Protection and savings products
Life insurance products meet different needs. This page looks at the benefits provided by protection and savings contracts, why a policyholder might buy them, and the risks they create for the insurer.
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Protection, savings and income
Life insurance may fall into one or more of the following three categories:
Protection - Provide the policyholder or their dependents with a benefit in the event of a specific circumstance (e.g. death, critical illness, or unemployment).
Savings - Allow the policyholder to save for the future (e.g. for retirement or to repay a loan).
Income - Allow the policyholder to take a lump sum and use it to produce an income.
At a high level, an insurer will want products to meet the needs of their chosen market for the product, whilst also achieving an acceptable return on the product for the risks they are taking on in respect of it.
Term assurance
A term assurance policy pays a benefit upon death of the insured life, provided that this occurs within the term of the contract.
The term of the contract is chosen at outset. Typically, no benefit is payable on surrender or upon expiry of the contract if the life is still alive.
What the product is used for
Term assurance policies can provide protection against financial loss for dependents in the event of the insured's death at a lower cost than under an endowment or whole of life insurance contract with the same level of benefit.
Decreasing term assurance policies may be used to meet various policyholder needs, such as the following:
Repaying the balance outstanding under a repayment loan in the event of the insured's death.
Providing an income for a family with children until such a time that the children become financially self-sufficient.
Covering a potential inheritance tax liability on money gifted, where the amount at risk reduces over time.
Where the policyholder is a corporate body (rather than an individual) term assurance contracts can be used to protect against the financial loss that might arise on the death of a key person within the organisation. The losses covered by such a contract might be those associated with the loss of important contracts, delays to a major project, and the cost of recruiting a suitable replacement.
Variations
Term assurance may be offered with critical illness cover, whereby the sum assured would be paid upon the insured being diagnosed with one of a predefined range of critical illnesses, but is still alive. Term assurances may also be convertible, meaning that the life insured has the option to convert the policy into an endowment or whole of life assurance before the end of its term, or to roll on as another term assurance policy, without any further underwriting being carried out.
Term assurance may be sold as a flexible unit-linked policy with a small savings element and it may be possible for the insured life to increase the savings element or add additional risk coverages during the term of the policy.
Group life term assurance policies also exist, which employers can use to provide life insurance benefits to employees whilst they are in employment. The benefits provided to employees by these contracts will be similar to those provided under individual term assurance policies, but with the following exceptions:
The benefit amount will often be expressed as a multiple of the insured's salary.
The insurer will often specify a free cover limit (which will vary from scheme to scheme) beyond which benefits for an individual will be subject to medical underwriting.
The premium payable will often be calculated by applying a unit rate based on the average age of the lives insured and the average sum assured under the scheme. These unit rates will be reviewed periodically (e.g. every year or every three years).
The policyholder’s perspective
Term assurance is attractive to policyholders because it provides life insurance protection at a usually affordable cost (relative to endowments and whole of life assurances).
In its convertible or flexible form, term assurance combines the attractions of low-cost death cover with the certainty of being able to either convert the policy into a permanent form of contract when it can be afforded or renew the term of the original contract, both without health evidence being provided unless the benefit level is increased.
The insurer’s perspective
The main risk to the insurer is mortality. Significant anti-selection risk will be present, which is mitigated through underwriting, and a mortality risk may arise through selective withdrawals.
The insurer will also be exposed to a financial risk from withdrawals at times when the policy reserve is negative.
This risk may be particularly significant for decreasing term assurance policies, since the level premiums charged in later years may be considerably greater than the cost of future benefits. To mitigate this, the premium paying term of the policy may be limited to be less than the full policy term.
The insurer will also be exposed to expense risks, since the actual marginal costs of administering a contract need to be met within premiums' expense loadings.
This risk can be substantial, particularly for long-term policies.
Income protection insurance
Income protection insurance provides the insured with regular benefit payments during periods of incapacity. The benefit is thus in the form of a temporary annuity payable until the insured recovers, dies, or the annuity term ends (whichever comes first).
The aim of income protection is to replace part of the income the insured would lose if they became unable to work due to accident, mental health condition, or illness.
The insured event is therefore incapacity (i.e. the inability to work) of the insured due to illness or accident.
