Recently there have been some rumblings in the life insurance industry. I know, big surprise. It seems life insurance agents and industry professionals love to disagree.
First, make sure you read last week's post, “Introduction to Indexed Universal Life Policy Loans“.
It's important for you to have context for the discussion below.
The particular disagreement in this instance relates to loans on indexed universal life insurance. What's been circulating is a rumor of sorts. And the rumor is that the fixed rate loan feature of indexed loans is going to be trouble.
For whom, you ask?
The rumor is that the fixed rate loans cause problems for insurers and policyholders alike.
What's the logic behind the claim?
Let's assume that a life insurance company has a fixed interest rate on it’s indexed policy loan. Some time later prevailing interest rates rise beyond that fixed rate. The insurer has to decrease the cap rate to narrow the spread between the collected loan interest and what it pays out on the indexing account.
In other words, the life insurance company cannot afford to maintain such a large spread. The spread between what they collect in loan interest and what they pay out on the indexed account must close.
There are several problems with this claim.
Remember How Indexing Works
An indexed universal life insurance contract is unique because of its indexing feature. The indexing feature is what allows an IUL contract to have cap rates of 12% or more in most cases.
Life insurance companies are able to create this feature by using a small amount of collected premiums to hedge. With IUL, the insurer purchases call options to achieve the hedged investment.
For example, let's assume that you choose the annual point-to-point S&P 500. This would allocate the “hedging budget” to buy one year S&P 500 call options. Please understand that I am oversimplifying this a bit for the sake of brevity.
But this provides the foundation you need to understand the rest of this post. And why the claim that's been floating around the industry is flawed.
Indexed Universal Life Insurance Loan Mechanics
Remember, indexed universal life insurance contract have more than one policy loan option. Today we're only concerned with one of them, the index loan.
Indexed loans are non-direct recognition-like loans. That means that the policyholder can have an outstanding policy loan and earn interest. Always remember, policy loans are only pledging the cash values as collateral. You're not actually borrowing your cash value. The insurance company is making you a loan and using the cash value as collateral.
An example will help clarify understanding:
Let’s say I have an indexed universal life insurance policy with $100,000 in cash surrender value. All the money is allocated to the one year S&P 500 point-to-point option. The policy has a floor of zero and a cap of 12% (No worse than zero nor any better than 12% in any given year).
My guaranteed fixed indexed loan interest rate is 5%.
With this policy I will earn an annual interest rate of whatever the percentage change is in the S&P 500 for the year up to 12%.
I take a policy loan for $10,000.
The loan will accrue interest at a rate of 5% per year. The interest I earn on the $10,000 that I pledged as collateral for the loan will earn anywhere between 0 and 12%. This could be good for me. Why?
There is potential for a favorable spread between what my loan accrues in interest and what I earn on the money pledged for the loan.
Back to the Argument
So the argument I laid out in the beginning of this post suggests that the spread between the loan rate and the cap rate is problematic. The problem will arise if interest rates increase beyond the 5% loan interest rate on my contract.
The claim suggests that indexed universal life insurance contracts that do not guarantee a fixed loan interest rate (and instead leave it up to market interest rates) will be a better bet if rates rise. Why?
Because in that scenario the insurance company can raise the loan interest rate. That will in turn narrow the spread between accrued interest on the loan and interest earned on the index account.
This argument attempts to use whole life insurance to illustrate the problem. And it's true that such a spread would put a strain on companies issuing whole life insurance.
But this assumes that life insurance accounting is equal. It's not. There is a big difference in how a life insurance company pays dividends on whole life and how it creates funds to pay interest on IUL.
Whole life dividends are paid from excess earnings derived from operations and investment income. Please understand that with whole life, derivatives are not typically part of the equation.
Insurers cannot speculate with money in the general account. Their is a specific purpose they have in purchasing call options for indexed products. It is only to create earnings needed to pay the interest promised in the indexed account.
The investment strategy for whole life insurance assets is different from IUL. The difference is minor, but significant as it relates to loan spread stability.
Cash values in a whole life insurance contract that are pledged as collateral must be moved to safer assets. That means they will be lower yielding and the cash values will not earn as much.
This is true even if the insurance company practices non-direct recognition. Yes, even if the company wants to pay the same dividend interest rate to all policies. Whether the policy has an outstanding loan or not.
A company that has a large block of non-direct recognition whole life policies could be strained by rising rates. Particularly, if they have a fixed loan interest rate and prevailing rates rise above their fixed loan rate.
They could be collecting less than they are earning on the collateralized policy reserves.
Whole life insurance is dependent on fixed income investments to generate interest (or dividends). Indexed universal life insurance is able to use a small (but important) buy of call options to keep the loan spread narrow.
Putting it together
Life insurance companies use fixed income investments (bonds) to cover guarantees for IUL. Obviously it's pretty hard to get a 12% yield on fixed income investments. So, they use the gains from call options to cover the additional interest needed up to the cap rate. This mechanism creates interest generating functions differently than dividends on a whole life policy.
Loan interest rates are several percentage points above the guaranteed rates offered in all contracts that I’m aware of at the moment. This is favorable for the life insurance companies and their policyholders. It means that life insurance companies can cover guarantees with collected loan interest.
And it allows the call option to perform its intended purpose. This in turn places the insurer under no strain if market interest rates rise above guaranteed fixed loan interest rates.
The same applies for indexed universal life insurance contracts that have variable rates with a cap in the event market interest rates rise above that guaranteed capped interest rate.
So even though the insurer must reallocate assets held for indexed universal life insurance when a loan is taken, the guarantee is easily covered and the interest paid on those assets it entirely up to movement in the market, which is inextricably tied to appreciation in the call option.
Uncapped variable loan interest rates could potentially leave more money for the hedging budget, which affords the insurer the opportunity to increase cap rates.
However, in order to net the same result to the policy holder as a fixed rate product, the cap rate would need to increase to maintain an equivalent interest spread. This requires more risk for you (the policyholder) to hope that higher loan interest rates will mean higher cap rates that outpace increasing loan interest.