We’re still sitting in the longest period of low interest rates in decades. Signs are beginning to point to rates rising within the next couple of years, but what does this mean for insurance?
Recent price increases for UL
Autumn 2010 saw premium rates start rising for long-term, fixed-price life and health insurance. The biggest impact was on Level Cost of Insurance (LCOI) rates for Universal Life, with companies finally dealing with the low or zero profits they experienced for many years.
Now, there have been three major rounds of re-pricing since interest rates were pushed to rock bottom. And most companies have gone through a final, fourth, round of rate tweaking. Depending on a client’s age, gender and smoking status, LCOI rates have increased as much as 70% since 2010.
Why current prices are high
While the interest rate has been the biggest factor impacting premiums, other forces are in play.
LCOI and T100 have always been lapsed subsidized products. All level-premium long-term products build up substantial reserves to support the original level of premiums, even as actual costs of insurance rise as policyholders age.
Neither T100 nor LCOI has a cash surrender value, so when a policy lapses, the released reserves turn into income for an insurer. Companies pricing these plans must assume low lapses, and as companies experienced lapse rates that were even lower than assumed and therefore did not get released reserves, premium rates had to increase commensurately. Many of these changes happened before the interest rate collapse, but not all.
While those shifts were taking place, accounting and financial standards boards around the world were adopting more stringent accounting and financial reporting measures that heavily penalized both volatility (mark to market) and historically higher rates in reserve calculations. IFRS, Basel and Solvency I and II have all had dramatic impacts on companies’ financial reporting and earnings. Reserves were strengthened, and investment-value adjustments reflecting those market shifts hit the balance sheets — and ultimately the income statements.
Historically, life insurance products have been slow to adjust to market forces, and the industry showed little innovation.
Interest rates were relatively flat from the 1940s through the middle 1970s. And while people were living a bit longer, which was reflected in mortality tables, this had minimal pricing impact. What’s more, the industry was slow to automate, and people still did the bulk of the processing work. This kept costs high for firms.
The result was a slow and continuous build-up of in-force products (Whole Life, endowment and term) based on low rates, higher mortality than today and high expense assumptions. The reserves and cash values of these plans became enormous and insurance companies’ assets grew exponentially.
The ramp up
In the late 1970s, interest rates began to rise, and the trend continued well into the 1980s. IBM’s introduction of the PC meant agents could now produce computerized illustrations. Companies responded with product innovations and a breed of new-money life products hit the streets.
These products, which based premium rates on current yields instead of massive insurance company investment portfolios, offered premiums with 20% to 40% discounts over traditional products. The premiums were not guaranteed and would adjust every few years (five-year cycles were common) based on where interest rates moved. As interest rates in the market kept rising, initial policy interest rates continued to track this, and client premiums continued to fall.
Simultaneously, the life insurance distribution system was evolving. Up to this time the vast majority of agents were in the captive career channel. But they began to shift towards independence through broker contracts and the emerging MGA channel. Those brokers began offering products from multiple companies – including less expensive new-money products.
The result: rampant replacement
Agents were now able to make easy sales.
They could approach almost anyone and simply ask, “Do you own life insurance?” If the prospect answered yes, the agent could offer a discount between 30% and 50% over current plans. Even better, once new policies were in place, clients could cancel their old policies and benefit from substantial cash values released on surrender.
This double win meant clients got lower costs going forward and a cash settlement now; the agent got a new sale and new first-year commission and bonus.
As interest rates kept rising, companies developed Single Premium Adjustable Whole Life (SPAWL) and Refundable Premium SPAWL.
SPAWL offered to roll over the cash value of the client’s old policy and pay for the new policy in one shot. For the client, this meant the same coverage and no more premiums.
The ability to issue these single-premium, quick-pay products came to an abrupt end when the 1982 Federal Budget introduced the concept of a Tax-Exempt Life Insurance Policy and Maximum Tax Actuarial Reserves (MTAR). These new rules capped the amount of value in a policy to the equivalent of the cash values in a 20 Pay Endowment at Age 85 policy.
Paying premiums up front in a single premium was gone, and UL became the favored new product for new-money plans.
By the time the mid-1980s hit, all of this was about to come crashing down.
New-money premium rates were not sustainable and upon renewal they started to increase. This was especially true with SPAWL: when the products were repriced, interest rates had fallen dramatically and clients were now asked to deposit substantial additional premiums to maintain their policies. What had looked too good to be true a few years earlier turned out to be exactly that.
Products that promised no more premiums after a certain year also began to crash. Vanishing points of 6, 7 and 8 years now became as many as 20 years, effectively doubling or tripling clients’ total premiums.
Despite all this, UL products started to take off, because they still had the potential of higher returns and offered great flexibility. As interest rates crept up in the early 1990s, so too did market returns. With UL now offering an array of investment options, agents were still able to justify return projections based on a variety of market-based indices in the low- to mid-teens.
The fall continues
Into the 2000s, insurance companies dealt with the fallout of new money and vanishing premium product offerings. Several class action lawsuits were brought and settled.
Strong equity markets, meanwhile, continued to fuel investment options in UL until 2008. But fortunately agents were now starting to illustrate and sell using more conservative assumptions – in many cases, the contractual guarantees stated in the policies as opposed to current market rates.
Fierce competition for UL market share made companies reluctant to adjust product features and prices for fear of losing share. But eventually companies realized they were losing on these products because the insurance rates were just too low.
Finally, in 2010, a key market leader increased UL LCOI rates by double-digit percentages. Then, companies rushed to bring new rates to the market.
Most companies moved fast, since an influx of new business at unprofitable premium levels would lock in future losses. When companies announced these price increases, an initial sales rush ensued, with many agents telling clients and prospects, “Buy now; the price is going up on [date].”
Companies were swamped with new applications and term policy conversions to lock in the current LCOI rates.
As the market absorbed these rate increases, companies still couldn’t achieve their target ROIs — so a cautious second round of increases began. A short time later, a third round began as companies became comfortable their peers would match their price increases. A final round of fine-tuning occurred as companies took advantage of this new market reality to finally achieve appropriate pricing levels.
While this was occurring, other, less visible, price increases took place.
For years, the industry knew that Joint Last to Die (JLTD) rates were underpriced but, as with LCOI, no one wanted to be left out competitively. So, buried within many of the LCOI price announcements was a comment that Single Life Equivalent Ages (SLEA) adjustments would occur. These were not small changes, since at the ages at which JLTD was sold (typically 65-plus), even a one-year adjustment could mean a 5% rate change, or more.
More noticeable than the SLEA change was the almost-continuous reduction in contractual guarantees on the investment options in the UL contracts: guarantees crashed from 3% and 4% to 0% and then blipped up to 1% in some cases.
We now have a completely new paradigm. Rates for LCOI in UL are as high as 70% above 2008 levels, SLEAs are up one to three years, and there are low guarantees on investment options. These plans are essentially 50% to 100% more expensive than their mid-2000 levels.
This puts us in an environment akin to the pre-1970 era.
But when interest rates go up, all it will take is one company to lower premiums before we could see another round of product innovation and lower costs reminiscent of the 1980s.
Byren Innes is senior strategic advisor, Financial Services Consulting and Deals, at PwC.