Policy terms and benefits
The policy document needs to clearly specify the circumstances under which the benefit will become payable and the circumstances under which it will cease. For example, unemployment, redundancy, early retirement, and reluctance to return to work should not be covered by income protection insurance. Similarly, policies may not cover all types of illness or injury (e.g. attempted suicide).
It is common for a person to be unable to work for a period of time, recover, and then later become unable to work again. As such, income protection insurance is often written as a long-term policy under which a number of separate periods of benefit payment can occur without the policy ceasing. Policies are written for either a fixed term or to an expiry age (which will often be the expected age of retirement).
Policies written on a long-term basis may be quite expensive. As such, shorter-term contracts (e.g. with benefits payable for a maximum two to five years in the event of incapacity) can be an alternative which enable the policyholder to obtain protection at a more affordable price whilst also giving them cover for a period during which they may recuperate or adjust their lifestyle.
The insurer will generally not pay a benefit during the first weeks of sickness (known as the deferred period). This is because most employers will pay sickness benefits for short-term sickness. The deferred period also makes premiums lower.
Some income protection policies may provide a rehabilitation or proportional benefit to policyholders who return to work on a part-time basis or in a less strenuous (and less well-paid) role. This benefits both the insurer (since return to work is encouraged) and the policyholder (whose path to a full recovery is hastened).
Premiums and group cover
Policy premiums are often paid regularly and are level throughout the policy term. Inflation-linked premiums are also common, in which case both premiums and benefits will increase at the same rate. The rate of increase will be based on a specified index and may be subject to caps and/or floors. Premium rates may be reviewable at the insurer's discretion (e.g. in light of actual claims experience across the whole portfolio of business). In many cases, premiums may be guaranteed for a predetermined period of time (e.g. the first five years of the policy) and reviewable thereafter.
Income protection insurance is typically written on a without-profits basis, with no benefit being paid if a sickness claim is not made. Benefits may be level or escalating (both in and out of claim) with increases being of a fixed pre-specified amount or based on a pre-specified index.
Income protection insurance exists in both individual and group form, with the latter being bought by employers to provide benefits to their employees. Group income protection scheme benefits are usually expressed as a proportion of salary gross of tax and may also include pension contributions. Employers who offer employees an ill-health retirement pension may still wish to offer an income protection scheme since the former will only provide employees with an income for permanent disability, whereas the latter will offer an income for temporary incapacity. Employers may also use group income protection schemes to cover some of the risk of having to pay employees sick pay.
The policyholder’s perspective
The main needs that an income protection policy meets for policyholders are the following:
Providing a replacement income when the policyholder is unable to continue in their own (or possibly any) occupation and cannot earn an income. This need is particularly important when the individual has dependents. In the short-term after the onset of an illness, the individual's employer may retain responsibility for the employee's continuing income for a defined period of time (e.g. six months). Thereafter, the individual will be dependent on state welfare benefits, personal financial resources, and insurance. Employers may arrange income protection on behalf of their employees, or it may be down to the individual worker (particularly if they are self-employed) to purchase the insurance.
Providing an income stream designed to match the policyholder's monthly loan servicing costs. The service of loans (particularly a mortgage on one's own house) can prove a major outgo from an individual's disposable income.
In the UK, many lenders are keen to ensure that mortgage payment protection (also known as 'waiver of mortgage') insurance is in place when the loan agreement is being negotiated. These policies aim to safeguard the loan against the borrower’s inability to work due to illness, disability, or other defined criteria. The benefit under these policies will be structured to cover both the interest on the loan and the vehicle used to cover repayment of the capital. A rider to the policy may also cover the risk of unemployment. Care should be taken to ensure that the product is appropriate for customer needs and circumstances, including both health and employment situation.
It may be the responsibility of the individual or the lender to arrange this cover. In either case, the premiums will be payable by the borrower and the benefits will be assigned to the lender. The benefit level may need to be restructured in the light of fluctuating interest rates.
Policyholders of income protection policies may also require a regular income on incapacity to cover premiums they are paying for other types of insurance policy (e.g. endowment assurance or individual pension arrangements). The cost of such policies is typically small, reflecting the small size of the premium and the limited anti-selection. This cover may be provided as an automatic rider benefit on an income protection policy and is rare to take out on a stand-alone basis (except, perhaps, to cover substantial pension premium contributions).
