How Impact of Low Interest Rates on Life Insurance Companies

Long-term commitments to pay beneficiaries of a policy upon the death of the insured are made by life insurance firms. For these future payouts, insurance companies put some of the premiums they receive for investment so that they expand over time. Nonetheless, low interest rates present some problems for the life insurers in the long run.

If interest rates remain low for an extended period, insurance companies earn less on their investments. This makes it difficult for them to build up sufficient assets for the future obligations. That is, low interest rates over a long time can adversely affect life insurers’ profit margin.  This leads to an important question: impact of low interest rates on life insurance companies

How impact of low interest rates on life insurance companies?

Many mistakenly believe that cash-value life insurance policies are set in stone and that the death benefit is guaranteed forever. However, it’s smart to treat your life insurance like any other investment that’s reviewed regularly, especially when interest rates are low—as they have been for years now.

Life insurance companies are one of the largest purchasers of bonds and mortgages in the United States. Those investments are repackaged into annuities and life insurance products that reflect the yields of the underlying investments. As a result, interest rates have a direct impact on insurance companies, their new products, and their existing policies, particularly in their general account portfolio products.

Impact of low interest rates on life insurance companies

The problems that arise from low interest rates are present in each structure and its subtypes of insurance products: the risks are different, and the possibilities for recovery are also different.

What was the outlook like in 2012? In retrospect, it appeared that low interest rates were going to be a transitory phenomenon. However, low interest rates remained through to 2016. Some policyholders expect that rising interest rates will enable their policies to make up for lost returns in previous years. However, it is crucial to point out that this strategy does pose some period requirements that are longer to realize due to how carrier portfolios function.

Carrier investment portfolios generally trail the market by a couple of years for the reason that the investment portfolios are made up of various bonds with different durations. In low-interest rate environments, it leads to a mindset that carriers have better investment abilities and access to better investments so that they can get higher returns from policyholders. They don’t.

 – Anticipating Rates

Most life insurance products with declared dividends or crediting rates assume the current market environment stays constant for the life of the policy. Regulatory restrictions preclude the use of earning rates higher than what’s currently being credited.

For example, a whole-life policy issued in 1990 may have had a dividend interest as high as 10%. The interest rate level would have been depicted over the length of the policy sales illustration, which shows how a policy would react to a specific set of assumptions that typically spans several decades. The actual dividend interest rate declined over the years to the current level of 5%, a reduction of 500 basis points from the original earnings assumptions.

Earnings today are 50% of the assumed rate that was depicted in the original sales illustration. Carriers, agents, insureds, trustees, or other advisors didn’t anticipate these rate decline levels at the time the policy was issued. When such levels of decline are compounded over several decades, the effects can be significant. It forces them to make tough decisions, including dividend and credit reductions, cost of insurance increases, workforce layoffs, and modifications to new products for sale.

 – Guarantees

Insurance companies provide policyholders with various guarantees. For example, universal and whole-life policies contain minimum cash value interest rate guarantees and the older blocks of business have guarantees that range from 3% to 5%.

Carriers struggle when they’ve purchased 3% bonds but are forced to credit guaranteed rates of up to 5%. The persistent low interest rates the carriers earn on their general account investments provide strong motivation to:

• Decrease crediting rates on force universal life policies
• Decrease dividend rates on whole-life policies
• Increase costs of insurance—monthly cost of insurance protection based on age, gender, health benefit, and death benefit

 – Whole Life Policies

The reduction in dividend rates may have material detrimental implications for some whole-life policies. It’s also a reflection of how mutual and stock companies are adjusting their general account products to reflect the impact of low-yielding bonds.

Product designs that will be hit hardest are those using dividends via surrenders or dividend elections to reduce out-of-pocket costs and policies using term riders. Heavily loaned policies will likely experience diminished values as well.

Dividend rates at New York Life and Penn Mutual remained stable this year at 6.2% and 6.34%, respectively. However, three large mutual companies reduced their dividend rates:

• Northwestern Mutual from 5.45% to 5%
• Guardian from 6.05% to 5.85%
• Mass Mutual from 7.10% to 6.70%

 – A Note on Term Riders

Policies with term riders resulted from consumer demand for lower premiums. It paired a traditional whole life base policy with a term rider to achieve lower illustrated premiums.

