Life Insurance Research Report

May 10, 2021 | Author:Bullseye Financial |Tagged:

Section 1 – Introduction

Just like any insurance products one may have, with a life insurance product, the policyholder pays a premium to the insurer who provides the insured with an agreed level of cover upon his/her death. The agreed sum assured will be paid to either the named beneficiaries or the policyholder’s estate. In the UK, there are different types of life insurance policies summarised as follows:

  • Term life insurance plan
    • Level term insurance plan
    • Increasing term insurance plan
    • Family income benefit plan
  • Permanent life insurance plan
    • Whole life insurance plan
    • Universal life insurance plan
  • Endowment life insurance plan

Term life insurance plan is the simplest form of insurance policy and offers the insured a set number of years’ coverage. This type of insurance plan requires a regular premium payment and pays out a fixed lump sum upon the insured’s death. Once the term expires, the policyholder can either renew it for another term, convert the policy to permanent coverage, or allow the policy to terminate. The primary types of term life insurance are level insurance, increasing term insurance plan and family income benefit plan.

The advantages of term life insurance plan are 1) the beneficiaries can receive a specific lump sum (death benefit), providing certainty and assurance to the beneficiaries when the insured is no longer around, and 2) compared to permanent life insurance plan, term life insurance plan is less costly.

The disadvantages are 1) if the policyholder does not renew the contract when it expires, the insured will no longer be covered, and 2) the policy has no value other than the guaranteed death benefit and features no savings component as found in a permanent life insurance product.

Level term insurance plan is renewable term life insurance with coverage decreasing over the life of the policy at a predetermined rate. Mirroring the amortization schedule of a mortgage, the premiums are usually constant throughout the contract.  For an increasing term plan, the premiums are lower when the insured is younger and would increase as he/she gets older.

For a family income insurance plan, instead of providing a lump-sum in the event of death within the specified term of the policy, it would provide a regular, deemed required funding to the beneficiaries over the term of the policy on a tax-free basis. The payments, however, will only be made from the time of the claim to the end of the plan. For example, if the original term of the plan was 30 years and a claim on death was made in year 20, only 10 years of payments would be made.

The advantages of this insurance plan are 1) some beneficiaries would rather receive a regular income than have to worry about investing a large lump-sum, and 2) family income insurance plan is usually cheaper than term insurance plan. The main disadvantage, however, is that the payments only cover the remaining time of the plan from the time of the claim. Using the above example, if it were a standard term insurance plan, even the death claim was made in year 29, the total lump sum will be paid to the beneficiary.

Permanent life insurance plan is an umbrella term of life insurance policies that do not expire. This type of insurance plan combines a death benefit with a savings portion. It also enjoys favourable tax treatment. Unlike term life insurance, permanent life insurance lasts the lifetime of the insured, unless non-payment of premiums causes the policy to lapse.

Permanent life insurance plan allows cash accumulation. The policyholder can access the cash while alive, by borrowing against that cash value or in some instances, withdrawing cash from it outright to help meet needs such as paying for a children’s college education or covering medical expenses. There is often a waiting period after the purchase of a permanent life policy during which borrowing against the savings portion is not permitted. This allows sufficient cash to accumulate in the fund.

The two primary types of permanent life insurance are whole life and universal life. Whole life insurance offers coverage for the full lifetime of the insured and guarantees payment of a death benefit to the beneficiaries. The policy includes a savings portion, called the “cash value” which can grow at a guaranteed rate (return expectation will be discussed in the next section). Interest may accumulate on a tax-deferred basis. The policyholder can remit payments more than the scheduled premium to grow the cash value more quickly. In addition, dividends can be reinvested into the cash value to earn interest. Universal life insurance also offers a savings element in addition to a death benefit, but it features different types of premium structures (i.e. policyholders can adjust their premiums and death benefits) and earns based on market performance. Compared to whole life, it requires lower premium.

