Topie 5 Universal Life Insui nee We have studied a wide range of traditional life insurance products. Generally speaking, the benefit provided by a traditional life insurance is determined when the policy is established, The premiums, which are often determined by the equivalence principle, are also fixed. The policyholder must pay premiums according to the agreed premium schedule, or otherwise the policy would be discontinued, By contrast, universal life insurances are highly flexible, The policyholder may vary the amount and timing of premiums (within some constraints). The insurer deducts from each premium the expense charge and the cost of insurance, which is used to support the death benefit provided by the policy. Once the expense charge and the cost of insurance have been deducted, the remainder of a premium is placed into an account where it can grow and car interest over the life of the policy. The benefit provided by the policy needs not be fixed, and very offen, it depends on the account value (ie, the balance of funds in the account) when the benefit is paid Any interest that the account value earns is eredited back to the account value and invested, so essentially, the policyholder’s money is earning money. You may therefore view a universal life policy asa mixture of lie insurance and an investment product 5.1 Basic Policy Design and Account Value Accumulation Let us define the following notation: P, Premium for the 1 time period, paid at time 11 EC, The expense charge (also called MER, for Management Expense Rate) for the * time period, deducted from the account value at time ¢— 1 Col, The cost of insurance for the ¢" time period, deducted from the account value at time el AV, The account value at time ¢, before premium and deductions & ‘The credited rate of interest for the /" time period (i.e. from time ¢—1 to time 0) ‘The accumulation of the account value over the " time period (je, from time ¢— 1 to time 1) is illustrated in the following diagram: 1of 19Expense Cost of Charge Insurance (ec) (Col,) Deduet Account Value (av) Account Value Vn) Accumulate at the credited rate of interest ca) Add Premium, @ Time t—1 Time ¢ Keep in mind that the premium (P.), expense charge (EC) and the cost of insurance (Col) are for the 1 time period and are deducted or paid at time — 1, Assuming the policy is still in force at time 1, we have the following relation for account value accumulation: AY, =(AV,, +2 EC, -COL)(1+iF) Note: ~The credited interest rate is declared by the insurer and is based on the investment performance on the insurer's assets. ~The amount of premium P, is at the policyholder’s diseretion. = The expense charge EC, is determined by the insurer. = The length of each time step depends on the frequency of premium payments. In The accumulation of account value may be calculated at yearly or monthly time steps. 2of 19Example 5.1.1: For a basic universal life policy, you are given: (i) The account value at 1 = 10 (before premium payment and deductions) is 10,000. (ii). The policyholder pays premiums at ¢= 10 and r= 11. Each premium is 500. (iil) ‘The expense charge is 1% of each premium. (iv). The costs of insurance deducted at ¢= 10 and ¢= 11 are 20 and 15, respectively (v) The credited interest rate over the period from = 10 to = 12 is 2% per annum effective. Assume the policy is still in force at r= 12. (a) Calculate the account value at ¢= 12 if the length of each time step is one year. (b) Calculate the account value at ¢= 12 ifthe length ofeach time step is one month, Solution: (a) Here, the length of each time step is one year. At ¢= 11, the account value is given by AV. At AV 12, the account value is given by (b) Here, the length of each time step is one month. The eredited interest rates are calculated as follows: Leis =1+i = At I= 11, the account value is given by AV, At AV 12, the account value is given by We will sce in the next section how the cost of insurance is calculated. 30f 195.2. Cost of Insurance and Surrender Value Suppose that a universal life insurance policy is in force at time ¢~ 1. At time ¢, there are three possibilities Possibility (1): The policy is still in force At time ¢, the policy can still be in force. In this case, the process described in Section 5.1 repeats. Possibility (2): The policy is surrendered At time ¢, the policyholder can choose to surrender the policy. In this case, the policyholder will be paid a surrender value. The total cash available to the policyholder on surrender is the account value (AV,) minus the surrender charge (SC,), which is determined by the insurer. This amount ‘of money is called the cash value (CV) of the contract. Mathematically, CV, = max(AV,—SC,, 0) Possibility (3): The policyholder has died Death may oceur between time ¢~| and time ¢. In this case, a death benefit must be paid at time 1, The amount of death benefit depends on the contract type. Type A: Specified Amount For a specified amount (Type A) contract, the total death benefit is level. The total death benefit offered by Type A contract is called the Face Amount (FA) of the poliey. Type