#281 | Portfolio Rates & Life Insurance

In his 2005 commencement speech at Kenyon College, David Foster Wallace told a story that has since been cemented as an iconic parable in American culture. It goes like this:

“There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says ‘Morning, boys. How’s the water?’ And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes ‘What the hell is water?’”

You can’t tell that story without getting a knowing chuckle out of your audience because everyone knows that we, as humans, take virtually everything about our existence for granted. That’s true for life – and it’s also true for life insurance.

Since 1981, we’ve been in a persistently declining interest rate environment. Rough math tells you that any person who is below the age of 61 and has been in the life insurance business their entire career has never sold life insurance in a rising interest rate environment. We have essentially been in a single rate cycle for the entire working lifetime of the vast majority of insurance agents selling life insurance today. They – we – are fish in water when it comes to interest rate cycles.

Fixed income products from bonds to mortgages to collateralized loans are priced at today’s rates. Each fixed income instrument sits in its own particular place on the credit spectrum paying a rate that reflects its duration, credit risk, rate structure, ability to be called, liquidity, taxation and a host of other factors. Relative opportunities are judged solely on the basis of the market spot rate paid today. The rate cycle is not a factor.

But for life insurance that uses portfolio rates, which is virtually every permanent policy in the market, the opposite is true – the rate cycle matters more than the market spot rate. Why is that? Because market rates are only reflected for the new money component of the portfolio rate calculation. The remainder and vast majority of the portfolio reflects previous new money invested rates for prior tranches of invested assets.

In a falling interest rate environment, the gap between new money rates and portfolio rates works to the advantage of the life insurer for the purposes of marketing and illustrating new products because portfolio rates will consistently be higher than new money rates. That’s why the rate cycle is vastly more important than new money rates in terms of the relative performance of life insurance products to market-based alternatives. In a falling interest rate environment, life insurance outperforms new money market alternatives. End of story. Take a look at the Northwestern Mutual dividend interest rate, which is about as pure of a view into portfolio earnings as we can get, since 1919:

Since 1919, the average Moody’s Aaa yield has been 5.7%. Over that same period of time, the average Northwestern Mutual dividend interest rate has been 5.77%. This makes perfect sense – the life insurer is investing in bonds, so why would we expect it to provide performance in excess of bonds over the long run? You wouldn’t. But because of the mechanics of portfolio crediting, prolonged cycles of rising or falling rates produce a gap between portfolio yields in life insurance and market interest rates that is necessarily corrected when the cycle turns the other direction.

Just how big is the current disconnect between new money rates and portfolio rates? Consider a life insurance company that is currently yielding 4.85% to its overall Whole Life portfolio, which can be calculated by looking in the statutory filing at the block reserves and the block investment income. I pulled the new bond purchases for the life insurer (again, from the statutory filing) and calculated the invested yield for the first 800 bond purchases (tallying up to nearly $5 billion) made throughout the year listed alphabetically by issuer. On average, new bonds for this insurer yielded just 3.22%. Take a look at the bonds ranked by yield:

On top of that, the life insurer had a barbell strategy for buying bonds. About 45% of the purchases were 10 years or less in maturity and the remainder were in long-maturity bonds with a whopping 40% with maturities of greater than 25 years. Take a look at the breakdown of maturities below:

This is a single case study on a single insurer that stands in for the rest of the industry to make a simple point – life insurer new money yields are quite different from their portfolio yields. And, crucially, the disconnect between the new money yields and portfolio yields is here to stay. If life insurers are buying 25 year+ bonds, then it’s going to be a very, very long time before that money rolls over and can be reinvested to reflect new money rates.

Once you look at the data, the reason why portfolio rates have stayed stubbornly above market interest rates for the past 40 years is as obvious as the fact that a fish is swimming in water but, as Wallace explains later in the speech, “the point of the fish story is merely that the most obvious, important realities are often the ones that are the hardest to see and talk about.” That’s certainly the case with portfolio rates. We all know how the math works, but it’s exceedingly hard to see in the real world and even harder to talk about. Why? Because it’s uncomfortable and inconvenient.

If you really want to simplify things, you could argue that three stories propelled the bulk of the sales growth in the life insurance industry over the past decade:

  1. That Whole Life performance is better than market interest rates
  2. That Indexed UL performance is better than market interest rates
  3. That Indexed UL (and Whole Life, to a lesser degree) can be levered up to deliver stellar returns through premium financing by borrowing at market interest rates to pay premiums.