Small professional partnerships (e.g. doctors, dentists, vets, etc) are often dependent on each partner's support to provide full services to their clients. As such, the disability of one partner could seriously impact the fee stream from the partnership and provide a risk of client loss. Partners of such businesses may therefore purchase a form of income protection insurance on each other. This is known as Locum Protection insurance. The benefit of Locum Protection insurance provides for the salary and other employment costs of a temporary replacement professional so that the business can continue to provide their services in full. A short deferred period would be applicable to Locum Protection insurance.
In summary, there are three groups who perceive the greatest need for income protection insurance:
Employers, who are keen to pass on the financial responsibility for sick employees to an insurer after a limited period of time (group income protection insurance).
Self-employed persons, who do not have the comfort of an employer sponsored income protection scheme and must purchase individual income protection insurance.
Individuals who do not have provision through their employer.
The insurer’s perspective
Income protection products are complex, particularly in relation to:
the measurement of morbidity risk;
difficulties in relation to admin systems (which must be equipped to deal with the complexity of the product's design);
issues relating to underwriting and claims management (which are more complex for income protection than for other products).
the inappropriateness of standard published tables of morbidity without adjustment (due to these not being reflective of the actual risks written by insurers and due to them being out-of-date).
The risk to the insurer is the risk that actual benefits paid are higher than expected. This may be due to higher than expected inception rates and/or lower than expected recovery rates.
Claim costs in relation to income protection policies will be affected by the following issues:
Benefit limits must be imposed to give policyholders an incentive to return to work. This is usually done through use of the ratio of post-claim income to pre-claim income (both net of tax and after allowing for any state benefits), which is known as the replacement ratio. The replacement ratio is an important indicator of likely claim experience (the lower the ratio, the greater the incentive to return to work and thus the better morbidity experience is likely to be).
There is complexity in underwriting income protection policies. Certain occupations may be difficult to cover, due to high potential disability risk. Some individuals may have difficulty in obtaining income protection due to their own (or family) medical history.
There may be various circumstances under which claims will not be paid. Exclusions for cover may include claims arising from alcohol and drug abuse, self-inflicted injury and attempted suicide, war and civil unrest, or failure to follow appropriate medical advice. Claims may also not be payable whilst the claimant is outside of an agreed geographical location. It is important that policy conditions are unambiguous to avoid the risk that they are interpreted by the courts or regulatory supervisor in favour of the claimant where disagreements arise in relation to claims entitlement.
It is difficult to find objective criteria to determine eligibility under the definition of 'incapacity'. Defining incapacity based on the failure of activities of daily living may be an objective approach, but if it is based on the failure of activities required to continue one's own occupation then this may be more difficult to assess.
Early intervention programs may be set out by insurers to encourage early notification of potential future incapacity. In some cases, this may enable the problem to be treated to avoid it becoming a claim. This may lead to lower inception experience and lower treatment costs payable by the insurer.
The cost of guaranteed premium rates must be funded. An insurer's claims experience will be subject to influences completely outside of their control (e.g. economic and social influences such as unemployment trends). Even if experience is proceeding as expected, guarantees will be expensive due to the reserves required to be held against the risk of experience deteriorating in the future. Due to greater claims uncertainty associated with health insurance products, guarantee loadings appropriate to income protection policies are likely to be significantly greater than guarantee loadings for a mortality product.
Where premiums are reviewable, the insurer has the comfort of knowing that premiums may be adjusted in light of emerging experience. However, the extent to which premiums may be adjusted is likely to be limited due to the risk of selective withdrawals in the event of premium increases. Capping increases to reviewable premiums at new business rates should reduce the issues relating to persistency arising from premium increases (since policyholders would be unable to obtain cover elsewhere at a lower cost).
Insurers' control mechanisms, particularly applicant underwriting/acceptance and the appropriateness of premiums charged, will be very important for income protection products. This necessitates splitting applicants by risk factor (e.g. occupation, area of residence, age, etc) and requesting sufficient information prior to acceptance to properly assess the risk posed. Appropriate information must also be requested to substantiate any claims arising. This information should be checked for consistency with the information provided during the policy application process. The level of benefit payable at the time of a claim being made should also be checked against the applicant's current salary to ensure that they retain an incentive to return to work.
