes LTC benefits within a life insurance policy or an annuity contract, is being sold. These types of products, which allow a policyholder to drawdown on his or her death benefit (in the case of a life insurance policy) or account value (in the case of an annuity) to pay for LTC benefits, are seeing good traction. As a matter of fact, according to LIMRA data, the life-LTC combo product accounted for over one-quarter of total U.S. individual life sales in 2018. We expect these LTC-combo products to see continued growth, with increasing insurer participation resulting in a fairly competitive marketplace.

We consider these combo products to be less risky than their older stand-alone LTC cousins. The actual LTC benefit is usually a shorter duration, and there is better alignment of interests between consumer and insurer given the LTC benefit is drawing down from the face value of the life insurance or account value of the annuity. Also, these combo-products were priced in the currently low-rate environment. These combo products won't be an equivalent substitute to the benefit-rich, original stand-alone LTC insurance products. But they could offer LTC benefits to policyholders, while also providing a way to better manage the LTC risk for insurers.

Related Criteria And Research

Following The Trail Of U.S. Insurers' Long-Term Care Assumptions, Jan. 10, 2019