The appeal of each of these stories rests, to varying degrees, on the ability to illustrate what amounts to perpetual arbitrage between market interest rates and portfolio yields. This is the soft underbelly of the life insurance industry. We’ve seen life insurance products outperform market rates for so long that we’re starting to believe that we have a structural advantage over market rates. And, heck, think about the story. Life insurance has performed well through the painful 1980s, the euphoric 1990s, the crash of 2000, the credit crisis of 2008 and the great recovery that followed. But all of those cycles are equity cycles. When it comes to interest rates, we’ve been in one cycle for the last 40 years – falling interest rates. That’s it. We’re like a middleweight boxer who has been chewing through featherweight opponents and hoisting up our belts like we’re the champion.

What’s potentially stepping into the ring, however, is an opponent of an altogether different caliber and the story of structural outperformance for life insurance is about to get its clock cleaned. Rising interest rates would flip the relationship we’ve seen between portfolio rates and market interest rates on its head. Everything we’ve taken for granted, everything we’ve understood, everything we’ve told clients about the performance of permanent life insurance products will change in a rising interest rate environment.

We know what will happen with Whole Life because the chart above comparing Aaa yields to the Northwestern Mutual dividend interest rate already gives it away – whole life dividends will materially lag rising interest rates. For some agents selling Whole Life, that’s going to amount to an existential threat to their business. I’ve heard more than a few agents position Whole Life as a way to outperform market interest rates, especially in a premium financing context, and I’ve never agreed with that characterization. My way of describing Whole Life is that, in the long run, it delivers corporate bond-like returns with muni-bond tax treatment and money market liquidity. That’s a pretty stellar combination that warrants a place in any client’s portfolio and is a part of mine. It doesn’t need to be gussied it up as if it can deliver better returns than corporate bonds. That’s not accurate or necessary.

Positioned correctly, Whole Life is a viable and even desirable product even in a rising interest rate environment. When rates rise, bond values drop. Clients who are using bond ladders for income are going to be faced with the raw choice of liquidating their depreciated bonds or not taking income. Clients with Whole Life don’t face that conundrum. In a rising interest rate environment, Whole Life cash values still increase. That’s why Whole Life serves as a counterbalance to traditional fixed income alternatives and warrants a place in the portfolio, even in a rising rate environment. With Whole Life as a part of the mix, clients can use their stable cash value for income rather than their depreciated bonds. That’s a solid value proposition.

Indexed UL is a little bit trickier. In the same way as Whole Life, the yields backing Indexed UL products will lag market rates in a rising rate environment. For how long? For as long as rates are rising. If rates went up constantly for the next 30 years – which is more or less what we saw from 1950 to 1980 – then the yields backing Indexed UL will lag for the entire period of time. The same goes for Whole Life, but Indexed UL has another challenge in the form of option prices. All else being equal, the price of call options increase when interest rates increase. In a rising rate environment, not only would the portfolio yield decline but option prices would also go up, which means that caps and any other form of participation in index performance will go down. Indexed UL, in many ways, will be more of a victim of rising interest rates than Whole Life.

This brings us to premium financing. Buying a Whole Life or Indexed UL product with cash puts the client on the horns of a theoretical dilemma between the opportunity cost of capital and the actual performance of their product. Premium financing a Whole Life or Indexed UL puts the client on the horns of an actual dilemma between the performance of the product and the real cost of the loan that was taken out to buy the policy. The relationship between market interest rates and policy performance grows a very sharp set of teeth in the form of collateral calls, interest expense and potentially the need to exit the arrangement.

For premium financing, a consistently rising interest rate environment is potentially fatal, regardless of whether the policy being financed is Whole Life or Indexed UL. In that situation, the loan rate would be increasing while policy performance lags indefinitely. Clients would be faced with collateral strain if they’re accruing interest and more cash out of pocket to satisfy loan interest if they’re paying interest annually. Neither is a particularly savory outcome if the original intent of the premium financing transaction was to take advantage of some sort of perceived or illustrated arbitrage between the cost of the loan and the performance of the policy.

