Everybody wants to know what is going to happen with the insurance industry if interest rates go up, go down, stay the same, etc. So, we figured today was as good a day as any to address some speculation but also to discuss what the industry does to plan for various interest rate movements—because it’s not as reactionary as people tend to believe.
So, does the insurance industry just sit around and wait to see what will happen, then scramble around to figure it out after that?
As much as the people at the financial blogs who like to make money bashing life insurance want you to believe that’s how it works, no. That’s not what how it works.
There is a little forethought. I’m understating it—there’s a lot of planning and modeling that takes place at life insurance companies to address interest rate risk.
Let’s start with the doom and gloom first, then we’ll move on to sunnier pastures.
Say interest rates stay low—which probably isn’t going to happen, at least to the degree that they’re at right now. We know that one of the biggest threats facing insurers is interest rates that continue to trend below various targets that they have set as profit markers. Insurers derive a vast majority of their profits from the spread that is achieved over and above the interest rates they have guaranteed policy owners.
An example illustrates the point: if you buy a Universal Life Insurance policy, and the company guarantees you 2.5%, and they buy bonds that pay 4.5%, life’s not so bad.
If, however, fifteen years down the road, the 2.5% guarantee is still in place but they can’t buy bonds that pay any more than 2.25%, life isn’t so good. Now, that’s an extreme example, and not what the insurance companies are facing, but it illustrates the point.
Keep in mind that the life insurance industry has been dealing with this prolonged period of artificially low-interest rates for nearly a decade. There’s no doubt it has compressed their margins substantially.
In prior decades, the insurance industry was in a situation where they could guarantee you 5% on a portion of your cash in a Whole Life policy. Yes, you read the correctly…5% on the guarantee.
Then they would take that money and put it into a bond that paid about 8.5%. Things were great and with participating Whole Life Insurance, they returned a big portion of it to the policyholder.
So, it was good for the insurance company, good for the policyholder, and life was good for everyone. These days, that scenario isn’t quite as rich.
Now that we’re here as a result of this prolonged period of super low-interest rates, what do we speculate will happen if insurance companies if they have to continue to deal with low-interest rates moving forward?
In the short-term, the likelihood is that they won’t have to deal with low-interest rates. Interest rates are certainly on the rise…for now.
First let’s take a detour and make an important distinction: When everyone talks about the Fed raising rates, that’s the Fed fund rates. The Federal Reserve doesn’t control rates on long-term bonds. It can influence, but it cannot dictate.
Interest rates on long-term bonds are set by the market.
How interest rates apply to whole life insurance
If rates continue to stay low, insurance companies will continue to struggle, not in terms of solvency, but in terms of getting you the return you were hoping to get. There’s a good chance that if you bought a Whole Life Insurance policy twenty years ago, and their dividend interest rate was over 8% at the time, your policy has greatly underperformed what you hoped it would.
And if interest rates continue to stay low, it will continue to underperform into the future. Actually, it’ll always underperform because you can’t get back the interest that you lost for the last 10 years.
Insurance companies can’t just pay more because they want to. These are competitive companies. They don’t want to be in a position where they can’t deliver more value to policyholders, and they all dread the dividend announcement if it’s going down.
This has never been a solvency issue; nor will it ever likely be one. Insurers go through myriad stress tests to evaluate how their portfolios will perform in a number of different interest rate scenarios. As a result of this, it puts them in a position where they can sustain low-interest rates. They don’t like it, but they can sustain it.
It’s not an issue of whether companies will fold or have massive financial crises. It’s much more about not getting exactly what you want, but we never truly know how things are going to work out. We can just make educated guesses.
How interest rates apply to indexed universal life insurance
Pivoting slightly, there is another form of life insurance that we use for cash accumulation, and that’s Indexed Universal Life Insurance. The impact of sustained low-interest rates for IUL is a much more complicated discussion.
We know that low-interest rates create a smaller budget for insurers to buy bonds and buy options. But if the market is relatively stable, that creates a cheapness to the options portion, which could work out quite well.
We really want to reiterate; safety is really not a concern. Loss of money is not a concern. The same stress testing that mutual insurers are facing with Whole Life Insurance is identical to the Indexed Universal Life Insurance. They’re going through the same process.
As interest rates rise, the one thing we have to practice is patience. We saw substantial interest rate reductions in the 2009 timeframe and again around 2013/2014, and Whole Life dividend interest rates remained relatively stable until just a few years ago. The last couple of years is when we’ve seen bigger declines.