B: Specified Amount plus the Account Value For a specified amount plus the account value (Type B) contract, the total death benefit is the account value plus a fixed amount, which we denote by X. For both types, the death benefit is subject to a corridor factor requirement, which stipulates the minimum amount of insurance coverage required by the tax laws. The minimum total death benefit is defined by the corridor factor (y,) times the account value (AV,) at death. Taking the corridor factor requirement into account, the total death benefit at time ¢ can be expressed as follows. ‘Total Death Benefit Specific Amount (Type A): max(FA, y; AV.) Specific Amount plus the Account Value (Type B) max(AV, +X, 9, AV) ‘The difference between the total death benefit and the account value is known as the Additional of 19Death Benefit (ADB), If the corridor factor requirement is satisfied, then the ADB for a specified amount (Type A) contract, which equals FA — AV,, decreases as the account value increases, but the ADB for a specified amount plus the account value (Type B) contract is a constant. Ifthe corridor factor requirement is not satisfied, then the ADB equals (), ~ 1) AV, for both types. Hence, we have the following expressions for the ADB at time Additional Death Ben Specific Amount (Type A): ADB, = max(FA — AV,, (7,~ 1)AV,) Specific Amount plus the Account Value (Type B): ADB, = max(X, (7 AV) Example 5.2.1: For a specified amount universal life insurance policy, you are given: (The face amount of the policy is 100,000. (ii) The account value on December 31, 2011 was 50,000. Gi) On January 1, 2012, a premium of 2000 was made. No other premiums were made in 2012, (iv) The expense charge and the cost of insurance deducted on January 1, 2012 were 150 and 200, respectively. (v) The credited interest rate in 2012 was 6% per annum effective. (vi). The corridor factor applicable in 2012 was (vii) The surrender charge applicable in 2012 was 10 per 1,000 face amount, Caleulate the following: (a) The cash value of the policy on December 31, 2012: (b) Suppose that death occurred in 2012 and that the death benefit was payable at the end of the year of death, Calculate the amount of death benefit. Solution: (a) First, we need to project the account value on December 31, 2012. The account value on December 31, 2012 is given by ‘The cash value of the policy on December 31, 2012 is given by (b) This isa Type A policy. The total death benefit is given by Sof 19Suppose that at the time of death, the policyholder's account value is AV,, The amount of AV, will cover part of the total death benefit, and the shortfall (i., ADB,) will be topped up by the insurer. It is now clear that the cost of insurance collected at the beginning of a time period is used to support the expected ADB over that time period. In general, the cost of insurance can be caleulated by the following formula. General Formula for the Cost of Insurance: Col, = 4; xv, x ADB, where ~ Cor isthe cost of insurance for the period, deducted from the account value at time ¢ ~ 1, = 47 is the death probability (for the / time period) used to calculate the cost of ~ _y, is the discount factor for discounting the cost of insurance to time 1 1, = ADB, is the additional death benefit at time 1 Note: (D) The credited interest rate and the interest rate for calculating the cost of insurance are not necessarily the same. For this reason, the notation v (2) fpremiums are paid annually, then the cost of insurance is just the single premium for a 1- ‘year term fife insurance with sum insured equal to the ADB. ‘The actual calculation of the cost of insurance is a lot more complicated than it seems. This is because of the following circular relationship, ‘The cost of insurance Col, is a function of the additional death benefit ADB,, which is a function of the account value AV,. However, AV, depends on Col,, which is deducted at the beginning of the time period. We now discuss how this problem can be solved, First, lot us consider a specified amount (Type A) policy. Ifthe corridor requirement is satisfied, then ADB, = FA~AV, = FA-(AV,,+ 2 BC, ~Col, (142) bof 19Let Col! be the cost of insurance when the corridor factor requirement is satisfied. We have Col/ = 4 xv, x ADB, = g)xv,x[ FA -(AV,,, +2 EC, ~COL,)(14)] which implies FA-(AV,, +2-EC,)(1+7)] Ta, (1¥e) I the corridor factor requirement isnot satisfied, then ADB, =(y, -I)AV, =(7, -I)(AV,,+ BEC, ~Col, (I+) Let Col! be the cost of insurance when the corridor factor requirement is not satisfied. We have Col = 47¥, (7, -L)(AV,, +B EC, —Col; )(1 +. INAV, +P EC, (Ise) Tay, (7, (14) 4% ( Finally, the insurer should charge Col, = max(Cal/,Col) forthe cst of insurance Formula for Cost of Insurance for a Specified Amount (Type A) Policy: Col, = max(Cot/ Cot) where col = av, [FA-(AV,, +2 -EC,)(1+i dh, aye) col = INAV, +2-EC,)(1 +e Leqy, (y,-D(l4i) We now consider a specified amount plus the account value (Type B) poliey. If the corridor factor requirement is satisfied, then the additional death benefit is ADB, = . The cost of insurance is simply Col, = gy, ‘The