Analysis of life insurance policy surrender activity causes, impact, and suggestions for chubb life

FOREIGN TRADE UNIVERSITY FACULTY OF INTERNATIONAL ECONOMICS o0o MIDTERM REPORT analysis of life insurance policy surrender activity causes, impact, and suggestions for chubb life Course name Risk Mana. TABLE OF CONTENTS ABSTRACT 5 INTRODUCTION 5 DISCUSSION 7 Chapter 1. Theoretical basis 7 1.1. Life insurance 7 1.1.1 Definitions and meaning of Life Insurance 7 1.1.2 Overview of a Life Insurance contract 7 1.2. Life Insurance Policy Surrender 9 1.2.1 Definitions 9 1.2.2 Surrender benefits vs. surrender penalties 11 Chapter 2. Research problem status 12 2.1. Life Insurance Disintermediation 12 2.1.1. Policy Surrender 12 2.1.2. Policy Loan 13 2.1.3. Surrender Option Considerations 14 2.2. Factors influencing the surrender behavior of Life Insurance policyholders 14 2.2.1. Macroeconomic factors (External environment) 14 2.2.2. Household characteristics (Internal environment) 16 2.3. Impact of mass surrenders on the insurers liquidity 16 2.3.1. Estimation of the loss when a case of surrender occurs 16 2.3.2. Estimation of the total loss when mass surrenders occur 19 Chapter 3. Solutions to the research problem 22 3.1. Methods to prevent and handle mass surrenders for government policymakers 22 3.1.1. One potential course of action in such circumstances would be to suspend the payment of surrenders. 22 3.1.2. Policymakers need to ensure that macroeconomic stability is maintained. 22 3.2. Methods to prevent and handle mass surrenders for Chubb Lifes policymakers 23 3.2.1. Regulators should take caution when lowering surrender penalties. 23 3.2.2. The balance between surrender benefits and surrender penalties 23 3.2.3. A dynamic model: participating contracts 24 3.2.4. A system of liquidity management 25 CONCLUSION 28 REFERENCES 29

FOREIGN TRADE UNIVERSITY

FACULTY OF INTERNATIONAL ECONOMICS

o0o

MIDTERM REPORT

analysis of life insurance policy surrender activity: causes, impact, and suggestions for chubb life

Course name: Risk Management & Insurance Course code: TMAE308(GD1-HK1-2223).1 Group Number: 5

Instructor: Ph.D Hoang Thi Doan Trang

Hanoi, September 2022

2.2 Factors influencing the surrender behavior of Life Insurance policyholders 142.2.1 Macroeconomic factors (External environment) 142.2.2 Household characteristics (Internal environment) 162.3 Impact of mass surrenders on the insurer's liquidity 162.3.1 Estimation of the loss when a case of surrender occurs 162.3.2 Estimation of the total loss when mass surrenders occur 19

3.1 Methods to prevent and handle mass surrenders for government policymakers 223.1.1 One potential course of action in such circumstances would be to suspend the

3.1.2 Policymakers need to ensure that macroeconomic stability is maintained 223.2 Methods to prevent and handle mass surrenders for Chubb Life's policymakers 233.2.1 Regulators should take caution when lowering surrender penalties 23

3.2.3 A dynamic model: participating contracts 24

LIST OF TABLES

Table 1 Surrender cost of policyholder by year (Chubb Life’s policy)

Table 2 Insurer’s expenses for a case of surrender

Table 3 Total business (US$bn)

Table 4 General accounts (US$bn)

14192021

LIST OF FIGURES

Figures 1, 2 A sample of Premier Youth Universal Life insurance contract

Figure 3 Illustration of the total contract value of the participating contracts 1826

