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December 15, 1993

Federal Reserve Bank of Cleveland

Long-Term Health Care:
Is Social Insurance Desirable?
by Jagadeesh Gokhale and Lydia K. Leovic

JL he aging of the U.S. population portends steep increases in the demand for
health care services well into the next
century. Although many Americans rely
on public health programs and private
health insurance to provide financial protection for a diverse group of medical
risks, the availability of such support for
long-term disabilities is woefully inadequate. As of 1992, fewer than 10 percent
of those age 65 or older were covered by
private long-term care insurance.
Expenditures on long-term care can be
economically devastating for the families of disabled persons and may potentially sap public budgets. Total spending on nursing home services stood at
$60 billion in 1991, of which more
than half was financed by federal,
state, and local governments (see figure 1). Policymakers engaged in reforming the country's health care system must bear in mind that as the baby
boom generation ages, the problems associated with ensuring adequate longterm care will be exacerbated.
This Economic Commentary explores
the underlying reasons for the private
insurance market's failure to cover
long-term care risks adequately. It also
evaluates several proposals for funding
long-term care through social insurance. We contend that none of these
proposals considers the potential negative economic impact of the intergenerational wealth redistribution implicit
in social insurance schemes.

ISSN 0428-1276

• Problems Facing Private Insurers
At the individual level, long-term care
is best financed by purchasing insurance because future needs are uncertain and the potential costs are enormous. In 1990, the average annual cost
of a nursing home stay was between
$25,000 and $35,OOO.2 The private
market for insuring long-term care expenses is extremely thin, however.
Only 2.4 million long-term policies
were sold in 1991, of which just 8.7
percent were employer sponsored. In
the same year, direct payments by individuals accounted for 43 percent of
nursing home receipts.
Much of the failure of the long-term
care insurance market can be traced to
the twin problems of adverse selection
and moral hazard. Both concern the
pricing of insurance for a group of potential purchasers whose chronic disability risk is unknown, and both significantly increase the costs of private
In general, the probability of requiring
extended care rises markedly with age.3
Thus, most young persons opt out of
purchasing such coverage even at extremely low prices. This means that individuals who do buy long-term care insurance — older Americans — are
precisely those with the highest risk of requiring extended care in the near future4

The inability to sell long-term care insurance to young people compels an
increase in the price at which private

As the baby boom generation ages,
ensuring adequate long-term health
care will become an increasingly important issue on the national agenda.
A one-year nursing home stay averaged between $25,000 and $35,000 in
1990, yet as of 1992, only 10 percent
of Americans age 65 or older had private long-term care insurance. This
Economic Commentary takes a look
at why the private insurance market
has failed to cover extended-care
risks adequately and examines the
wealth distribution problems that socially funded insurance entails.

providers can profitably offer coverage
to the elderly. Even among the elderly,
relatively healthy individuals may
choose to forgo coverage, driving up
the average risk of disability among the
remaining pool of potential purchasers.
The increase in the price of insurance
caused by such an "adverse selection"
of the riskiest individuals into the pool
of potential buyers means that many
elderly Americans cannot afford longterm care insurance (see table 1).
The moral hazard problem refers to the
change in individuals' behavior after
purchasing insurance. For example, a
person who buys long-term care insurance may not protect his health to the
same extent as someone who does not.
Because a significant amount of extended care is currently provided by


relatives, pricing long-term insurance at
lower rates may mean less care by family members and higher-than-anticipated
claims on insurers.
A third important reason for the limited
availability of private insurance is the
difficulty of predicting increases in the
cost of extended medical care. This applies particularly to nursing home services, which account for the largest share
of long-term care outlays (82 percent
in 1988). Among all health care services, the rise in the cost of nursing
home care has been the steepest —12.6
percent per year between 1970 and
1990. For any large group of insurance purchasers, the fraction that will
suffer chronic disabilities within a
specified period can be predicted with
a fair amount of precision. With appropriate pricing, individual risk can then
be diversified across the group. However, the risk of loss stemming from
large and uncertain increases in the
cost of providing long-term care is one
that applies equally to each insured individual and that cannot be diversified.



SOURCE: Suzanne W. Letsch et al., "National Health Expenditures, 1991," Health Care Financing Review
Winter 1992, pp. 1-30.


Age of Buyer


Individual and Group
Association Base Plan


Employer Sponsored


SOURCE: Health Insurance Association of America (footnote 4).

