How to make life insurance products better in a rising-rate environment

By Pierre Ghorbanian | March 9, 2018 | Last updated on March 9, 2018
5 min read

It seems like the insurance industry has been on a wild ride over the last 10 years: record low interest rates, tax and regulatory changes, the rise of fintech—and we’re not done.

This year, insurers are implementing new reserve rules (the Life Insurance Capital Adequacy Test, or LICAT) and planning a full implementation of International Financial Reporting Standards accounting rules by Jan. 1, 2021, which will significantly impact level COI and limited-pay universal life (UL) plans, as well as other similar guaranteed products.

The industry has responded to these changes by introducing new longer-term insurance options such as Term 15, 25 and 30 plans, as well as simplified-issue products. We have also seen a shift toward products with less inherent market volatility, such as whole life.

Effects of fixed income

While we are slowly seeing a rising trend in long-term interest rates, it can take years for a change in benchmark rates to affect insurer crediting rates.

In addition, the spread that insurers earn (i.e., the difference between the insurer’s investment portfolio and what is credited to the policy) has been narrowing. Older blocks of business with higher guarantees create greater compression on the spread required for an insurer’s new business.

With that said, it’s not all bad news when it comes to a rising-rate environment.

Some insurance products credit their returns based on the yield to maturity of their fixed income investments, which is advantageous if the insurer holds bonds to maturity. Therefore, since the bonds are not sold at a discount, there is no loss realized. By creating insurance products that use fixed income in such a manner, insurers can pass on more value to the policyowner over time.

Insurers have been thinking about ways like these to get better yields without creating more uncertainty and risk to the insurer or policyholder. Let’s examine a few.

Principal protection with equity upside

Some U.S. insurers are offering principal protection with equity upside on their indexed UL policies. In Canada, this strategy can sometimes be found on indexed annuities, or guaranteed market indexed accounts sold inside Canadian UL policies.

This type of protection is possible because the principal is used to purchase a bond. The insurer then uses the bond’s yield to buy call options. The primary advantage of this approach is principal protection with the potential to earn returns that are better than fixed income.

With UL policies, these types of products essentially allow policyowners to protect their net deposits (after insurance charges are deducted) and to potentially earn annual returns that credited to the policy’s fund value. Subsequent-year returns are based on the total fund value and the interest credited from the prior year. Therefore, policyowners won’t be as exposed to market volatility.

Using options on whole life insurance

Some insurers, mostly in the United States, use options to enhance the investment returns earned on their whole life portfolios instead of depending on fixed income returns. Canadian insurers are starting to introduce this approach. How do these option-based investment strategies compare with a traditional whole life investment strategy?

In a traditional strategy, the insurer typically allocates between 60% and 70% of a given premium to fixed income (after expenses). The remaining 30% to 40% is allocated to non-fixed income investments such as equities.

In today’s environment, the total annual return on the fixed income portion will currently likely be in the 3% to 4% range. Returns may be smoothed with prior years’ returns using a formula. Note that a company’s mortality and expense experience is also considered before the company’s dividends are distributed to policyowners.

In an options-based whole life investment strategy, the whole premium (after expenses) is allocated to fixed income, thus creating principal protection. Then, 30% to 40% of the total fixed income yield is used to purchase call options. Those options allow the insurer to participate in the upside of the equity markets without risking the principal; in a down market, all the company would forfeit is the cost of the call option.

What’s a call option?

A call option is a contract that gives the purchaser the right to buy a security from a seller at a certain price on a certain date (called the expiry date). Say you enter into an agreement with a seller for the right to buy 100 shares at a price of $1,000 today. Assume it costs you to $50 to enter into this agreement. On the expiry date, say the market value of 100 shares increases to $1,200. You would then exercise the call option to buy the shares for $1,000, and then sell the same shares on the open market for $1,200, giving you a gross gain of $200 (or a net gain of $150: $200 minus $50). If the market value of the share had decreased from $1,000 to $800, you would not have exercised the call option, but you would have forfeited the $50 transaction cost.

Diversification using options

An options-based approach allows for greater geographic diversification. Using S&P500 call options, for example, provides greater asset exposure and diversification outside of Canada. Matthew Smith, AVP and pricing actuary at ‎BMO Life Assurance Company, notes that “most whole life products in the Canada marketplace are comprised almost entirely of Canadian fixed income and equities. This lack of diversification outside of Canada can increase the investment risk for the policyholder.”

Case study

Let’s compare two plans on a 50-year-old male non-smoker. Assume that a policyowner pays a base premium of $25,000 for 10 years on a guaranteed 10 pay whole life plan. The traditional whole life policy has a current dividend rate on its investment portfolio of 6.25%, while the options-based whole life policy offers 5.5%.

Click on the image to enlarge it. Line graph comparing Total death benefit vs options based and traditional whole life insurance

Both products provide good value to the policyowner. They project similar long-term values, but the options-based WL plan achieves that value with less volatility.

In light of the slow impact that rising interest rates can have on fixed income portfolios, it’s wise to review the impact that lower returns. This is also illustrated on the chart by showing the difference in total death benefit for returns that are 1% less than the company’s current dividend scale. As you can see, the gap in death benefit between traditional WL at 6.25% and traditional WL at 5.25% is much wider than the gap between option-based WL at 5.5% versus 4.5%.

Explaining these relationships to clients can help manage their expectations and paint a more realistic picture of what they could earn on their policies.


The insurance industry has experienced a lot of challenges to its status quo, but it’s also taking the opportunity to design more innovative products. As advisors, it’s good to stay on top of such trends to be able to offer the most suitable policies for clients.

Pierre Ghorbanian, MBA, CFP, FLMI, is the Advanced Markets Business Development Director at BMO Insurance.

Pierre Ghorbanian