ALEXANDER MELNIKOV () (Department of Mathematical and Statistical Sciences, University of Alberta, Edmonton, Alberta T6G 2G1, Canada) YULIYA ROMANYUK () (Financial Markets Department, Bank of Canada, 234 Wellington, Ottawa, Ontario K1A OG9, Canada)
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The paper uses the efficient hedging methodology in order to optimally price and hedge equity-linked life insurance contracts whose payoff depends on the performance of several risky assets. In particular, we consider a policy which pays the maximum of the values of n risky assets at some maturity date T, provided that the policyholder survives to T. Such contracts incorporate financial risk, which stems from the uncertainty about future prices of the underlying financial assets, and insurance risk, which arises from the policyholder's mortality. We show how efficient hedging can be used to minimize expected losses from imperfect hedging under a particular risk preference of the hedger. We also prove a probabilistic result, which allows one to calculate analytic pricing formulas for equity-linked payoffs with n risky assets. To illustrate its use, explicit formulas are given for optimal prices and expected hedging losses for payoffs with two risky assets. Numerical examples highlighting the implications of efficient hedging for the management of financial and insurance risks of equity-linked life insurance policies are also provided.
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