This report analyzes life insurance surrender activities to determine the factors influencingthe surrendering behaviors of policyholders, estimates the impact of mass surrenders onthe movement of the insurer’s cash flows, and finally, comes up with somerecommendations for life insurance policymakers in preventing and handling masssurrenders The factors mentioned in this research are divided into two main types:macroeconomic factors and household characteristics, which can also be consideredexternal and internal factors respectively We as the research team believe that thesignificant relationship between policy surrender and these factors strongly supportsinsurers' efforts to understand and actively manage disintermediation risk via insurancecontract features and investment policy It is also evident that surrender activity is one ofthe significant motivations for the innovation and replacement of insurance policies Later

on, the impact of mass surrenders on the financial liquidity of an insurance company will

be elaborated on in the case of Chubb Life Vietnam and the event of a mass surrender inKorea We will then take a look at the methods implemented by insurance companies inthe world, specifically in some developed countries, before drawing some next steps forgovernment policymakers and Chubb Life’s life insurance policymakers

[Keywords: life insurance, surrender, policy, Chubb Life]

INTRODUCTION

Purchasing a life insurance policy is one of the best ways to protect your family if somethingwere to happen to you It’s also an essential part of any healthy retirement plan However,sometimes people find themselves with life insurance policies they no longer want orneed, so they just simply surrender their policies when the need arises In 2020, surrenderbenefits and withdrawals accounted for the largest portion of the $747 billion at a total of

$323 billion Recognizing such reality, our group decided to choose the topic “Analysis

of Life Insurance Policy Surrender Activity: Causes, Impact and Suggestions for Chubb Life”

Chubb is the world’s largest publicly traded P&C insurance company and the leadingcommercial lines insurer in the U.S With operations in 54 countries and territories,Chubb provides commercial and personal property and casualty insurance, personalaccident and supplemental health insurance, reinsurance and life insurance to a diversegroup of clients Chubb has more than $200 billion in assets and reported $46.8 billion

of gross premiums

written in 2021 Chubb’s core operating insurance companies maintain financial strengthratings of AA from Standard & Poor’s and A++ from A.M Best.

Chubb Life is the international life insurance division of Chubb Chubb Life has been inVietnam since 2005 and launched its Fund Management Company (Chubb Life FundManagement Company Limited) in 2013 Chubb Life in Vietnam (Chubb Life InsuranceVietnam Company Limited) offers a range of life protection, health, savings, andinvestment-linked insurance solutions through its agents and its wide network of offices

As surrendering life insurance policies is gaining popularity around the world, Chubb Lifealso gets involved in this problem This essay will talk more specifically later on usingone of the most popular products of Chubb Life, Premier Youth Universal Life which isspecially designed for children, as an example

Through the process of researching and analyzing data, our group aspires to achieve threemain goals First and foremost, we want to cover the theoretical basis of life insurance andlife insurance policy surrender Secondly, we hope to analyze the mass life insurancesurrender activities, using Premier Youth Universal Life as a model contract In this part,

we will also point out factors that influence the surrender behavior of life insurancepolicyholders, both in the external and internal environment Finally, through ourfindings, we propose some options and solutions to prevent and handle mass surrendersnot only government policymakers but also Chubb Life’s policymakers

We would like to express our gratitude to Ms Hoang Thi Doan Trang for her assistanceduring our research and study We are bound to make mistakes in our final research due to

a lack of time and advanced knowledge, but we are eager to receive feedback from Mrs.Hoang Thi Doan Trang to improve our report

We send you our best wishes for future success!

