Long-Term Care Insurance

Insurance is licensed and regulated by each state. The federal government has had regulatory authority when the insurance is provided through most employer-provided benefit plans. Tax-favored employee benefits are regulated by the federal government, but this regulation has been primarily focused on ensuring that employee benefits are not provided in a way that favors one class of employees over another.

Until 1996 the federal tax code did not recognize long-term care as a tax-exempt employee benefit. This has resulted in a great deal of ambiguity concerning the tax treatment of premiums paid, the tax treatment of benefits received by policyholders, and the treatment of the reserves accumulating to pay future long-term care benefits (especially prior to 1989). Much of the ambiguity stemmed from the fact that the preferential tax treatment of health insurance was derived from a 1954 definition of medical care, which was so explicit to leave lawyers wondering if assistance to function on a daily basis or to remain independent despite chronic conditions would be included. That is, so much of the definition was related to the diagnosis and treatment of a disease to render serious questions about nonmedical services even when they were necessary because of a medical condition.

If it had been clear that long-term care is covered by the medical definition, then long-term care insurance could be treated like health insurance. Health benefits in a health insurance plan are not treated as either federal or state taxable income, and if the premiums are paid by an employer the premiums are not treated as taxable income either. Long-term care insurance relies on prefunding, much like whole life insurance, but clearly long-term care insurance pays benefits prior to death. In the case of whole life insurance, the insurers intend to invest the premiums in a reserve fund that is used to pay benefits. The earnings on those reserves are not taxed at the federal level and often not at the state level and hence premiums are lower than they otherwise would be.

The Health Insurance Portability and Accountability Act (HIPPA) of 1996 made long-term care insurance explicit in the federal tax code (Tapay and Feder). In so doing, the federal government defined long-term care insurance in ways in which states had not. This actually created two kinds of long-term care insurance. That which is only state approved and that which is both state approved and qualified for preferential tax treatment by the federal standard. While each state has its own standards to define long-term care, no state had established standards like those in HIPPA. For example, to be federally qualified, the long-term care insurance policy must pay benefits if the policyholder has limits in two or more activities of daily living. Most states that have such a standard use a criterion of limitations in three or more activities of daily living.

While HIPPA added clarity for the tax treatment of long-term care insurance policies that meet federal standards, it may have inadvertently left even more uncertainty for state-licensed policies that do not meet the federal standards. Furthermore, tax preferences not only lower the cost of the policy, they imply an implicit signal from the government that suggests an endorsement of long-term care insurance. This is seen as critical for selling insurance by insurance industry experts who have acknowledged just how difficult it has been to sell long-term care insurance policies, especially to people under the age of sixty-five.