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A risk-based model for the valuation of pension insurance

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  • Chen, An

Abstract

In the US, defined benefit plans are insured by the Pension Benefit Guaranty Corporation (PBGC). Taking account of the fact that the PBGC covers only the residual deficits of the pension fund the sponsoring company is unable to cover and that the plans can be prematurely terminated, we consider a model that accounts for the joint dynamics of the pension fund’s and sponsoring firm’s assets in order to effectively determine the risk-based pension premium for the insurance provided by the PBGC. We obtain a closed-form pricing formula for this risk-based premium. Its magnitude depends highly on the investment portfolio of the pension fund and of the sponsoring company as well as the correlation between these two portfolios.

Suggested Citation

  • Chen, An, 2011. "A risk-based model for the valuation of pension insurance," Insurance: Mathematics and Economics, Elsevier, vol. 49(3), pages 401-409.
  • Handle: RePEc:eee:insuma:v:49:y:2011:i:3:p:401-409
    DOI: 10.1016/j.insmatheco.2011.06.002
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    References listed on IDEAS

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    1. Nielson, Norma L. & Chan, David K. W., 2007. "Private pensions and government guarantees: clues from Canada," Journal of Pension Economics and Finance, Cambridge University Press, vol. 6(01), pages 45-66, March.
    2. Jeremy I. Bulow & Randall Morck & Lawrence H. Summers, 1987. "How Does the Market Value Unfunded Pension Liabilities?," NBER Chapters,in: Issues in Pension Economics, pages 81-110 National Bureau of Economic Research, Inc.
    3. Broeders, Dirk & Chen, An, 2010. "Pension regulation and the market value of pension liabilities: A contingent claims analysis using Parisian options," Journal of Banking & Finance, Elsevier, vol. 34(6), pages 1201-1214, June.
    4. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, vol. 3(3), pages 183-193, June.
    5. Alan Marcus, 1987. "Corporate Pension Policy and the Value of PBGC Insurance," NBER Chapters,in: Issues in Pension Economics, pages 49-80 National Bureau of Economic Research, Inc.
    6. Jeffrey R. Brown, 2008. "Guaranteed Trouble: The Economic Effects of the Pension Benefit Guaranty Corporation," Journal of Economic Perspectives, American Economic Association, vol. 22(1), pages 177-198, Winter.
    7. Feldstein, Martin & Seligman, Stephanie, 1981. "Pension Funding, Share Prices, and National Savings," Journal of Finance, American Finance Association, vol. 36(4), pages 801-824, September.
    8. George Pennacchi & Christopher M. Lewis, 1994. "The value of Pension Benefit Guaranty Corporation insurance," Proceedings, Federal Reserve Bank of Cleveland, pages 735-756.
    9. David W. Wilcox, 2006. "Reforming the Defined-Benefit Pension System," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 37(1), pages 235-304.
    10. Joshua D. Rauh, 2006. "Investment and Financing Constraints: Evidence from the Funding of Corporate Pension Plans," Journal of Finance, American Finance Association, vol. 61(1), pages 33-71, February.
    11. Jin, Li & Merton, Robert C. & Bodie, Zvi, 2006. "Do a firm's equity returns reflect the risk of its pension plan?," Journal of Financial Economics, Elsevier, vol. 81(1), pages 1-26, July.
    12. Fiona Stewart, 2007. "Benefit Security Pension Fund Guarantee Schemes," OECD Working Papers on Insurance and Private Pensions 5, OECD Publishing.
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    Citations

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    Cited by:

    1. Chen, An & Uzelac, Filip, 2014. "A risk-based premium: What does it mean for DB plan sponsors?," Insurance: Mathematics and Economics, Elsevier, vol. 54(C), pages 1-11.
    2. Dirk Broeders & An Chen & Birgit Koos, 2014. "Utility-equivalence of pension security mechanisms," DNB Working Papers 414, Netherlands Central Bank, Research Department.

    More about this item

    Keywords

    Pension insurance; PBGC; Defined benefit plan; Correlation; Sponsor support;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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