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A Finite Difference Approach to the Valuation of Path Dependent Life Insurance Liabilities

  • Bjarke Jensen

    (SEB Fixed Income Research, Landem�rket 10, DK-1119 Copenhagen K, Denmark, e-mail: bjarke.jensen@seb.se)

  • Peter L�chte J�rgensen

    (Department of Management, University of Aarhus, Bldg. 350, DK-8000 Aarhus C, Denmark, e-mail: ecolochte@econ.au.dk)

  • Anders Grosen

    (Department of Finance, Aarhus School of Business, DK-8210 Aarhus V, Denmark, e-mail: gro@asb.dk)

This paper sets up a model for the valuation of traditional participating life insurance policies. These claims are characterized by their explicit interest rate guarantees and by various embedded option elements, such as bonus and surrender options. Owing to the structure of these contracts, the theory of contingent claims pricing is a particularly well-suited framework for the analysis of their valuation.The eventual benefits (or pay-offs) from the contracts considered crucially depend on the history of returns on the insurance company's assets during the contract period. This path-dependence prohibits the derivation of closed-form valuation formulas but we demonstrate that the dimensionality of the problem can be reduced to allow for the development and implementation of a finite difference algorithm for fast and accurate numerical evaluation of the contracts. We also demonstrate how the fundamental financial model can be extended to allow for mortality risk and we provide a wide range of numerical pricing results. The Geneva Papers on Risk and Insurance Theory (2001) 26, 57–84. doi:10.1023/A:1011264408187

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Article provided by Palgrave Macmillan in its journal The Geneva Papers on Risk and Insurance Theory.

Volume (Year): 26 (2001)
Issue (Month): 1 (June)
Pages: 57-84

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Handle: RePEc:pal:genrir:v:26:y:2001:i:1:p:57-84
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  1. Aase Nielsen, J. & Sandmann, Klaus, 1995. "Equity-linked life insurance: A model with stochastic interest rates," Insurance: Mathematics and Economics, Elsevier, vol. 16(3), pages 225-253, July.
  2. 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.
  3. Steinar Ekern & Svein-Arne Persson, 1996. "Exotic Unit-Linked Life Insurance Contracts," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 21(1), pages 35-63, June.
  4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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