The absence of adequate insurance coverage forces the disabled into one of
three situations. They can 1) stay at
home and either purchase home health
care services or rely on family and
friends, 2) enter a nursing home as a
private-pay patient, or 3) enter a nursing home with the expectation of later
qualifying for the state's Medicaid program. While nursing home care absorbs the predominant share of longterm care spending, almost 80 percent
of the elderly and about 40 percent of
the severely disabled live at home.7
Many of those who initially enter nursing homes as private-pay patients ultimately deplete their assets and end up
on Medicaid. In general, however,
there is an excess demand for nursing
home facilities because most states
limit the supply of beds in an effort to
control costs. This forces some disabled individuals to remain at home.
Regardless of which of these three situations actually occurs, spouses and children of the disabled bear a large share
of the burden either directly, by providing care themselves, or indirectly,

through receiving lower inheritances as
assets are depleted to purchase nursing
home services. Taxpayers also bear a
portion of the burden through Medicaid support.
• A Rationale for Public
Provision of Long-Term Care
In the mid-1980s, the Reagan administration supported legislation aimed at
encouraging the private insurance market to cover long-term medical contingencies. Unfortunately, progress on
this front has been painfully slow. For
the reasons mentioned above, private
insurers are unwilling to take on risks
that seem to ensure only losses.
By the end of 1991, 131 private insurers were offering extended'Care policies
of various types, but none covered all
of the expenses associated with such
services. Insurers limit their risk exposure by imposing high deductibles and
long waiting periods, as well as relatively short maximum covered lengths

of stay. They also set maximum benefit
levels years in advance and limit inflation adjustments. Although some of
these restrictions have been eased recently by several larger insurers, the
private market for long-term care coverage still accounts for only 1 percent
of the total spending on such services.
Because the development of a mature
private insurance market for extended
health care is uncertain, some have proposed instituting a social insurance
scheme with broad public participation. They argue that Social Security
and Medicare, which are intended to provide only a floor of financial security for
the elderly, have been successful. These
programs leave to individual discretion
the option to purchase supplementary
health insurance or to increase personal
saving. Proponents of a social insurance
scheme for long-term care services recommend mandatory participation to provide a basic level of long-term coverage,
leaving open the option to purchase

supplementary insurance via additional
trade-offs with private pension plans and
personal saving.
Some of the proposals currently on the
table envision a system similar to Medicare. But this would mean imposing
standardized eligibility criteria and uniform benefit packages that may narrow
the choices available to the disabled
and their families. Furthermore, restrictions on the quality and type of care
provided may require a restructuring of
the existing nursing home stock and
services. For that reason, some have
proposed an "indemnity" approach
wherein cash benefits would be triggered based on prespecified levels of
disability. Under this system, the individual would retain control over the
type and quality of care. Various alternatives for financing such schemes
have been floated, including higher individual taxes and the creation of a
separate long-term trust fund, employer funding of insurance premiums,
or a tax on Social Security benefits.
The Clinton administration's Health Security Plan is a social insurance plan
that mandates long-term care for all
"without regard to income or age." It
would expand home- and communitybased services through federal funding
of expenditures that exceed states' current Medicaid outlays and state-only
spending on the severely disabled. It
also envisages setting, enforcing, and
monitoring minimum standards for private long-term care coverage. Premium
payments made by individuals and employers for qualified long-term care
policies would be tax deductible.
• Social Insurance: A Solution?
The public health insurance and security
schemes in force today, the largest of
which are Medicare, Medicaid, and Social Security, have engendered sizable
wealth redistributions from younger to
older generations. Recent research suggests that this trend may constitute part of
the explanation for the decline in U.S.
saving over the last two decades. Because the probability of developing a disability requiring long-term care increases
significantly with age, the introduction of

a social insurance plan would involve a
wealth transfer from those less likely to
require extended care in the future to
those more likely to need it — that is,
from younger to older generations.
Even if participation were restricted to
persons over a certain age, say 65,
there would still be a redistribution of
wealth from all younger to older generations because once such a program
is initiated, today's younger generations would expect, upon turning 65, to
begin subsidizing their elders. The net
benefits accruing to the first set of elderly, who will surely receive more than
they contribute, would represent a
windfall gain, the burden of which
would descend on the pocketbooks of
all future Americans. This redistribution, coupled with the fact that the elderly would now have more health insurance via yet another annuity, is likely
to decrease saving and, therefore, bequests by the elderly.
While the failure of the private insurance
market for long-term care may provide
some rationale for instituting a public program, adopting a plan that ignores the implications for intergenerational wealth redistribution is likely to hamper future
U.S. economic growth by reducing saving and investment. The rationale for
mandatory participation in any social insurance program is to protect the prudent
members of society from the (future) liabilities of those who are improvident.
But including in the group individuals
who failed to insure themselves adequately in the past transforms the program from an insurance to a transfer
mechanism. Thus, long-term care financing poses a dilemma because the insurance and transfer aspects of the problem
are intertwined: Informational problems
cause the private long-term care insurance
market to be thin, but social provision
through universal participation promotes
a wealth redistribution toward the elderly
that reduces the private incentive to save.
The solution, then, must separate these
two aspects of the problem. Younger
generations need to save today to meet
their own future extended-care needs.
Therefore, a funded but generationspecific program wherein the contribu-

