Academic journal article Journal of Risk and Insurance

Housing, Health, and Annuities

Academic journal article Journal of Risk and Insurance

Housing, Health, and Annuities

Article excerpt


Annuities, long-term care insurance (LTCI), and reverse mortgages appear to offer important consumption smoothing benefits to the elderly, yet private markets for these products are small. A prominent idea is to combine LTCI and annuities to alleviate both supply (selection) and demand (liquidity) problems in these markets. This article shows that if consumers typically liquidate home equity only in the event of illness or very old age, then LTCI and annuities become less attractive and may become substitutes rather than complements. The reason is that the marginal utility of wealth drops when an otherwise illiquid home is sold, an event correlated with the payouts of both annuities and LTCI. Simulations confirm that demand for LTCI and annuities is highly sensitive to the liquidity and magnitude of home equity.


Among the most significant difficulties in financial planning for the elderly are these: length of life, health status, and medical expenditures are stochastic; a large fraction of wealth is typically tied up in a home; and moving out of the home generates psychic and financial costs. These considerations are related: poor health is associated with old age, exit from the home, and rapid mortality.

Home equity products, long-term care insurance (LTCI), and annuities hold the promise of consumption-smoothing benefits for the elderly by addressing these issues separately. Home equity loans, reverse mortgages, and sale-leasebacks allow homeowners to consume housing wealth without moving out of the home. LTCI spreads large medical expenses across states of the world. Annuities transfer wealth from those who die young to those who live a long time. Relatively weak demand for these products among the elderly has spawned a large literature evaluating the strength of different explanations.

Bequest motives, adverse selection, moral hazard, and partial public provision of LTCI and annuities through Medicaid and Social Security may well dampen demand for private actuarial products. However, these factors do not easily explain away the smallness of private markets. Several papers have shown that with empirical pricing and plausible bequest strength, annuities remain attractive. (1) Finkelstein and McGarry (2003) and Davidoff and Welke (2006) argue that selection may be favorable, rather than adverse, in the markets for LTCI and reverse mortgages. Brown and Finkelstein (2007) show that women face much better pricing for LTCI than men but do not have much stronger demand, calling into question supply-side problems as the dominant market failure. Ameriks et al. (2007a) show that long-term care expenditures are a major concern for wealthier households for whom Medicaid is unlikely to be an attractive alternative to LTCI.

Given the correlations among illness, mortality, and exit from the home, it is not surprising that a growing literature considers the interactions among demands for these actuarial products. Pauly (1990) shows that demand for LTCI may be weakened by the absence of a market for annuities because life after long-term care is typically short and there is public insurance against extremely high expenditures. In this case, LTCI serves primarily to transfer wealth from relatively young and healthy states to the public provider and to estates after death. If annuities are unavailable, then the marginal utility of wealth after death may be much lower than during life, and LTCI exacerbates this problem. By the same logic, demand for annuities should be increased by the presence of LTCI.

Annuities and LTCI may exhibit demand complementarity not only through the trade-off between consumption while alive and the size of the estate passed on after death but also through a liquidity channel. Turra and Mitchell (2004), Sinclair and Smetters (2004), and Ameriks et al. (2007a) show that absence of LTCI may weaken demand for illiquid annuities. …

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