SECONDARY GUARANTEES FOR UNIT LINKED LIFE INSURANCE THE NEED, FEATURES AND RESERVING

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1 SECONDARY GUARANTEES FOR UNIT LINKED LIFE INSURANCE THE NEED, FEATURES AND RESERVING By Irvinder Singh Kohli, Rajneet Kaur, Ritu Behl & Ankur Goel ABSTRACT This paper introduces ULIP products and talks about the effects of Lapse in ULIP products. There are secondary guarantees offered as part of UL products in the U.S. insurance market to address the problem of lapses. The paper introduces Secondary Guarantee (SG) and the methods of estimation of secondary guarantees (called No Lapse Guarantees) as well. The consumer's perspective as well as the insurer s perspective is provided for these secondary guarantees. Also covered are the regulatory reserves calculated in the U.S. insurance market for these ULIP products with secondary guarantees. KEY WORDS Segmented reserves, K factor, X-factors, Secondary Guarantee. OVERVIEW OF SECONDARY GUARANTEES Life insurance historically has been characterized in terms of promises made by insurance companies to compensate policy beneficiaries under certain contingent events. Different forms of guarantees have been used in life insurance, as well as various means of analyzing and establishing financial support to assure these promises can be met. The lower interest rate environment has led to a new generation of secondary guarantee structures, notably featuring shadow account designs. Secondary guarantees assure that if certain conditions are met (usually the payment of a specified premium level on a cumulative basis), coverage continues even if cash surrender values might not be positive. The state of life reserving requirements for life products with long-term guarantees appears be at a critical juncture, with reserving requirements of XXX and AXXX being a solution towards this end. Our paper aims to explain the working of secondary guarantees and the reserve requirements that have been put forth by American regulatory authorities to maintain the solvency of the company. Note: - Authors would like to give special thanks to Dr. K. Sriram and Sandeep Narang for their input and support. Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 1

2 OUTLINE Section A Introduction to ULIP Products Effect of Lapse in ULIP Products Introduction to Secondary Guarantee (SG) Methods of Estimation of SG Consumer s Perspective Insurer s Perspective Section B Introduction to Reserving for Secondary Guarantees XXX Regulation by NAIC Steps Involved in XXX Reserves Calculation: AXXX Reserve Introduction AXXX Reserve Steps for Calculation and X Factors Effects of XXX and AXXX Reserving Insurer s Perspective Conclusion References Appendix A: SECONDARY GUARANTEE IN ULIP 1. Introduction to Unit Linked Insurance Product (ULIP): ULIPs are insurance plans in which policy value varies according to the value of underlying assets. These products offer flexibility of protection and investment. They are a combination of Mutual Funds and a Life Insurance Policy. Investment in these products is denoted as Units and the value of such units is called Net Asset Value (NAV). NAV is calculated on the basis of the value of underlying assets and the level of charges levied by the company. Benefits are payable either at maturity or upon claim, depending upon NAV. In some policies, certain guaranteed benefits are also offered. A range of investment is offered under these products. In India, most investments offered are a mix of Equity, Debt and Real Estate. Another attraction for ULIP products is the flexibility offered to policyholders in deciding the premium, benefit and investment mix. A policyholder can switch funds per options offered by the insurance company. Similarly, policyholders can reduce or increase the premium (by paying a minimum premium as specified by the company) depending on account value per his/her requirement. A policy remains in force until the account value is greater than the COI charges, which can be deducted on a monthly basis. 2 Effect of Lapse in ULIP Products: Policyholders take ULIPs in anticipation of better returns as compared to traditional products. This also comes from the fact that the policyholder has flexibility in deciding the investment mix. They may have a higher proportion of investment in Equity or Real Estate. This provides the policyholder real returns over Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 2

