#8: Case Study – Indexed Universal Life (Part 1: Product Features)

The first half of the series of ALM articles focuses on the theoretical concepts in actuarial science and quantitative finance, while the second half focuses on how these concepts are applied to practically manage an insurer’s balance sheet, and mainly related to the participating products (which to my opinion, is one of the most complicated products in terms of ALM because of both the complicated dynamic and the additional policyholder reasonable expectation (“PRE”) considerations).

By now, we I have already covered most of the theoretical background articles, so let’s start to get a sense of the practical applicable by a case study on the Indexed Universal Life (“IUL”).

This case study will be divided into 3 parts:

1. The first part is an introduction of the common features of an IUL.
2. The second part focuses on the ALM considerations of the fixed account. Or in another word, the ALM considerations of a normal Universal Life product.
3. The third part focuses on the ALM considerations of the index account, which is also application to other index-linked insurance products like indexed annuity and indexed endowment.

(A) Recaps

Let’s start by recapping the beginning of the series, in which I mentioned that the recursively actuarial formula is what lies in the foundation of all market-sensitive (senstive from the policyholder’s perspective) insurance products (unit-linked, universal life, index-linked products, GMXB, participating products, etc).

The recursive formula reads (See the article “Primer: The Retrospective Actuarial Reserve Formula”):

V(t)=V(t?1)?(1+i)+P(t)?B(t)?E(t)

Or, graphically,

The key difference between various types of market-sensitivity insurance products are mainly on

1. How the item i(t), i.e. the interest rate % or investment return % to be credited to V(t) (the account value or asset share) is determined;
2. Whether the actual benefits B(t) and expense E(t) are deducted from V(t) , or instead a pre-defined cost of insurance charge and expense charges are deducted from V(t); in the later case, also on whether the company has a discretionary (subject to certain caps) to adjust the charges; and
3. Whether there is any guarantee on either the value of V(t), or the minimum amount that can be drawn from V(t) upon withdraws, surrender, maturity or death, regardless of the actual investment performance.

(See “#2 From the Recursive Formula to Life and Saving Product Design”)

(B) IUL Product Design - Fixed Account Portion

Now, back to our case study that focus on IUL, and let’s use the typical designs used in Singapore and Bermuda lifers as an example. The product can be seen as a traditional Universal Life product, plus an annual choice to replace the interest rate credited by a call option on pre-defined market indices.

The Universal Life portion is normally known as the “fixed account”. The insurer invest the premium received into mainly fixed income assets (potentially plus some total return assets) which, after adjusting for the gain/losses, deducting pre-defined interest rate margin, additional smoothing, and other adjustment due to business or policyholder reasonable expectations (“PRE”) considerations, will be credited to the account value (i.e. the item i(t) that is credited to V(t)).

Note that as due to the above adjustments, the realized and unrealized gain/losses are in general not crediting to the account value immediately, but only gradually reflected in the future crediting interest rate (if the policyholders stay). Over time due to such pending-to-credit gain/losses, the nominal account value (as seen by the policyholder) can differ significantly from the shadow account value (the market value of the underlying assets, which for simplicity may also be referred as asset share).

The ALM challenges of this fixed account are same as that of a Universal Life product. It will depend on certain detailed features, for example,

• Versus unit-linked or participating products, there is a lack of either Market Value Adjustment ("MVA") or Adjustable Terminal Dividends to ensure a more equitable share of the realized and unrealized gain/losses between the leaving and staying policyholders.?Such creates the "Disintermediation Risk" in which the not-yet-credited losses are implicitly forgone, and will be absorbed by the staying policyholders and/or the company.
• (For some versions) In case there a high initial guaranteed cash value or equivalently a low surrender charges (e.g. to enable premium financing), the resulted disintermediation risks will be more material. Note that there is a significant difference between disintermediation risk and liquidity risk. The disintermediation risk is due to the loss forgone, which takes place even if the company has sufficient spare liquidity to pay the surrender charge, and it is not dependent whether the loss are realized or not.

Note that there is a significant difference between disintermediation risk and liquidity risk. The disintermediation risk is due to the loss forgone, which takes place even if the company has sufficient spare liquidity to pay the surrender charge, and it is not dependent whether the loss are realized or not.

• (For some versions) Minimum crediting interest rate guarantee, either in the initial period, or a lifetime guarantee. (This is the type 1(b) guarantee that is mentioned in the article “Similarities between Option-based (e.g. GMXB) and Participating Products”)
• (For some versions) A no lapse guarantee which guarantee that as long as the policyholder pays a certain required premium and without any withdrawals, the policy will stay inforce (i.e. providing death protection) even the account value turns zero or negative.

