Understanding the Death Benefit Switch Option in Universal Life Policies

Universal life policies are the most popular insurance contract design in theUnited States. They have either a level death benefit paying a fixed faceamount, or an increasing death benefit, which additionally pays the availablecash 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 toincreasing––a switch from increasing to level death benefit requires neitherfees nor additional evidence of insurability. To assess the impact of the deathbenefit switch option, we develop a model framework of increasing universallife policies embedding the option. Consideration of mortality heterogeneityvia a stochastic frailty factor allows an investigation of adverse exercisebehavior. In a comprehensive simulation analysis, we quantify the netpresent value of the option from the insurer’s perspective using risk-neutralvaluation under stochastic interest rates assuming empirical exercise probabilities.Based on our results, we provide policy recommendations for life insurers.