Chapter 4 - Unit & Index Linked Contracts

Question 1

List the main features of single premium unit-linked investment products. [5]

2015_s2

Answer 1

Main features:

• The single premium is paid into an investment fund which purchases a number of units that represent a share of that fund.
• There is usually a range of funds that the policyholder can choose from.
• The total value of an individual policyholder’s fund at any time is the number of units multiplied by the unit price.
• The value of the units depends on the value of the assets underlying the investment fund (the unit price will be calculated daily as the value of the assets changes).
• The policyholder’s share (i.e. the number of units) changes when a cashflow relating to the policy occurs (e.g. deduction of a charge, a switch to another fund, payment on surrender or maturity).
• The insurance company will deduct charges from the policyholder’s fund.
• These may be deducted from the premium before it is invested (e.g. bid/offer spread);
• or on a regular basis from the unit funds (e.g. annual fund management charge).
• The charges are kept by the insurer to cover expenses and cost of guarantees.
• The insurer will aim for charges to exceed expenses guarantees, to give profit to the insurer
• The value of the policy at maturity is usually the (bid) value of units.
• A surrender penalty may be deducted from the value of the units if the policyholder withdraws from the contract.

Question 2

Under this product, the policyholder invests a single lump sum in a unit-linked fund and may withdraw a certain percentage of the unit fund on a monthly basis until their death or their unit fund is exhausted. If the policyholder dies before their fund is exhausted, the balance is paid to their nominated beneficiaries.

Outline briefly the risks accepted by policyholders who take out such a policy. [3]

2019_s2

Answer 2

Risks to the policyholder:

Benefits not received due to:
* Policyholder living much longer than expected and hence, because the monthly income is not guaranteed for life, money could run out.
* There is no maximum withdrawal rate so funds can be depleted earlier than expected.
* Insolvency of the insurer.

Benefits lower than expected due to:
* Poor performance of the assets underlying the units resulting in lower benefit payments.

• Policyholders may select investment funds that poorly reflect their risk appetite and/or need for capital protection, resulting in volatile investment returns.
• The unit fund being eroded by fund management charges, particularly if fund management charges are revised upwards by the insurer.
• Taxation changes impacting on amounts received.
• Income received in real terms can be eroded due to high inflation given that the return of the assets may not necessarily be inflation- linked.