Chapter 1 Theoretical basis

1.1 Life insurance

1.1.1 Definitions and meaning of Life Insurance

Life insurance (or life assurance) is a contract between an insurer and a policy owner A

life insurance policy guarantees the insurer pays a sum of money to named beneficiarieswhen the insured (often the policyholder) dies in exchange for the premiums paid by thepolicyholder during their lifetime

Depending on the contract, other events such as terminal illness or critical illness can alsotrigger payment The policyholder typically pays a premium, either regularly or as one lumpsum The benefits may include other expenses, such as funeral expenses

Life policies are legal contracts and the terms of each contract describe the limitations ofthe insured events Often, specific exclusions written into the contract limit the liability ofthe insurer; common examples include claims relating to suicide, fraud, war, riot, andcivil commotion Difficulties may arise where an event is not clearly defined, forexample, the insured knowingly incurred a risk by consenting to an experimental medicalprocedure or by taking medication resulting in injury or death

1.1.2 Overview of a Life Insurance contract

The beneficiary receives policy proceeds upon the insured person's death The ownerdesignates the beneficiary, but the beneficiary is not a party to the policy The owner canchange the beneficiary unless the policy has an irrevocable beneficiary designation If a

policy has an irrevocable beneficiary, any beneficiary changes, policy assignments, orcash value borrowing would require the agreement of the original beneficiary.

Contract terms

Special exclusions may apply, such as suicide clauses, whereby the policy becomes nulland void if the insured dies by suicide within a specified time (usually two years after thepurchase date; some states provide a statutory one-year suicide clause) Anymisrepresentations by the insured on the application may also be grounds for nullification.Most US states, for example, specify a maximum contestability period, often no morethan two years Only if the insured dies within this period will the insurer have a legalright to contest the claim on the basis of misrepresentation and request additionalinformation before deciding whether to pay or deny the claim

The face amount of the policy is the initial amount that the policy will pay at the death ofthe insured or when the policy matures, although the actual death benefit can provide forgreater or lesser than the face amount The policy matures when the insured dies orreaches a specified age (such as 100 years old)

Costs, insurability, and underwriting

The insurance company calculates the policy prices (premiums) at a level sufficient tofund claims, cover administrative costs, and provide a profit The cost of insurance isdetermined using mortality tables calculated by actuaries

Mortality tables are statistically based tables showing expected annual mortality rates ofpeople of different ages As people are more likely to die as they get older, the mortalitytables enable insurance companies to calculate the risk and increase premiums with ageaccordingly Such estimates can be important in taxation regulation

The mortality tables provide a baseline for the cost of insurance, but the health and familyhistory of the individual applicant is also taken into account This investigation andresulting evaluation are termed underwriting Health and lifestyle questions are asked,with certain responses possibly meriting further investigation

Specific factors that may be considered by underwriters include:

● Personal medical history

● Family medical history

● Driving record

● Height and weight matrix, otherwise known as BMI (Body Mass Index)

Based on the above and additional factors, applicants will be placed into one of severalclasses of health ratings which will determine the premium paid in exchange for insurance

at that particular carrier

Automated Life Underwriting is a technology solution that is designed to perform all orsome of the screening functions traditionally completed by underwriters, and thus seeks toreduce the work effort, time and/or data necessary to underwrite a life insurance application.These systems allow point-of-sale distribution and can shorten the time frame for issuancefrom weeks or even months to hours or minutes, depending on the amount of insurancebeing purchased

Death benefits

Upon the insured's death, the insurer requires acceptable proof of death before it pays theclaim If the insured's death is suspicious and the policy amount is large, the insurer mayinvestigate the circumstances surrounding the death before deciding whether it has anobligation to pay the claim

Payment from the policy may be as a lump sum or as an annuity, which is paid in regularinstallments for either a specified period or for the beneficiary's lifetime

1.2 Life Insurance Policy Surrender

1.2.1 Definitions

Policy surrender activity is the termination of an insurance contract by the policyholder

before the maturity or occurrence of the insured event where a cash value is available forpayment to the policyholder

Life

Insurance Policy surrender activity

On surrendering a Life Insurance Policy, the policyholders terminate the policy andreceive surrender value from the insurer The amount of money they receive will be lessthan the death benefit or the income stream they would have received if they had kept thepolicy until maturity However, surrendering the policy may be the best option if thepolicyholders need access to cash for an emergency expense or other purpose

