It doesn’t look like there will be a happy ending for the over 100,000 CalPERS long-term care policy holders who are represented in the class action lawsuit, Wedding v. CalPERS. That doesn’t mean there’s a good outcome for CalPERS either. However, things should work out for the plaintiffs’ attorneys.
The bone of contention is that CalPERS approved an eye-popping 85% increase in premiums in 2013, hitting only the policies with the most generous payment features. The plaintiffs contend that these increases weren’t permissible and are seeking substantial damages.
The case has been grinding through the California courts since 2013. Judge William Highberger, in his decision from a June 10 trial, explicitly called on the legislature and state government to bail out the long-term care scheme.
Needless to say, this is a highly unusual step for a judge to take in a contract dispute. At a minimum, it signals an expectation that CalPERS will lose and lose big.
But CalPERS losing would be of no benefit to the policyholders as a whole (there could be some reallocation among them). It’s highly unlikely that the state will throw money at CalPERS. Unlike CalPERS’ pensions, the state has no obligation. The long-term care insurance plan was set up to be self-funded. So in a worst-case scenario, and “worst-case” looks all too likely, the relevant plans will be insolvent.
If the case results in a significant money judgment against CalPERS, and the judge’s body language is that that’s a probable outcome, the only place the funds can come from is the long-term care plans themselves. As we’ll discuss, that means that CalPERS would need to bankrupt the long-term care plan or take other measures to deal with their insolvency. Note that CalPERS has just put out a bid opportunity for an outside bankruptcy counsel.1
But expect CalPERS to drag things out. Defaulting on this scale would be a huge embarrassment. CEO Marcie Frost and General Counsel Matt Jacobs will do everything they can to try to kick this mess over to successors. The most likely course is for CalPERS to appeal and put off a formal bankruptcy or alternative (a runoff plan?) as long as possible.
Moreover, CalPERS does not appear to be taking Judge Highberger’s mission of pleading with the state and legislature for more money. The trial ended June 11. The judge asked the plaintiffs to prepare a draft ruling by June 19 with any comments by CalPERS due June 25. As you can see, the “draft” ruling was filed on July 1, although since the hearing was public, interested parties would have attended and anyone could also have ordered (and paid for) a trial transcript earlier. In other words, what happened in the trial was not a state secret, in particular Judge Highberger’s instruction to CalPERS to go to the Governor and legislature cup in hand.
Yet here it is, July 17, more than halfway between end of the trial and the date when CalPERS is next to appear in court, August 21. One would have to think if CalPERS had made any request to the legislature, or even briefed Senator Jerry Hill (chair of the Senate public pension/state employees committee) and Assemblyman Freddie Rodriguez (Hill’s counterpart) on the June trial, it would have gotten to the press by now.
So is CalPERS planning to poke a stick in the judge’s eye by doing nothing before August 21? Even this apparent failure to act as of yet, given that Judge Highberger signaled a sense of urgency, isn’t a good look.
Of course, any attempt to secure a rescue makes the probable insolvency of the long-term care plans more visible, which is something CalPERS no doubt is keen to avoid, Nevertheless, one has to assume CalPERS must through the motions, even though it’s an obvious non-starter, as we explain below.
Even forcing draconian spending limits on CalPERS’ staff (no more international travel or ice cream socials!) would make only a teeny weenie difference for the long-term care policies. CalPERS’ administrative budget comes overwhelmingly from other trust assets, namely its pension and other health care plans. Any savings from belt-tightening would have to be used for their benefit, so the result would presumably be a pro-rating. These long-term care plans, as much as they are important to the policy holders, simply don’t amount to all that much relative to the total assets CalPERS manages.
We’ve embedded his decision at the bottom of the post; you can find other major filings here.
But how did CalPERS get into this mess? The short version is that the long-term care insurance industry is top to bottom in trouble due to insurers launching the product in the 1990s without the foggiest idea how to price it, and got things badly wrong. And CalPERS made additional big mistakes all on its own.