Procedures for monitoring an ongoing claim will then be put in place. These may include periodic visits to the policyholder and continuing medical certification, the frequency of which will depend on the severity of the condition. At present, such monitoring processes focus increasingly on the rehabilitation of the claimant and, where appropriate, are conducted by specialist nurses.
The free cover limit (also known as the non-selection limit) is the amount of cover an individual may be automatically granted without underwriting.
The aim of free cover limits is to enable most lives in a group income protection scheme (other than the very highly paid) to be accepted for cover without underwriting, provided the following conditions are met:
The scheme is greater than a specified size.
The scheme has compulsory membership.
The members satisfy an 'actively at work' requirement.
Due to issues relating to statistical credibility and anti-selection, free cover levels will be lower for smaller schemes.
Critical illness insurance
Critical illness insurance pays a lump sum benefit to the policyholder if they are diagnosed with one of the defined conditions. Some common conditions (e.g. cancer, heart attack, stroke, etc) may legally be required to be covered by the policies in some jurisdictions. Critical illness policies may be simplified to cover a smaller number of conditions to make the policies cheaper whilst still covering the most likely critical illnesses. The policy may offer the option for the lump sum to be paid in instalments with any outstanding amount payable on death.
The benefit under a critical illness policy may be payable upon one of the following occurring:
Upon the happening of some event, independent of its extent (e.g. a heart attack or stroke, where specific medical evidence could be used to check that the event had occurred).
On reaching a defined degree of impairment (e.g. losing the ability to walk unaided or losing the ability to speak).
Upon undergoing a surgical procedure (e.g. having a major organ transplant or a heart bypass operation).
Benefit structure and additional cover
The benefits paid under a critical illness policy may take the following forms:
In some cases, partial benefit payments may be made for certain conditions or for lower levels of impairment, whilst the remaining cover stays in place.
An accelerated critical illness benefit brings forward all or part of a death benefit, whereas a stand-alone critical illness benefit is payable independently of any life cover.
Critical illness insurance may be sold on a reviewable or guaranteed premium basis.
Unlike income protection insurance, critical illness insurance is not designed to indemnify the policyholder. As such, the insurer must be on guard against non-disclosure and anti-selection through their underwriting and claims processes.
In some jurisdictions, critical illness insurance has been sold to impaired lives. Such products are designed to incentivise the customer to get treatment for their condition to get better premium rates.
Additional covers on critical illness products could include the following:
Terminal illness cover. This cover is not based on the diagnosis of a specific disease but rather the severity of the condition and its effect on life expectancy (e.g. any condition which is expected to result in the person's death within a 12 month period). This may be an attractive rider benefit to a critical illness policy since, without it, a policyholder could suffer a severe illness which reduces their life expectancy significantly without qualifying for the critical illness benefit.
Terminal illness cover fits more naturally into an accelerated critical illness policy than a stand-alone one, since terminal illness cover will effectively just bring forward the payment of the death benefit (making the cost of the extra cover small).
Children's benefit. This cover pays a benefit upon diagnosis to each child covered (usually up to the age of 18) as well as the policyholder. This cover would cease only upon the policyholder making a claim.
Total and permanent disability. The permanence of the disability upon which a claim is payable under this type of cover distinguishes it from income protection cover (which also pays out on temporary major disability).
The insurer’s perspective
Critical illness insurance is a theoretically simple product, which is one factor making it attractive to consumers. The lump sum payout, which cannot subsequently be withdrawn, is attractive to consumers who are wary of insurers' promises to look after them. The claims trigger of diagnosis or undergoing a procedure is easy to explain, which is also attractive to many consumers.
Nonetheless, insurers will need to implement some controls to ensure fair play. Exclusions for some conditions and point-of-claim underwriting will still be necessary. Definitions of some conditions (e.g. heart attack) may differ between insurers within the same market, which complicates the issue of claims acceptance. Certain conditions may require evidence that the actual condition covered is more severe than the colloquial understanding of the headline condition (e.g. lay-person understanding of what constitutes a heart attack may not meet the insurer's threshold for a payout).