That doesn’t mean the deal itself has to fail. For clients who were using premium financing properly as a tool to secure permanent insurance with an external exit strategy, rising interest rates don’t have a meaningful effect on the economics of the transaction. But if the client was told that the trade was “free” insurance with no real risk, then there’s going to be a serious problem – especially if the client is one of the unfortunate folks who have gotten tangled up in premium financing geared towards people who are not accredited investors and where the usual criteria to get into the trade is just to be employed. For those folks, a long-term performance disconnect could be fatal to their financial security, swamping whatever savings and reserves they have before they even realize what they bought and the risks that it entailed.

The first order of business for any person looking to ensure that their accumulation-oriented or premium financing transactions are going to stand the test of time is to remove the effects of portfolio crediting from their illustrations and proposals. How can you do that?

For Whole Life, that means illustrating lower dividends than the current dividend interest rate. Take the company I referenced previously as a case study – their net DIR (what is actually credited to cash values) is 4.85%, which reflects the yield earned on the Whole Life block of business. That should be reduced to somewhere in the neighborhood of 3.2%, meaning that the DIR should be adjusted for illustrate purposes downward by 1.65%. That would eliminate the illustrated benefit of portfolio rates and more accurately reflect the long-term performance of the product in the context of current market rates while still preserving the illustrated benefit of any outside business earnings on the dividend.

For Indexed UL, reflecting current market interest rates comes in two forms. I’ve always made the case that there are two ways to look at illustrated rates in Indexed UL – forwards and backwards. The forward approach is to align the illustrated rate with the current fair-market value of the cap, which is the price of the options to hedge the cap. From that view, you’d want to illustrate Indexed UL at around the same 3.2% as in Whole Life because the invested fixed income assets should be close to identical.

The backward approach uses historical data applied to the hypothetical assumption that the cap never changes, which is the way the current AG 49-A works. The question, then, is how to set a fair-market cap. You can get a feel for what that rate would be by looking at the IUL Benchmark Index that I maintain regularly. Right now, the fair-market cap in today’s environment is about 5.5%. Applying AG 49-A, that leads to an illustrated rate of about 3.75%. At that rate, you can be assured that you’ve safely eliminated the impacts of using portfolio rates while still preserving the hypothetical historical rate methodology and its highly speculative assumptions about the stability of the cap, future equity returns mirroring past equity returns and the use of the average rather than a more conservative percentile.

For premium financing, removing the effect of portfolio rates means aligning the anticipated returns in the product with the anticipated interest cost of the loan. it is completely inconsistent to assume a long-term loan rate of (say) 2% while illustrating as if today’s portfolio rate-driven dividend rate or IUL illustrated rate will hold up over the same period of time. The easiest way to align a premium financing proposal is to increase the loan rate in the future. To their credit, the proposals I see often assume rising loan rates and, if they don’t, it should be an immediate red flag. To put it bluntly, there should never be a premium financing illustration that shows a sustainable gap between the illustrated policy performance and the cost of the loan – unless the client is ultra high net worth and can consistently borrow money at rates lower than the yields of a highly rated corporate bond.

Now, if all of these illustrated rates and protocols strike you as absurdly low and you can’t imagine yourself illustrating Indexed UL at 3.75%, let alone 3.2%, then ask yourself this question – what the hell is water? Because of 35 years of consistently falling interest rates, life insurance agents today have seen a single relationship between yields paid in life insurance contracts and market interest rates for their entire career – namely, that life insurance yields are reliably higher than market interest rates. This is water.

And the reality is that the water is being drained out of the bottom of the fishbowl. We physically can’t have another 35 years of interest rate declines to the same magnitude as what happened from 1980 until now, when Aaa bonds went from yielding 14% to 3%. It can’t happen. We are either heading for a prolonged low-rate environment where portfolio rates eventually meet new money rates at 3% or we are heading for an inflationary environment with persistently rising interest rates where portfolio rates lag new money rates. The only thing we know is that we’re not going to see portfolio rates consistently above new money rates.

To extend the fishbowl analogy way farther than it should go, let me make one final observation – fish have gills, not lungs. Fish are made specifically to survive in water. Without water, fish die. Are you a fish? Have you been swimming in the water of portfolio rates for your entire career and selling the story that life insurance outperforms market interest rates? If that’s the case and you know – for sure – that the water is running out of the fishbowl, then you’d better make sure you’re ready to grow a set of lungs.