infonet-economy

Universal life policies are the most popular insurance contract design in the
United States. They have either a level death benefit paying a fixed face
amount, or an increasing death benefit, which additionally pays the available
cash value, and both types include the option to switch from one to the other.
In this paper, we are interested in the fact that--unlike a switch from level to
increasing--a switch from increasing to level death benefit requires neither
fees nor additional evidence of insurability. To assess the impact of the death
benefit switch option, we develop a model framework of increasing universal
life policies embedding the option. Consideration of mortality heterogeneity
via a stochastic frailty factor allows an investigation of adverse exercise
behavior. In a comprehensive simulation analysis, we quantify the net
present value of the option from the insurer's perspective using risk-neutral
valuation under stochastic interest rates assuming empirical exercise probabilities.
Based on our results, we provide policy recommendations for life insurers.