As the Federal Reserve's zero-interest-rate policy enters its ninth year with no realistic end in sight (Lehman Brothers' bankruptcy occurred 8 years ago this week, and the Fed Funds target was officially cut to zero three months later), we are beginning to witness the cumulative impact of this seemingly perpetual "emergency policy." Yield spreads have been compressed, retirement withdrawal rates are being reconsidered, and the strain on pension funds and other investment collectives is becoming greater by the day.
Another insidious impact of the low-return environment has received decidedly less attention, however, perhaps because it usually doesn't reveal itself until the afflicted party has already passed away. I'm talking, of course, of life insurance, and the effect that decreased investment returns have had on required insurance amounts. Simply put, Fed policy has caused large portions of America to become suddenly underinsured, and there's not much that most people can do to address the issue.
Defining the problem
When determining the appropriate amount of a lump-sum insurance payout that would be required to cover all future financial needs, financial advisors and insurance brokers always include some assumption of potential investment returns in recommending an appropriate level of insurance. The greater the investment return, the less insurance is required in order to meet a given level of expenses (and vice versa).
The math is actuarially similar to that involved in determining appropriate levels of pension funding and contributions, and many of us are of course aware of the current state of many pensions stemming from overly rosy return assumptions.
To see how this dynamic plays out in the insurance world, it's useful to consider a case study. Consider a working individual in his or her early 30s, who wants to acquire enough insurance to provide an annual stream of $100,000 of income for his or her spouse, to last a period of 20 years. Ignoring any tax impacts, and relying on the capital liquidation approach of assessing our insurance need (the alternative capital retention approach is generally useful for insurance salesmen, but of limited practical value for the rest of us), how much insurance is required to provide that income stream?
The answer, of course, depends upon what investment return can realistically be achieved by the surviving spouse upon receiving the insurance payout. The magnitude of the difference, though, might surprise you.
The lower lines on that chart correspond with higher return assumptions: a 6% inflation-adjusted return would require barely more than $1 million of insurance, whereas a 2% inflation-adjusted return would require nearly 50% more insurance in order to satisfy the income requirement, an amount in excess of $1.6 million.
Worse yet, the gap grows as investment returns continue to decline:
While a decrease in return assumption from 6% to 5% requires an increase of only $100,000 in order to restore the underinsurance gap, a decrease from 3% to 2% requires almost an additional $150,000 in order to restore stasis.
That amount continues to grow exponentially as rates creep into negative territory, which is a condition that is no longer relegated to the theoretical realm of textbooks. In fact, negative real returns are becoming an increasing reality in today's investing environment, and those who are purchasing life insurance need to be aware that they are a very legitimate possibility going forward.
All told, even a fairly modest decrease from a 2% positive real return to a 2% negative real return will increase an individual's insurance need by more than 50% (from $1.63 million to $2.49 million in our example above).
Unfortunately, for many insured individuals, a condition of underinsurance is not always easily addressed. Insurance premiums increase fairly rapidly with age (and with any changes in health status), and it's entirely possible that an insured individual will be completely unable to qualify for additional life insurance once the need has been discovered. At an extreme, of course, the underinsured condition isn't discovered until after the death of the insured, at which point it of course is too late to address the problem.
If you have an insurance policy that's been in place for a number of years, it's worth reassessing the policy based on the current interest rate environment to determine if your level of insurance is still sufficient to meet your needs. In the event that it is not, determine whether or not you can economically acquire additional insurance. If not, it will be necessary to communicate that gap to any potential beneficiaries, in case they need to make other arrangements (like saving up an additional nest egg, as a form of self-insurance).
An additional risk
Unfortunately for us, the impact on our required insurance amount isn't the only risk created by the persistent low interest rate environment. A decreased investment return also has a negative impact on the companies that issue our insurance policies, introducing a new form of counterparty risk for those of us who hold insurance policies.
While negative interest rates are a relatively new phenomenon, the early returns for insurance companies are anything but positive. At the very least, we can expect to see a continuation of what we've already witnessed in our prolonged zero interest rate environment, which is an embrace of riskier investments by insurance companies, as they attempt to meet the investment returns that their own actuarial assumptions require them to meet in order to cover their projected insurance payouts.
If all of this sounds a bit familiar to you, it should. Back in the financial crisis of 2008-09, the insurance giant AIG (NYSE:AIG) nearly imploded (and required a massive government bailout) as a result of souring investments in collateralized real estate bets. Without government backing, a significant number of insurance policies would have evaporated overnight, leaving an untold number of insured individuals in a suddenly vulnerable position.
The problem faced by insurance companies is strikingly similar to that faced by pension funds and by insured individuals themselves: In order to keep premiums low enough to be economically viable for their customers, insurance companies typically rely on earning an investment return on incoming premiums, during the time period before any payouts are required to be made. By the time the insurable event occurs, the insurance company has (theoretically) earned a compounded return on the paid premiums over time, allowing them to meet the payout need with room to spare.
Naturally, when insurers write policies - particularly those that are expected to be in force for multiple decades - their decision on where to set premiums is informed not just by basic actuarial assumptions but by financial market conditions as well. Policies that were written in 2006 (when the Fed Funds Rate stood at 5% - I even remember having an HSBC online savings account that paid in excess of 6% interest back then) by definition had lower premiums, since the bank could reasonably expect to earn a solid carry on its customers' premiums over the years that the policy was in force.
But as investment returns have come under pressure, most insurers now find themselves in a tight spot: On most types of insurance policies, they can't increase their premiums for in-force policies, since premiums are typically guaranteed at the time the policy is written. Unless they've fully locked in their investment return (by "matching" the duration of their investments with the expected duration and timing of their liabilities), the insurance companies' only remaining option is to increase the amount of investment risk that they accept in order to meet their "required return" thresholds. Hence, AIG.
Of course, in 2008-09, AIG was largely alone in its struggles, as most of the insurance industry remained unaffected (or at least, not directly threatened) by the crisis. It was AIG's greed and/or recklessness - rather than an underlying economic necessity - that created its vulnerable situation. But as we approach a decade's worth of historically low interest rates, the strains are starting to show, particularly for those insurers with a significant global footprint (remember, rates are low in the United States, but even lower elsewhere around the world).
For insured individuals, it's hard to know what to do with this information - counterparty risk is, unfortunately, a very difficult problem to solve. One potential option would be to spread your insurance policies out among more than one insurer, but doing so is cumbersome, and it also may not be an option for those of us who have already had our policy in place for several years (for the same reason that we might not be able to adequately address an underinsured condition).
Ultimately, the proper way for an individual to address this sort of counterparty risk will vary by state. Unlike bank accounts, which enjoy federal-level insurance via the FDIC, backstop guarantees of insurance companies are managed at the state level.
Understanding the particulars of your state's insurance guarantees (and also understanding the strengths and weaknesses of your state's overall fiscal situation) will help inform your best course of action going forward. Counterparty risk is never a clean situation to perfectly address, but understanding your maximum theoretical exposure is a necessary first step.
While most people already understand and expect that historical investment returns are not likely to hold much meaning over the coming decades, the application of that knowledge has mostly been limited to their investment accounts and their savings behaviors. If you haven't considered the potential impact of record-low interest rates on your insurance situation, then time is of the essence. The longer you wait, the more expensive it will be to address any potential insurance gaps, and an excessive delay may mean that the problem becomes unsolvable. Don't let that happen to you; determine your likely investment returns, and recalculate your insurance needs today.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.