The Policy Loan Debate Explained

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by L. Carlos Lara

Until 1976, no one in the life insurance industry had ever done an empirical analysis of the policy loan option in an insurance contract. With the life insurance industry being centuries old, the fact that this type of research had never been done before is quite surprising. However, in 1976, two industry insiders, Wilfred A. Kraegel1 and James F. Reiskytl,2 dug deep into transactions of the Actuarial Society of America; the records of the American Institute of Actuaries; the general proceedings of the American Life Convention; and other journals, conferences, and court renderings of the 1800s and early 1900s to uncover a host of revealing historical facts about this unique policy feature that brought serious scrutiny to their findings by other members of the actuary societies of that day.

Neither the motivations to undertake such a study nor the year in which they were done are happenstance. These actuaries were looking to change things. In 1974 the percentage of policy loans compared to ordinary life insurance reserves—loosely speaking, the fraction of the insurers’ assets in the form of outstanding policy loans—had reached a high level of 18 percent, exceeded only by the early 1930s when a peak figure of 21 percent had been reached. But the prevailing fear in the 1970s was inflation. It was projected that inflation, if not abated, would send the percentage ratio to 34 percent by 1989—yet in reality, in some respects, it turned out worse!

This Lara-Murphy Report article explains why and in doing so helps the Authorized IBC Practitioners gain a greater understanding of where the policy loan controversies of today first originated. Though some of the specific concerns of that earlier time no longer exist, the disputes as to whether policy loans are actually good or bad for the life insurance industry continue to this day. What we hope to demonstrate is that the causes for the negative numbers have plausible explanations, but central among them was a statutory embedded fixed policy loan interest rate that was below market rates of interest. At the time this was very good for policy owners, but not so good for the life insurance companies. The painful consequences that followed for the life insurance companies teach us once again that government’s direct role in the market and the machinations of the Federal Reserve can be devastating to businesses and the economy.

Financial Institutions

If you look far back enough into history you will find that all financial institutions have black marks on their record. The life insurance industry is no exception. The difference is that compared to Wall Street and commercial banks their records are less tarnished and created less havoc on the general economy. One other notable attribute is that insurance companies have learned from their mistakes and have made important risk management adjustments that have strengthened their business model.

But the forces of government intervention and bad monetary policy remain uncontrollable foes even now as they have been throughout history.

To put all this into proper perspective we should first say something about financial institutions in general. Life insurance companies, like commercial and investment banks, are financial intermediaries. They are “intercessor” institutions for providers and users of money. Other forms of financial intermediaries in our economy include finance companies, mutual funds, and hedge funds. Financial intermediaries are in essence the consummate middlemen. All intermediaries issue their own financial products such as insurance policies, certificate of deposits, or mutual funds shares, to individuals and businesses and receive money for them. These monies are in turn invested in financial markets in primary securities such as bonds, mortgages, and stocks.

The larger portions of an economy’s population do not have the time, resources, or ability to gather comprehensive information about each possible financial undertaking. Intermediaries serve an important role in the economy by disseminating adequate financial information between buyers and sellers, facilitating risk and liquidity transformation, and through economies of scale they reduce transaction costs. For this reason financial intermediaries have historically taken in large sums of money from the investing public. As of the year-end 2012 life insurance companies held $5.6 trillion3 in financial assets compared to $15 trillion in assets held by banks. The commercial banks and by extension investment banks are directly regulated by the Federal Reserve while the insurance industry is regulated by the individual states with the federal government overseeing it indirectly.

Life insurance companies are unique intermediaries and operate differently from banks and investment firms in that they are actuarial as well as financial intermediaries. The financial products they sell offer protection as a first objective and the accumulation of savings as a second. In a real sense life insurers can be considered to be a liability driven business since they take in funds from individuals and businesses today to make conditional payments in the distant future. This leads life insurers to invest in a collection of long-term assets, mostly bonds. A recent study4 of the entire insurance industry done by the Federal Reserve of Chicago shows that 74.8 percent of life insurers’ general account assets in 2012 were bonds with 44.2 percent of the aggregate being made up specifically of corporate bonds. Additionally, life insurance companies tend to purchase these fixed-income securities with fairly long maturities in order to match their long-term liability commitments. This investment strategy of matching the duration of assets to the duration of liabilities is known as asset–liability matching and is intended to limit companies’ exposure to interest rate risk. This is a practice that is continually being refined by life companies as they navigate the new world of systemic risk.