same as a Type A contract, the additional death benefit is ADB, =(y, —1)AV, if the corridor factor requirement is not satisfied. Hence, for Type B, policy, we also have wey, 1)(AV,) PEC, (Lip Leavy, (7, “(4 7of 19Formula for Cost of Insurance for a Specified Amount plus Account Value (Type B) Policy: Col, = max(Cot! Cot’) » (7, -IAV,, +B EC, (+7) Tray (7, -D(Lre ) Example 5.2.2: For a universal life insurance policy, you are given: where Col (i) The death benefit is 100,000 plus the account value at the end of the year of death. The benefit is payable at the end of the year of death. il) ‘The account value on December 31, 2011 was 20,000 (ii) On January 1, 2012, a premium of 1,000 was made, No other premiums were made in 2012. (iv) The expense charge deducted on January 1, 2012 was 100. (v)_ The credited interest rate in 2012 was 1% per annum effective. (vi). The surrender charge applicable in 2012 was 10 per 1,000 face amount (vii). There is no corridor factor requirement for this policy. (viii) In calculating the cost of insurance, it was assumed that the probability of death in 2012 was 0.001. The interest rate used was 3% per annum effective. ix) The policyholder is alive on December 31, 2012. Calculate the account value on December 31, 2012, Solution: ‘The required value, AV,, the asset value on December 31, 2012, can be calculated with the following relation: We have AV, = 20000, P; = 1000, EC,= 100 and j; = 0.01, We need to calculate the cost of insurance Cob, Statement (vii) says that there is no corridor requirement for this policy, and Statement (i) says that it is a Type B policy. Hence, Col! = 45v,X Given X= 100000, v,=(1 + 0.03)" and g! =0.001, we have Substituting, we obtain Bof 19Example 5.2.3: Consider a specified amount universal life insurance policy. You are giver: (i) The policyholder is exactly aged 40 at the beginning of the year. (Gi) The account value at the beginning of the year is 50,000. (iii) At the beginning of the year, a premium of 3,000 is made. No other premiums are made in the same year. (iv) The face value of the policy is 100,000. (v)_ The expense charge is a flat amount $0 plus 2.5% of each premium (vi) The death benefit is payable at the end of the year of death. ‘The following basis is used to calculate the cost of insurance: = Interest: 3% per annum effective = Mortality: Illustrative Life Table Assume that the credited interest rate for the year is $% per annum effective, Calculate the cost of insurance deducted at the beginning of the year for each of the following cases. (a) There is no corridor factor requirement for this policy. (b) The corridor factor for the year is 2.5. Solution: (a) _ If there is no corridor factor requirement, then We are given v, =(1+0.03)", FA = 100000, AV, : = 50000, P; = 3000, EC; = $0 + 0.025 x 3000 = 125 and jf = 0.05, Also, from the Illustrative life table, we obtain 4G, = dy, =0.00278. This gives (b) When there is « corridor requirement, Col, ~max (Col Col’). We have calculated Cols in part (a). We now calculate Col; as follows: 9 of 195.3. Other Policy Features Having studied the basic specification ofa universal life insurance, we are now ready to discuss some additional policy features. Policy Loan Many universal life policies provide the option for the policyholder to take out a loan using the account value as collateral, This loan is called a policy loan. If a policy loan is taken, then the surrender value payable to the policyholder on surrender would be the cash value less the outstanding loan balance. Let us consider the following example. Example 5.3.1: For a specified amount universal life insurance policy, you are given: (i) The face amount of the poliey is 100,000. i) The account value on December 31, 2011 was $0,000. (iv) policy loan was taken. As of December 31, 201, the outstanding balance of the policy Joan was 30,000. The interest on the loan in year 2012 was 8%. (iv) On January 1, 2012, a premium of 2,000 was made. No other premiums were made in 2012. (v)_ The expense charge and the cost of insurance deducted on January 1, 2012 were 150 and 200, respectively. (vi) The credited interest rate in 2012 was 6% per annum effective. (vii). The surrender charge applicable in 2012 was 10 per 1,000 face amount. Calculate the surrender value payable to the policyholder if the policyholder surrendered the policy on December 31, 2012. Solution: First, we need to project the account value on December 31, 2012. For convenience, wwe refer December 31, 2011 to /— 1 and December 31, 2012 to t. We have ‘The cash value of the policy on December 31, 2012 is given by On December 31, 2012, the outstanding balance of the policy loan is 30000 x 1.08 = 32400, Hence, the surrender value payable to the policyholder is, 10 of 19Secondary Guarantees To make a universal life insurance product more attractive, insurers often provide one or more secondary guarantees. One common guarantee is the no lapse guarantee, under which the death benefit cover continues even ifthe account value declines to zero, provided that the policyholder pays a pre-specified minimum premium