Conditions covered by a critical illness product tend to be those:
that are perceived by the public to be serious and to occur frequently;
that can be defined clearly, to avoid ambiguity at the point of a claim. Avoiding ambiguity in the definitions of critical illness conditions is not easy and is a particular problem where the benefit structure leads to the use of complex medical terminology.
for which sufficient data is available to price the benefit. This is generally difficult to achieve in practice, particularly when attempting to project future trends in the frequency and severity of such conditions.
A further condition that is sometimes added to the list of desirable features of a critical illness condition is the ability to avoid anti-selection. Examination of claims that arise early in a policy's term can identify a degree of anti-selection (particularly in relation to benefits paid for cancer diagnoses).
When critical illness insurance was launched in the UK, many insurers kept premiums reviewable due to the unknown nature of future risks. However, competition subsequently pushed some insurers into offering guarantees (on benefits and/or premiums) at little extra cost. The cost of such guarantees needs to be reflected in the premium differential charged.
The policyholder’s perspective
A variety of needs are met by a critical illness insurance policy, including the following:
Funding medical costs for illnesses which require expensive surgery, other treatment, or medical aids (e.g. specialist equipment installed in the individual's home).
Repaying a mortgage or other loan when the policyholder is diagnosed with a critical illness.
To provide an income (e.g. by converting the lump-sum benefit into an annuity) when the individual cannot work due to a critical illness.
Business partners may purchase critical illness cover on the lives of one-another such that the benefit will fund the buyout of a partner's stake in the partnership if they are diagnosed with a critical illness.
Covering recuperation or rehabilitation treatment after illness.
Funding a change in lifestyle which would improve the claimant's health (e.g. moving to a less stressful but lower paid job following a heart attack).
It is important to consider whether a critical illness policy is the best means of meeting the needs described above. In some cases, other types of insurance may be more focused on these needs and/or may be more comprehensive. Since the benefit is payable in cash, this gives the policyholder freedom to choose whether to use it to meet personal needs or convert it to produce an income (e.g. by purchasing an impaired life annuity).
The benefit paid by a critical illness policy can represent a windfall to the policyholder, since it may far outweigh the immediate medical costs or longer term detriment to quality of life associated with the critical illness. This means that the benefit is not directly related to policyholder needs, which may lead to issues of anti-selection and the principle of indemnity. Similarly, since the benefit is not directly related to policyholders' needs, the benefit payable may fall short of what is required for medical and other costs. This represents a key risk to the policyholder.
Critical illness cover can provide financial peace of mind, but it is not comprehensive in the diseases and medical procedures covered.
Group critical illness insurance may be seen as a valuable benefit by employees and may therefore be offered by employers as part of a benefits package designed to attract and retain staff. Critical illness insurance may be offered to employees for whom income protection insurance is not available (e.g. some blue-collar occupations) and is then of particular value when Total and Permanent Disability cover is included.
Endowment assurance
An endowment is a contract to pay a benefit on survival to a pre-specified date and thus serves as a savings vehicle. The contract may also pay a significant benefit on the death of the life insured, if this occurs prior to the maturity of the contract, to provide protection for dependents. This is known as an endowment assurance. A surrender value is typically payable on endowment policies.
Endowment assurances may be used for a specific purpose (e.g. to provide a lump sum on retirement, as a saving vehicle to help repay an interest-only mortgage at the end of its term, etc). Endowment assurances may be with-profits (conventional or accumulating) or unit-linked.
A range of variants of endowments exist around the world, including the following:
With-profits endowments.
Unit-linked endowments.
Low-cost endowments. These policies have a sum assured that is less than the target maturity value (e.g. the amount of the loan for which the endowment was taken out to repay). The product is designed to reach the target amount during the term of the policy (e.g. through the addition of bonuses) but there is no guarantee that the target will be met. Premiums are therefore lower than for a full endowment where the sum assured is equal to the target maturity value.
Mortgage endowments.
Traded endowments. These are policies where the beneficial ownership may be transferred from the policyholder to another party. The second party pays a premium to the original policyholder and also pays all subsequent premiums due under the policy. The second party then receives the benefits payable under the policy (either at maturity or on earlier death of the original life insured).
