With interest rates climbing, many investors are wondering how this will impact their financial portfolios, including their life insurance. The Federal Funds rate was 1.00% on June 9, and it is expected to climb to at least 2.62% by the end of the year in response to recent inflation.
The impact of rising interest rates can be directly correlated to the performance of many asset classes. For instance, when interest rates increase, the rates of treasury notes tend to increase where the price of fixed-rate bonds decline. But what about the performance of a cash value life insurance policy such as a whole life, universal life (UL) or indexed universal life (IUL) policy? Should a policyholder expect a policy’s crediting or dividend rate to move in tandem with interest rates? The answer is “yes”—but not right away and, with some types of policies, not for a while.
Your Existing Policies
A whole life or universal life policyholder can benefit from rising interest rates in the way of an increase to a policy’s dividend rate or crediting rate, respectively, in a few ways. First, the insurance company must benefit from greater returns from their investment portfolios where premiums are invested. In many situations, there could be a lag before these portfolios are able to invest the new money in the higher rate environment and pass along investment gains to policies. This may also assume that the carrier’s expenses and mortality costs/charges remain stable or decrease in order to receive the appreciation of higher returns.
Over the last several years, as interest rates have fallen and remained at historic lows, carriers were forced to adjust to the environment by lowering policy dividends and crediting rates. While this can be frustrating, policyholders can take comfort in that the process works in reverse when interest rates rise, albeit at a delay. As rates drop, insurance company portfolios have many long-term investments locked in at higher rates.
As a result, there is a lag in the reduction in policy dividend and crediting rates following the decline in interest rates. If a policy is held for several decades, it is likely to experience periods of both rising and falling interest rates. The good news is that several life insurance companies have already responded by increasing crediting rates and/or creating new money policies series.
For New Policyholders—New Money Products
According to a 2022 report from Oliver Wyman, “The Impact of a Rising Interest Rate Environment,” some carriers in the life insurance industry are likely to pivot toward “new money” products. These are policies that are supported by a life insurance company’s new or relatively new investment portfolio and include universal life and indexed universal life contracts. New portfolios can more easily take advantage of current interest rates, whereas existing portfolios, usually those backing in-force whole life contracts, may have a drag from prior, low interest rates.
These new money types of policies will likely not only be attractive for those looking to purchase life insurance but also for those with existing policies. The richer benefits and reduced cost of new money products may likely drive some whole life policyholders as well as owners of older UL and IUL to consider surrendering or conducting a tax-free IRC Section 1035 exchange to reinvest the proceeds either elsewhere or in new life insurance products.
A rising interest rate environment allows purchasers of new cash value life insurance policies the ability to apply leverage and finance their policy’s premiums.
Premium finance allows a qualified purchaser to preserve cash and keep funds invested elsewhere where they earn a higher return. The process is typically accomplished in six steps.
1. The lender makes a loan to the policyholder.
2. The lender makes the premium payment.
3. The policy is pledged as collateral with the gap between the loan amount and cash value secured by pledging other assets.
4. The policy owner makes debt service payments to the bank.
5. Either the policy’s cash value or its death benefit in excess of the loan balance is payable to the owner or beneficiary, respectively.
6. Cash value disbursements from the policy may be used to repay the loan at some point while the policy is in effect.
Since the premiums are being borrowed, two risks to premium finance are interest rate increases and policy underperformance. While borrowing rates are increasing, utilizing various forms of fixed rates will help mitigate these increasing interest rates.
IUL policies are popular for having both downside protection and upside potential when it comes to performance. By tying policy performance to available indices, an IUL crediting rate can far exceed the crediting rate of standard UL policies as well as the dividend rates declared for whole life policies. A guaranteed minimum crediting rate may prevent a negative return should the selected indices perform poorly.
Rising interest rates can positively impact IUL policies in at least three ways, all of which enhance a premium finance arrangement. First, the insurance company may be able to quickly increase the minimum crediting rate on new money IUL policies, contributing to better performance. Second, some carriers may forgo new money products and raise caps and participation rates on enforce policies. Third, as interest rates have risen, more insurance companies are investing in volatility control index choices that reduce option costs and allow for the raising of performance ceiling caps, permitting increased performance potential.
Take Advantage Of Rising Interest Rates
By understanding how interest rates affect life insurance, existing policyholders and prospective ones can take steps to make sure their policies are performing optimally. Premium finance may be one of those steps. Given its complexity and risk, when considering premium finance, it is important to work with an experienced team of qualified financial, legal and tax experts when implementing this strategy.
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