Asset/liability Management for Universal Life

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Asset/liability Management for Universal Life
Grant Paulsen Rimcon Inc. November 15, 2001
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(No Transcript)
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Step 1 Split the product in two
Reinsurance Premiums Benefits
Risk charges
Expenses
Insurance Fund
Expense charges
Surrender charges
Taxes
MER/spread
Net death benefit (face value)
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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

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Step 3 Match the insurance fund (the hard part)

• Reserve components of a typical UL policy
• Present value Duration
• Risk charges 6,488,404 10
• Net benefits (4,881,908) 21
• Ceded premiums (2,157,152) 20
• Ceded benefits 2,435,406 19
• Expense charges 693,615 10
• 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.

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If interest rates fall 1
Present value Risk charges 6,488,404
7,163,944 Net benefits (4,881,908)
(6,475,137) Net 1,606,496
688,807 A 1 rate decline removes 917,689 worth
of profitability from the line of business.
Reserves will increase by roughly this amount.

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The largest risk is in the risk (COI) charge vs.
net benefit cash flows
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(No Transcript)
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Combined COI Charge Death Benefit Cash Flows
Reinvestment is assumed at product pricing rate
ALM Problem How do we lock in the reinvestment
rate at time of issue
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Inter-segment Notes
3. Use the cash to buy long-dated assets that
better match the liability profile.

1. Sell this cash flow to annuities.
2. Sell the asset that the inter-segment note
replaces and transfer the cash from Annuities to
Universal Life
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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 gt 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

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Problem cash flow components

• Crediting rate margin
• depends on fund size gt 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

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Summary

• UL is far more complicated than most other
  insurance
• products interest rate risk is potentially
  huge.
• Cash flow dynamics are complex, and dont 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.