3 and above inflation. Hence, lapses of ULIPs depend on the economic situation, as shown in the graph below. We have compared the average movement of BSE Sensex and Lapse Rates over the period The graph does not consider lapses which occur in Duration 1, since they can be driven by other noneconomic factors. The relation of lapses with the sensex movement has been shown below for ULIP products. These products have investments in different assets, and as the asset values move, the values of the policies under ULIP products move. Thus, it can be very well expected that the policyholder s behavior on lapses would move as per investment values. This expectation is supported by the graph. Lapse Rates Vs Sensex Movement Lapse Rates (Count Lapse Basis) Rates (Count Basis) 20.00% Lapse Rates Vs Sensex Movement 15.00% 20.00% 10.00% 15.00% 10.00% 5.00% 5.00% 0.00% Policy Duration 0.00% Policy Duration Sensex Sensex 50% 40% 30% 20% 10% 0% -10% -20% Avg. Change in 50% 40% 30% 20% 10% Sensex 0% -10% -20% Avg. Change in Sensex Why are insurance companies concerned about lapses in ULIP policies? The insurance company amortizes the expense incurred in writing a policy over the policy period. Initial / Acquisition Expenses are very high. Since a company cannot charge complete Initial / Acquisition Expenses in the first year of the policy, it is amortized over 3 5 years. Any lapse of policy during this period results in loss to the company due to nonrecovery of expenses; therefore, companies use a surrender charge during this period to deter lapses. Although insurance companies build in surrender / lapse costs while pricing the product, lapses due to changes in the economic scenario are beyond their control and they are unable to price them. Also, a highly conservative lapse rate will result in a higher premium and an uncompetitive product. Introduction to Secondary Guarantee (SG): A ULIP lapses under conditions when the policyholder stops paying the premium or the account value is low. Due to low account value, the policy is unable to cover the mortality expense (COI). Additional complexity is added because ULIP products offer flexibility in premium amount and timing. When the return in investment is not good, account value reduces without any fault of the policyholder and the policy lapses. To avoid such situations in which lapses are due to changes in economic scenario and the ultimate loss is of the policyholder, a company can offer a Secondary or No Lapse Guarantee in ULIPs. The insurance company guarantees to keep the policy in force until a set year or to a certain age if the premium is paid in an amount equal to or greater than the required payment for each interval. A Secondary Guarantee reduces lapses, which is beneficial for both insured and insurer. The policyholder is not affected even if the account value of the policy is negative, unless he is paying the minimum premium specified; while the insurer is not worried about increases in lapse rates due to changes in the economic situation. Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 3

4 The graph below shows lapse rates of ULIP products in the U.S. market. It can be observed that lapse rates have significantly decreased from as compared to Secondary Guarantee products were introduced in the U.S. market in the late 1990s, and the impact on lapse rates was significant. 14.0% Trends in UL Policy Lapse Rates 12.0% Lapse Rates 10.0% 8.0% 6.0% 4.0% % 0.0% Policy Duration 3. Methods of Estimation of SG: A secondary guarantee is estimated using two methods: Shadow Accounting Method Specified Premium Method Shadow Accounting Method: Under this method a separate account known as a shadow account is created for each policy. Shadow account calculations are independent from the regular ULIP accumulation value. They are, in fact, never used to determine cash surrender values their only purpose is to determine whether secondary death benefit guarantees are in effect. They may use unique credited rates, cost of insurance factors, and loads within this calculation. With most of these products, if the shadow account is positive, the secondary guarantee requirement is considered to have been met and the policy will not lapse regardless of an insufficient cash surrender value. Through the design of the parameters used in the shadow account calculation, the duration of the secondary guarantee can be controlled. This was one of the primary reasons for the development of shadow account designs, as companies sought to develop mechanisms that addressed consumer needs and allowed a range of guarantees to be delivered over a continuum of premium scenarios. Stipulated Premium Method: This method guarantees that a contract will stay in force as long as some minimum premium amount is paid every premium period. For example, if a policy pays a stipulated premium of Rs. 500 per month, he is guaranteed that his policy will be in force until age 100. Another example can be to pay Rs.1,000, which will ensure that the policy will remain in force for the next three years. The stipulated premium method is the simplest Secondary Guarantee method to understand, but it does not necessarily produce the lowest guaranteed premiums, and it is not as prevalent today. However, even with a higher premium, a stipulated premium method that provides catch-up at any time with no interest can be very appealing to those wanting to invest their own money while minimizing their outlay to the insurance Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 4

