Risk Management and Insurance

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RISK MANAGEMENT AND INSURANCE

As people age, the chances increase that some conditions (e.g., disability) or events (e.g., retirement, loss of spouse) may alter their financial status. Risk management is a field that seeks to reduce the economic costs that would otherwise be associated with those conditions and events. These costs may be reduced both by reducing the probability or severity of the event (e.g., adding safety railings) and by reducing the economic losses should the event occur (e.g., through insurance). For some events there are good insurance products on the market, and for others there are not. Several components of the total retirement package (pensions, retiree health plans, long-term care policies, and personal care provided for those who need special assistance) may help in the management of post-retirement risks. Individual risks are discussed in more detail in other entries in this encyclopedia; in this section general risks and insurance considerations that are important for the management of these risks will be examined.

Post-retirement risks

It may seem surprising that the term risk heard so frequently in casual conversations and in discussions with financial professionals, has no single, widely accepted definition. However, all definitions share the concept of uncertainty. From the perspective of the individual, uncertainty arises for two reasons. First, even though the probability of occurrence can be predicted for a group (e.g., the risk of death at a specific age), its timing cannot be predicted for an individual. Second, even though the average loss from an event’s occurrence may be estimated, variations in actual losses across individuals will occur. Thus, the risk of retired-life events can be considered in two parts; (1) the probability of occurrence, and (2) the loss associated with an event’s occurrence.

A review of the pattern and economic costs of post-retirement risks suggests that retirement income distributions may not be well matched to the risks faced in the post-retirement years. Social Security benefits are paid to couples as a family, and reflect the work history of both members of the couple. In addition, benefits are continued to the surviving spouse. These benefits are indexed to provide increases linked to increases in living costs. Private pension benefits may be distributed in one of several forms: as a lump sum, as a level income, as an indexed income, and as an income with continued payment to a survivor after one of the annuitants dies. None of these forms has any component linked to changing consumption needs. Insurance can help provide security and help protect against some changing needs, but it does not offer a perfect solution.

Events of the post-retirement period

There are a number of events, some of which are described below, that can change the economic circumstances of the individual retiree after retirement. The example in Table 1 illustrates one of these hypothetical individuals.

In this example, Joan’s family members are critical in her support from age seventy-seven until her death. But since no suitable family household was available for her to join, she has lived in special housing since age seventy-five. Starting at age seventy-eight, she has needed daily support, and starting at age eighty, support throughout the day.

The higher out-of-pocket costs of accommodating her functional limitations places Joan at risk of outliving the resources that she and Robert may have thought sufficient for their lifetimes. For low-income persons, Medicaid is available to pay for nursing home care, but not for help until the individual is severely disabled. If Joan had purchased long-term care insurance, exactly when benefits would be payable would vary depending on the provisions of the specific insurance policy, but benefits would have probably started around age eighty. Joan’s medications are about $250 per month, which are paid for by her private insurance, but not by Medicare. Many private insurance programs, however, limit what can be paid for drugs, and some policies offer no coverage for prescription drugs. If Joan has limited assets and income, she may become eligible for Medicaid at some point between ages eighty and eighty-two.

This example is presented to illustrate some of the economic issues involved with the gradual change of functional status, including the use of the telephone, ability to drive, ability to pay bills and manage personal affairs, management of medication, and going out independently. It intends to illustrate the key issue in risk management: how to assure coverage of increases in living costs when neither the timing nor the size of those increases can be precisely predicted for any individual.

Increasing life expectancies, even for retirees, increase the risk of a person outliving their resources. One can protect against this risk by annuitizing assets; for example, choosing a payment form that will continue income payments regardless of the number of years the annuitant (and surviving spouse) lives. However, other post-retirement risks interact with length of life in ways that make this an imperfect strategy for complete insurance of levels of economic well-being. For example, inflation over a longer lifetime will further erode the purchasing power of an annuity that is not indexed for inflation. In addition, while lengthening lifetimes may extend the period of joint survival for a couple, it also extends the number of years of widowhood when one’s spouse dies. Likewise, lengthening life expectancies increases the chances that at least one parent may still be alive when an individual retires, raising the possibility that a parent’s health care needs may place demands on a retiree’s resources.

Changed consumption needs. A variety of unexpected post-retirement changes in family, work, and health status can lead to changes in consumption needs. The death of a spouse diminishes the food and clothing consumption needs of a now smaller household, but may increase the costs of leisure and household repairs that were formerly provided by the deceased spouse. It may also mean there is no longer someone available to help other household members. Loss of functional status by any household member increases health care costs and may increase transportation and home maintenance costs when that person is no longer mobile or requires facility adaptations. If someone’s retirement planning did not incorporate the chances of these post-retirement risks, then the selected pattern of resource distribution may not be well matched to subsequent needs.