What Are Policy Loans?

In addition to bonds, the life insurance companies hold several other types of investments including mortgages, equities, real estate, cash, derivatives and other short-term investments comprising a total of 15.3% of invested assets as of 2012. One such investment among this group is the policy loan. As of 2012, the life insurance industry’s aggregate assets in policy loans stood at only 3.7%!5 This is a ratio to take careful note of in light of the theme of this article. As you can see policy loans remain a very small percentage of invested assets. This is a strong indicator that tells us that no matter what the problems may have been with regards to policy loan excesses in the past, corrective measures and changes within the industry have obviously altered all of that.

According to a leading life insurance textbook:

“Policy loans are unique among life insurance investments for two reasons. First, they are not made as the result of an investment management decision. They are options exercised at the discretion of the policyowner. Second, because loans should never exceed their cash values and unpaid principal amounts may be deducted from cash surrender or policy death proceeds, the safety of principal associated with most loans is absolute.”6

Curiously policy loans do not have many of the characteristics of an investment, or as an asset for that matter. It would seem that from the company’s point of view they have no market value at all. Unless the policy owner decides to repay the loan it never matures, but is instead subtracted from the death benefit at death or when the policy is surrendered. From an accounting standpoint and the nature of the insurance business it seems reasonable to see them more as a reduction of liabilities (rather than an increase in assets), because an outstanding policy loan reduces the amount that the insurer contractually owes to the policyholder in the event of a surrender or death.

The truth is that the life insurance industry created the policy loan option in 1848 in order to dissuade policyholders from surrendering their policies. It was a brilliant idea at a time when there were very limited resources for credit for the surging middle class. Also consider that from the standpoint of the policyholder liquidity is a very important characteristic when considering an investment. However, surrendering an insurance policy for its cash value also means giving up an equally important element—protection. Since the cash value is in a sense an amount be longing to the policyholder in the first place, the policy loan option was a natural consequence of sound thinking on the part of the insurance industry. Better to grant the policyholder a loan than to have him opt for surrendering his policy when he needs his cash. As one actuary put it, “A policy loan then is really a cash-value withdrawal, temporary or permanent. We probably make an analytical mistake if we view it in the traditional way (as an investment or an asset).”7

Providing credence to this view of policy loans is a 1910 Supreme Court ruling on their nature. In “Board of Assessors of the Parish of Orleans v. New York Life Insurance Company, 216 U.S. 517. The Court noted that a policy loan creates no personal liability of the policy owner, so that it is not a debt, even though interest is charged.”8 This finding struck this author so profoundly that a complete review of an official U.S. government report of all Supreme Court Decisions Overruled By Subsequent Decisions9 was carefully examined up until 2010. No overruling existed. Providing that no new evidence has been introduced in the last four years to change this fact, this ruling stands to this day.

Nevertheless during the 1960s there developed a rising tide of criticism from the insurance industry toward policy loans that portrayed them as “unwise, un-businesslike and dangerous.”10 By 1976 they were being seriously considered for complete removal from the insurance contract. What most financial professionals may not know is that ever since 1906 almost all of the state laws mandated the policy loan option to be a part of all life insurance contracts. Though there may be a few straggler states that do not have a statutory policy loan requirement, competition amongst life insurers has forced all companies to include the policy loan provision in their contracts.

The Real Issue Was The Rate Of Interest

Why did such a negative view of policy loans develop in the insurance industry that carries over even to this day? If the insurance industry created the policy loan in the first place, why were they so eager to recall that decision and attempt to remove it from the contract altogether? Actually, it even seemed odd to many in the life insurance profession in 1976 though they fully recognized their core problem. One actuary in particular expressed it this way:

“If we were car dealers it is a little like saying—here we have built this option into our cars, an option that we have reflected fully in our price, but we are going to ask our dealers not to promote this feature in their sales approach, and will urge our customers not to use it too frequently, because it will impair the operating efficiency of their vehicles.”11

The culprit, of course, was the statutory low fixed rate of 5% and 6% maximum on policy loans during the periods of 1906 through 1969. This was because state laws typically followed the pattern of English usury laws. The rate did eventually move up to 8% in 1975 but by law it remained fixed—contrasted with an inflationary economy that raised the price of borrowing money to historic highs. The industry, quite frankly, was stuck. If there had been such a thing as a variable interest rate at that time there wouldn’t have ever been a problem.