5 company for lifetime guarantees. Stipulated Premium is calculated to meet XXX and AXXX reserves (as described in a later section) specified by regulators. So, until the policyholder pays the Stipulated Premium. his policy remains in force. 5. Consumer s Perspective Secondary Guarantees in universal life policies are a feature whose time seems to be right. Many universal life policies were sold with the anticipation of high interest earnings. Many whole life policies sold at the same time used unrealistic dividend projections. At this time we find many people who will outlive their insurance policies. Often these people feel as though they have been burned and they don t want to be burned again. They have an option to increase the premium in their current policy, but even that won t guarantee the death benefit. Guarantees look very good to them. With today s secondary guarantees it is often possible to issue a new policy under a 1035 Exchange and produce lower premiums with lifetime guarantees. Secondary guarantees in universal life policies can be very attractive for those seeking long-term death benefit guarantees where cash value is of little importance. A universal life insurance policy with a secondary guarantee offers: Flexible payments Policyholders may choose to pay a single premium or pay level premiums over a set amount of time or until a certain age. Secondary guarantee The secondary guarantee benefit provides a safety net which ensures that the policy will remain in force to the desired age (up to age 121), as long as the planned premiums are paid on time and no loans or withdrawals are taken from the policy. The policyholder must realize that if the premium required to provide the secondary guarantee is not paid on a timely basis, even though the policy may still be in force, the secondary guarantee may not be recoverable; or if it is, the catch-up premium with interest may be exorbitant. 6. Insurer s Perspective With the secondary No Lapse Guarantee, the insurer can definitely expect lower lapses on this range of product as depicted in the graph on page 4. Lower lapses would lead to higher profits and credibility. There is a marketing advantage with the new feature added. The sale can be advantageous for a company offering such a guarantee with the universal life product. If an insurer does not offer the No Lapse Guarantee while most other insurance companies do, it can lead to a loss in market share. Apart from these advantages, the insurer also needs to understand the requirement of prudent reserves for this new range of product and make sure that it is maintaining sufficient reserves at any point in time. RESERVING UNDER NO-LAPSE GUARANTEE PRODUCTS Overview Before secondary guarantees came into the picture, insurance companies used to follow the traditional method of reserves calculation, keeping them equal to cash value or account value. But when secondary guarantees were launched as an additional feature with UL policies, a need for X-rated reserves arose, as traditional reserves turned out to be insufficient for the additional guarantee provided. This made it difficult Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 5

6 for insurance companies to keep the policy in force and maintain reserves in case the cash value/account value went below zero. In this section we will be explaining the two methods of reserving under secondary guarantee products: XXX reserves and AXXX reserves, stating the secondary guarantee type under which they work and defining the mechanism that both follow. 1. Introduction: First we will define the XXX reserving technique and explain the concept of segmented reserves calculated under this technique, then take the final reserve calculation. In the next section, AXXX reserves are explained by first demonstrating the basic definition and then the steps involved in the methodology. 2. XXX Regulation by NAIC: 2.1 The National Association of Insurance Commissioners adopted a revised version of the valuation of the Life Insurance Policies Model regulation in March 1999, often known as Regulation XXX. This regulation came into effect on January 1, 2000 and does not apply to policies issued prior to the effective date. 2.2 Regulation XXX imposes conservative assumptions and valuation methodologies for determining the level of statutory reserves for term life insurance policies with long-term guarantees of premium rates. These conservative assumptions result in significantly higher reserve levels for insurance businesses subject to regulation XXX. 2.3 Under regulation XXX, a life insurer that has issued term life insurance policies with long-term guarantees of premium is required to hold statutory reserves equal to the greater of : 2.4 The amount determined under a method in which each policy is considered a part of segments classified under segment valuation method. 2.5 The amount determined under a method where each policy is treated as a different segment under unitary valuation method. 2.6 Prior to XXX regulation, reserves were calculated solely under unitary valuation method and no segmentation was done. Since, XXX follows conservative assumption methodology; reserves calculated under segmented valuation method are significantly higher than the ones calculated earlier under unitary valuation method. 3. Steps Involved in XXX Reserves Calculation 3.1 Segment Classification Criteria: 1 First, we determine the minimum premiums required to keep the secondary guarantee in force for each of the coming years from policy start date to maturity period. It follows the increasing pattern: the increasing mortality rates and similar factors to keep the policy going for succeeding years. These premiums are basically calculated as the present value of future benefits for each year, using guaranteed assumptions for interest and mortality rates. 2 Secondly, we would have the table of valuation mortality that we are required to follow for the life products under consideration. 3 A segment is defined by comparing the ratio of successive gross premiums to the ratio of successive valuation mortality rates. Whenever the ratio of successive gross premiums is more than the ratio of successive mortality rates, a new segment is created. We start as in the first segment. 3.2 Calculation of Segmented Reserves: 1 We will calculate the present value (PV) of future death benefits and the minimum premiums required to keep a secondary guarantee in force for each year, as explained in 3.1(1). Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 6