The Long-Term Care Insurance Industry Debacle and CalPERS’ Additional Mistakes
In the 1980s and 1990s, insurers launched long-term care policies. They saw the opportunity to provide protection against the need of older people to foot the bill for nursing or at-home care. It proved to be a growth business, but not in the way that they had hoped.
The insurers, who had no experience, made a number of serious miscalculations. The first was in considerably over-estimating the number of people who would “lapse”, as in drop coverage, which would mean the monies they had paid in could be used for the benefit of those who continued to pay. Second was in adopting a payment model like that of the life insurance industry, specifically that policy-holders would stop paying premiums once they filed a claim. Since policy-holders can wind up receiving benefits for years (even before you get to “lifetime benefits”), this was a considerable sacrifice of potential premium income.
Third was these were long-term policies, and like life insurance and pensions, they depend on investment income. The insurers didn’t price in the protracted period of negative real interest rates that has been prevalent post-crisis.
Two additional decisions made this sorry picture even worse for most long-term care insurers. Many sold policies that promised no or low increases in premiums for the life of the policy. Industry leader Genworth sold many policies of this type. As the Wall Street Journal put it:
When sales of long-term-care insurance were ramping up in the 1980s and 1990s, companies thought they had found the perfect product for middle-class families—and that’s how they pitched it.
The annual premium was designed to hold steady until a claim was filed and premiums then halted, though the rates weren’t guaranteed. Many policies paid out benefits for life.
Finally, many also sold policies that promised lifetime benefits. In contrast to allowing for a fixed maximum policy amount, these policies capped only the amount that would be paid out per day or per year. This proved to be a catastrophically bad decision, particularly given the incentives.
If the insured has only a fixed maximum amount, they have reason not to start putting in claims until they really need to since they are at risk of exhausting the funds in their policy. By contrast, with a lifetime benefit, the insured will want to start drawing benefits as soon as possible, particularly since they would also stop paying annual premiums. As the Journal explained:
It turned out that nearly everyone underestimated how long policyholders would live and claims would last. For example, actuaries, insurers and regulators didn’t anticipate a proliferation of assisted-living facilities. And they assumed families would do whatever they could to avoid moving loved ones into nursing homes, holding down policy claims.
By the late 1990s, assisted-living facilities were widely popular. Especially at well-run ones, staff members looked after policyholders so well that they lived years longer than actuaries had projected.
CalPERS made all these mistakes and then some. Not only did it market its own “inflation protected” option hard, as well as offer a “lifetime” product, but appeared to get high on its belief in its investment acumen. It underpriced the polices compared to competitor offerings by about 30% and did not set up reserves either. One rationale was that its lack of its profit motive allowed it much more pricing room. Another reason for its considerable underpricing was CalPERS assumed much higher investment returns than private companies, out of a view that it made sense to put the policy premiums heavily in the stock market. CalPERS has since retreated to a more conventional insurance investment strategy. The resulting lowering of the return assumption has in turn worsened the underfunded status of these policies.
How the CalPERS Debacle Unfolded
In 1995, California passed legislation authorizing CalPERS to establish a long-term care program on a not-for-profit, self-funded basis. Not only eligible state employees, but even their family members could participate.
CalPERS allowed enrollees to choose from a variety of options. The lead plaintiff, Holly Wedding, opted for both “inflation protected” and the lifetime option. This was a popular combo:
CalPERS had very aggressive language in its marketing materials regarding the inflation protection, which allowed for benefits to increase at the rate of 5% a year. If you look at the ruling embedded at the end of the post, the final page shows an “Exhibit A” which shows premiums staying flat over the 15 year time frame displayed in the chart. The judge, over CalPERS objections, also gave “considerable weight” to the testimony of Sandra Smoley, the Secretary of the California Health and Welfare Agency who had been tasked to CalPERS to assist in the marketing of the long-term care policies as “Honorary Chairwoman”. From his decision:
Ms. Smoley came away with the impression that persisted for 20 years that rates would not increase, and testified it was “very definitely” her understanding that “the plans with built in benefit increases will cost more on a monthly basis initially but you lock in a rate now that is designed to remain level over the life of the plan that won’t rise simply with age.”