The fixed low interest rates on policy loans especially in the older policies naturally encouraged the use of arbitrage by thousands of Americans that only accentuated the festering problem. The more sophisticated policy owners would borrow at the low policy loan rate and invest elsewhere at a higher rate. In 1913 Congress had passed a law permitting the deduction of interest paid on indebtedness when computing net taxable income. Although no indebtedness is involved in a policy loan, ac- cording to the Supreme Court ruling three years earlier, policy owners customarily deducted the interest. Consequently, the interest deductibility created an even greater impetus for arbitrage. Still others extended this idea into another area that came to be known as the “mini-dip” whereby the cash value was used to pay for the policy itself. “If premiums and interest are paid with sufficient frequency, cash values will build up, permitting discretionary borrowing for other purposes.”12

Finally, there was the matter of the creation of inequality between borrowers and non-borrowers as it pertained to the distributable surplus on all participating policies. Actuary tradition had always pointed out that “equity requires that surplus be distributed to policy owners in proportion to their contribution to it.”13 So naturally, there was fear that excessive policy loan borrowing would eventually lead to discrediting the industry.

In reality when a person can borrow at below market rates and invest the proceeds in market rates he or she is wise to do so. The right to a policy loan is the same as a call option on a bond. But in examining the entire spectrum of the problem, what we see in summary is that an inflationary economy, coupled with regulation that prevented insurers from increasing the policy loan rate to keep pace with the money market rate of interest, set the life insurance industry up for a fiasco.

The Past Is Not Easily Forgotten

As stated earlier, none of these issues exists any longer. Today almost all life insurance companies are permitted by law to use a variable interest rate on policy loans, the tax deductibility of the interest paid on a policy loan has also been removed as a general rule, and we now have a choice of direct or non-direct recognition life insurance companies to deal with the inequality issue of the divisible surplus.

If this is the case, then why are there lingering debates and strict company policies regarding policy loans among various life insurers? I would offer that the reason is that the memories of the unprecedented economic volatility of the 1960s and then again in 1979-1982 are not yet in the too distant past. These years marked the end of the postwar era in which the industry was driven by demand for income security and protection, but rapid inflation and soaring interest rates shifted the demand to investment accumulation. Once interest rates were deregulated, insurers responded to the competitive pressure from other intermediaries with a wide variety of interest sensitive products. They also boosted yields on their general accounts in an attempt to regain their financial footing by intentionally mismatching assets. In other words, purchasing high-yield long-term bonds to fund short-term liabilities. The results were disastrous when the junk market faltered.

hese ramifications extended into the late 1980s when “[l]iquidity demands (policy loans and surrenders) soared, and the industry escaped massive cash flow insolvencies only because most policy owners failed to exercise their rights efficiently.”14 The trend, however, took its toll and in 1991 A. M. Best had to list 103 life insurers of the 2,000 in operation as insolvent during this period.

This industry 5 percent failure rate is the same as the one experienced during the Great Depression of the 1930s when 20 of the 350 life insurance companies failed, but it was considerably less than bank failures. There were 4,000 bank failures out of 25,000 in operation during the Great Depression, or 16 percent and 1,200 bank failures out of 7,000, or 18 percent, during the 2008 financial crisis. The point is that over the span of U.S. history life insurance company failure rates still remain considerably lower than commercial banks and all other financial intermediaries.

The main thing to keep in mind from all these implications is that it did change the life insurance industry from what it used to be to something dramatically different. Drawing again on the Chicago Federal Reserve report,15 at the end of 2011, 64 percent of the life insurance industry’s total reserves were for annuities, while 30 percent of them were for life insurance. This is a stark contrast to that of 1960 during which 72 percent of total reserves were for life insurance and just 18 percent was for annuities. As we pointed out at the recent Night of Clarity event in Nashville, the universe for the beloved dividend-paying Whole Life insurance contact is now very small comparatively speaking. Fewer than 50 insurance companies currently offer the product. There is an entire new generation of Americans who are totally unfamiliar with all of its multi-dimensional benefits. When specially designed by an Authorized IBC Practitioner, Whole Life provides a form of privatized banking that is not only very useful for business and individuals, but helpful to the insurance industry and the economy as well. The room for growth in this area of the business is enormous.

