Dynamic Contracting in Long Term Care (LTC) Insurance Markets

We study the role of dynamic contracting frictions in limiting the size of the private market for long term care (LTC) insurance. Building on Harris and Holmstrom [1982] and Hendel and Lizzeri [2003], we develop a multi period model of the LTC insurance market with symmetric learning and one-sided commitment. Insurers can commit to offering future premia but consumers may lapse to contracts offered by competitors after underwriting. We consider a set of market features and characterize the equilibrium contracts for each. All equilibrium contracts feature front loading: higher early premia finance later premium caps that insure against the possibility of entering a higher risk class and receive higher premia (reclassification risk). We show that longer termcontracts provide better insurance against reclassification risk, but at the cost of heavier early period loading. A numerical illustration confirms these results. We then show that when insurers are allowed to adjust premia based on past health realizations, specifically because health class assignment is assumed to be persistent, buyers with a history of sickness remain in riskier pools and receive less protection against future reclassification risk.