Interest Rates, the Emergency Fund Hypothesis and Saving through Endowment Policies: Some Empirical Evidence for the U.K.

Interest Rates, the Emergency Fund Hypothesis and Saving through Endowment Policies: Some Empirical Evidence for the U.K. Introduction Historical trends in most industrial countries indicate that, compared to other forms of financial saving, saving through life insurance has been declining over a long period. Explaining these trends requires examining the factors determining household saving through life insurance. In this connection, various hypotheses have been advanced in the literature, but few have been subject to rigorous empirical testing. (1) This article provides econometric tests of some of these hypotheses for the endowment policies written by British life insurers, using time series data for 1952 through 1985. Apart from these tests, the results also provide estimates of the degree to which saving through life insurance is sensitive to its various determinants. The model of saving through life insurance used in this study is first outlined. Then empirical results are discussed and hypotheses about the relevance of various factors (e.g., interest rates) that have been suggested in the literature as exerting an important influence on such saving are tested. Households can adjust their saving through life insurance in a number of ways. Typically though, the main effects operate through changes in the allocation of new wealth to life policies and through surrenders. The empirical results based on the model estimated in this study do not, however, allow unambiguous inference about the effects on policy surrenders, which represent the main mechanism via which households adjust their existing holdings of the life insurance asset. Consequently additional evidence is provided on the hypotheses as they pertain to policy surrenders. These findings are, however, specific to one segment of the British life insurance sector: endowment policies. In conclusion, the findings are summarized and their implications discussed. Saving through Life Insurance: The Model Various options are available to holders of endowment policies written by British life insurers, in the event they wish to respond to changing capital market conditions by modifying their saving through these policies. They can simply forfeit their policies as they would term policies; they can make the policies paid-up, whereby, even though they cease making premium payments, they retain the benefits these policies offer; they can seek policy loans on the surrender value; or, they can seek a cash surrender. Two hypotheses in the literature attempt to explain changes in household saving through life insurance, via the mechanisms mentioned above: (i) the interest rate hypothesis, and (ii) the emergency fund hypothesis. The former argues that saving through life insurance is sensitive to rates of return; positively to internal rates of return on endowment policies, and negatively to rates of return on other financial assets. The hypothesis has been examined with respect to policy loans in the United States by a number of researchers [see for example, Hogan (1970), Schott (1971), Pesando (1974), and Cummins (1978)]. The latter hypothesis, originally proposed by Linton (1932), is based on the premise that households regard their savings in life policies as a source of emergency funds which they can draw upon in times of need (e.g., during recession-induced unemployment), either by taking out policy loans or by seeking surrenders. Cummins (1975) tested this hypothesis for the United States for both policy loans and surrenders. His results did appear to support the hypothesis, particularly for surrenders during the 1950s. In the following section, British data on endowment policies are used to examine these hypotheses in terms of the sensitivity of saving through endowment policies to changes in their own rates of return and alternative rates of return, and in a variable constructed to reflect emergency fund considerations. …