Modified endowments. These policies exist in the USA. These are policies where higher premiums have been paid than are allowed under USA life insurance tax legislation. The endowment therefore loses the special tax treatment given to life insurance contracts in that jurisdiction due to the overpayments and is thus converted into the modified version of an endowment which is classified differently (and less beneficially) for tax purposes.
Group endowments also exist to enable employers to provide benefits for employees upon retirement (and maybe also upon death in service).
The policyholder’s perspective
There are a number of potential consumer needs met by endowments, including the following:
The savings element can enable them to meet a need such as the repayment of a loan after a given term.
The protection element of the contract can protect a policyholder's dependents in the event of the policyholder's death.
The policyholder may be able to access a surrender value in the event that they have to surrender the policy prior to the full term.
A policyholder may purchase an endowment with the expectation that the maturity value would exceed the target sum required so that the excess benefit may be used for other purposes.
However, endowments are only attractive if the investment markets provide a sufficient return to achieve the target level of benefit. If investment returns are not adequate, the policyholder risks receiving a maturity value that is below their target sum, or having to increase their premiums or increase the policy term to keep the policy on-track to obtain the target maturity value. Even if the policy does have sufficient value to cover the target sum, there is the risk that the maturity value of the policy is nonetheless lower than achieved by other companies' products or by policies linked to better performing funds.
There is also the risk that the value payable on surrender does not represent good value to the policyholder (particularly in early years of the contract).
Overall, there is the risk that the policyholder does not fully understand the nature of the policy they have purchased and its investment risk.
The insurer’s perspective
Due to the savings nature of endowment contracts, they expose the insurer to greater investment risk than for, for example, term assurance policies. The extent of this investment risk depends on the level of investment guarantees provided to policyholders (i.e. whether the policy is unit-linked, without-profits, or with-profits).
The nature of the death benefit provided under the policy will determine the level and nature of any mortality risk associated with the policy. The following are possible approaches to the death benefit:
A significant death benefit. For example, a without-profits contract where the death benefit is equal to the maturity benefit. There will be significant mortality risk at early policy durations, but this will decrease as the policy duration in force increases. Anti-selection risk may also be present in respect of this mortality risk. The extent of this anti-selection risk will depend on the extent of the actual, or perceived, choice the policyholder had in effecting the contract.
The return of premiums or 'fund'. The mortality risk in this case is likely to be insignificant, except near the start of the contract.
No death benefit (i.e. a pure endowment contract). Here there will be only a longevity risk, the significance of which will increase with policies' duration in force.
There will also be an expense risk associated with these contracts, since the actual marginal costs associated with it need to be met. At times when the asset share of the policy is negative, there is a financial risk from withdrawal. At other times, whether such a risk exists depends on how any withdrawal benefit payable compares to the asset share. The group version of these contracts present no additional risks and any anti-selection is likely to be much reduced (particularly if it is compulsory for all eligible members to join the group contract). The capital requirements for these contracts will be similar to those for a whole life assurance.
It is important for the insurer to correctly set out policyholder expectations regarding the policy at the time it is taken out. If policyholder expectations are not appropriately set, the insurer risks being accused of mis-selling the contract.
Universal life
Universal life insurance is primarily sold in North America. It combines a term assurance element with a cash account earning tax-deferred interest.
This is similar to a whole of life assurance product, but allowing the policyholder to use the interest from savings accumulated within the policy to help pay premiums over the policy's term. Policyholders can therefore choose to pay more than the cost of the insurance to build up the cash value of the policy, or to pay just enough to cover the cost of the insurance. These policies give policyholders flexibility to vary their premiums and benefit levels (subject to underwriting for benefit increases).
The policyholder pays a premium which covers the cost of their death benefit under the term assurance element, with any excess being used to build up a cash value for the policy. The cash value of the policy is credited with interest each month. The interest rate is determined by the insurer, but may be subject to a contractual minimum. The cost of insurance (and any other contractual charges) may then be deducted from the cash value of the policy.
If the monthly premium payment plus interest on the policy's cash value is less than the charges for the policy then the policy's cash value will fall. If the policy cash value is insufficient to cover the cost of insurance and charges then the policy will lapse.