Surrender Value

Surrender value is the amount that a policyholder receives from the life insurer when he

or she decides to terminate a policy before its maturity period In most cases, the cashsurrender value will be less than the premiums paid

A life insurance policy acquires a surrender value in the following two scenarios (theduration may depend on each company):

● When the policy duration is 10 years or more: In this situation, the surrender value

of the life insurance policy is obtained if the premium amount is regularly paid atleast for three consecutive years

● When the policy duration is less than 10 years: In this situation, the life insurance

policy gets a surrender value if the premium amount is regularly paid at least fortwo consecutive years

Types of surrender value

● Guaranteed surrender value

The guaranteed surrender value is the amount guaranteed to the policy holder in case ofvoluntary termination of the policy by the policyholder before maturity

Guaranteed surrender value is determined based on the surrender value factor specified inthe policy document The surrender value factor is the percentage of total premiums paid.Surrender value factor increases with the number of years of the policy The surrendervalue factor will grow close to 100 percent of the total premiums paid when the lifeinsurance policy progresses nears maturity In this case, the guaranteed surrender value iscalculated as total premiums paid multiplied by the surrender value factor

● Special surrender value

This special surrender value of a life insurance policy is customarily higher than theguaranteed surrender value However, this entirely depends on the insurance provider.Special surrender value relies on sum assured, bonuses, policy term and premiums paid

To understand this, one needs to first know what paid-up value is Suppose thepolicyholder stops paying premium after a specific period, the policy would continue, but

at a lower sum assured, which is termed as paid-up value

Paid-up value = (Original sum assured x Total premiums paid) / Total premiums payable

On discontinuing a policy, the policyholder gets a special surrender value, which isdetermined with the formula:

SSV = (Paid-up value + Accrued bonuses) x Surrender value factor

Where: SSV = Special Surrender Value

1.2.2 Surrender benefits vs surrender penalties

Surrender benefits

Surrender benefits are the surrender value that the insurer pays the policyholder whenthey give up the policy

Surrender penalties

Surrendering of the policy before maturity attracts a penalty in the form of a surrender fee

or surrender charge—the amount that a policyholder pays to the life insurer when he orshe decides to terminate a policy before its maturity period Surrender fees act as anincentive for policyholders to maintain their policies and reduce the frequency of earlywithdrawals

If the insured terminates life insurance before maturity, he will usually need to pay thesurrender charge The charge generally gets subtracted from the policy’s surrender value

Chapter 2 Research problem status

2.1 Life Insurance Disintermediation

According to the CFAI Volume 4 Glossary, disintermediation refers to the withdrawingfunds from financial intermediaries (usually insurance companies) for placement withother financial intermediaries (other insurance companies, banks, etc.) offering a higherreturn or yield One may withdraw funds from a financial intermediary for the purposes ofdirect investment, such as withdrawing from a mutual fund to make direct stockinvestments

2.1.1 Policy Surrender

In order for insurers to gain profit, liquidity, and in extreme cases, solvency, life insurancepolicy persistence is the core essence Most life insurers' expectation is to recapture theirinitial policy issuance expenses over a period of time; hence, a policy that lapses(typically due to insufficient premiums being paid) after only a few years will force animmediate write‐off of deferred acquisition costs Lapsation and surrender activityrepresent an erosion of the customer base, which likely will lead to an increased fixedadministrative cost per policy and require substantial marketing expenditures to rebuild.While the costs of disintermediation are well researched, the causes of heightened surrenderactivity are still controversial Two hypotheses, which are the emergency fund hypothesis(EFH) and the Interest Rate Hypothesis (IRH) have some success in addressing lifeinsurance loan and surrender activity From the EFH perspective, in a time of necessityand crisis, such as prolonged or severe unemployment or the reduction in personalincome, a trend in lapses, loans and surrender activity is expected to emerge In addition,according to the IRH, a rise in interest rates results in policy surrenders as policyholdersmove funds out of fixed interest rate insurance products and into higher market rateinstruments This would also mean that spending on insurance products tend to increasewhen interest rates are low as life insurance crediting rates generally would reflect incomefrom investments made during a period of higher interest rates

