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Optimal pension insurance design

  • Døskeland, Trond M.
  • Nordahl, Helge A.

In this paper we analyze how the traditional life and pension contracts with a guaranteed rate of return can be optimized to increase customers' welfare. Given that the contracts have to be priced correctly, we use individuals' preferences to find the preferred design. Assuming CRRA utility, we cannot explain the existence of any form of guarantees. Through numerical solutions we quantify the difference (measured in certainty equivalents) to the preferred Merton solution of direct investments in a fixed proportion of risky and risk free assets. The largest welfare loss seems to come from the fact that guarantees are effective by the end of each year, not only by the expiry of the contract. However, the demand for products with guarantees may be explained through behavioral models. We use cumulative prospect theory as an example, showing that the optimal design is a simple contract with a life-time guarantee and no default option.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 32 (2008)
Issue (Month): 3 (March)
Pages: 382-392

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Handle: RePEc:eee:jbfina:v:32:y:2008:i:3:p:382-392
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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  1. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
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  9. 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.
  10. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
  11. John Y. Campbell, 2006. "Household Finance," NBER Working Papers 12149, National Bureau of Economic Research, Inc.
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  13. Michael J. Brennan, 1993. "Aspects of Insurance, Intermediation and Finance*," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 18(1), pages 7-30, June.
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  15. Brennan, Michael J. & Schwartz, Eduardo S., 1976. "The pricing of equity-linked life insurance policies with an asset value guarantee," Journal of Financial Economics, Elsevier, vol. 3(3), pages 195-213, June.
  16. Bjarne Astrup Jensen & Carsten Sørensen, 2001. "Paying for Minimum Interest Rate Guarantees: Who Should Compensate Who?," European Financial Management, European Financial Management Association, vol. 7(2), pages 183-211.
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