Conclusion

The reality is that the existence of policy loans against cash values dates back to the mid-1800s, but the life insurance industry has never vigorously promoted them. It’s true that issues regarding policy loans were serious during the Great Depression, but since then there had been little concern until inflation hit in the late 1960s. But now we recognize why. The painful experiences that followed these events profoundly affected the industry. Life companies came to under- stand their business in light of the new economy and the gaining of this new understanding paid off.

The crucible for the industry’s strength and resiliency was proven during the Great Recession of 2007-2008. Here we saw the pouring of the public’s confidence and funds come back into the conservative financial sector with marked increases going into the Whole Life product specifically. When everything else in the market place failed and there was nowhere else for businesses and individuals to go, the life insurance companies were standing strong, ready to provide the high demand for safety.

Today matching asset-liability cash flows in a low interest rate environment is the industry’s new challenge, but when the next crisis hits again—and it will hit—the life insurance companies are poised and ready for another tremendous inpouring of funds. We plan for the Authorized IBC Practitioner to be there to help the public facilitate that transition.

References

  1. Wilfred A. Kraegel, http://digicoll.library.wisc.edu/cgi/f/findaid/findaididx?c=wiarchives;view=reslist;subview=standard;didno=uw-miluwmmss0137
  2. James F. Reiskytl, https://www.soa.org/search.aspx?go=True&q=&page=1&pagesize=10&or=True&docvector=[session%2C+1]&refine=ARABSmFtZXMgRiBSZWlza3l0bBYBYXV0aG9yc3NlYXJjaGFibGVtdWx0aQECXiICIiQ=&taxid=4294967459
  3. The Sensitivity of Life Insurance Firms To Interest Rate Changes, Berends, McMenamin, Plestis and Rosen, Federal Reserve Bank of Chicago http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2013/2Q2013_part2_berends_mcmenamin_plestis_rosen.pdf
  4. The Sensitivity of Life Insurance Firms To Interest Rate Changes, Berends, McMenamin, Plestis and Rosen, Federal Reserve Bank of Chicago http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2013/2Q2013_part2_berends_mcmenamin_plestis_rosen.pdf
  5. The Sensitivity of Life Insurance Firms To Interest Rate Changes, Berends, McMenamin, Plestis and Rosen, Federal Reserve Bank of Chicago
  6. Life Insurance, Kenneth Black, Jr., Harold D. Skipper, Kenneth Black, III, Copyright 2013 by Lucretian, LLC, www.Lucretian.com
  7. Transactions of Society of Actuaries, 1977 VOL. 29, Policy loans and Equity, Wilfred A. Kraegel and James F. Reiskytl https://www.google. com/?gws_rd=ssl#q=policy+loans+and+equity%2C+1977+vl.+29
  8. Transactions of Society of Actuaries, 1977 VOL. 29, Policy loans and Equity, Wilfred A. Kraegel and James F. Reiskytl
  9. Supreme Court Decisions Overruled By Subsequent Decision, Authorized Government report http://www.gpo.gov/fdsys/pkg/GPO- CONAN-2002/pdf/GPO-CONAN-2002-12.pdf
  10. Transactions of Society of Actuaries, 1977 VOL. 29, Policy loans and Equity, Wilfred A. Kraegel and James F. Reiskytl https://www.google. com/?gws_rd=ssl#q=policy+loans+and+equity%2C+1977+vol.+29
  11. Transactions of Society of Actuaries, 1977 VOL. 29, Policy loans and Equity, Wilfred A. Kraegel and James F. Reiskytl
  12. Transactions of Society of Actuaries, 1977 VOL. 29, Policy loans and Equity, Wilfred A. Kraegel and James F. Reiskytl
  13. Life Insurance, Kenneth Black, Jr., Harold D. Skipper, Kenneth Black, III, Copyright 2013 by Lucretian, LLC, www.Lucretian.com, Participation/ Policy Value provisions Chapter 5, page 103
  14. Life Insurance, Kenneth Black, Jr., Harold D. Skipper, Kenneth Black, III, Copyright 2013 by Lucretian, LLC, www.Lucretian.com, A Short History of The Life Insurance Industry, Chapter 9, Pages 202-205
  15. The Sensitivity of Life Insurance Firms To Interest Rate Changes, Berends, McMenamin, Plestis and Rosen, Federal Reserve Bank of Chicago http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2013/2Q2013_part2_berends_mcmenamin_plestis_rosen.pdf