Despite the two aforementioned hypotheses are explanatory, a research conducted by Darand Dodds (1989) explored the relationships amongst interest rates, unemployment, andnet flow of funds into endowment life insurance policies and surrender activity in theUnited Kingdom gives some interesting results The result proves that there is a directrelation between surrender activity and unemployment, yet no such relationship wasidentified between interest rates and surrender activity With these findings, Dar andDodds have supported the EFH Another attempt was conducted in Outreville (1990) by

Using U.S and Canadian data from the period 1955–79, Outreville finds thatunemployment has a

significantly positive effect on early lapsation while personal income has a significantlynegative effect He finds no significant relationship between interest rates and ordinarylife insurance policies that lapse within 13 months of the policy issue date Therefore,Outreville finds support for the EFH but not for the IRH.

However, in Russell (1997) dissertation, he examines surrender activity at both theindustry and company level He finds evidence that surrender activity is positively related

to inflation, real interest rates, and unemployment, while surrender activity is inverselyrelated to real per capita income The results provide support for the IRH and mixedsupport for the EFH

2.1.2 Policy Loan

Policyholders may withdraw a portion of their cash value without terminating coverage

by taking out a policy loan Since exercise of this option may result in disintermediation

of life insurance savings, clues to what drives surrender activity may be found in whatstimulates policy loan demand, which in this case are EFH and IRH

Pesando (1974) and others have examined the interest sensitivity of life insurance cashflows, including flows in the form of surrenders and policy loans A strong positiverelationship between interest rates and policy loan volume, supporting the IRH wasobserved

Cummins (1973a) reached a similar conclusion using life insurance company reservesrather than surrender values, where higher reserves mean a higher aggregate level ofpolicy loans Cummins found considerable evidence in support of the IRH, but found norelationship in support of the EFH His theory, that variable policy loan interest rateswould likely reduce interest rate arbitrage possibilities and loan demand, became testablefollowing implementation of variable loan rates in the early 1980s Carson and Hoyt’s(1992) findings support the theoretical contentions of Cummins (1973a)

Carson and Hoyt (1992) focused on the impact of interest rates (policy loan rates and marketinterest rates) and unemployment on policy loan demand They found that implementation

of the NAIC’s model legislation recommending variable rate policy loans had reduced thedemand for policy loans significantly, and they concluded that variable loan rateseliminated most of the interest rate arbitrage that was possible during the pre‐ 1985 era offixed rate loans Carson and Hoyt claim that policy loan demand was determined largely

by interest rates; these findings support the IRH They also found that changes in policyloan demand are inversely related to unemployment, providing evidence against the EFH.However, findings in 2010 conducted by Liebenberg, Carson, and Hoyt (2010) examine

families, among other findings Further support for the EFH is provided by Liebenberg,Carson, and Dumm (2012) in their microeconomic analysis of life insurance demand.

2.1.3 Surrender Option Considerations

Life insurance surrender fee is applied when the Policyholder requests to terminate theinsurance within a period of time of the Insurance Contract Life insurance surrender fee

is applicable for six (06) years

The first year of Insurance at the rate in the following table:

Table 1 Surrender cost of policyholder by year (Chubb Life’s policy)

2.2.1 Macroeconomic factors (External environment)

Taken from previous research, it is highly acknowledged that to determine life insurancedisintermediation, the three biggest factors which are Emergency Fund Hypothesis (EFH),the Interest Rate Hypothesis (IRH), and/or the Policy Replacement Hypothesis (PRH)should be taken into consideration With that in mind, we believe forming an equationwith all three variables to model the life insurance surrender activity is necessary:

Surrender = f(Liquidity Needs, Arbitrage, Market Dynamics)

With:

Liquidity Needs: income, employment (referring to EFH)

Arbitrage: short and long term interest rate (referring to IRH)

Market dynamics: rate of new to existing life insurance business (referring to PRH)

The equation shows significant relationships indicating that surrender activity across thecash value life insurance line is affected by a series of macroeconomic factors and marketconditions, which we will further analyze in the next section.

