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.

The Effect of Low Interest Rates

The impact of low interest rates manifests differently in each insurance product structure and its subsets—the risks are different and the options for recovery vary.

In 2012, it seemed that low interest rates were going to be a short-lived anomaly. However, the low rates lingered through 2016. Some policyholders are hoping an uptick in interest rates will allow their policies to recover from years of declining yield. It’s important to note that this strategy does require a longer time period to be successful because of the way carrier portfolios work. 

Carrier investment portfolios tend to lag behind movements in the market by several years due to the various durations of the bonds that make up investment portfolios. In low interest rate environments, this can create a misperception that carriers have superior investment expertise and access that allows them to pass along higher yields to policy holders. 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 policy holders with various guarantees. For example, universal and whole life policies contain minimum cash value interest rates 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 means 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 policy holders 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. 

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

We’re Here to Help

If you’d like more insight on how the low interest rate environment may be affecting your life insurance policy, contact your Moss Adams professional.