Economic policies generally do not affect all segments of society the same, and the low interest rate environment we have been in since Lehman’ s bankruptcy is no exception.
Low interest rates heavily favor borrowers. There is no bigger beneficiary of low interest rates than the federal government because there is no bigger borrower. But businesses that need to borrow to expand also benefit, as do consumers who finance large purchases such as houses and cars.
Low interest rates penalize savers, because the options to allocate their savings generally don’t offer historically competitive returns. Any segment of society, such as retirees, needing a safe stream of income from their investable assets will be hurt in an environment like the one we are currently in.
The Federal Reserve Bank lowered interest rates as an emergency measure in response to the liquidity crisis of 2008, but eight years later, the rates are still at historical lows. They are now impacting areas not contemplated eight years ago, such as life insurance.
Most life insurance policies have guaranteed premiums that cannot be increased by the life insurance company. But when the premiums are insufficient to support the policy because the interest rate assumptions were wrong, the insurance company will stop marketing that class of policies and introduce a new class of policies with increased premiums.
Several companies have already taken this approach, and if interest rates remain low, more surely will. They will have to, if they want to remain solvent. While this tactic won’t affect current policyholder’s premiums, it could increase the amount of coverage that they need. How so?
The capitalization of earnings method of determining the amount of life insurance needed is dependent on the interest rate assumption used. For example, someone earning $10,000/month would need $2 million at 6% ($2 million x 6% = $120,000 ÷ 12 months = $10,000).
Change the interest rate and the amount changes. At 8%, the amount need drops to $1.5 million while at 4%, it increases to $3 million. So someone who procured their policy 10-15 years ago and used a then reasonable 6% interest rate now realizes that that amount will probably not provided the level of income it would have at the time of policy inception.
The primary reason that life insurance proceeds (paid by reason of death) are income tax free is that the government realizes that most people are underinsured as it is, and if they were to tax the death benefit, it would leave that much less for the beneficiaries.
But the extended low interest rate environment could unintentionally wind up having the same effect. Don’t let that happen to you or your clients. Make sure your life insurance program is doing what you intended it to by reviewing it and making any necessary changes.