James Sullivan
James Sullivan

Combination Products May Shake Up the LTC Insurance Marketplace

Three-year-old tax law change may generate renewed interest in long-term-care (LTC) insurance.

October 13, 2009
by James Sullivan, CPA, PFS

Tax legislation signed into law in 2006 but not effective until 2010 will increase sales of long-term-care insurance. At least, that is what the insurance industry is hoping. Hope rests on the Pension Protection Act of 2006 (PPA), which provides tax benefits for life insurance policies and annuity contracts that are combined with long-term-care (LTC)  insurance riders (referred to as combination plans).

Only the tax treatment of combination plans is new; the plans are not. While the sale of traditional LTC insurance policies peaked in 2002 and has been declining since, combination policies have found a marketplace even before the tax benefits of the PPA become effective. In 2008, first-year premiums on combination contracts are estimated to have reached $650 million compared to $600 million for traditional stand-alone policies.

The insurance industry is responding to the 2010 law change with new products. The actuaries at the actuarial and consulting firm of Milliman estimate that currently 10 companies offer annuity combination plans and they expect that number to double in 2010. Over 20 companies already market life-combination plans, and that count is also expected to increase.

As interest grows, CPAs need to be conversant with the tax treatment and the basic design of combination products. Clients may initiate the discussion or it may be appropriate to bring these plans to the attention of clients.

This article discloses the basic structure of combination plans.

Introduction to Combination Plans

Combination plans — whether a life insurance or annuity contract — offer LTC insurance coverage through a policy rider. A rider is an optional benefit that can be added to the life or annuity contract for an additional premium.

Permanent life-insurance policies and non-qualified annuities contain cash value. The cash value consists of the premium paid into the contract less insurance costs and expenses plus earnings. The basis in the contract consists of the premiums paid in reduced by prior untaxed withdrawals. When a contract is sold, surrendered or annuitized the distribution of the basis is not taxable. Distribution of earnings is taxable.

In a combination plan, the payment of the LTC rider charge to pay for the coverage is from the cash value contained in the base policy — the life insurance contract or the annuity. LTC benefits paid under the terms of the rider come from two sources. The first source comes from the policy itself — either the cash value of the annuity or the accelerated payment of the death benefit from the life insurance policy. The second source is paid by the insurance company that is independent of payments made from the base policy.

Example: A life/LTC combination plan provides not only for the accelerated payment of death benefits to pay for LTC expenses, but also provides for additional payments to be made by the insurance company. There may be two riders. Under the first rider, payment of the death benefit (a portion of which is a pro-rata reduction to cash values) is accelerated to pay for covered LTC expenses. A second rider may provide for extended benefits. This rider pays additional benefits after the entire stated amount of the death benefit has been paid out under the first rider.

Example: An annuity/LTC combination plan provides for benefits to be paid from a combination of the cash value of the annuity and payments by the insurance company. Assume the rider provides for LTC protection equal to three times the premium. A $100,000 premium provides $300,000 of LTC protection. If the annuity beneficiary goes on claim and submits a reimbursable bill for $1,000 the payment is made from the cash value of the annuity until it is depleted. The remaining $200,000 of benefits will be paid by the insurance company from its reserves.

Comprehensive combination life/LTC riders should be distinguished from life-insurance riders that merely accelerate death benefits to pay for LTC. An accelerated death benefit rider on a life insurance policy provides for the payment of some or all of the death benefit prior to the death of the insured, if he or she is diagnosed as terminally or chronically ill. These accelerated payments are nontaxable pursuant to Internal Revenue Code (IRC) 101(g).

Pension Protection Act of 2006 (PPA)

The PPA changed, and in some cases clarified, the income tax treatment of combination plans. The tax law changes are effective January 1, 2010 for contracts issued after 1996.

Specifically, PPA addresses:

  1. In 2009 and prior years, charges paid using cash values in the life or annuity combination policy are treated as distributions. Those distributions are reported as taxable income to the extent there are undistributed gains within the contract. In 2010, charges from within the policy will technically still be considered distributions by the IRS but they will not be reported as taxable income.
  2. The payment of charges will reduce the policy holder’s basis in the contract (but not below zero). This has the effect of potentially increasing the gain realized by the policy-holder should the policy be surrendered or sold. Your clients may not treat the charges as paid first from any undistributed gain within the policy although this would be the preferred approach.
  3. Charges made from the insurance policy or annuity cash value are not deductible as an itemized deduction under IRC Section 213(a).
  4. The tax law changes apply only if the LTC insurance policy offered through the rider is qualified. A qualified LTC insurance policy meets the requirements of IRC Section 7702B(b)(1). Benefits paid out of a qualified LTC contract are tax free.
  5. In 2010, life and annuity policies with qualified LTC insurance riders are eligible for tax-free exchange under IRC Section 1035.
  6. The tax benefits provided are not available for qualified annuities purchased through retirement plans.

Critics argue that due to the reduction of policy basis for charges paid on the LTC rider and the inability to deduct the premium under IRC Section 213(a), the tax benefits may not offer much real benefit.

On the other hand, the reduction in basis issue is moot in those cases in which the entire base plan value is paid out as tax-free LTC benefits. For annuity combos, this represents the only way to harvest gains on a tax-free basis. The broadening of the 1035 exchange definition also has significant value. Annuity and life insurance policyholders will be able to exchange existing policies, with earnings, into a combination product on a tax-deferred basis.


There are significant nontax benefits riders offer, such as, more affordable LTC insurance coverage and less restrictive underwriting. The LTC insurance is more affordable because the combination plans include an element of self funding.

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James Sullivan, CPA, PFS, MAS, is Investment Counselor at Core Capital Solutions LLC and has almost 25 years of experience in individual tax, investing and personal financial planning. Before joining Core Capital Solutions LLC as an Investment Counselor, he spent over 20 years at Arthur Andersen LLP specializing in financial planning, investments and individual tax planning. His primary focus today is assisting his clients enhance their overall retirement through proper investing, goal setting and tax planning.