7 2 The next step is to determine the K factor for the different segments that we have created under segment classification. For each segment, the K factor would be calculated by taking the division of the PV of DB with PV of GP for the respective segment. 3 After that, net premium is determined for each year by multiplying the gross premium for each year by the K factor for the segment the premium amount comes under. 4 Finally, segmented reserves are calculated by deducting the PV of future net premiums (as calculated in Step 3) from the PV of future death benefits and accumulating the reserves to the present year of consideration. 3.3 Unitary Reserves Calculation: The first step is to calculate the PV of future DB and PV of future GP as we did in the case of segmented reserve calculation. After this, a single K factor is calculated by dividing the total of the present value of future death benefits for all years by the total present value of future gross premiums. We would have present value of net premiums calculated for each year, where the net premium is obtained by multiplying the gross premiums by the K factor. Unitary reserves are then calculated by deducting the present value of future net premiums from the present value of future death benefits, accumulating the same to the present year. 4. AXXX Reserves (or AG 38) 4.1 Actuarial Guideline AXXX (also known as AG 38) addresses reserving issues on universal life products with secondary guarantees under the shadow accounting method. These reserves are referred to as AXXX Reserves. 4.2 Promulgated effective December 1, 2003 (or in some cases, earlier), it addresses certain statutory reserve requirements for secondary guarantee products not clearly addressed under XXX reserving methodology. 5. AXXX Reserving 5.1 Steps Involved in Reserve Calculation: 1 We will calculate the traditional basic reserves and deficiency reserves, keeping the assumption that minimum premiums needed to keep the policy in force were paid under the contract. 2 Next, we will determine the actual payments made by the policyholder in excess of minimum payments required. This amount is taken as equal to positive shadow account value under the shadow accounting method of secondary guarantee. 3 Determine the single payment at each valuation date that would be necessary to fund the secondary guarantee for the remaining period until the policy maturity date, assuming the minimum premiums had been paid to that point. 4 The next step is to calculate the ratio (R) by dividing the excess payments that were calculated in Step 2 with the single payments required for each year as assessed under Step 3. 5 Determine the amount of Net Additional Premiums, i.e. the amount that the policyholder has ended up paying in addition to the premium payment to the insurance company. We calculate this by multiplying R by Net Single Premium minus the sum of the initial basic reserve and deficiency reserve. 6 The final deficiency reserve is determined by multiplying the initial deficiency reserve (Step 1) by the factor (1-R) while initial deficiency reserves are over and above the XXX reserves, if the reserves calculated using X factors (as explained in 5.2 below) are higher than the XXX reserves. Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 7

