What to Know Before Purchasing a Long-Term Care Rider

The insurance industry has changed since I began my career. Long-term care insurance policies were the recommended option, and the company I started with even had their own stand-alone home health care policy.

A New York Times article “Aged, Frail, and Denied Care by Their Insurers (opens in new tab)” left me stunned on how insurance companies that sell traditional long-term care insurance policies deny claims when needed most and I had witnessed this on multiple occasions. It was difficult endorsing this product after all the backlash. According to AARP, 52% of people who turn 65 today (opens in new tab) will develop a severe disability that will require long-term care at some point in retirement. The U.S. Department of Health and Human Services reports that 70% of people over 65 will need long-term care (opens in new tab) at some point in their lives.

So, how do you approach such a delicate subject? Of course, you can always self-pay or apply for government benefits — such as Veterans Aid and Attendance or Medicaid — but the qualification rules are strict and continually changing. For instance, the Department of Veterans Affairs implemented new guidelines on net worth and asset transfers (opens in new tab) in September 2018.

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Long-term care insurance is still an option, but even large companies, such as GE, intend to impose a $1.7 billion premium increase through 2029 on its roughly 274,000 long-term care insurance policyholders. The average policyholder age is 77. Can you visualize getting hit with a substantial premium increase on your long-term care insurance policy after paying on it for over 12 years? (Learn more by reading 6 Options to Fund Long-Term Care in Retirement.)

While there are other options to traditional long-term care insurance — including life insurance and annuity long-term care riders — not all are structured the same. In fact, there are two styles of riders that are often confused: 1.) long-term care riders; and 2.) chronic illness riders.

What is a long-term care rider?

A long-term care rider is an add-on or feature to a life insurance policy or an annuity under IRC §7702B (opens in new tab) (the Internal Revenue Code concerning the treatment of long-term care) designed to help pay for the costs of long-term care services. Claims paid on these can be either temporary or permanent (as opposed to chronic illness riders, which are only for permanent conditions). In order to qualify for services, they must be recommended by a licensed health practitioner — such as your doctor.

Long-term care benefits from a life insurance or annuity rider are paid in two ways:

Indemnity policy

With an indemnity policy, once the insured person qualifies for benefits, monthly payments are paid out according to the contract. The policy automatically pays the specified dollar amount directly to the policyholder each month, regardless of what the care actually costs.

Benefits paid in excess of the HIPAA “per diem” (or per day) limitation are subject to taxation. The HIPAA per diem rate for 2019 is $370 per day (up from $360 per day for both 2017 and 2018).

For example, say a 65-year-old woman purchases an annuity with a long-term care rider for $100,000 that provides an immediate benefit of about $300,000 (or $137 per day for up to six years). If she were to qualify for long-term care benefits in the following year (age 66), she’d receive about $141 per day, as the benefit grows over time based on the contractual guarantees. (It’s important to note that not all insurance companies operate the same way.) Since this amount is below the HIPAA per diem rate of $370 per day, all benefits paid would be tax-free!

Reimbursement policy

With a reimbursement policy, you’d only be “reimbursed” for your actual long-term care costs, instead of receiving a steady amount, like an indemnity policy.

Using the same example above, we’d have to find out how much the woman is spending in order to be reimbursed. Let’s say her costs were $120 per day and her daily maximum is $141, the $120 would be paid and the remaining $21 would be placed back into the pool.

It’s imperative to note that while some may prefer the reimbursement policy in order to extend their benefits, the indemnity policy is simpler in many instances, and the excess can be used for other significant non-medical purchases.

What is the difference between a chronic illness rider and a long-term care rider?

A chronic illness rider is under IRC § 101(g) (opens in new tab) to help pay for permanent qualifying events. It’s similar to a long-term care rider where two out of six Activities of Daily Living (ADLs) or severe cognitive impairment can trigger benefits, and a licensed health care provider — such as your doctor — will have to certify this. However, chronic illness policies only pay when it’s likely the illness will last the rest of your life — not temporarily.

For example, a 70-year-old who suffers a stroke would receive long-term care benefits under a long-term care rider but not necessarily a chronic illness rider. In many instances, a stroke would not be sufficient to receive benefits under a chronic illness rider. If that person is deemed to recover, the chronic illness policy will not pay any benefits (the chart below).

If the stroke is one from which they’ll never recover and is deemed “permanent,” the chronic illness policy will pay benefits according to the contract.

It’s extremely important to know that a chronic illness rider is not long-term care. I have witnessed many instances where both financial advisers and insurance agents have confused the two and misrepresent a chronic illness rider as a long-term care rider.

Let’s review the differences between a long-term care rider and chronic illness rider:

Pension Protection Act of 2006

The Pension Protection Act of 2006, which went into effect in 2010, opened up an immense tax-efficient opportunity. For those with life insurance or annuity policies with substantial taxable gains, they can do a tax-free 1035 exchange into a new life insurance or annuity with a long-term care rider.

Here are the types of the policies that are eligible to be transferred tax-free to a new policy:

While a life insurance policy can be exchanged to both another life insurance policy as well as an annuity, an annuity can only be transferred to another annuity.

For example, a 70-year-old has an existing annuity that was purchased for $100,000 and is now worth $200,000. He or she can do a 1035 exchange into a new annuity with a long-term care rider that guarantees $600,000 worth of benefits. The person would pay no taxes on the exchange … and could potentially receive all of those long-term care benefits tax-free.

As you’re looking into a lifelong investment for long-term health care benefits, remember to take all of these factors into consideration. And be sure to fully understand the differences between a chronic illness rider and a long-term care rider, because confusing the two could lead you to make a costly mistake.