If the policyholder surrenders their policy then they will receive the value of their cash account.
Universal life insurance is similar to whole of life assurance, but with the following differences:
The cost of the insurance element is reviewable annually.
Administrative expenses and insurance costs are transparent to the policyholder (unlike the assumptions used to calculate premiums for whole of life assurance).
The key advantages of universal life insurance are its premium flexibility (subject to any minimum/maximum amounts) and adjustable death benefits (subject to underwriting for increases).
Universal life policies may also offer policyholders the option to take out a loan on the cash value of the policy. These loans require interest payments to be made to the insurer (since the insurer foregoes any investment benefit on the money it loans to the policyholder).
The policyholder’s perspective
In addition to providing benefits for their beneficiaries in the event of their death, there are various other reasons why individuals may purchase universal life insurance, such as the following:
To access loans offered through the product.
As a vehicle from which money may be withdrawn.
To fund a pension.
For tax planning.
Due to the complexity of universal life products, there is the risk that the policyholder does not fully understand the nature of the policy they have purchased. This can be an issue later in the policy term if the product does not perform in the way the policyholder expected. For example, if the actual rate of interest paid on the cash account is less than expected then they may have to increase their premiums to maintain the policy, or lapse the policy.
Policyholders also need to consider the long-term effect of varying their premiums. To remain active, a policy must have sufficient available cash value to cover the cost of the insurance. The policyholder may be required to make higher than expected payments if they have previously skipped payments or paid less than originally planned in early years of the contract.
Policyholders may also be unaware that, in some cases, the guarantees within a universal life policy may be tied to the policyholder continuing to pay premiums. If the premium is not paid on time, the guarantee may be lost and cannot be reinstated.
Some policies may offer a 'no lapse' guarantee, where a policyholder's coverage remains in force provided that they paid the required premium in a timely manner, even if there is not sufficient cash value in the policy to cover the mortality costs. This guarantee may be lost if the premium payment is not made as agreed, even if the coverage itself is still in force. In some cases, this guarantee may not be reinstated once lost.
The insurer’s perspective
Universal life insurance policies were developed in the 1980s in response to competitive pressures within the market for traditional whole of life assurance policies. Since then, insurers have continued to make changes to the basic universal life product to keep the product attractive to consumers. However, additional features which make the products more attractive to consumers also create additional complexity for the insurer (e.g. complexity of administering the contract).
Decreases in interest rates can put pressure on existing universal life contracts. Policyholders may need to increase their premiums, accept that their policies will eventually lapse, or surrender their policies to access whatever cash value is left. This makes clear communication about adverse changes particularly important.
Investment bonds
Investment bonds are similar to unit-linked and index-linked products, but are paid for with a single up-front premium.
A variety of specialist single-premium investment bonds have been developed over time. Two broad types of investment bond include guaranteed equity bonds and high income bonds.
Both of these types of investment bond offer benefits that are linked to equity markets, but they also offer significant guarantees. To offer upside equity returns and downside protection, derivatives are used to back benefits.
Types of investment bond
Guaranteed equity bonds
A guaranteed equity bond is a single premium contract with a fixed term.
At maturity, the benefit payable is the higher of the value of an equity link (e.g. an investment index or a basket of such indices) and a guaranteed minimum amount. Where the equity link is to a basket of indices, the policy value may be based on an average of these indices or, in some cases, the maximum of the indices. The appropriate investment index to which an investment bond may be linked would usually be one based in the jurisdiction in which the bond is sold (e.g. the FTSE100 in the UK).
The value of the equity link at maturity would typically be some percentage of the single premium paid, increased in line with the growth of the index. The guaranteed amount is typically equal to a percentage of the single premium paid (which may be less or more than 100%). The closing value on which the index linked value of the contract is based is often averaged over the past 12 months of the period to reduce policyholder's exposure to a late market crash.
Guaranteed equity bonds usually pay a death benefit that is guaranteed to be no less than the amount of the single premium paid for the bond. Surrender values for investment bonds are generally not guaranteed. However, use of American-style put options could allow such guarantees to be offered.
These contracts would be backed by either of the following:
A zero-coupon bond and call options.
Shares in the linked index and put options.
