There are many indications that interest rates could rise a number of times over the course of 2022. Last week we saw the first increase in benchmark interest rates since 2018. How will that impact your life insurance policy and the structure put in place as part of your estate and business succession plan?
The impact on business owners and their participating life insurance policies:
Business owners and entrepreneurs who own participating life insurance policies will recognize that life insurance companies use long term assumptions for rates of return on assets invested in the participating account, insurance claims, expenses and policy terminations when pricing participating life insurance products. These pricing assumptions are used to determine the guaranteed basic premium, guaranteed basic coverage, and guaranteed cash value. When actual results for any of these factors in combination are better than what was assumed in pricing the products, a policyowner dividend may be distributed. So how can rising interest rates impact the actual results for rates of return?
Premiums from all participating life insurance policyowners go into the participating account, which is invested in a mix of fixed income (such as public bonds, private placements or commercial mortgages) and non-fixed income investments (such as public equity, real estate or private equity). The overall exposure to fixed income vs. non-fixed income matters – a higher mix of fixed income assets may mean a greater impact from rising interest rates.
In a rising interest rate environment, we would generally expect to see pressure on the market value of fixed income investments, such as bonds. However, when calculating the participating account’s investment return and dividend scale interest rate (DSIR), many companies do not include unrealized losses or gains for fixed income assets (which are not divested during the year). What this means is that lower bond prices (from higher interest rates) won’t be captured in the DSIR – unless that asset is sold during the year. Uniquely, the income or coupon component is the key driver for fixed income asset returns.
The correlation between the duration of fixed income portfolios and interest rates:
The length of the fixed income portfolio is also a key consideration – shorter duration fixed income portfolios mean faster reinvestment of existing assets into new money rates available in the market. Therefore, the level of current market interest rates is important as those assets are reinvested – if current new money interest rates are lower than those of existing portfolio fixed income assets, that will result in further downward pressure on the DSIR. Rising interest rates will help to alleviate that pressure and may ultimately have a positive impact on the DSIR if market interest rates are above maturing asset yields.
The impact of rising interest rates on non-fixed income investments is more uncertain. If interest rates are rising due to a strong economy, then asset classes like public equity can perform well. However, as interest rates increase, especially real interest rates, there is the potential for pressure on the returns for some of those non-fixed income asset classes.
Ultimately, rising interest rates may impact the underlying asset classes in varying ways. However, given that many participating accounts continue to hold the majority of their assets in fixed income investments, all else equal – higher interest rates could potentially lead to an improved outlook.
Many high-net-worth clients use a strategy which assigns their participating life insurance policy to a bank or other lending institution as collateral for a loan. Depending on the variation of the strategy used, the loan generally replaces all or a significant portion of the funds used to pay insurance premiums, thereby preserving cash flow needed to continue growing your business or investment portfolio. Interest rates on these loans are typically floating rates of Prime + a spread. As interest rates rise, the interest rate charged on these loans will also rise, increasing the cost of the loan each year. Although rising interest rates will increase the annual cost of the program, it can still be a cost-effective way to obtain the life insurance coverage needed as part of your business and estate plans.
With any strategy, it is important to test under different assumptions. The life insurance illustrations created use different assumptions for policyholder dividends that may be credited. This is done to demonstrate the impact over time on policy cash values and death benefit of differing DSIRs. It’s important to note that dividends are not guaranteed nor are the life insurance illustrations.
The same type of sensitivity analysis should be done on the loan interest rate, demonstrating a combination of rising and falling interest rates in combination with increases and decreases in the company’s DSIR. This will demonstrate the impact on the net cost of the strategy under varying scenarios.
Finally…
If you are concerned about rising interest rates, reach out to your insurance expert and request they run inforce illustrations for the life insurance policy and sensitivity test those illustrations under increasing interest rate scenarios.
The information provided is accurate to the best of our knowledge as of the date of publication, but rules and interpretations may change.
This article has been written and provided by The Canada Life Assurance Company.
