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The Insurance Time Bomb

Any senior citizen with a retirement nest egg understands what it means to live in an era of financial repression and near-zero interest rates. It means your savings cannot grow without a greater level of risk than you might have taken in the past.

But the war on savers doesn’t only affect people with savings accounts; a lot of other financial instruments are savings by another name. Any product that relies on a third party getting between you and your money for a long period of time is now suspect, because the world’s central banks have changed the rules of the game.

Take life insurance. The chance that a 40-year-old man will die sometime in the next year is quite a bit lower than the chance that a 90-year-old man will die in the same period. That is why the cost of insuring a 40-year-old is so much lower. This is a basic function of insurance, but it plays out differently for different types of coverage.

For a term life insurance policy, low interest rates are not a huge problem. As people get older, the need for such insurance typically diminishes. Many people who purchase term life insurance do so to cover a finite period of risk – for instance, the period between their children’s birth and adulthood. While it is usually possible to renew term policies at increasingly high premiums, most people eventually let their term policies lapse at some point before they die. The premiums they pay are never recovered – but then, neither are the premiums you pay for fire insurance on your house if there is never any fire.

But some life insurance policies are intended never to lapse. The two most common types are whole life insurance and universal life insurance, both of which are usually designed to stay in force indefinitely. Instead of replacing the insured’s earning potential for a set period, the benefit in these policies is meant to provide, say, funds to support a business or to pay estate taxes or to provide an inheritance to heirs.

Insurance companies typically invest premiums from permanent life insurance policies conservatively, so that even after paying death benefits for the occasional premature death, with interest and some capital gains there will be enough money left over to eventually cover the insured’s death benefit, no matter when the person dies. This “leftover” money is the policy’s cash value. As a policy’s cash value grows, the insurer’s own risk of loss shrinks. Therefore cash value is really just another form of savings.

But in a repressed world, cash values cannot grow as quickly, so the insurer’s risk cannot decline as quickly. Unfortunately for insurers, financial repression has no effect on how quickly their customers age. This leaves insurance companies with three options. They can raise premiums. They can make up the shortfalls from some other source. Or they can fail.

Obviously, companies will try to avoid option number three in any way they can. That leaves options one and two. After years of interest rates hovering near zero, insurers must face the reality that many decades-old policies were designed for a different world and act accordingly. As The New York Times recently reported, in many cases that translates into drastic premium hikes. It can also take the form of chasing higher returns through riskier investments, as was the case with MetLife’s foray into hedge fund investing. The experiment, however, proved short-lived, as MetLife has said it will drop most hedge fund investments after a spate of poor performance.

The risks of financial repression manifest similarly in long-term care insurance, about which my colleagues and I have written previously, as well as disability insurance and fixed annuities. Financial repression is a time bomb for the insurance industry, with a slow-burning fuse. The longer central banks hold interest rates down, the more likely that bomb will eventually detonate.

These consequences are almost certainly not part of the calculation when the Federal Reserve and other central banks decide that the best way to promote growth today is to penalize savers – and thus, to shortchange the needs of tomorrow. But the effects will continue to spread, with insurance customers in line to feel the pain.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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