The relative mix of shares or bonds relative to options would depend on the percentages used to calculate the maturity benefits of the contracts.
The primary reason why guaranteed equity bonds are only available as single premium contracts is the issue of obtaining appropriate derivatives to back the contracts. The terms an insurer may offer policyholders are crucially dependent on the price at which such derivatives may be obtained. For regular premium versions, the insurer would not know the future terms on which the required derivatives could be obtained and thus would not be able to calculate the appropriate terms to offer policyholders.
An insurer would face issues with estimating new business volumes, mortality, and withdrawals if attempting to enter into derivative contracts now to cover future regular premium variants of these contracts. This would make the product excessively risky to the insurer and thus too expensive to be marketable.
High income bonds
A high income bond is similar to an equity bond, but with the aim of providing a significantly higher income than can be obtained from a deposit account or fixed interest securities. These higher expected returns usually come at the expense of total security of the capital invested.
A common structure for high income bonds is the following:
A single premium.
A fixed term (typically five to six years).
Return of capital at the end of the contract term, provided that the reference index has not fallen by more than a specified percentage.
Return of capital minus income received over the term of the contract, if the index has fallen by more than the specified percentage.
However, structures may vary considerably. For example, multiple reference indices may be used with the requirement that none fall by more than the specified percentage for full return of capital.
A high income bond will typically consist of the following elements:
A temporary annuity, to provide the income during the policy's term.
A zero-coupon bond to provide a minimum capital guarantee (which is typically low relative to the initial premium paid).
Call options to provide exposure to equity price movements.
Precipice bonds
A precipice bond is a specific type of investment bond which provides a fixed level of income over a fixed investment period displaying the following characteristics:
The return of the policyholder's initial capital at the end of the investment period is determined using a pre-specified formula based on the performance of an equity index, a combination of indices, or a basket of selected stocks.
The policyholder is exposed to a range of outcomes in respect of the return of their initial capital:
If the equity index/indices perform within certain thresholds, the initial capital is repaid in full. Otherwise, the policyholder may lose a substantial portion (or all) of their initial capital.
Reductions in the amount of initial capital repaid may be geared (e.g. a 2% reduction in capital returned for every 1% fall in the reference index).
The above gives rise to the name 'precipice bond': If the equity index falls past a certain point, a steep fall in the capital returned will be seen.
Depending on the nature of the capital guarantees offered, high income bonds may fall into the category of precipice bonds.
The policyholder’s perspective
Policyholders are attracted to investment bonds by the guarantees offered and the potential for capital gain or relatively high income.
However, the risk of the insurer defaulting or of capital losses on withdrawal may not be fully understood by policyholders.
The insurer’s perspective
Insurers have devised this type of product to attract a profitable share of the investment market by offering valuable guarantees and/or high income.
To the extent that expense and mortality (and possibly withdrawal) guarantees are offered, the insurer will face sources of risk. The insurer keeps all dividends from the equities it holds to compensate them for any guarantees and gearing of returns. Expenses may be covered (at least in part) by any income earned from the investment in the index. However, if this income proves to be less than anticipated, an expense loss may be incurred by the insurer.
The primary risk associated with this product, however, is the counterparty risk associated with the derivatives used. Due to the term of these contracts and their specific features (e.g. averaging returns over the last 12 months of the contract), over-the-counter derivatives are typically used rather than exchange-traded ones. Depending on the collateralisation of these over-the-counter derivatives, they may be exposed to greater counterparty risk than exchange-traded derivatives.
The terms offered on these contracts will be dependent on the economic conditions at the point the contract is sold. In particular, the cost of any minimum return guarantee will be higher when interest rates are low. For guaranteed equity bonds, the investment income earned from the reference index will be lower in a low-interest environment. For high income bonds, the cost of the annuity providing the guaranteed income will be higher in a low-interest environment. For both types of bond, the price of the asset used to back the maturity guarantee (e.g. the zero-coupon bond) will be higher in a low-interest environment.
There may be a marketing risk associated with these contracts, since consumers may not always understand fully the risks associated with them. This risk will exist no matter how well the risks are described in marketing materials. This risk will often arise during the sales process due to salespeople recommending the product to an investor for whom it is not suitable.