at each premium date. This guarantee comes into effect when the account value (AV,) and the premium (P,) are not sufficient to cover the cost of insurance (Col). Example 5.3.2: For a universal life insurance contract, you are given: (i) The total death benetit is 10,000 plus the account value at the end of the year of death, Gil) At the beginning of the year, the account value (before premium payment) was 5,000 and a premium of 1,000 was made. No other premium was made during the year. (iii) The expense charge is 50 plus 5% of each premium, (iv) The cost of insurance for the year was 300. (v) The credited interest rate for the year was 10%. (vi) The policyholder died during the year. The death benefit is payable at the end of the year. Let « be the death benefit payable if there is a guaranteed minimum death benefit of 20,000, and let fe the death benefit payable if there is no such a guarantee. Find a ~ f. Solution: First, we need to project the account value at the end of the year. The account value at the end of the year is given by In the absence of the guarantee, the total death benefit would be If'there is a guaranteed minimum death benefit of 20000, the total death benefit would be Hence, Hof 195.4 Projecting Account Values Given assumed values of premiums and credited rates of interest, we can project the account values of a universal life policy in future years (assuming the policy is still in force during those years) using the relation AV, +P EC, -Col,)(1+4) which was introduced at the beginning of the chapter. The projected account values can be used for the following purposes: (1) They show how the policy works under the idealized assumptions. (2) They give us the total death benefit and surrender benefit values which are needed for profit testing. We will discuss profit testing in the next section, Example 5.4.1: Consider a universal life insurance sold to (40). The death benefit is 100,000 plus the account value at the end of the year of death, You are given: (i) The following basis is used to calculate cost of insurance: ~ Mortality follows the Illustrative Life Table. = Interest rate is 5% per annum effective. ii) For each premium paid, the expense charge is 50 plus 2% of the premium. (iii). There is no corridor requirement (iv) ‘The death benefit is payable at the end ofthe year of death. Project the account value at the end of the third year using the following assumptions: = The policy remains in foree for three years. = Interest is eredited to the polieyholder’s account at 3% per annum, = The policyholder pays a premium of 3,000 at the beginning of each year. Solution: (Note: Since there is no corridor requirement, the cost of insurance for a specified amount plus the account value poliey is 4/v,¥.. We have X= 100000, », =1.08"' and q) = 0.00278 (trom the IMlustratve Life Table) Let us project the account value year by year: 12 0f 19First yea ‘Account value at the beginning of year: 0 Premium: Expense charge: Cost of insurance: Account value at the end of year: Second year: ‘Account value at the beginning of year: 2703,9952 Premium: Expense charge: Cost of insurance: Account value at the end of year: ‘Third year: ‘Account value at the beginning of year: $469.4913 Premium: Expense charge: Cost of insurance: Account value at the end of year: 13 of 19Example 5.4.2: The surrender penalties for the specified amount plus the account value universal life insurance described in Example 5.4.1 are as follows: Year of surrender 12 3 4 Penalty 3000 2800 24001000 Using the assumptions stated in Example 5.4.1, project the cash values at the end of years 1, 2 and 3 Solution: At the end of the first year, the projected account value AV; is 2704.00, The projected cash value is At the end of the second year, the projected account value AV2 is $469.49. The projected cash value is At the end of the third year, the projected account value AV is 8296.37. The projected cash value is Example 5.4.3: For two universal life insurance policies issued on (60), you are given: (i) Policy 1 has a level death benefit of 100,000. (ii) Policy 2 has a death benefit equal to 100,000 plus the account value at the end of the month of death. For each policy: (i) Death benefits are paid at the end of the month of death, (i) Account values are calculated monthly. (iii). Level monthly premiums of G are payable atthe beginning of each month (iv). Mortality rates for calculating the cost of insurance: a. Follow the Illustrative Life Table. Assume UDD for fractional ages. (v) Interest is credited at a monthly effective rate of 0.004 (vi) The interest rate used for accumulating and discounting in the cost of insurance calculation isa monthly effective rate of 0.004, (vil) Level expense charges of & are deducted atthe beginning of each month, At the end of the 36" month the account value for Policy | equals the account value for Policy 2. 