Understanding the Death Benefit Switch Option in Universal Life Policies

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.