I often mention “Interest Rate Arbitrage” in my posts and videos. I realized recently that I’ve never formally defined exactly Interest Rate Arbitrage. In this post I will define the term and explain how it is used in a life insurance context.
Goal
The goal of this post is to define interest rate arbitrage and help you understand why it exists in a life insurance policy.
If this sounds interesting to you, keep reading.
What Is Interest Rate Arbitrage?
As I use it, interest rate arbitrage is the difference between the rate at which the cash value is growing and the policy loan interest rate. When I use the term, this is what I am referring to. However, many other banking applications rely upon there being some interest rate arbitrage.
Banks engage in interest rate arbitrage everyday. They take in deposits and pay a very low interest rate on those deposits. They in turn loan out that money (and then some!) and charge higher interest rates. The banks keep everything in the middle.
It is interest rate arbitrage that makes a Life Insurance Retirement Plan (LIRP) so powerful. It is also important in both The Double Play and in Premium Financing.[1]
While the definition is easy to understand, the reason it exists is a little harder to understand. How is it possible that a policy-owner can borrow against a policy at a rate that is lower than the policy is earning?
Why Does Interest Rate Arbitrage Exist?
It may seem confusing to many people that the insurance company will make loans at rates less than what it credits in dividends. However, you should realize that there are many reasons why interest rate arbitrage is possible. In this section, I will shed some light on why policy loan rates are generally lower than the dividend/interest crediting rates.
Investment Risk
Different investments carry different risks. The insurance company manages the risk of an entire investment portfolio. Lower grade bonds carry higher default risk, so borrowers must pay higher interest rates to compensate for that risk. US Treasuries, considered very safe bonds, offer less interest.
When an insurance company makes a policy loan, they view it as an investment. They don’t charge high interest rates because they consider these loans very safe investments. The policy’s cash value secures the loan as collateral. Because the loans are 100% secured, they present low risk and don’t require a high return.
If a mortgage borrower defaults, the bank must undertake a costly and time-consuming foreclosure process before they can take possession of the property and recover their investment. They also risk the property value falling, potentially preventing them from recouping their entire investment.
Long Term Yields vs Short Term Yields
Understand that Life insurance companies are investing to cover long term liabilities. Life insurance policies may be inforce for 50 or more years. This means that insurance companies have the freedom to invest in bonds of any maturity with little regard to liquidity. As a result, they typically invest their reserves in longer maturity investments to capture a higher yield. This is called a Liquidity Premium. For this reason, it is important to understand that the cash value of a life insurance policy should outperform shorter term bond returns.
Interest rates usually behave predictably and can be modeled by a yield curve. What the yield curve shows is bond yields by the term of the investment (Maturity). Generally, the shorter the term, the lower the yield. This means that investors demand higher rates if they are going to tie up their money for a longer period.
Yield Curves
I wrote “usually” in bold because as of recently, interest rates are not behaving normally[2]. The yield curve is inverted due to inflation and market uncertainty. When the yield curve is inverted, it means that short term interest rates are higher than long term interest rates. This is shown in the following graph:
This graph shows the Yield Curve Jan, 2023, Jan, 2022, and Jan, 2021. The graph clearly shows that interest rates are higher across all maturities right now. The graph is also showing that short term rates are higher than long term rates at present.
Before you panic, understand that an inverted yield curve is a pretty rare occurrence. The graph above shows how few times it has happened in the last 50 years. But that said, the late 70’s and early 80’s were a mess.
Interest Rate Arbitrage and Policy Type
Both Whole Life and Indexed Universal Life (IUL) policies allow for positive interest rate arbitrage. Remember, all insurance companies invest their reserves in the Debt markets, regardless of whether they offer “Whole Life” or “IUL” products. The underlying investment strategy remains the same.
Investment risk and bond duration make Whole Life Interest Rate Arbitrage possible, as we discussed earlier.
Hedging further enhances Interest Rate Arbitrage for IUL. Insurance companies want the cash value to grow as quickly as possible. Faster cash value growth reduces the net amount at risk to the insurance company more quickly, as the cash value forms part of the death benefit.
In an IUL, the insurance company doesn’t credit the net gain on reserves to the policy as a dividend, unlike in whole life policies. Instead, they use this money to hedge in the index options markets. This hedging allows them to capture a premium over the debt market return. The “Caps” and “Floors” in an IUL represent the market index movements that hedgers can capture. While returns may fluctuate more year to year, they will never turn negative.
Historically, IUL interest crediting rates have earned a premium of about 1 to 2% above the Moody’s Corporate Bond yield.[4]
Conclusion
The goal of this post was to define interest rate arbitrage. Since it can be hard to understand how an insurance company can make loans at rates lower than they are earning, I also explained how that is possible. Insurance companies can earn a premium by managing the risk in their investment portfolios and by investing in longer maturity bonds. The cash value of IULs also earns a premium due to the hedging activities.
[1] For more information on LIRP: Check out this and this. For more information on Premium Financing, check out this web page.
[2] January 2023. You can find current yield curve data here.
[3] This is already a long post. Check out last month’s post to understand why faster growth on the cash value helps the insurance company.
[4] Check out Section 3 of this blog post for a more detailed explanation of this premium.
