What your clients need to know about rising interest rates

By David Bauer and Brandi Graver

Are your clients watching interest rates rise and wondering how those rates impact their financial plans? One of life insurance’s advantages is the fact that it is a non-correlated asset and is not strictly tied to market fluctuations.

However, insurance is still influenced by interest rates. Interest rates impact the assets that insurance companies hold on their balance sheets as well as the math behind many popular advanced sales concepts.

Insurance companies’ assets

While interest rates may move in the same direction, they may not move at the same time. The rates on some financial instruments may lag behind those of other instruments. The interest rates of bonds and certificates of deposit typically are fixed at the time they are issued and remain constant for the instrument’s term.

Bonds typically make up between 65% and 70% of the general account of life insurance companies. Bonds with longer-term durations usually fund participating whole life policies, while shorter-term instruments usually fund current-interest products such as fixed universal life. In that regard, we would expect the crediting rates on fixed universal life policies to increase sooner than the dividend crediting rate of participating whole life policies.

The interest rates on debt instruments behave similarly. Mortgages typically comprise between 10% and 15% of life insurance companies’ general accounts and because of their long-term nature, do not immediately respond to changing interest rates.

Advanced sales concepts

Higher interest rates also affect the appeal of many popular advanced sales concepts.

Premium financing is a frequent funding strategy for larger life insurance purchases. The interest rates charged by commercial lenders on premium financing loans typically track current rates. As these rates increase, premium financing transactions can be expected to become more expensive.

The interest rates used in most split-dollar arrangements, whether for business or personal applications, are controlled by Congress and published by the Internal Revenue Service. The Applicable Federal Rates are stated for short-, mid- and long-term durations. The short-term AFR governs loans of up to (and including) three years, the mid-term AFR governs loans over three years in duration and up to (and including) nine years, and the long-term AFR governs loans that are longer than nine years. The AFR for a particular transaction is based on the current rate at the time the transaction is initiated and may remain constant for the duration, depending on the loan structure.

Demand notes are governed by the Blended Annual Rate which is an average of the short-term AFRs for January and July of a given year and is published annually by the IRS. The split-dollar regulations require that each premium advance be treated as a separate loan, which may cause certain term loan structures to be administratively burdensome. Demand notes may be easier to administer, but the entire loan balance will be subject to current interest rates.

Split-interest transactions, such as Grantor-Retained Annuity Trusts are governed by the “7520 rate,” which is also published monthly by the IRS. The 7520 rate is defined as 120% of the mid-term AFR. The 7520 rate applicable to the transaction (such as a GRAT) is fixed at the time the transaction is initiated. GRATs are generally more effective when the 7520 rate is low.

A Charitable Remainder Trust is also governed by the 7520 rate. The remainder interest is determined by the 7520 rate for either the current month, or either one of the previous two months. As the 7520 rate increases, the amount of the charitable tax deduction will also increase, making the strategy more favorable. Once the trust is established, future rate increases will have no effect on the amount of the deduction.

Interest rates will inevitably rise and fall over a client’s financial lifecycle. Clients should work with their financial advisors to make sure their portfolio and planning techniques meet their goals and needs. Life insurance can be uniquely effective when included in a diversified financial plan. The certainty of life insurance can offset market volatility and instability often associated with other assets.

David Bauer CLU, ChFC, is director, advanced sales, Crump Life Insurance Services. He may be contacted at [email protected].

Brandi Graver, CLU, is director, advanced sales, Crump Life Insurance Services. She may be contacted at [email protected].