For over a decade, our economy experienced historically low interest rates as we emerged from the 2008- 09 financial crisis and then from the pandemic. But other factors have emerged recently, and we have found ourselves in an escalating inflationary period.
To counter inflation, the Federal Reserve has sharply spiked interest rates in a relatively short period. Interest rates on new money investments have experienced sudden increases, while existing interest-sensitive investments have taken a downward path.
Banks and insurance companies, both heavy investors in interest-sensitive products, have struggled with adapting this environment into their business models.
Let’s focus on one area common to banks and insurance companies – bank-owned life insurance, or BOLI.
How will rising interest rates affect BOLI assets held by a majority of banks? Interest rates that influence BOLI asset values have been declining since the early 1980s, when BOLI became an attractive and viable asset for banks to acquire.
Over the last 30 years, there have been occasional interest rate blips up and down, but nothing has been as dramatic or impactful as the interest rate climate since 2008. Let’s dive into the details of how interest rates have affected BOLI assets.
When Interest Rates Rise — What to Expect from Your BOLI Asset
The Premise of BOLI
BOLI is an asset that accrues value over its life, from the purchase price to an eventual maturity amount paid at the death of the insured. It’s life insurance, not a bond. The rate of accrual changes yearly due to two primary factors: interest earnings and insurance charges. But the maturity value never changes unless it’s increased to meet federal statutes on the definition of life insurance.
While the BOLI asset accrues, the bank recognizes noninterest income on a tax-preference basis with a final noninterest income amount attributed to the payment of maturity value at death. So, how does the subject of rising interest rates – or, for that matter, any change in interest rates – influence the BOLI asset?
- BOLI is not a “mark-to-market” asset; it’s always carried at book value.
- Rising interest earnings in BOLI improve noninterest income.
- Increased interest earnings can improve the long-term internal rate of return of the BOLI if they cause an increase in the maturity value.
How to Determine BOLI Interest Earnings
Generally, insurance carriers follow one of two methodologies for valuing their investment portfolios supporting BOLI contracts:
- Book Yield is commonly followed for general account and hybrid separate account products. Its yield is a consistent measure of the aggregate investment portfolio yield of insurance carriers and translates well to the interest earnings for general and hybrid account products. Because the insurance carrier guarantees the value of the BOLI asset, the bank isn’t subject to the investment risk and mark-to-market exposure.
- Total Return is associated with the stable value accounting methodology for separate account products. It’s a measure of the performance of the investment accounts underlying separate account products, as the valuation is not unlike that of a mutual fund. Although the carrying value of separate account products is at book value, the fact that the investment risk of the investment accounts remains with the bank exposes the bank to potential interest earnings and asset value volatility.
How to Declare Interest Earnings
Insurance carriers follow one of two approaches for declaring the interest earnings for BOLI: portfolio method or new money method. The portfolio method is most commonly applied for BOLI contracts, as the carrier determines an aggregate portfolio book yield for declaring interest earnings for all policyowners regardless of the date of purchase. The new money method is an approach where the initial interest earnings of the BOLI purchase are based on the book yield of new investments. Each BOLI purchase can have its own series of interest earnings, as the new money is integrated into the aggregate portfolio over time.
Portfolio Method
Carriers will often say their portfolios turn over, on average, 10% per year. This is due to maturities, selling decisions and net positive cash flow for new investment purchases. As the reinvestments occur, the overall portfolio book yield is influenced by the direction of the change in book yields of the new purchases compared to the aggregate portfolio book yield. If the new purchase book yield is below the aggregate book yield, the aggregate will fall. If the new purchase book yield is above the aggregate, the aggregate will rise. This is where the statement, “Crediting rates will lag going down in a falling market and will lag going up in a rising market” comes from. The statement describes the methodology employed for portfolio products for most BOLI carriers in determining interest earnings.
New Money Method
You may ask, “What’s the difference if the carrier follows the new money method?” These products will have the interest earnings for new BOLI purchases based solely on the book yield of investments the carrier can acquire at the time of purchase, or they may use a blend of new money and portfolio for new BOLI purchases. The future interest earnings will become a blend of the new money integrated into the aggregate portfolio over a period of years consistent with the investment portfolio turnover rate. With new money products, every purchase group has its own series of interest earnings rates due to the starting point and the blending rate.
What’s interesting about new money products is that if new money rates are below portfolio rates, the projected cash value performance of new money products isn’t likely to meet the levels of portfolio products for many years into the future. This results from the fact that most insurance companies invest similarly, which translates to similar aggregate investment returns on their portfolios, creating an upper threshold on ultimate interest earnings.