Financial Modeling Module\finmod_s2_01_other_products

FinancialModeling–Section2:OptionsEmbeddedinFinancialProductsOtherFinancialProductswithGuarantees/EmbeddedOptions–LifeInsurancesNO-LAPSEGUARANTEESAUniversalLifeInsurancecontractmightincludeaNo-LapseGuarantee(NLG)provisionforaguaranteeofthedeathbenefit.AslongastheannualpremiumapolicyholderpaysisatleastasgreatasthatspecifiedbytheNLGprovisionandthecumulativepremiumtestismet,thepolicywillnotlapse,regardlessofmarketconditions.UniversalLifeInsurancewithanNLGprovisionoffersthelowestguaranteedpremiumofanypolicytypeforanextendedperiodoftime.Terminsuranceofferslowerguaranteedpremiums,butevenwith30-yearleveltermplans,coverageoftenceasesbeforelifeexpectancy.Wholelifeofferslifetimeguaranteedpremiums,butwiththeaddedcostofhighguaranteedcashvalues.WholelifepremiumscanbemuchhigherthanthatofaNLGpremium.Blendingwholelifewithtermcanreducethepremiumoutlay,butonlybysacrificingthedeathbenefitorpremiumguarantee.EQUITY-INDEXEDLIFEINSURANCE1Equity-indexedlife(EIL)insuranceissimilartoequity-indexedannuities,exceptitisalifeproductnotanannuity.Essentially,anEILproductisauniversallifeproductwherethecreditedinterestrateonthefundislinkedtoanoutsideequityindex,withaminimumguaranteedrate.Thereare,however,severaldifferencesbetweenEILandEIA.AnEILpolicyhas:.Unpredictablepremiumcashflow(theoreticallyeachdollarofpremiumcominginneedstobehedgedseparatelytomatchassetsandliabilities).Smallpremiums(toensuresufficientvolume,aEILproductmayrequireminimumpremiumoveracertainperiodofyears).Complicatedaccountvaluedeductions(fromdailycashaccountfirst,thenfromequity-indexedbucketswhichwillchangethenotionalamountbeinghedgedduringtheyear)1SOAstudynoteFET-101-07,Equity-IndexedLifeProducts©2013SocietyofActuaries1CANADIANSEGREGATEDFUNDS2ThesegregatedfundissuedbyCanadianinsurersissynonymouswiththevariableannuityproductsintheU.S.SegregatedfundsaresimilartoMutualFundsbutareofferedthroughinsurancecompanies.AsegregatedfundisissuedintheformofanindividualvariableannuitycontractofferingcertainmaturityanddeathguaranteesthataresimilartothoseofferedwithvariableannuitiesintheUnitedStates.AfeaturecommonlyfoundonsegregatedfundproductsinCanadaistheguaranteedminimumaccountvalue(GMAV).GMAVguaranteesareturnofaminimumvalue(suchasreturnofpremium)uponmaturity,regardlessoftheactualinvestmentperformanceoftheunderlyingassets.AnothercommonfeatureofsegregatedfundproductsistoallowthepolicyholdertoraisetheGMAVtothecurrentaccountvalue(asfrequentlyasonceperyear)inexchangeforextendingthematuritydate(dialbackthematurityclock).GUARANTEEDINVESTMENTCONTRACTFundingagreements(sometimesisreferredtoasstablevaluefund,orguaranteedinvestmentcontract)areinvestmentproductsthatinsurancecompaniessellstolargeinstitutionssuchasabanks,brokeragehouses,andmoneymarketfunds.Institutionsplacetheirmoneywiththeinsurertoearninterest,oftentimevariablebutwithaguaranteedfloor.Contractscanbelongterm,shortterm,orevergreen(i.e.,havenospecificterminationdate).ASSETTYPEPRODUCTSAcallablebondallowsthebondissuertoredeemthebondatsomepointbeforethebondreachesmaturity.Inotherwords,onthecalldate(s),theissuerhastheright,butnottheobligation,tobuybackthebondsfromthebondholdersatadefinedcallprice.Thus,theissuerhasanoption,forwhichitmaypayintheformofahighercouponrate.Ifinterestratesinthemarkethavegonedownatthetimeofacalldate,theissuerwillbeabletorefinanceitsdebtatacheaperpriceandsowillbelikelycallthebond.Onetheonehand,withacallablebond,investorshavethebenefitofahigheryieldthantheywouldhavehadwithanon-callablebond.Ontheotherhand,ifinterestratesfall,thebondswilllikelybecalled,andtheycanonlyre-investatthelowerrate.Thisiscomparabletoselling(writing)anoption—theoptionwritergetsapremium,buthasalossiftheoptionisexercised.CONVERTIBLEBONDAconvertiblebondallowsthebondholdertoconvertthebondintosharesofcommonstockofthebondissuer,atanagreed-uponprice.Itisahybridsecuritywithdebt-andequity-likefeatures.Althoughaconvertiblebondtypicallyhasacouponratelowerthanthatofsimilar,non-convertibledebt,theinstrumentcarriesadditionalvaluethroughtheoptiontoconvertthebondtostock,andtherebyparticipateinfurthergrowthinbondissuer’sequityvalue.Thebondholderreceivesthepotentialupsideofconversionintoequitywhilehasdownsideprotectedwithcashflowsfromthecouponpaymentsandthereturnofprincipaluponmaturity.2SOAstudynoteFE-C151-08,chapter13ofLifeInsuranceProductsandFinance©2013SocietyofActuariesFinancialModeling–Section2:OptionsEmbeddedinFinancialProducts2finmod_s2_01_other_products.docxOtherFinancialProductswithGuarantees/EmbeddedOptionsFromtheissuer'sperspective,onebenefitofraisingcapitalbysellingconvertiblebondsisapotentialreducedcashinterestpayment.Anotherbenefitofconvertiblebondisthattheconvertibilityasanoptionhelpsaligntheinterestsofinvestorsandbondissuers,thereforealleviatetheagencyproblemfromthecorporategovernanceperspective.Reverse-convertiblebondworksinanoppositedirectioninthatanissuerhasanoptiontoconverttoequity.MORTGAGEBACKEDSECURITIESMortgageholderscanchoosetoprepaythemortgage.Becauseofthisprepaymentoption,mortgageandmortgage-backedsecurities(MBS)behavelikeacallableamortizingbondwiththecallpricerepresentingremainingprincipalplusanticipatedrefinancing/transactioncost.Mortgageholderscanalsowalkawayfromtheirmortgagepayment,aputoptiontheycanexerciseundereconomicrecession(whichistypicallyaccompaniedbydepressedhousevalues).Anoption-adjustedspread(OAS)hastobeaddedtobenchmarkcurveexantetoevaluatethevalueofmortgageandMBSproducts.Pleasereturntothee-learningprogram.©2013SocietyofActuariesFinancialModeling–Section2:OptionsEmbeddedinFinancialProducts3finmod_s2_01_other_products.docxOtherFinancialProductswithGuarantees/EmbeddedOptions