This week, the Fed made very clear its intentions to begin easing its long-standing practice of pumping money into the US economy. This means that they want to push up interest rates in the wider economy – a day many of us have been waiting for.
Many things will come with higher interest rates, but a major negative that everyone is dealing with is the higher cost of borrowing money. This will ̵1; theoretically – affect life insurance with cash value. At least those who use a variable loan interest rate.
So when interest rates rise this year, will you pay more interest during the year with outstanding insurance loans? The short answer is probably not. That said, now is a good time to revisit the topic of political lending in the tactical sense.
Variable loans and their common fixed indices
Most insurance contracts with variable loans – at least for the rest of their lives – link the loan interest rate to the Moody’s Corporate Bond Index. These contracts usually also contain a succession plan should this index cease to exist.
As of January 2022, the index is 2.65%.
Most life insurance policies do not allow the loan interest rate charged on insurance loans to fall below the guaranteed accumulation rate for the insurance – in fact, most people place a difference between the guarantee accumulation rate and the lowest loan interest rate.
On average, the minimum loan interest rate for these variable loans is 100 basis points above the guaranteed accumulation interest rate. This means that for a large number of existing insurances, the lowest loan interest rate is 5% – this presupposes insurances issued under a 4% minimum guarantee, which was the norm until the beginning of 2022.
With loan interest rates usually at 5% and Moody’s Index at 2.65%, we have a lot of ground to cover before life insurance loans experience an interest rate increase. While it is quite possible that Fed activity will eventually take us there, I would not predict that interest rates would rise that much so quickly during the year.
But what happens if we get there?
If inflation continues to be a bee in Jerome Powell’s hood, it is possible that we will find ourselves in a world where the Moody’s Index exceeds 5%. In this scenario, it is absolutely possible that lending rates on these policies will increase. But nothing happens in a vacuum.
Rising interest rates also give strength to the probability of rising dividend rates. When insurance companies can buy bonds with higher returns, the investment return will increase. This increase in investment profit will result in a positive movement in the dividend.
I would predict that coming to an interest rate environment where the Moody’s Index is high enough to cause an increase in these variable loans will also be an environment that can yield higher dividend rates on entire life insurance products.
Direct recognition probably has an advantage here
Although I still do not believe that dividend recognition has an absolute advantage regardless of the method used, sharply rising interest rates that cause borrowing rates to jump before dividend rates throughout the company are not as big a problem for direct recognition contracts.
Since most direct recognition contracts link the dividend to be paid on cash values that back a loan to the loan interest rate, a rising loan interest rate will potentially also increase the dividend to be paid.
We have planned for this
We have been planning for higher interest rates for over a decade. Part of our product selection process included looking at how products behaved in a range of scenarios, and rising interest rates have always been a factor that you need to keep in mind.
We have long held the view that contractual provisions play a role – that is why we do not indulge in silly meaningless details such as dividend recognition per se. The recommendations we have made over the years have taken into account the possibility of rising interest rates, and the impact it would have on political loans, and we are quite convinced that we have a solid strategy for this.