Death of a spouse. A spouse’s death can cause a major change in both the personal and financial situation for the survivor. While group probabilities of losing a spouse can be calculated, an individual’s death may be unexpected, leaving a spouse bereaved and impoverished. The survivor is most often female, but there are also differences in what typically happens after the loss of a spouse. Men are much more likely to remarry. Women often experience a substantial decline in economic status and discover that they and their spouse had not planned adequately for widowhood. Women’s longer life expectancies and marriages to younger men means that survival as a widow is expected to be much longer than it is for widowers.

A financial retirement plan for a couple is not adequate unless it also provides for what happens when one of them dies. There are a variety of different financial strategies available to help in planning for widowhood. Assets are generally left to the survivor, but depending on other resources of the survivor, they may not be adequate to meet lifetime needs. Life insurance provides lump-sum funds for widowhood. Survivor options in pensions and annuities provide for continued income, and a fully owned home can be an important asset.

Other family changes. Retirees increasingly find themselves responsible for the physical and financial care of parents and children. Unexpected events in the lives of these individuals and their families can lead to immediate changes in the financial demands placed on retirees. This can be addressed by reviewing the financial strategies of these individuals, but for parents of retirees there may be few options at their time of life (see discussion of uninsurable risks below).

Inflation. Price increases erode the purchasing power of savings, with a relatively low rate of 2 percent reducing purchasing power by one-third over a twenty year period, and a rate of 5 percent reducing it by two-thirds. Asset, annuity income, and life insurance amounts need to be planned with the expectation of future inflation, the exact path of which can only be imperfectly estimated. Social Security benefits rise annually with the consumer price index, but, in general, employer-provided pension benefits do not. Investment strategies in which the growth in personal assets counteract the effect of inflation on the purchasing power of a retiree’s portfolio can be used.

Unexpected health care needs. Post-employment medical coverage is important for retired individuals and spouses, particularly for retirees below the age of eligibility for Medicare coverage. While persons age sixty-five and over are covered by Medicare, this program covers only a portion of medical costs and does not provide coverage for prescription medications.

Changes in functional status. A decline in the ability to perform designated activities of daily living may require special help. These are tasks required on a daily basis, such as eating, toileting, and dressing. They are important because the ability to perform such tasks is the way most long-term insurance policies determine eligibility for receipt of benefits. Organized retirement systems do not adjust to increasing income needs as functional status declines, though medical coverage may reimburse for some care, and long-term care insurance can help pay for part of the cost of special disability help. However, as described below, the gradual nature of functional declines may not be well accommodated by insurance. Some declines can be addressed initially by redesigning housing space to make it more user-friendly to those with the anticipated problems, or so it can accommodate assistants.

It is important to be aware well ahead of time of the possible need for these services, and what is covered and what is not covered by available insurance. The alternative is financing extra costs through savings or income.

How insurance fits in

Insurance allows a large number of people who share a similar risk to pool their risks. For insurance to be viable, there needs to be a large group with similar risks, and it must be impossible or very difficult for them to determine in advance which particular individuals will have losses and when they might occur. Legally, insurance can be provided only when there is insurable interest and a legitimate purpose for the insurance. For example, it is reasonable to sell life insurance to people who have an economic loss if the person insured dies, but not reasonable to allow a person to purchase life insurance on strangers. That would be gambling, and there is no insurable interest. In addition to needing a large pool of people, there must be an insurance organization willing to provide and market the product, and a large enough marketplace so that the product is financially viable. Insurance is regulated in every state, and insurance arrangements must comply with the regulations.

Life insurance. There are a wide variety of different types of life insurance policies available. These policies can be used to provide death benefits upon the loss of a spouse, and many of them can also be used to help accumulate retirement assets and to address other risks. Some policies have provisions that allow the benefits to be paid out early in the event of severe disablement, so that they can be used to help pay for long-term care. Inflation should be considered in determining the amount of life insurance needed.

Health (medical) insurance. Health insurance covers both expected and unexpected health care costs. Depending on policy design, all costs may not be covered, and premiums and benefits caps may or may not increase with inflation. Medicare pays for about half of the total health care needs of the elderly. Some employers offer supplemental coverage for retirees, but others do not. A premium may be required for employer-sponsored coverage. If there is no employer coverage, then there are two different strategies for buying insurance to add to what Medicare covers. Medicare supplements work in partnership with traditional Medicare and cover some of what Medicare does not cover. Many do not cover prescription drugs, and those that do offer only limited coverage. Federal law specifies eight different benefit designs that can be offered as Medicare supplements.

Another alternative for Medicare-eligible persons is a Medicare+Choice plan. Under these plans, the federal government pays a flat amount per covered person to the plan, and a total benefit package is offered by the plan. The plan is chosen instead of traditional care. These plans differ in whether they charge premiums in addition to the payment by Medicare, and in what benefits are offered. Different plans are available by geographic area, and enrollees are limited to the use of contracted physicians and hospitals. Some of these plans offer prescription drug coverage, but others do not. There are generally limits on what is offered, so plans need to be analyzed carefully. Depending on the geographic area, what is available will vary, and it may be quite expensive. Purchasing coverage can be difficult for those in poor health, and many states have high-risk pools available for covering people who have difficulty purchasing coverage as an individual.

