1035 Tax-Free Exchange - Part 3

As the policy loans on minimum deposit life insurance contracts increased in amount, so did the interest costs.

In the past, there was little reason to be concerned about a 5 percent policy loan that was deductible. Additionally, the loan didn't affect the investment results of the contract. Policy owners received the same dividend regardless of whether they had borrowed on their policies or not. This strategy was particularly advantageous when interest rates were increasing in the 1970s and early 1980s.

However, it was inevitable that insurance companies would have to do something about the disintermediation (people borrowing at the low 5 percent guaranteed rate to invest at higher rates of return elsewhere). The flow of funds being lent out at 5 percent when money-market mutual funds were paying rates in the high teens was devastating to insurance company portfolios. As a result, companies took the following actions:

1. They either increased the guaranteed loan interest rate on whole life policies being issued at the time to 8 percent or made the interest rate adjustable.

2. They made upgrade and enhancement offers to existing policy owners. The basics of these offers were that if the policy owner agreed to pay current market rates of interest for any loans, the company would provide higher future dividends.

3. They began issuing conduit-type policies, such as variable and variable universal life (VUL). These are policies in which the policy owner accepts the return provided by market conditions. Variable policies provide separate accounts, often in addition to the company's general portfolio and, after charging a management fee, pass all investment returns (good and bad) on to the policy owner.