(C) IUL Product Design - Index Account Portion

The additional feature of the Indexed Universal Life is the “index account”. At the beginning of each policy anniversary, the policyholder can choose instead of receiving the interest income in the fixed account, they will receive an interest that is linked to the positive performance of certain market index under a pre-defined period, which is usually a one-year period after the policyholder electing to allocate into such index account.

There are a few details which we will discuss later, which include:

• Type of indices – Whether it is a single asset class (e.g. SP 500) or a multi-asset index. And in case of multi-asset index, what is the rule to determine the weight of each asset class at any point of time.
• Number of indices – it is relatively easy to support multiple indices and allow the policyholder to allocate between the fixed income and different index accounts in the beginning of each policy anniversary.
• Determination of the Participating Rate – i.e. the notional of the index exposure as % of the notional amount of the index account. This is in turn determined by the available budget to “buy” the index exposure, and the prevailing cost of the instrument to get the index exposure.
• Other features like caps, Asian options, volatility control, excess return etc to help cheapen or stabilize the cost of the instrument.
• Moreover, on top of the interest to be credited after one-year, the company also need to determine the early termination crediting rule, in case the policy is terminated by death or surrender in the middle of the policy year.

Regardless of the variation, it is important to note that in general the interest credited to the index account is floored by zero regardless of the actual index performance. Therefore, the most natural instrument to achieve such index upside is to long (buy) call options (or call spreads if there is a cap in the index account crediting interest rate).

If the company use call option (or call spread) to achieve such payoff, there is no explicit hedge cost and the guarantee (payoff floored by zero) is implicitly embedded in the call option. In this case instead of referring as a “hedging cost”, it is more correct to refer to amount spend to enter into an option as the “call option budget”.

Alternatively, due to put-call party, the company can instead of entering into a (ATM) call option, to enter into a future/forward on the index, and protect the downside by buying a (ATM) put option. In this case, there is an explicit “hedging cost” which is the (time decay) of the put option premium.

This type of guarantee falls under type 1(a) in the article “Similarities between Option-based (e.g. GMXB) and Participating Products”. And counter-intuitively, it is the easiest type of guaranteed to be managed from an ALM perspective.

(D) IUL vs Unit-Linked Product with Princpal-Protected Funds

Finally, please note that there is a difference between (a) an IUL from (b) a unit-linked product that consists of a fixed income fund (proxy of the fixed account) and a few funds that invest into principal protected index-linked notes (bond plus call options).

• In the IUL design, the “switch” between the fixed account and the index account is related to the interest portion only – i.e. whether the interest earned are used to credit the account value, or to buy the call options. The principal amount is always invested into bonds (and in the same bond portfolio) regardless of the split between the fixed account and indexed account.
• Yet if we use a unit-linked product to proxy an IUL, each time we switch from fixed account into the index accounts, we need to sell units of the money market fund and invest into units of the funds that invest into the structure notes.
• Another minor difference is who are providing the guarantee. In the case of an IUL, the guarantee is provided by the insurer, as supported by its available capital and hedging strategy. In the case of a unit-linked product investing into principal-protected index-linked notes, the guarantee is provided by the issuer of those notes.
• Finally, as already discussed above, some of the gain/losses are not immediately reflected in the Account Value of the fixed account of an IUL, while for the case of an Unit-Linked product, the Account Value is generally based on the market value (net asset value) of the underlying funds.

(E) Advantage of Indexed Universal Life in terms of Policyholder Communication

In terms of policyholder communication, there is a clear advantage of the IUL which is reasonably transparent, but not “too” transparent:

For the fixed account,

• The amount of interest credited in the fixed account is clearly updated to the policyholders from time to time. And that the policyholder can verify the (nominal) account values using the crediting interest rate and charges communicated.
• However, the insurer does not need to disclose the actual investment returns of the underlying investment portfolio. This avoids the issue that an unrealized loss upon rising risk-free rate be incorrectly perceived as a poor investment performance, which may result in panic surrender that is against the interest of the policyholders. (See similar discussion in the article “Why not Making Everything Transparent?”)

The index account adds another layer of transparency

• While the policyholder may not able to understand the drives of discretionary elements like the participating rates, caps, etc,
• Once these parameters are set, the amount of interest to be credits in that year will be mechanically following the index performance.
• Moreover, the index values are generally computed by a 3rd party index providers based on objective rules, and published regularly in different public sources.

We end the discussion of the IUL product features here. In the next 2 articles, we will discuss the ALM considerations and the investment & hedging strategies of the Fixed (which is same as a traditional universal life) and the Index Account, respectively.