tions of each generation are insulated
from the claims of other (older) generations is worth considering.13 If those
requiring long-term support in addition
to their existing health care benefits are
to be accommodated, this could be
done via separate and explicit transfers
that would, by law, be phased out over
time as the need for them tapers off.
• Conclusion
For most people, especially younger individuals, developing a disability that
will require extended care is a lowprobability event. Yet the resources that
must be expended to provide for such
an eventuality are enormous. Thus, protecting against long-term care contingencies is best accomplished through
purchasing insurance.
Unfortunately, the private market for
extended-care insurance faces significant informational problems that make
such coverage prohibitively expensive
for many Americans. This provides the
motivation for proposing a publicly
funded program. However, unless safeguards against the intergenerational redistribution of wealth from younger to
older generations are adopted, such a
provision could prove detrimental to
U.S. economic growth in the long term
by reducing saving and investment.


1. Long-term care includes nursing home
and home health care services for treating
chronic health conditions and disabilities related to aging, physical diseases, and mental
illnesses that prevent individuals from performing the normal activities of daily life.
2. See The Consumer's Guide to Long-Term
Care Insurance, Health Insurance Association of America, Washington, D.C., 1991.
3. Two-thirds of the disabled and more than
80 percent of the severely disabled are over
65 years of age. Among persons 85 or older,
55 percent have some disability. By contrast,
only 13 percent of those age 65 to 69 and just
2 percent of those under age 65 suffer any degree of disability.
4. In 1991, the average age of purchasers of
private long-term care insurance was 69. See
Long-Term Care Insurance in 1991: Policy
and Research Findings, Health Insurance
Association of America, Washington, D.C.,
February 1993.

5. Physicians' fees were in second place (up
11.8 percent), followed by hospital bills
(+11.7 percent), dental costs (+10.4 percent),
and drugs (+9.5 percent). See Katharine R.
Levit et al., "National Health Expenditures,
1990," Health Care Financing Review, Fall
1991, pp. 29-54.
6. Medicaid eligibility is met if the disabled
individual has less than $1,500 in liquid assets if single, and less than $2,250 if married.
If the nursing home stay exceeds six months,
the individual is required to sell his home and
a lien is placed on its value equal to the value
of subsequent nursing home expenses (unless
the home is occupied by a spouse or childcare provider).
7. See "A Call for Action: Financial Report
of the U.S. Bipartisan Commission on Comprehensive Health Care," Washington, D.C.:
U.S. Government Printing Office, 1990.
8. See William J. Scanlon, "Possible Reforms
for Financing Long-Term Care," Journal of
Economic Perspectives, vol. 6, no. 3 (Summer
1992), pp. 43-58. See also Yung-Ping Chen.
"A Three-Legged Stool: A New Way to Fund

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, Ohio 44101
Address Correction Requested:
Please send corrected mailing label to
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Material may be reprinted provided that
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of reprinted materials to the editor.

Long-Term Care," in Care in the Long Term:
In Search of Community and Security, Washington, D.C.: National Academy Press, 1993,
pp. 54 - 70.

Implications for Intergenerational Transfers,
Inequality, and National Saving," National
Bureau of Economic Research Working Paper No. 4182, October 1992.

9. See Health Security: The President's Report to the American People, White House
Domestic Policy Council, U.S. Government
Printing Office, October 1993.

13. Permitting funds to be invested in nongovernment securities, for example, may be
used as a means of enhancing the credibility
of such protection. This would reduce or
eliminate direct government control over the
disposition of the funds.

10. See Laurence J. Kotlikoff, Generational
Accounting: Knowing Who Pays, and When,
for What We Spend, New York: The Free
Press, 1992.
11. See Jagadeesh Gokhale, "The Decline in
U.S. Saving Rates: A Cause for Concern?"
Federal Reserve Bank of Cleveland, Economic Commentary, September 15, 1993.
12. Apart from redistributing wealth from
younger to older generations, public financing of long-term care would further promote
the annuitization of the elderly's resources.
This may induce the elderly to deplete their
resources at a faster rate and to leave smaller
bequests. See Alan J. Auerbach, Laurence J.
Kotlikoff, and David Weil, "The Increasing
Annuitization of the Elderly: Estimates and

Jagadeesh Gokhale is an economist and
Lydia K. Leovic is a senior research assistant
at the Federal Reserve Bank of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Resen>e

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