Calculating Interest Rates: A Guide For Life Insurance Policies

Life insurance is based on the sharing of the risk of death by a large group of people. The premium rate for a life insurance policy is based on two underlying concepts: mortality and interest. A third variable is the expense factor, which is the amount the company adds to the cost of the policy to cover operating costs. Companies invest your premiums in bonds, stocks, mortgages, real estate, etc., and assume they will earn a certain rate of interest on these funds. Calculating the rate of return (RoR) on your life insurance policy helps you understand how much your investment has grown over time.

Calculating the rate of return on whole life insurance

Calculating the rate of return on the death benefit

If you purchase a whole life policy with a $250,000 death benefit and pay $200 per month in premiums, the death benefit rate of return is extremely high if you pass away in the first year. Your loved ones would receive the full $250,000 even though you only paid a few hundred dollars in premiums. However, as the years go on, and you continue paying premiums, the death benefit rate of return decreases because your total contribution grows closer to the payout amount.

Calculating the rate of return on the cash value

On the cash value side, the rate of return works differently. Imagine you buy the same $250,000 whole life policy at age 30, paying $200 per month. By age 70, you decide to surrender the policy for its cash value, which has grown to $100,000. After paying a total of $96,000 in premiums, your cash value rate of return would be a positive 4.7%. However, if you surrender the policy early — before enough cash value has accumulated — the rate of return would likely be negative due to high surrender charges and the policy needing time to accumulate cash value.

Calculating the overall rate of return

To calculate the overall rate of return on your whole life insurance, subtract the total premiums paid from the total cash value of the policy, divide this sum by the total premiums paid, and multiply the resulting figure by 100. This will give your rate of return, expressed as a percentage value.

Key considerations

• Whole life insurance policies have guarantees that typically ensure the cash value equals the death benefit by the time the policy matures, which usually falls between ages 95 and 121.
• If you take out loans against the policy and don’t pay them back, this will lower the cash value.
• Dividends can play an important role in boosting your whole life insurance policy’s rate of return, especially if you have a participating policy.

How life insurance rates are determined

The premium rate for a life insurance policy is based on two underlying concepts: mortality and interest. A third variable is the expense factor, which covers the operating costs of selling insurance, investing premiums, and paying claims.

Life insurance is based on the idea of sharing the risk of death among a large group of people. To predict the cost to each member of the group, mortality tables are used to give the insurance company a basic estimate of how much money it will need to pay for death claims each year. By using a mortality table, a life insurer can determine the average life expectancy for each age group.

The second factor used in calculating the premium is interest earnings. Companies invest premiums in bonds, stocks, mortgages, real estate, etc., and assume they will earn a certain rate of interest on these funds.

The third consideration is the expenses of operating the company, including salaries, agents' compensation, rent, legal fees, postage, etc. The amount charged to cover each policy's share of expenses is called the expense loading and can vary from company to company.

Insurers typically classify applicants using terms like "super preferred", "preferred", and "standard", with super preferred being the healthiest category. They then calculate premiums based on the applicant's risk class, age, gender, smoking status, health, family medical history, driving record, occupation, and lifestyle.

The type of life insurance chosen also affects the cost, with term life insurance being the least expensive and permanent life insurance costing more due to the cash value component and potentially longer coverage period.

While there is no exact formula for calculating the amount of life insurance needed, it is generally recommended to multiply your salary by the number of years left until retirement to estimate the death benefit.

How to get the best life insurance rates

Getting the best life insurance rates involves understanding how insurers calculate their rates and what factors influence the amount of your premium. Here are some tips on how to get the best life insurance rates:

• Compare quotes from multiple insurers: Life insurance companies calculate rates differently, so obtaining and comparing quotes from several providers can help you find the most affordable option for your desired coverage amount and type.
• Choose term life insurance: Term life insurance is generally the most affordable option as it provides coverage for a specified period without building cash value. Permanent life insurance, on the other hand, is significantly more expensive due to its lifelong coverage and cash value component.
• Opt for a medical exam: Policies that require a medical exam tend to offer lower premiums because they provide the insurer with detailed information about your health. Without the exam, insurers must account for the risk of unknown health factors, resulting in higher premiums.
• Buy a policy early: Insurers offer their best rates to young, healthy applicants. As you age, your risk of health issues increases, and your life expectancy decreases, leading to higher premiums. Buying coverage early locks in lower rates and ensures protection before potential health issues arise.
• Improve your health: Maintaining a healthy lifestyle, such as eating well, exercising regularly, and avoiding smoking, can positively impact your rates. Improving your health metrics, such as BMI, cholesterol, and blood pressure, may help you access lower premiums.
• Work on your rating factors: Insurers consider various rating factors when determining your premium, such as age, health, occupation, hobbies, and habits. While you can't control all these factors, addressing the ones you can influence, such as quitting smoking or losing weight, may help you obtain a lower premium.
• Buy only what you can afford: Calculate how much life insurance you need, get quotes for that amount, and choose a policy that fits your budget. If necessary, reduce your coverage to stay within your budget. Some coverage is better than none, and you can always purchase more when your financial situation improves.
• Consider rounding up your coverage: Sometimes, buying a slightly higher amount of coverage can result in a discount. Ask insurers about their "benefit tiers" or thresholds for premium discounts.
• Pay premiums annually: Some companies charge an additional service fee for frequent payments. Paying your premium annually or semi-annually can save you up to 5% on your overall cost.