The term rider is a combination of one-year term insurance—which increases in cost with age— and paid-up additions. The base policy premium is fixed while the term portion isn’t guaranteed. Gradually, the term insurance is replaced with paid-up additions purchased using dividends. Reductions in dividends mean fewer paid-up additions are purchased, which results in more one-year term insurance being necessary. To cover the added cost, out-of-pocket premiums are increased or death benefit coverage is reduced.

 – Universal Life Policies

In a universal life policy, the premiums become part of the cash value that grows tax-deferred based on the carrier’s investment return.

In a current assumption universal life policy, the cash value is primarily invested in fixed-income investments, which is the general account of the insurer. Once the policy is issued, carriers have two ways of making money:

• Cost of insurance charges
• Interest rate spreads, which is the difference between what carriers earn and what they credit on the policy

With declining yields, carriers reduce amounts credited to policies to maintain their targeted spreads. However, many carriers are now in a situation where they’re unable to maintain these spreads due to their guaranteed minimum level of crediting. If carriers can’t profit from the interest spread, their only alternative is to increase the costs of insurance. 

This means policyholders could be required to contribute a higher premium to their universal life policy or suffer the consequences of the policy lapsing sooner than anticipated. Another option is to walk away from the policy and accept the losses to prevent impact of low interest rates on life insurance companies.

 – Next Steps

Regularly review your insurance to see if the policy is meeting your original expectations and if it’s still aligned with your goals. This can also help you identify subpar performance before the policy’s cash value is depleted, which gives you time to implement changes if needed.

If you have an underperforming policy, here are some changes to consider:

• Lower the death benefit to an amount that will allow the policy to run to maturity with no further premiums (as opposed to paying the higher suggested premium and keeping the same death benefit)
• Purchase a new policy or exchange for another with no-lapse guarantees that aren’t affected by market performance
• Convert or exchange the policy into a paid-up reduced death benefit with no further premiums
• Sell the policy in the secondary life settlement market
• Surrender the policy for existing cash value

Reviewing your annuities: Top items to consider

Like life insurance, annuities deserve a regular checkup, too. As a result of the impact of low interest rates on life insurance companies, more frequent reviews may be necessary. Items to consider:

 – Annuity performance relative to the market:

A fixed annuity that held great promise at the time it was sold may not have the best interest rate today. Also, fixed-indexed annuities can have a high cap rate locked in the early years, but this can fall dramatically over the life of the annuity.

 – Is the company holding the annuity a market leader?

The financial turmoil over the last decade means that formerly shining industry leaders may have lost some of their luster. Some companies have even gone out of business and transferred their assets to other companies.

 – Fees and costs:

• Have they increased since the product was purchased?
• How do they compare to similar contracts available today?

 – Are there new annuities available that are a better fit?

Insurance companies regularly offer new products designed to meet clients’ needs and concerns. In today’s market, there may be a variable or fixed-index annuity that fits better than the current contract.

If you have a life insurance policy or an annuity that needs to be reviewed, please contact us to discuss how to avoid the impact of low interest rates on life insurance companies.

FAQs

1. Who is harmed by low interest rates?

Like anything else, \there are always two sides to every coin—low interest rates can be both a boon and a curse to those affected. In general, savers and lenders will tend to lose out while borrowers and investors benefit from low interest rates.

2. How do interest rates affect whole life insurance?

For a whole life or universal life (UL) policyholder to benefit from rising interest rates with an increase to a policy’s dividend rate or crediting rate, respectively, first the insurance company must benefit from greater returns from their investment portfolios where premiums are invested.

References:

• https://www.aol.com/news/2012-12-18-low-interest-rates-impacting-your-life-insurance-company.html
• https://www.investopedia.com/ask/answers/061515/how-much-do-changes-interest-rates-affect-profitability-insurance-sector.asp