This is particularly damaging to CalPERS. By virtue of being included in Judge Highberger’s ruling, it is now a finding of fact.
CalPERS apparently realized it had overpromised early on. Even though it had engaged Towers Watson to perform the initial actuarial work (Towers Watson has already settled with the CalPERS policy-holders for over $9 million), it brought in Coopers & Lybrand for a review in 1996. Coopers warned CalPERS that it had mispriced the inflation-protected policies, was likely to face “criticism that it had ‘low balled premiums” with the intent to increase them later, and would indeed need to do so. Despite receiving this report, CalPERS continued to tell policy-holders that premiums were “carefully and conservatively set” and “designed to remain level”.
CalPERS did increase rates, in 2003 (blaming it on the stock market) and in 2007 (“to stabilize the fund”). CalPERS attributed its 2009 increase primarily to the inflation protection feature:
In 2013, CalPERS announced it was going to implement an 85% increase, falling only on the holders of policies with inflation protection and/or lifetime benefits on “Comprehensive” and “Nursing Home” policies sold between 1995 and 2004. The CalPERS board and staff members stated that an advantage of this big increase was that it would get many of these policy-holders either to cancel their policies altogether, or forego the inflation protection and lifetime benefits features, which was the only way to escape the increases.
Key Issues in the Case So Far
In the interest of not over-taxing readers, I will greatly simplify (and hopefully not oversimplify) the discussion of some of the important issues in the case, in order to focus on Judge Highberger’s bailout request.
In his ruling (which included settling a cross complaint), the judge did agree with CalPERS that it could raise premiums, just not to cover any shortfall resulting from the inflation protection feature:
…..the Court also finds that CalPERS can implement across-the-board increases which include Inflation Protection insureds as long as the 20 reason for the increase is some matter of general applicability to all insureds; e.g., anticipated lapse rates of all insureds, longer than expected longevity of all insureds, longer duration on claim by all categories of insureds, and/or a further change in the discount rate.
This finding does not give CalPERS much relief. CalPERS has claimed that it would have needed to raise premiums by 67% (as opposed to 85% on the targeted group) to all long-term care policy-holders for the policy years in question to get to the same place it did in shoring up the fund. But the action CalPERS took, of not raising premiums at all on policy-holders who didn’t have the big ticket coverage features, looks like an admission that it was these features solely that are the cause of the insolvency the funds would otherwise have experienced.
And so far, CalPERS hasn’t offered any good explanations, save for ones along the lines of “We needed to raise rates to keep paying claims.” That falls well short of making a case for any reason other than the inflation protection feature at issue.
Maybe CalPERS is saving its ammo for trial, but this lame rebuttal does not look good.
On top of that, the plaintiffs may be able to do some pretty simple math and show the funds in question would be deeply underwater by virtue of the inflation-protection feature alone. That leaves CalPERS to try to ‘splain that no, a lot of other things were the real cause. Juries don’t like complicated explanations. If a simple computation of the cost of the inflation protection feature shows it renders the long-term care policies insolvent in a serious way, it’s hard to see how CalPERS can make any response, not just legally but practically.
Judge Highberger’s Futile Bailout Request
It is hard to understand where Judge Highberger is coming from. CalPERS has repeatedly stated in its filings that the long-term care policies were set up as self-funded. Unlike state employee pensions, there is no government guarantee. CalPERS also described, in some detail, the serious financial consequences to the long-term care policy holders if the appeals court did not reverse the trial court’s approval of class certification (it didn’t).
Judge Highberger repeatedly acknowledges that the state is not obligated to save CalPERS from the mess it created. For instance (emphasis ours):
While CalPERS did have the State Department of Insurance review the original contract and certain sales materials, CalPERS is not regulated by that agency and this Long Term Care Plan does not qualify for assistance from the California Life and Health Insurance Guarantee Association or the California Insurance Guarantee Association….
