Asset/liability Management for Universal Life. Grant Paulsen Rimcon Inc. November 15, 2001

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1 Asset/liability Management for Universal Life Grant Paulsen Rimcon Inc. November 15, 2001

2

3 Step 1: Split the product in two Premiums Reinsurance Premiums Benefits Policyholder fund Risk charges Expense charges Surrender charges MER/spread Insurance Fund Expenses Taxes Return of fund on death or surrender Net death benefit (face value)

4 Step 2: Match the policyholder fund For index linked accounts, buy the underlying index Track liability balances on at least a weekly basis Compare asset returns with index returns and identify sources of tracking error asset/liability mismatch transaction costs backdating tracking of assets to index (i.e. exchange traded funds, index futures) tax effects

5 Step 3: Match the insurance fund (the hard part) Reserve components of a typical UL policy: Present value Duration Risk charges 6,488, Net benefits (4,881,908) 21 Ceded premiums (2,157,152) 20 Ceded benefits 2,435, Expense charges 693, Expenses (566,236)?? Surrender charges 248,522?? Commissions (1,641,296) 2 Investment income tax (455,153)?? Crediting rate margin 304,609?? Net total 468,811 Note: figures vary (a lot) depending on age of policyholder, age of policy, policy features, fund types, MER levels, modeling assumptions.

6 If interest rates fall 1% Present value Risk charges 6,488,404 7,163,944 Net benefits (4,881,908) (6,475,137) Net 1,606, ,807 A 1% rate decline removes $917,689 worth of profitability from the line of business. Reserves will increase by roughly this amount.

7 The largest risk is in the risk (COI) charge vs. net benefit cash flows 1,400,000 Annual Risk Charge Cash Flows 1,200,000 1,000, , , , ,

8 0 (200,000) (400,000) (600,000) (800,000) (1,000,000) (1,200,000) Annual Death Benefit Cash Flows (net of fund) (1,400,000)

9 Combined COI Charge +Death Benefit Cash Flows 1,000,000 Combined Cash Flows for 1000 Policies ($1 million of annual premium) Reinvestment is assumed at product pricing rate 500,000 0 (500,000) (1,000,000) (1,500,000) ALM Problem: How do we lock in the reinvestment rate at time of issue

10 Inter-segment Notes Combined Risk Charge + Benefit Cash Flows 1,000, , Use the cash to buy long-dated assets that better match the liability profile. 0 (500,000) 1. Sell this cash flow to annuities. (1,000,000) (1,500,000) $ Annuity Asset & Liability Cash Flows 800, , , , , , , , Sell the asset that the inter-segment note replaces and transfer the cash from Annuities to Universal Life

11 Other cash flow components Ceded cash flows premiums and benefits usually have similar durations small positive cash flow (pricing vs. reserving assumptions) long duration offsets some death benefit cash flows Expense charges generally fixed same duration as premiums Expenses interest rate theoretically = inflation + real interest rate higher interest rates => higher inflation theoretical duration is zero how does valuation model treat inflation? Surrender charges short term (generally 5 years or less) surrenders (fund depletion) fall when interest rates rise

12 Problem cash flow components Crediting rate margin depends on fund size => higher fund returns mean larger fund and more crediting rate cash flows when equity markets fall, future MER cash flows decline too movement from equity linked to GICs reduces MERs in high-return scenarios, fewer policies lapse effective duration very sensitive to model assumptions and can only be determined through scenario testing do you believe the current 2-3% MERs will hold up for 40 years? Investment income tax based on a 5-year moving average of 10-year Cda bond yields you have to pay IIT even if equity returns are negative Expenses interest rate theoretically = inflation + real interest rate

13 Summary UL is far more complicated than most other insurance products interest rate risk is potentially huge. Cash flow dynamics are complex, and don t depend only on interest rates. Duration (including key rate duration) is not sufficient. Assumptions (including policyholder behavior) have a large impact on cash flow dynamics (and reserves). You need a well thought out model. You need to understand the valuation software well enough to be sure it is implementing the model correctly. You need to sensitivity test the key assumptions.

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