Policy Loan Interest Rates: A Critical Evaluation

Abstract

Life insurance companies traditionally establish a policy loan interest rate that remains fixed throughout the life of a policy. Periodic adjustments in the interest rate are necessary, however, because of competition, interest rates in the economy change, and regulatory constraints are sometimes modified. As a result, there is a structure of policy loan interest rates, rather than a single rate. present system creates problems for policyholders, insurance companies and regulatory officials. From a policyholder and regulatory point of view, the basic issues are equity among policyholders and equity between the company and policyholders. From the insurance company's position, the policy loan interest mechanism produces either adverse or favorable financial selection. This paper studies the structure of policy loan interest rates, explores the problems that arise from the traditional approach, and suggests that a variable policy loan interest rate plan is preferable to the present system. Increasing attention is being directed to the rising volume of life insurance policy loans. percentage of life insurance company assets invested in policy loans has increased steadily since 1955, but there was an unusually large increase in the volume of policy loans in 1966,1 and another abnormally heavy demand for policy loans is now underway. Policy loans for a number of companies during the first six months of 1969 are running 50 to 60 percent higher than for the same period a year ago, and one observer has predicted that in 1969 the yearly increase in the volume of policy loans will be at least twice the record increase of 1966.2 Glenn L. Wood, Ph.D., C.L.U., is Professor of Finance at Califomia State College Bakersfield. Dick L. Rottman, Ph.D., C.L.U., C.P.C.U., is Associate Professor of Finance and holds the Nevada Insurance Education Foundation Chair at the University of Nevada, Reno. This article was submitted in July, 1969. 1 Life Insurance Fact Book, (New York: Institute of Life Insurance, 1968), p. 86. 2 Aan Abelson, Up and Down Wall Street, Barron's. July 7. 1969. p. 19. Although the policy loan provision is relatively simple and life insurance company policy loan practices are fairly routine, policy loan transactions create a number of subtle complexities for insurance companies, regulatory officials, and policyowners. Most of the concern centers around questions of adverse financial selection and equity among policyowners. These problems are most apparent when the policy loan interest rate appears to be inappropriate for the times. When interest rates on other loans are much lower than policy loan interest rates, policyowners are apt to criticize the excessive interest charge on policy loans, and there may be pressure to reduce the policy loan interest rate.3 But when other interest rates are higher than the policy loan rate, policyowners regard the cash value in their life insurance policies as an attractive source of funds. It is during 3Lewis W. Douglas, The Case for Reduced Interest Rates on Policy Loans, Journal of the American Society of Chartered Life Underwriters, Volume 1, no. 3, (March, 1947), p. 218.