By Marko Djuranovic and Eric Naison-Phillips
In the aftermath of the financial crisis in 2008, interest rates steadily decreased and hovered around historical lows. Given that the general account investment portfolios of life insurance companies are predominantly invested in fixed income instruments, the resulting downward yield pressure has caused insurers to increase the pricing of guaranteed products or exit the guaranteed life insurance product market completely. For the past decade, clients interested in fully guaranteed life insurance have been encouraged to acquire it before pricing is increased further. Today, with interest rates starting to climb again, the logical question is whether we can expect pricing for guaranteed products to fall in response.
While we have no way of knowing exactly what the future market for guaranteed products will look like, it is important to understand that rising interest rates are only one of several components of life insurance product pricing.
Drivers of Guaranteed Life Insurance Product Pricing
-- For pricing to decrease, life insurance companies need to believe that long-term interest rates will rise and remain higher than they are today. Returns on life insurance company general account assets are highly correlated with yields on a portfolio of rolling long-term corporate bonds, so it is natural to expect that rising interest rates would drive down insurance premiums. However, it is important to note that the duration of bonds in life insurers’ portfolios ranges from 7–12 years so higher-yield bonds will be incorporated slowly as existing bonds mature. Additionally, looking at the experience of various life insurance companies that introduced fully guaranteed products to the market 10–15 years ago, with overly optimistic interest rate assumptions, we can expect insurers to be cautious in increasing their long-term assumptions for bond yields over the next 30–40 years.
-- The cost of statutory reserving requirements may increase along with rising interest rates. Due to their low cash values, guaranteed life insurance policies are some of the most capital-intensive products for life insurance companies to reserve for. Therefore, in addition to weighing future interest rates, an insurer must also consider the overall cost of tying up capital in reserves for a product. As interest rates rise, the cost of that capital can be expected to rise as well.
-- The Tax Cuts and Jobs Act of 2017 has a net negative impact on pricing of guaranteed life insurance products. While lower tax rates are good for life insurance companies’ surplus, the new tax law also contains: 1) an increase in the Federal DAC Tax assessed on life insurance companies (this tax is used to amortize the upfront acquisition costs of a policy over its expected lifetime), which is generally passed on to the policyowner as a premium charge; and 2) changes in the computation of a life insurance company’s tax reserves, which are likely to increase reserving requirements for fully guaranteed products with little-to-no cash surrender value. Higher reserving requirements generally translate to higher pricing.
-- Life insurance pricing increases with age. While some individuals may be inclined to delay acquiring guaranteed life insurance because they expect pricing to decrease, it is important to note the direct correlation between aging and pricing. As individuals get older, the dollar amount of premiums paid per unit of life insurance coverage increases, and insureds generally do not get healthier as they get older.
Alternative Methods for Taking Advantage of Rising Interest Rates
-- Opt for Lifetime Premiums: Stretching the funding of life insurance coverage over the lifetime of the insureds, instead of over 10 years or less, has two consequences. First, it is less capital-intensive for the policyowner in the short-term and allows a portion of funds that would otherwise be used to pay upfront premiums to be invested elsewhere. Second, it provides a hedge against inflation because a sustained inflationary environment will mean that future premiums will be paid with inflated, less valuable currency.
-- Shift a Portion of Coverage to Guaranteed Variable Universal Life: Guaranteed Variable Universal Life (GVUL) has the same guaranteed features of Guaranteed Universal Life. Additionally, because the cash value in the policy can be invested in mutual funds at the policyowner’s discretion, GVUL benefits from upside participation if the investments perform well. Given that a rising interest rate environment is often correlated with rising equity markets, this product gives the policyowner the opportunity to capture the benefits of a rising interest rate environment. These policies may also build significant cash value, which is held in a separate account and is not subject to creditors of the life insurance company.
As a decrease in guaranteed life insurance pricing due to rising interest rates is by no means a given, holding off on the acquisition of coverage can be counterproductive to planning strategies and may ultimately increase the cost. Instead, individuals interested in acquiring guaranteed coverage should consider proceeding with the acquisition before aging and/or other pricing mechanics kick in, increasing the cost above today’s market, while taking alternative steps to mitigate the impact of rising interest rates.