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Insurance functions best when it is used to cover high-cost low-probability risks ? things that aren?t likely to occur, but would be devastating if they did. Technically, paying insurance premiums on an ongoing basis has a slightly greater expected loss than just retaining the risk, but the trade-off ? converting a potential financial disaster into a manageable ongoing premium ? is appealing.
Yet long-term care coverage has a challenge: What was once believed to be a higher-cost, lower-probability event has now turned into a very high-probability event with an increasingly large volume of lower-cost claims. As a result, long-term care insurance has begun to morph from effective insurance into something that looks more like just prepaying long-term care expenses in advance ? at a high premium rate and with little insurance leverage.
Perhaps it?s time to reform long-term care insurance policies so that they once again focus on high-impact, low-probability events. For instance, what if elimination periods for long-term care insurance were increased to allow for a two- or three-year deductible, instead of today?s common three-month period? That way individuals could take the significant premium savings and use it to cover their care during that time period.
Could such an increase in deductibles reduce the cost of long-term care insurance coverage enough to make it affordable once again to at least a much larger segment of the general public?
SHIFTING ODDS
For insurance to effectively manage risk, an event should have both low likelihood and relatively high impact.
When insurance covers a small number of high-impact events, the cost of operating the insurance company is very small relative to the amount of premiums and potential claims. When insurance covers low-impact events (with lower-cost claims, but at greater frequency), overhead ends up consuming a larger percentage of the premiums ? reducing the implied leverage of the insurance.
In fact, if the risk is inexpensive enough, it would be much cheaper to simply self-insure and avoid the share of premiums that goes to the insurance company?s overhead and profits ? especially if the likelihood is so high that the expense can be reasonably anticipated.
Unfortunately, this dynamic of high-cost/low-probability versus low-cost/high-probability events is present in the world of long-term care insurance. When first created, the insurance was...