The benefits of return smoothing in insurer's cover funds – analyzes from a client's perspective

Traditional life insurance typically uses some mechanism that is aimed at smoothing the returns of the (collective) assets in the insurer's so-called cover fund. We consider a generic smoothing mechanism and numerically analyze how it impacts the risk-return characteristics of a traditional life insurance contract distinguishing between pathwise volatility (of the annual returns) and the volatility of terminal wealth. We find that pathwise volatility is significantly reduced while the distribution of terminal wealth is hardly affected. We conclude that using multiple segregated cover funds (that come with different asset allocations) as building blocks for more complex products enables insurers to offer a variety of risk-return profiles of terminal wealth in combination with a rather low pathwise volatility (compared to investments without smoothing mechanism). This increases subjective attractiveness for a typical consumer. We consider a variety of such products (static and dynamic investment products) and compare them to similar purely market-based products that do not use an insurer's cover fund. Analyzing risk-return characteristics, (objective) utility, and (subjective) attractiveness under Cumulative Prospect Theory and extensions of it, we conclude that products that become possible by implementing multiple segregated cover funds can increase both, objective utility and subjective attractiveness.