Fair Valuation of Life Insurance Liabilities: The Impact of Interest Rate Guarantees, Surrender Options, and Bonus Policies
AbstractThe paper analyzes one of the most common life insurance products - the so-called participating (or with profits) policy. This type of contract stand in contrast to Unit-Linked (UL) products in that interest is credited to the policy periodically according to some mechanism which smoothes past returns on the life insurance company's (LIC) assets. As is the case for ULL products, the participating policies are typically equipped with an interest rate guarantee and possibly also an option to surrender (sell-back) the policy to the LAC before maturity. The paper shows that the typical participating policy can be decomposed into a risk free bond element, a bonus option, and a surrender option. A dynamic model is constructed in which these elements can be valued separately using contingent claims analysis. the impact of various bonus policies and various levels of the guaranteed interest rate is analyzed numerically. we find that values of participating policies are highly sensitive to the bonus policy, that surrender options can be quite valuable, and that LAC solvency can be quickly jeopardised if earning opportunities deteriorate in a situation where bonus reserves are low and promised returns are high.
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Bibliographic InfoPaper provided by School of Economics and Management, University of Aarhus in its series Management Working Papers with number 1999-1.
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Other versions of this item:
- Grosen, Anders & Lochte Jorgensen, Peter, 2000. "Fair valuation of life insurance liabilities: The impact of interest rate guarantees, surrender options, and bonus policies," Insurance: Mathematics and Economics, Elsevier, vol. 26(1), pages 37-57, February.
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
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