Implications of low interest rates for insurers

Low interest rates can have a significant impact on the financial performance of life insurance firms. Here are some implications of low interest rates for insurers:

• Earnings on interest-earning bonds decline: Life insurers hold a substantial amount of interest-earning bonds (over 60% in aggregate) in their asset portfolios. When interest rates are low, the investment earnings on these bonds decrease. As a result, some life insurers may shift their investments towards riskier, higher-earning assets to boost returns.
• Earnings compression on insurance products: The earnings on certain life insurance products, such as annuities and cash value life insurance policies, are dependent on the spread between the interest earned by the insurer and the interest credited to the customer. During periods of low interest rates, this spread narrows, compressing the earnings for insurers.
• Difficulty in increasing earnings through bond sales: Insurers cannot easily increase their earnings by selling existing low-yield bonds and purchasing higher-yielding bonds. The low-yield bonds would have to be sold at heavily discounted prices, resulting in capital losses that would offset the benefits of buying higher-yielding bonds.
• Impact on liquidity and borrowing costs: Rising interest rates can affect the liquidity of life insurers, as cash flows from assets and liabilities can become mismatched. Additionally, insurance companies seeking to issue bonds or roll over short-term debt may face higher borrowing costs, putting downward pressure on profitability.
• Challenges with benchmark interest rates: Some life insurers have products linked to benchmark interest rates like the London Interbank Offered Rate (LIBOR), which is being phased out. This presents challenges as they transition to alternative rates, such as the Secured Overnight Financing Rate (SOFR).
• Reinvestment risk and disintermediation: While higher interest rates generally reduce reinvestment risk for life and retirement providers, a sharp rise can introduce disintermediation risk, negatively impacting their balance sheets. A gradual change in rates is preferable, but carriers would need to adjust rate guarantees and pricing more frequently.
• Impact on product structure and features: Higher interest rates may make equity-indexed life insurance and annuities less attractive to policyholders. Insurers will need to review product structures and features to ensure coverages are adequate and competitive.
• Reinsurance and deals: Rising interest rates can lead to a cooling of the reinsurance transaction market as insurers have less need to reinsure or transfer interest rate risks. Additionally, higher interest rates may lead to a decline in acquisitions due to higher valuation rates and distressed credit risk from highly leveraged deals.
• Asset adequacy and capital requirements: Insurers assess the adequacy of assets backing reserves under various interest rate scenarios. A rapid rise in interest rates can strain capital positions as asset market positions lose value faster than liability book value positions, negatively impacting risk-based capital ratios and company ratings.
• Investment management: Higher interest rates allow insurers to reconsider their investment approaches, potentially moving back to more traditional, fixed-income assets tied to specific liabilities. This can reduce their reliance on capital-intensive, high-yield assets.
• Financial reporting and taxation: Rising interest rates have implications for statutory asset adequacy and capital requirements, as well as financial reporting processes under generally accepted accounting principles (GAAP). Additionally, there may be potential derivative taxable losses that are non-admissible under statutory capital regulation, impacting capital depletion.

Implications of rising interest rates for insurers

Rising interest rates can have a significant impact on insurers, and there are several key areas where the effects will be felt. Firstly, higher interest rates will generally reduce reinvestment risk for life and retirement providers, making rate guarantees less expensive. However, a sharp rise in interest rates can introduce disintermediation risk, negatively impacting balance sheets. A more gradual change in rates will mitigate these risks, but carriers will need to adjust rate guarantees and pricing more frequently to respond to market pressure.

Insurers will also be better positioned to offer insured products with more substantial interest rate guarantees as rates rise. Life and annuity providers will have reduced pressure on margins earned from legacy blocks of annuity and insurance premiums with high minimum rate guarantees. With rising rates, they may be less inclined to offer buyouts on products like fixed annuities.

Rising interest rates can also affect product structure and features. For example, higher interest rates coupled with fluctuating equity markets may make equity-indexed life insurance and annuities less appealing to policyholders. In contrast, property and casualty (P&C) carriers may face difficulties with coinsurance terms, as coverage may not be adequate to make policyholders whole after a loss, especially a catastrophic one. Prescient insurers will review product structure and features to ensure coverages are adequate and go beyond legally required minimums.

Insurers will also benefit from rising rates as they may be able to increase risk premiums for standard products, leading to more favourable sector returns. However, carriers will need to balance return expectations with the increased options and benefits they may need to offer to remain competitive. P&C carriers, in particular, will face greater product pricing challenges due to the shorter-term nature of their coverages.

Rising interest rates typically result in a cooling of the reinsurance transaction market, as insurers have less need to reinsure or transfer interest rate risks. Life and annuity companies may choose to manage legacy business risks on their own and/or underwrite more new business. If so, they will need to weigh these benefits against their overall risk tolerances and capital levels.

From an investment management perspective, higher interest rates mean insurers will be able to consider rebalancing portfolios and potentially move back to more traditional investments, relying less on alternative asset classes. The search for yield will be less challenging, and insurance companies may be able to reduce their reliance on capital-intensive high-yield assets.

Finally, rising interest rates can have implications for financial reporting and taxation. Public companies will need to reevaluate their generally accepted accounting principles (GAAP) reserving under the new rates, especially under the requirements of the FASB's Long Duration Targeted Improvements (LDTI). While the effects on corporate taxation will take some time to manifest, rising rate scenarios carry the risk of creating significant derivative taxable losses that are non-admissible under statutory capital regulation, potentially leading to capital depletion.

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