Aging of the Elderly: An Intragenerational Funding Approach to Long-term Care

3. Longevity and Long-term Care Risks

The two important risks faced by those in old age are:
•    The risk of excess longevity
•    The need for long-term care and the run down in assets before the public program steps in.
The state pensions in both countries provide some protection for the longevity risk. Average life expectancy at age 60 or 65 is a poor guide to the years an individual may actually live, with a spread of mortality around the average (Wadsworth, Findlater, & Boardman, 2001). Managing a capital sum with a drawdown product to last for a lifetime whose length is uncertain can mean a seriously diminishing annual income for those who live a long time. Drawdown products themselves based on average life expectancy can be a very poor solution for those who live longer than average.
For those who require expensive healthcare, the current practice of user pays can mean that individual estates are quickly depleted, imposing costs on some of the working-age population whose inheritances diminish or disappear.
Today there are few, if any, suitable annuity products to meet the risk of outliving accumulated capital. Private pensions can be helpful but as noted, fewer employers are offering these and few of these pensions provide protection against inflation.
In the case of long-term care, private insurance products where they exist tend to be limited and circumscribed. Suppliers of long-term care insurance are affected by the uncertainties of future costs and demands including the inflation risk which makes it a difficult product to price as a single premium product. Exclusions for higher risk purchasers are likely. As Fenn (1999) notes the risks of getting it wrong in the face of multiple uncertainties are high, and significant loading charges are likely to make the insurance unduly expensive.
Thus long-term care is not well covered by private insurance as would be predicted. Yet there would be gains from pooling risks, as otherwise huge costs can fall on the uninsured and/or the financially naïve.5 If each person tries to save enough to pay for the maximum time they might need in care, given that the majority will not need such care, many people will die leaving unintended bequests. The obvious welfare gains to be had from pooling risks are not well exploited by private providers because of the special difficulties of the insurance contract.
Some of the difficult questions to be addressed, discussed in Barr (2001) are:
•    How will the care be allocated? How much, what type and on what basis?
•    How might costs and types of care be affected by new technological developments?
•    Can premiums rise if the patient becomes more risky (older, or unwell)?
•    Will there be a ceiling on reimbursement of the cost of care?
•    Is there a maximum duration over which benefits are paid, if so what happens if the individual lives beyond this period?
•    How will wage and price inflation affect the cost of care?
•    How are disagreements/bankruptcy of the insurer to be dealt with?
•    How much insurance is adequate, i.e., should there be any minimum level?
•    How integrated is it with existing public funding and/or provision for long-term residential care and what if policy changes?
In light of these difficulties and others, it is clear that any all encompassing contract, single premium product at age, say 65, will be near impossible to draw up. On the insurer’s side, problems arise because uncertainty, rather than risk, makes probabilities indeterminate. Moreover:
•    There is no accurate data to predict the probability with which future cohorts of retired will require care.6
•    Insuring from a young age gives more insurance protection because of the wide pooling, but the costs of uncertainty are higher.
•    The condition of independence of probabilities does not hold. Medical advances that prolong life may place everyone in a similar situation.
•    The relative cost of care is likely to continue to rise over time (Baumol’s cost disease), but the extent of this is uncertain.7
•    Adverse selection problems are high and may require intrusive questioning from the insurer.
Moral hazard may arise from several sources. The obvious one is that the person concerned may be more likely to demand care, but there are also worries that families likewise may push older relatives into care if there is insurance.8

3.1. Market Failure in Insurance for the Old

There is a clear case of market failure both in the provision of suitable annuity products to meet the longevity risk, and in the provision of private insurance for long-term care. New Zealand provides a good example of what happens when there is no state intervention of any kind in these markets. With no compulsion to annuitise, no tax incentives in the accumulation phase, and no encouragement to long-term care insurance, the markets are thin or nonexistent. This suggests that market-based solutions are unlikely to succeed and what is required is a re-envisioning of social insurance solutions.
The case for finding a solution to these market failures must be made on grounds of both individual welfare and public interest. Without insurance against these risks, it is likely that capital will be run down too early by those who live a long time and the costs of supplementary income top-ups, long-term care, and other age-related health expenditures will fall on the working-age population, either through higher taxes or as the families concerned meet the costs of their parents either directly or through receiving lower bequests. Means testing can lead to inappropriate divestment of assets too early in retirement and/or the setting up of trusts to disguise income and wealth. The costs of long-term care fall unevenly and unfairly on the unsophisticated or honest, while the trust mechanism allows cost shifting to the working-age population.
Older people who die early may pass remaining assets to the next generation, but the distribution of these bequests is likely further to widen the income and wealth distribution. Thus, without insurance to overcome these two risks, the impact on the working-age population would be arbitrary and inequitable.
From society’s point of view a requirement to annuitize a portion of wealth not only spreads the risk of longevity but prevents the early spending of lump sums and ensures an income stream to pay for at least some of the costs of healthcare and long-term care later in retirement. It is this thinking that lies behind compulsory annuitization in the United Kingdom, where extensive tax subsidies to retirement savings have permitted such rules.
Unfortunately, simply compelling annuitization without attention to design may simply force people to take unsuitable products. It can be argued this has been the case in the United Kingdom, where annuity rates have been falling for many years and annuities have been highly unpopular. Pressure to move away from compulsory annuitization has forced a policy change so that the pensions pots do not now have to be annuitized by age 75. Nevertheless, the absence of suitable drawdown products for modestly well-off people means that annuitization is still the only option. Annuities are seen as a lottery, with the size of the annuity critically dependent on the time of retirement, the gender of the retiree, and the way in which inflation impacts on the real value.

4. The Intragenerational Funding Concept

The basic idea of intragenerational funding is that the elderly themselves could help meet more of the costs associated with aging. The intent is to shift some of the burden from the working-age population through arrangements whereby the retired as a group would bear the reduction in consumption through the purchase of suitable social insurance.
Intragenerational funding of the risks of old age, such as increasing longevity and long-term care through suitable insurance mechanisms improves intergenerational equity by removing some of the burden from the working-age population. Without the proposed additional risk pooling among old people, taxes must be higher and certain unfortunate families must bear the disproportionate costs of the asset depletion of their parents. If parents do not have enough resources and become dependent on their children, then the children could in turn find it difficult to prepare for their own old age. The shifting and sharing of the burden can become an important rationale for the use of an intragenerational funding approach for long-term care (Chen, 1994).

5 As in the case where assets have not been protected and the state can take these in payment for care before providing any subsidy.
6 It is not clear, for example, whether predicted future increased longevity will in turn increase the average period spent in long-term care.
7 The theory known as Baumol’s cost disease, is that costs would rise relatively faster in the public sector, because the nature of the output was labour intensive and not as amenable to productivity changes as private output (Baumol & Bowen, 1965).
8 Barr notes that it could be rational not to insure oneself so as not to be put in care against one’s will (Barr, 2001, p.82). The moral hazard effect may reduce the welfare gains from insurance. For example, Zweifel and Struwe (1998) question the welfare gains that flow in theory from compulsory social insurance in Germany.

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