● Interest rates: To analyze the effect of IRH on the policy surrenders, we must use

four different models using interest rates of different length, this includes a term interest rate (90‐day), an intermediate‐term interest rate (10‐year), a long‐term interest rate (20‐year), and an interest rate spread variable constructed as thelong‐ term rate minus the short‐term rate While the the short, intermediated, andlong- term interest rates are used to test if there is a direct effect that interest rates

short-on surrender activity, the interest rate spread variable (Lshort-ongShort) is used tomeasure the potential for an economic downturn The IRH predicts a positiverelation between each of the interest rate measures and policy surrenders, and anegative relation between policy surrenders and the LongShort interest ratevariable

● Unemployment: State-specific unemployment is also added to the model as it is used

to calculate the EFH We believe that as unemployment increases, the lifeinsurance surrender activity will increase The team expects a positive correlationbetween the state-specific unemployment and surrender activity

● Real Per Capita Income: Apart from unemployment, real per capita income is also

a factor that contributes to test the EFH We expect that with an increase in realincome, there will be a reduction in state-specific surrender activity as people don’tneed to access the cash surrender value

● Policy Replacement: Sometimes, policy surrender occurs only because of new

policies with better conditions This can be explained when a universal lifeinsurance policy during a time of elevated interest rate is introduced, this wouldincrease the volume of new insurance purchases, thereby supporting the PRH

● Age: This factor the paper would like to place emphasis on people aged 65 or older

in a given year It is common knowledge that the main reason why people purchaselife insurance is to get financial security in the event of premature death Thismeans that when people get old, they may realize that life insurance is no longernecessary for them, and for old individuals who are no longer in the workforce,they may need money as savings and pensions can not cover their expenses As aresult, this would be consistent with the EFH

● Homeownership: Homeownership has also been a factor that relates to the need

for life insurance Owning a house is accompanied with many additional costs,

to have the money to cover these costs, they may not want to have additionalspending on life insurance premiums.

2.2.2 Household characteristics (Internal environment)

Apart from the aforementioned equation, we also believe that household characteristics(internal environment) also have an impact on the surrender of an existing life insurancepolicy We think that a child’s birth or a divorce creates a toll on a household’s finances,and to manage this shock, a household may surrender an existing life insurance policy andreceive the insurance’s surrender value

To examine how close life events and life insurance surrender are related, we estimate thefollowing regression model using Ordinary-Least-Squares (OLS):

LSit = β0 + β1Birth of a Childit + β2Divorceit + X’γ + δi + δt + it

With:

LSit: dummy variable, indicating whether household i surrendered his life insurance policy in year t

Birth of a Child: dummy variable for the birth of a child in year t and household i

Divorceit: dummy variable, indicating whether household i divorced in year t

X’ is a set of control variables, such as "recently unemployed" if the head of household isunemployed, household savings or investment portfolio

δi , δt are household and year fixed effects, respectively

The four independent variables from the data set are “number of children”, “Birth of a child”, “Divorce”, “Acquisition of Dwelling”.

Those variables ”Birth of a Child”, ”Divorce” and ”Acquisition of Dwelling” describe lifeevents that can possibly impose a liquidity shock on the household, forcing a household tosurrender his life insurance policy

2.3 Impact of mass surrenders on the insurer's liquidity

2.3.1 Estimation of the loss when a case of surrender occurs

Sudden cancellation of Insurance (or Surrender) not only causes damages to thepolicyholders but also has a significant impact on the insurance company In order tomaintain the contract efficiency for a long time as well as protect customers at any time