Endowment life insurance plan is a specialised insurance product which is often dressed up as a life-time goal savings plan. It usually couples term life insurance with a savings program. The policyholder can choose the amount to save each month and the time for this policy to mature. Based on the monthly contributions, a certain payout is determined, called an “endowment” when the policy matures. The beneficiaries can use this endowment for their lifetime spending such as the down payment of a mortgage, children’s college tuition, and medical expenses. If the insured dies before the policy matures, the beneficiaries will receive the payout as the death benefit and will still have the anticipated cashflow to fulfil their life-time goals.

Section 2 – Return Objectives

Historically, a life insurance company’s return requirements have been specified primarily by the rates that actuaries use to determine policyholder reserves, i.e. accumulation rates for the funds held by the company for future disbursement. In effect, the rate either continues as initially specified for the life of the contract or may change to reflect the company’s actual investment experience, according to the contract terms. Interest is then credited to the reserve account at the specified rate. This rate is thus defined as the minimum return requirement. If the insurer fails to earn the minimum return, its liabilities will increase by an accrual of interest that is greater than the increase in assets.

In the United States, with whole-life insurance policies, the minimum statutory accumulation rate for most life insurance contracts ranges between 3% and 5.5%. In a high interest rate environment (risk free rate of over 5%), the whole life insurance product can bring the policyholder a return of 8% to 10%. In the United Kingdom, the whole-life insurance policies show a similar return as those in the United States. However, as growing investor sophistication and competition in insurance markets led to higher credited rates, and as interest rates declined in recent years, the minimum statutory accumulation rates were reduced.

Based on ECB’s data on insurance corporations at the end of 2016, researchers found out that to meet the minimum return requirement, the portfolios of European insurers tend to adopt a more conservative return expectation by allocating more in bonds than equity. Research showed that their heavily weighted assets are corporate bonds (c. 45%) and investment fund shares (c. 25%). The remaining asset classes are shares and other equity (c. 9%), currencies and deposits (c. 8%), lending (7%) and other financial assets (7%). As the insurance portfolios prefer “guaranteed” returns and therefore sacrificed certain growth potential as we normally see in equities and other high-risk asset classes. This feature ensures higher certainty for a surplus in the policyholders’ reserves, however, limits the return to a “modest” return rather than an over 10% return.

The above also applies in the United States. The table below shows the portfolio yields of selected US life insurance companies between 1975 and 2010.

Industry Rate (%) Prudential (%) LincoIn National (%) AXA Equitable-NY (%)
1975 6.44% 6.47% 6.98% 6.22%
1985 9.87% 9.07% 8.49% 8.72%
1995 7.90% 7.47% 7.87% 6.88%
2000 7.40% 6.41% 6.93% 6.70%
2004 5.93% 5.55% 5.82% 6.23%
2010 5.37% 5.16% 5.48% 6.13%

Sources: Life Insurance Fact Book (2001); Best’s Insurance Reports (2005) Best’s Review (October, 2011).

Section 3 – Risk Objectives

Conservative fiduciary principles limit the risk tolerance of an insurance company portfolio. Confidence in an insurance company’s ability to pay benefits as they come due is a crucial element in the economy’s financial foundation. Therefore, insurance companies are sensitive to the risk of any significant chance of principal loss or any significant interruption of investment income.

Asset/liability risk considerations figure prominently in life insurers’ risk objectives, not only because of the need to fund insurance benefits but also because of the importance of interest-rate-sensitive liabilities.

The two aspects of interest rate risk are valuation concerns and reinvestment risk. They arise due to the mismatch between the duration of an insurance company’s assets and that of its liabilities (an easy example to understand the concept is to think about a bank. The bank’s liabilities include customers’ deposits which are usually short term and the bank’s assets include corporate loans and mortgages which are usually mid to long term). Other risk factors include credit risk and cash flow volatility risk.

Despite the above four risk-related considerations, competition has modified the traditional conservatism of life insurance companies, motivating them to accept and manage varying degrees of risk in pursuit of more competitive investment returns. Therefore, instead of a “low and guaranteed” return of around 5%, life insurance companies aim for a return between 8% and 10%.

 

By Dr.Wei Shi (CFA)