8 7 The final total reserves is determined to be the lesser of: 8 The net single premium 9 The sum of the initial basic reserve, deficiency reserve and net additional premiums (Step 5), less applicable surrender charges 10 The next important thing to be considered here is that the final total reserves figure is not allowed to drop below the sum of the initial basic reserve plus the deficiency reserve. Traditional CRVM reserves serve as a further floor. Eventually, final basic reserves are the difference between the final total reserves and final deficiency reserves. 5.2 X factors - Role in Reserves Calculation: X factors are the percentages that may be applied to the model select mortality rate factors for the purpose of calculating deficiency reserves. These may vary by policy year, policy form, underwriting classification, issue age or any other policy factor expected to affect mortality experience. As uncertainty concerning the level of unanticipated mortality increases, a conservative margin can be provided by selecting higher X factors. In determining anticipated mortality and in selecting X factors, the following could be points of consideration: 1 Relevant company experience 2 Deriving anticipated mortality 3 Periodic assessment of anticipated mortality 4 Adjustments to X factors 6. Effects of the XXX and AXXX Reserves: These reserve regulations are meant for providing rules concerning a minimum standard for valuation of plans with secondary guarantees and non-level premiums or benefits. It also aims at providing a table of select mortality factors and rules for their use. Below are the tables for a hypothetical product having a secondary guarantee and following the segmentation valuation method. In the second table, the insurer is charging the same gross premiums for all years, except for overcharging the insured $65 instead of $60 in Year 3. But that resulted in lowering the K factor from 0.57 to 0.55 for Segment 1, which eventually leads to keeping the sum of present values of Net Premiums the same for both the scenarios, thereby keeping the amount of reserves the same under both conditions. This explains the reason behind the adoption of this regulation by most insurance regulators, as this is intended to give the same benefits to the insurer even if the insurer tries to over-charge premiums to the insured to reduce the reserving requirement. Thus, the main idea is to discourage the practice of charging excessive premiums to insureds and giving fair treatment to them at the end. Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 8

9 7. Insurers Perspective: For insurers, as per a survey by the Internal Revenue Service (IRS), the debate continues as to whether XXX and AXXX reserves are unnecessary and redundant. Whether necessary or not, these definitely demand some additional capital be kept by the insurers for the secondary guarantee provided in excess of unitary reserves. Insurance companies have dealt with the issue in a number of ways by resorting to different financing options such as reinsurance, surplus notes and securitization. Another effective way could be reinsuring these reserves with an onshore captive unit that preserves the potential tax benefits of the reserve deduction. CONCLUSION: Our paper was aimed at explaining the features and advantages of secondary guarantees (No Lapse Guarantees). We have tried to give an idea as to the reserving requirements for these features and the impact of same. The purpose was to bring forward to the life insurers new, sophisticated guarantees that can be offered as part of the unit linked product, and reserve requirements that can be followed to maintain the solvency of the company. REFERENCES: Graph 1: Lapsation and its Impact on Indian Life Insurance Industry ( ) Committee Report of IRDA, India (web link : &mid=12) Graph 2: US Individual Life Persistency Report from SOA (web link: Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 9

10 APPENDIX Segmentation DURATION AGE Minimum Premiums Designated premiums Minimum Valuation Mortality Segments , , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % , % % 4 Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 10

11 XXX Reserves Calculation Segment PVFGP PVFDB K PVFNP PVFGP PVFDB K PVFNP POLICY GPYEAR PVFGP PVFDB NP PVFNP SEGMENTED RESERVES UNITARY RESERVES SEGMENT ED TERMINAL RESERVES SEGMENTS PVFGP PVFDB NP PVFNP Unitary Basic Terminal Reserve XXX Basic Reserve Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 11

12 DeficiencyReserves Calculation Segment PVFGP PVFDB K PVFNP PVFGP PVFDB K PVFNP Segmented Reserves POLICY GPYEAR X PVFGP PVFDB NP PVFNP Unitary Reserves SEGMENT ED Deficien Unitary TERMINAL cy Basic RESERVE S reserve s SEGMENTS PVFGP PVFDB NP PVFNP Terminal Reserve XXX Basic Reserve Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 12

13 End Of Year Designa ted premiu ms Def reser ves CALCULATION OF AXXX RESERVES Re d Def Re Increased Basic Reserve Basic Single Net Single Net add Surr Actual Reserves Excess payment Ratio Premium prem Char Reserves Contact Information Ritu Behl India Irvinder Singh Kohli India Ankur V. Goel India Rajneet Sokhi India Secondary Guarantees for Unit Linked Life Insurance The Need, Features and Reserving. 13

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