Many people are wondering why dividend and interest crediting rates are still so low after about three years of rising interest rates in the general economy. My goal in this article is to explain the Insurance Company responses to changes in Interest Rates since the 2020 lows.
The best place to start will be to look at interest rates in the general economy first. Then I’ll explain the options that Insurance Companies were facing and the decisions they ultimately made. I’ll finish up by giving you my thoughts on the actions that Insurance Companies took.
Interest Rates in the General Economy: 2020 to 2025
This graph shows the Moody’s Corporate Bond Yield for the last 100 years. You can see there was a period of rising interest rates from the Mid-1940s until just after 1980. Remember that the Fed went off the gold standard in 1971. This enabled massive money printing without any gold to physically back the currency.
As you might expect, more dollars chasing the same goods led to massive inflation.
Interest rates skyrocketed to keep up with inflation. The Federal Funds rate peaked at 20% in 1981!
Massive tightening by the Fed finally got inflation under control and rates began to steadily drop. The trend of decreasing rates lasted for nearly 40 years: 1981 to 2020. Rates in 2020 were lowered to all time lows in response to the COVID pandemic.,
What is important to keep in mind here is that companies continuously refinanced their debt as rates dropped. High yield bonds in the portfolios of insurance companies were called and new bonds issued with lower interest rates. Each time high yield bonds were called, the overall return on the insurance company reserves declined.
Learn more about the link between dividend rates and interest rates in this video
Impact on Dividend and Interest Crediting Rates
It’s important to realize that insurance company dividend and interest crediting rates remained higher than interest rates in the general economy during this time. That means that as rates dropped, insurance companies still held some bonds in their reserves with higher yields. While dividends dropped from 1980 to 2020, they still offered competitive dividend rates.
But all of that came to an end in 2020.
It’s important to realize that rising rates cause the opposite problem: Dividend and interest crediting rates will always be playing catch-up with market rates. This means that as interest rates began to rise, only new dollars flowing into the reserves were invested in higher rate bonds. Bond issuers weren’t going to refinance their low interest rate debt.
If you understand what I’m getting at, this means that rising interest rates after 2020 had little impact on the overall returns of their reserve portfolio. New cash inflows to the reserves were a drop in the bucket compared to the billions of dollars of reserve investments earning low rates.
Here’s an easy way to put that into context…
The Swimming Pool Analogy
Imagine a large backyard swimming pool with a current temperature of 75-degrees. What would happen to the pool temperature if the homeowner poured a gallon of boiling water into the pool? Pretty much nothing, right? A gallon of boiling water would barely impact the temperature of a bathtub!
Now imagine that you started filling an empty new swimming pool with boiling water. The pool temperature would be hot, right?
This left the insurance companies with only two options…
Insurance Company Response to Rising Interest Rates
Again, the Insurance Companies only had two viable options:
- Keep dividend and interest crediting rates low (Existing swimming pool), or
- Segment the reserves to offer better rates to NEW policy owners (new swimming pool)
Keep dividends and interest crediting rates low
This is the existing swimming pool in my analogy. New cash for investing into higher yielding bonds could only come from:
- New premiums from new policies, or
- Turnover of bonds that have matured.
Just keep in mind a couple of additional factors:
- Low rates put the insurance company at a competitive disadvantage for attracting new business, and
- Since most bonds were re-financed at lower rates, turnover would be minimal.
This is not a very attractive situation.
Remember that its an Insurance Policy
Now, while we as investors and policy owners want higher dividend rates, it’s important to remember that insurance policies are meant for the Death Benefit protection. The reserves only need to earn a minimal actuarial rate to guarantee the contract. This is also known as the “guaranteed rate”. This rate is designed to be super conservative and unlikely to ever occur in the real world.
Learn more about “Guaranteed Rates” and why you shouldn’t rely on them for planning.
It’s important to realize that Life Insurance Policies are designed to meet their obligations with only a 2-3% growth rate. While it’s nice when a company pays a 6% dividend, the insurance company would put themselves at risk if they counted on rates being at least 6% for 30-40 years. After all, just look at what rates did in the last 45 years!
The financial stability of the Insurance Company is paramount. If they fail to pay claims, the credibility of the entire industry could suffer. Their primary concern is viability, not paying high dividend rates.
But, of course, this needs to be balanced with the ability to attract new business, so…
Segmented Reserves
This is the option that many insurance companies picked. This is the new swimming pool analogy. All of the water filling it up is warm.
Segmenting the reserves meant that all of the old policies remained viable from a death benefit perspective. They just won’t be attractive from a Cash Value perspective. Higher interest rates on new policies would be attractive to new clients. All new money flowing into the policy would be invested in bonds with higher current interest rates.
My thoughts
I can understand the argument for either decision. I am both a policy owner myself and a Life Insurance Agent.
No Change
Whether the reserves were segmented or not, rising interest rates would take forever to impact the policy dividends and interest crediting. It wouldn’t have much of an impact on my own policy. While I could replace my policy for a new one using a 1035 exchange, it would mean a lower death benefit and 10 more years of policy charges eating away at the cash value.
And that said, since I was diagnosed with Chronic Lymphocytic Leukemia (CLL) five years ago, I couldn’t get a new policy anyway, so it’s a moot point.
Segmented Reserves
I can’t help but think most policy owners are thinking that the insurance company gave them a big middle finger. I can understand the perspective of the insurance companies that took this route, BUT most policy owners will not.
Should you replace your policy?
If you are paying premiums monthly or annually, I think it makes sense to “Cap” the existing policy and put your new premium into a new policy with higher dividends or interest crediting. If you are one of my clients, I’ll take care of these changes for you. Just ask. If you’re not a client, I can assist you with the policy changes you need to make. Use this link to book a consulting session.
If you’ve already funded your policy or are in the middle of a 5-pay (Five annual premiums to totally fund the policy), then it would probably make sense to keep it as is. We can however, run inforce illustrations to see if its cost-effective to switch to a new policy.
1035 Consequences
The Cash Value of your policy can be rolled into a new policy with no loss. However, all new premium would be subject to all of the normal fees associated with a brand new policy. That means another 10 years. It would also result in a lower death benefit for the money because you are now older and your premium dollars won’t buy as much Death Benefit.
“Capping” a policy
As long as you have paid at least 4 to 5 years of premium, we can lower the Death Benefit to the absolute minimum. Lowering the Death Benefit will lower the cost of insurance inside the policy. This will allow the policy to survive forever with the Cash Value already in it.
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No Rendering of Advice: The financial content in this document is provided for your personal education. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial advisor with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.
The sole purpose of life insurance is for the death benefit protection. Any other benefit is ancillary.
