An Econometric Analysis of the Demand for Life Insurance Policy Loans

Driving Forces of Policy Loan Demand Previous research has found several variables related to the demand for life insurance policy loans, including market interest rates (Schott, 1971; Bykerk and Thompson, 1979; Cummins, 1973), personal income (Wood, 1964; Rejda, 1966), the unemployment rate (Cummins, 1973), and costs of alternative sources of credit (Day and Hendershott, 1977). Policy loans constitute a form of disintermediation for insurers and are important because they disrupt insurer cash flow and impose an opportunity cost if the market interest rate exceeds the policy loan interest rate. (1) This article assesses the impact that redesigned life insurance policy loan provisions and changes in financial markets have had on the demand for policy loans and the risk of disintermediation. The research extends previous work - which has focused exclusively on periods of fixed loan rates - by investigating policy loan demand from 1970 through 1989, a period encompassing both fixed and variable loan rates. (2) Because the structure of policy loan demand may have shifted over the sample period, a test for structural change is performed. While previous econometric analyses of policy loan demand have used quarterly data, this study uses monthly data. Market Conditions On policies issued before 1980, loan rates generally were fixed at between 5 and 6 percent. Thus, for various reasons, when market interest rates were equal to or in excess of policy loan rates, relatively more policyowners exercised their option to access cash values, and insurers lost the use of large amounts of assets. Policy loans outstanding at the end of 1970 equaled $14.1 billion and grew to $34.8 billion by the end of 1979. In response to the problem of policy loan disintermediation, a number of remedies have been proposed to reduce the outflow of funds. Wood and Rottman (1970) examine the use of variable loan rates, and Kraegel and Reiskytl (1977) and Larsen (1981) discuss the use of adjusted dividends to borrowing policyowners. In an effort to mitigate disintermediation, the National Association of Insurance Commissioners adopted the Model Policy Loan Interest Rate Bill in 1980. A version of this bill is now law in all states. According to the Model Bill, insurers may not set interest rates on policy loans in excess of Moody's Composite Yield on seasoned corporate bonds two months prior to the interest rate determination date. As interest rates decline, insurers must reduce the loan interest rate accordingly (see Black and Skipper, 1987, p. 140). Thus, since the early 1980s, a growing percentage of policy loan interest rates has been sensitive to market conditions. Of course, the shift to variable loan rates was not immediate; typically only new policies contained the variable rate provision. However, insurers offered inducements to fixed loan rate policyowners to switch to variable rate policies. The inducements generally took the form of increased projected dividends or dividend scales dependent upon loan utilization. In the early 1980s, insurers began to offer enhanced dividends to policyowners in exchange for higher policy loan rates or variable loan rates. New fixed loan rates were often raised to 8 percent (see Black and Skipper, 1987). It is likely that the introduction of interest-sensitive policy loan rates has altered the demand structure for policy loans in the last decade. Other factors may be responsible for a shift in the demand structure for policy loans. The volatility of interest rates might affect demand for policy loans because the flexible nature of policy loan repayment enables policyowners to repay loans without incurring the prepayment penalties often associated with other types of loans. The deregulation of financial markets, which allows greater access to money market returns, also may have led to a shift in the demand for policy loans. The introduction of nontraditional policies, such as universal life and variable life, that are said to be less loan tolerant, may have had an impact on the demand for policy loans. …