14 of 19Calculate the ratio of the account value for Policy 1 at the end of the 37° month to the account value of Policy 2 at the end of the 37" month. Solution: The question did not mention anything about the corridor factor requirement, so we may assume that there is no corridor factor requirement. Policy 1 Policy 1 is a specified amount (Type A) policy. In the absence of a corridor factor requirement, the cost of insurance for the 37” month is Hence, the account value at the end ofthe 37" month is Policy 2: Policy 2 is a specified amount plus the account value (Type B) policy. In the absence of a corridor factor requirement, the cost of insurance for the 37th month is Hence, the account value at the end of the 37" month is We are given that AV}, = AV3,. As a result, 15 of 195.5 Profit Testing Using the techniques discussed in Chapter 4, we can profit test a universal life policy. To calculate the expected profit at time ¢, we need the following components: (1) Expected cost of death benefits and associated expenses For a specified amount (Type A) contract, the total death benefit is max(FA, j, AV,). Hence, per policy in force at 11, the expected cost of death benefits and associated expenses at time ris EDB (max (FA, 7,AV,)+E"). where £" is the expense associated with the death claim, and g" is the probability of death during the ¢ time period (.e, from time t~ 1 to time 1) For a specified amount plus the account value (Type B) contract, the total death benefit is max( AV; +X, 7, AV;). Hence, per policy in force at 1 ~ 1, the expected cost of death benefits, and associated expenses at time ¢is EDB, = q" (max (AV, +X, 7,AV,)+£*), (2) Expected cost of surrender benefits and associated expenses Assume that surrenders occur at year ends only. Let g” be the surrender rate at time 1 Then, the surrender probability at time 1 fora policy in foree at time 11 is (I=q!)4? Consequently, per policy in force at time 1 ~ 1, the expected cost of surrender benefits, and associated expenses is bb, =(1-f a (CV. +6"). where £* isthe expense associated with a surrender. (3) Expected cost of maintaining the account value The probability that policy in force at time ¢—1 will still be in force at time ¢ is (1-4/)(1-9"). Ifthe insurer holds the full account value as reserve for the contract, then per policy in force at time 1 the expected cost of maintaining the account value is EAN, = (I-a!)(I-a2)AV, 16 of 19The profit testing basis contains projected values of the insurer's earned interest rate (i), the incurred expenses (E5, £, , the death probabil the profit testing basis, we can calculate the expected profit emerging at time ¢ for each policy in force at time f— 1 by the following formula: Pry, =(AV,, +P -£,)(1+i")-EDB, ~ ESB, ~EAV, ies (qf) and the surrender rates (4). Using Note: (1) AV, is the account value at ¢— 1, projected by the procedure discussed in Section 5.4 (2) The insurer's earned interest rate (? is generally different from the credited interest rate i! ‘The earned interest rate is the rate that the insurer actually earns on its assets, while the credited interest rate is the rate at which the policyholder’s account accumulates. Typically, insurers will offer a credited interest rate that is lower than its carned interest rate. The difference is a source of the insurer's profit, We use i; when we project account values and. ‘f when we conduct profit testing. (3) Similarly, the expense charge EC, is generally different from the incurred expenses E,. The expense charge is typically higher than the incurred expenses, as the insurer wants the cexpense charge to be sufficient to cover the expenses incurred, We use EC, when we project account values and £, when we conduct profit testing (4) Given the values of Pr, for different time points, we can calculate the profit vector and the profit signature, Example $.5.1: Consider a 3-year term universal life insurance on (40). The total death benefit is 100,000, payable at the end of the year of death. There is no corridor factor requirement. You profit test the contract using the following basis: (i) Premiums of 2,500 each are paid at the beginning of years 1, 2 and 3. (Gi) The projected account values at the end of years 1; 2 and 3 are 2,000, 4,900 and 8,000, respectively. ii) Incurred expenses are 200 at inception, $0 plus 0.5% of premium at renewal, 100 on surrender, and 100 on death, (iv) ‘The surrender charge is 600 for all durations. (¥)_ The insurers eared rate of interest is 10% for all three years. (vi). Mortality experience is 120% of the Illustrative Life Table. (vii) Surrenders occur at year ends only. The surrender rates for years 1, 2 and 3 are 5%, 10% and 100%, respectively. (viii) The insurer holds the fall account value as reserve for the contract Wof 19Caleulate the following: (a) The profit vector (b) ‘The profit signature Solution: (a) The profit vector is (Pro, Pri, Pro, Pra). We now calculate each element in the profit veetor, Attime Initial expenses Pro Attime 1: AVo AV, P Ey EDB, ESB, EAV, Pr 18 of 19Attime 3 AV: AVs Pp EDB, ESBy EAV; Pry Therefore, the profit vector is given by (b) The profit signature is given by M=(T1, 11, 1s, 11,)'= (Phys Ph, p, Ph. 2, Ph)’, where ps is the probability thatthe policy is still in force at time ¢, We have Hence, the profit signature is 19 of 19