Since the Great Recession of 2007-2009, the Federal funds rate has been held near zero to help spur the U.S. economic recovery. However, with the decline in the unemployment rate, strong jobs growth in the second quarter of 2015 and low inflation, the Federal Reserve may begin to raise short-term interest rates before the end of this year.
Although no one can predict exactly when interest rates will rise or by how much, we all understand it will occur at some point. Because we have been in a low interest rate environment for so long, the natural question is how will higher market interest rates impact the credited interest rates on bank-owned life insurance (BOLI) policies?
To understand the impact of rising interest rates on BOLI carriers offering fixed-income products, it is first necessary to understand the carriers’ investment philosophies, portfolio compositions and interest crediting methodologies. Although the investment philosophy of each BOLI carrier differs, there are generally some common threads. The investment objective of most BOLI carriers is to build a diversified portfolio of securities across and within asset classes with a long-term orientation that optimizes yield within a defined set of risk parameters. The portfolio strategy often targets investment grade securities, both public and privately issued, with cash inflows that reasonably match the projected cash outflows of their projected liabilities. Corporate bonds are usually the largest holding in the portfolio along with commercial mortgages/mortgage backed securities, private placements, government/municipal bonds and other holdings. The duration of these portfolios is typically four to ten years.
Insurance companies use different interest crediting methodologies for BOLI business. Some carriers use a portfolio approach while others use a new money rate approach. In most cases, the carriers who use a new money rate approach blend it into the portfolio over time. The crediting rate in products from new money rate carriers is based on the carrier’s expected rate of return on premiums received currently. The crediting rate in products from portfolio rate carriers is based on a combination of the rate of return from new premiums as well as the balance of the general account assets of the company or the assets of the specific BOLI portfolio.
Rising interest rates will affect both new BOLI cases as well as existing BOLI policies. As noted above, insurance companies invest heavily in bonds. When market interest rates rise, yields on new bonds will increase while prices on existing bonds will decline. In anticipation of rising interest rates, some carriers shorten the duration of their portfolios or pursue a hedging strategy to manage risks.
Carriers using the new money approach will see a more immediate and positive impact on their initial credited rate for new BOLI policies as their rates, for newly issued policies, are based on current investments yields. Assuming a modest increase in rates, carriers using the portfolio approach may see little or no immediate change in their rate, but will likely see an increase in their credited interest rate over time. This will occur as the portfolio turns over and as new premium that is received is invested at a higher rate.
For existing general account and hybrid separate account BOLI policies, whether a new money or portfolio approach was used, there is no mark-to-market risk as the insurance company, not the policyholder, bears the price risk. For new money products, the interest rate credited to a new purchase is not likely to increase for several years after purchase since the underlying investments supporting the new money purchase typically have durations of four to ten years. Assuming slow and steady interest rate increases, both new money and portfolio products will likely increase over time with the portfolio products expected to increase more rapidly than the new money products. This is because the portfolio products will receive more new cash flows to invest at the higher rates.
A significant interest rate increase over a short period of time may cause most new premium to be placed in new money products, thereby reducing the new premium received into a portfolio product and slowing the time period it takes for the crediting rate to grow to market levels. If this were to occur, the crediting rates on portfolio and new money products would be expected to increase at about the same pace.
Please also bear in mind that it is important for directors and senior management of a bank to monitor not only changes in credited interest rates, but also the net yields. The net yield reflects the actual credited rate less mortality charges and, in some cases, policy fees or other administrative expenses. Accordingly, it is possible for one carrier to have a higher interest rate than another, but a lower net yield.
Many BOLI service providers will meet with their clients at least once a year to discuss the status and performance of their policies. At that meeting, it is vital for board members and senior management to review, among other things, the net yield earned on their policies to determine whether those yields are competitive in light of the type of policy purchased (new money, portfolio, blended portfolio) and current market conditions. Your service provider is well positioned to help you with that analysis and discussion of options, if changes are needed.
In conclusion, rising interest rates will occur at some point, but are likely to have a favorable interest rate impact on both new and existing BOLI clients using a fixed account over the long-term.
Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.