Long-term care insurance. Long-term care insurance provides for part of the cost of extra care resulting from frailty. It does not provide coverage for the less severely disabled, and it pays up to a specific limit, which may be less than the total cost of care. Some people may seem to be quite disabled and still not qualify for benefits. Inflation of these costs may be covered, depending on the policy design. Long-term care insurance can be purchased to cover an individual and spouse, and also parents, if they are living and insurable.

Annuities. Annuities provide insurance against the risk of outliving assets. They also provide coverage of investment risks, as the insurance company handles investments. They can be inflation adjusted, but most are not. A reverse mortgage is a special type of annuity that enables a person to borrow against the equity value in a home, receiving periodic payments which are repaid upon the death of the person or sale of the home.

What risks are not insurable

Inflation. It is not possible to insure against inflation directly, but various strategies can be used to offer a better hedge against inflation. For example, if annuities are purchased, either inflation-adjusted annuities with a fixed, built-in escalator, such as 3 percent or 5 percent can be used. An investment strategy for financial assets should take into account expectations with regard to inflation, and should also reflect the individual’s view as to the best investments considering the expected economic environment. Many people feel that investing part of their assets in common stocks is a good hedge against inflation. Whether this is sensible depends on the total portfolio, and on all sources of retirement income.

Other family changes. The death of a spouse is a very common change for elderly Americans, and the economic loss associated with the death of a spouse can be insured. Many older Americans also provide assistance to parents, children, or grandparents. This assistance can be in the form of care during frailty, it can be financial assistance, or it can be other support. In some cases, older Americans are asked to care for a parent after the spouse of that person is disabled or deceased. Generally, these are a challenge to plan for and are not insurable, but they are a reason for having more savings. Some of them can be partly insured. For example, long-term care insurance can be purchased on parents. [Life insurance can be purchased on a parent if the child expects to become responsible for the surviving parent after the death of one parent.]

Changes in functional status. Services to the frail elderly can be provided at home, in nursing homes, or in a variety of housing settings. In general, there is no insurance against moderate changes in functional status and the extra needs that result; long-term care insurance is activated upon evidence of need of assistance in several activities of daily living. An individual experiencing and needing help as functioning status declines may need to draw on savings. An individual can also plan housing that is flexible. Developments of the past several decades in public- and private-sector approaches to housing for older adults have been motivated in part by the need for housing that adjusts to these gradual, noninsurable, declines. For example, many elderly housing developments accommodate wheelchairs easily and have handrails in corridors for those with balance problems.

Another way to plan for moderate changes in functional status is to live near children or other family members who can provide some help if it is needed. Some retirement communities provide help. A continuing care retirement community (CCRC) integrates housing, medical care, assistance with daily living, and a variety of social and other activities. This type of community is of particular interest to actuaries, in that it often provides a form of medical and/or long-term care insurance. CCRCs typically require a down payment at entry and a monthly fee. They also have health requirements at entry and provide a range of services, some of which may require additional fees.

Changed housing needs. Owning a home with a good resale value offers a good chance that one will have the resources to move into different housing as needs change. The CCRC is a way of insuring that housing will be available that fits one’s needs as one becomes more frail. However, it does not guarantee that one will be near children, or fit new interests. There is no other direct financial vehicle to protect one in the event of changing housing needs.

Buying insurance

There are some general things to be aware of in buying insurance. In addition, there are details specific to each type of plan (these are not covered here). General things to watch for include:

Is the company licensed in my state?
What is the financial rating and reputation of the company? (Best’s is one service that rates insurance companies.)
How does the insurance policy match one’s specific needs? In all of these areas, there are a number of areas in which policies differ. Be sure that the details of the policy fit your needs.
Is the policy a good value? What sales charges are included?
What provisions does the policy include in the event one’s needs change or in the event one changes his or her mind later about this coverage?
Does the company have a good reputation for paying claims promptly and fairly? How committed is the company to the particular type of business? This is particularly important in areas like annuities and long-term care, where it is expected that the policy will be ongoing for the rest of one’s life.

Anna M. Rappaport Karen Holden

See also Annuities; Continuing Care Retirement Communities; Employee Health Insurance; Functional Ability; Health Insurance, National Approaches; Long-Term Care Insurance; Medicaid; Medicare: Widowhood, Economic Issues.

BIBLIOGRAPHY

Eschtruth, A. D., and Long, C. ‘‘A Primer on Reverse Mortgages.’’ Just the Facts on Retirement Issues, Number 3. Chestnut Hill, Mass.: Center for Retirement Research at Boston College, 2001.

Rappaport, A. ‘‘Retirement Needs Framework.’’ Retirement Needs Framework Monograph. SOA Monograph M-RSOO-1. Schaumburg, Ill..: Society of Actuaries, 2000.