Many of the outcomes which Plaintiffs and their counsel desire, e.g., reinstatement of lapsed policies, are only possible via a voluntary compromise since the only outcome of this case if it is litigated to closure is a money judgment against CalPERS and/or injunction regarding its future course of conduct in handling price increases for Long-Term Care coverage.
Yet Judge Highberger nevertheless is pumping for the state to shore up this garbage barge:
The Court is issuing this [Draft] Proposed Statement of Decision at this time because the parties are urged to contemplate the settlement option, which will necessarily involve the State’s Executive branch, particularly the Department of Finance, and the Legislature. Since the enrollees in the certified class are all sUite and local employees, including teachers in the CalSTRS system (or close family members), there are many additional concerned stakeholders, including the labor organizations representing sUite and local employees and the statf retiree associations.
So Judge Hightberger wanted to get his ruling out pronto so that CalPERS would take it to the Governor and the Legislature and get a bailout….because a lot of people who signed up for policies would be hurt otherwise. That may be a nice sentiment, but Judge Highberger by now must have taken note that people in the private sector who bought policies in this time frame and have not yet put in claims are also being hit with huge premium increases.
In other words, electing to spend taxpayer money to rescue insiders and their family members when similarly-situated people outside the CalPERS plans are taking the premium hits does not sound like a winning political proposition. I can’t see the Governor or the Legislature being receptive.
And on top of that, despite Judge Highberger’s sense of urgency, his timing is off. The State approved the budget for the upcoming fiscal year on June 13.
So what was the basis for Highberger’s belief that the Executive would ask for funding and the Legislature would sign off? Not surprisingly, it’s thin:
Under the legislative authorization, this product was to be financially self-supporting with no subsidies from the taxpayers or the public employers, although Government Code§ 21664(f) provides that “[i]t is the intent ofthe Legislature to provide, in the future, appropriate resources to properly administer the long-term care program.”
Ahem, “administer” does not mean “fund plan plan benefits”. “Administer” means execute the managerial tasks associated with the discharge of a prescribed activity. This language could be argued to mean at most an appropriation of funds to help CalPERS to run the plan. And the Legislature may have contemplated “resources” to mean thing like lending Sandra Smoley, the head of the Health and Welfare department, to help market the policies.
This section describes what is apparently Judge Highberger’s other ground for hope:
An inability of this Ca!PERS plan to just claims will create an obvious default by an arm of the State in the fulfillment of its contract obligations. This, in turn, could seriously impair the credit rating ofthe State.
Putting on my Wall Street corporate finance professional hat, no. The lack of any guarantee or other financial obligation on the part of the state for the CalPERS means having CalPERS have to bankrupt or otherwise deal with the insolvency of its long-term care policies is of no consequence for the state bond rating. By contrast, having the state rescue these policies could even be seen as a negative, in that the state is taking on new liabilities analysts hadn’t known about, raising the specter that the state might engage in other costly acts of charity.
What happens down the road as CalPERS is trapped in the vise of the lack of good options? Not only does the inability to raise premiums to cover the cost of inflation guarantee seem to assure insolvency, but it’s also not even clear procedurally how CalPERS could restructure the plans absent bankruptcy or a similar process that allowed the parties to redo the agreement. And with so many policy options, meaning differently situated policyholders, coming up with any solution even if you could wave a legal magic wand, is daunting.
But if CalPERS is true to form, it will put off the day of reckoning as long as possible. That will have the effect of favoring policyholders who’ve already put in claims (as in are drawing benefits) over those still paying in on the fond hope that they’ll be able to get benefits in the future when they need them. So CalPERS’ inaction is already creating winners and losers, and the losers may well lose big.
1 In theory, this posting could be for attorneys to work with CalPERS on the bankruptcy of municipalities and government entities that have pension plans with CalPERS, but CalPERS has dealt with several of those already, including ones that were litigated, and didn’t seek bankruptcy advice.00 Wedding v. CalPERS July 1 2019 filing