So, this means we went for about eight years with dividend interest rates moving a little bit, but we didn’t see substantial drops that were on par with the decline in interest rates.
The reason for this is insurers don’t buy bonds and trade them daily. If I’m an insurer that just bought a bunch of corporate bonds that were yielding 7.5% and interest rates go down, the bonds are worth more, but I’m probably not going to sell them because I didn’t buy them for capital appreciation. I bought them to cover the liability that I have with the policies that I issue.
If those are ten-year duration bonds, then no matter the interest rates, I’ll hold onto it.
We’re oversimplifying for sake of discussion. Life insurers are very good at this and have teams of very astute people who manage their portfolios.
As interest rates go back up, we have to keep in mind that for the past couple years, insurers have been turning over bond positions. Most of those turnovers were coming out of higher yielding bonds and essentially forced into lower yield bonds. As interest rates go up, we’re not going to see insurers sell off large positions of lower yielding bonds at a loss.
Remember our bond see-saw: Interest rates go up, bond prices go down.
As yields go up, they’re going to take all of the maturing bonds and absolutely love the fact that they can buy higher yields. But they can’t just decide to dump the lower-yielding bonds to buy the higher ones.
Remember, insurers are not investing like they have a retirement to deal with. It’s not the same mentality that you and I would be using to look for income during our golden years.
They are investing to deal with long-term, future obligations that are outstanding.
If someone buys a policy, and they have a million-dollar death benefit, that means the insurance company has to reserve money to meet that obligation. There’s money coming in, and there’s money going out: either to policyholders or other business expenses.
There’s a very complicated task in keeping your eye on the investment, but also managing the cash flow from all of their investments. Think about it this way…if you have a job where you’re paid a salary, you don’t really think that much about cash flow beyond how much of your money is coming in from your job and how much is going out to pay for your personal expenses.
But if you are managing a large insurance company, you have to figure out how to place incoming funds in an investment/asset that will achieve a certain yield to meet a certain target, that’s not just a regulatory target, but also a profit-generating target, balanced against the bills that have to get paid…it becomes a very, very complex equation.
Insurers are also plagued with the task of figuring out where to put the money to generate the yield that could not only make the policyholder happy but ensure that they can deal with all of the other expenses.
When the margin between those two is compressed to the point that it has been, it puts a lot of pressure on liquidity. If they’re short a month or two, they don’t like it, but they’re always keeping an eye on recovering. When they’re under that squeeze every month for ten years, it gets stressful, in terms of giving their policyholders what they were expecting
As interest rates start going back up, some of the pressure is certainly relieved. The insurance companies will be able to buy assets with higher yields, but we can’t expect that a 15% increase in the average yield on the ten-year means we’re going to see a commensurate dividend increase.
The Problem of Comparing Dividend Rates to the 10-Year Treasury
One of the problems the insurance industry might have set for itself is that a couple years ago it was very trendy for companies to compare the dividend interest rate against the ten-year yield over a period of time. Their point was to show that they maintained a dividend interest rate far in excess of the ten-year note, and it hasn’t moved downward nearly as quickly as the ten-year. It was a short-term focused idea to highlight the company’s strength.
The problem with that is when the ten-year starts going back up, we’re going to find it increases at a much sharper rate than the dividend interest rate does.
As for Indexed Universal Life Insurance: if rates go up, there’s a greater degree of nimbleness with that. Insurers might be able to capitalize on those higher yields earlier to create a larger budget for buying options, but they could run into the same problem that Whole Life does if they choose to hold onto the bonds they bought.
It’s highly influenced by the volatility in the market itself. More volatility means options are more expensive. If volatility increases with rising interest rates, that causes a bit of a problem for being able to increase or maintain cap rates. If interest rates rise, and the market remains stable, so they both increase, then that’s good news—but that’s the least likely scenario in our opinion.
Rising interest rates mean higher dividend interest rates in the future, but it means we should also see cap rates go up.
Insurers will want to see stability in interest rates before they start to change dividend and cap rates. It’s not enough for rates to just go up; they have to stay up. If the Fed raises rates in the manner which they are forecasting (three more hikes this calendar year), we will see the dividend in the ten-year rise significantly. But please don’t hold your breath for any drastic change in dividends or cap rates between now and the end of the year.
Brantley is a practicing life insurance agent and has been for over 18 years. After years of trying to sell like his sales managers wanted him to, he discovered that people want to buy life insurance if you actually explain the benefits.