Implicit Options in Life Insurance: Valuation and Risk Management

Participating life insurance contracts typically contain various types of implicit options. These implicit options can be very valuable and can thus represent a significant risk to insurance companies if they practice insufficient risk management. Options become especially risky through interaction with other options included in the contracts, which makes their evaluation even more complex. This article provides a comprehensive overview and classification of implicit options in participating life insurance contracts and discusses the relevant literature. It points out the potential problems particularly associated with the valuation of rights to early exercise due to policyholder exercise behavior. The risk potential of the interaction of implicit options is illustrated with numerical examples by means of a life insurance contract that includes common implicit options, i.e., a guaranteed interest rate, stochastic annual surplus participation, and paid-up and resumption options. Valuation is conducted using risk-neutral valuation, a concept that implicitly assumes the implementation of risk management measures such as hedging strategie

Risk and capital transfer in insurance groups

The aim of this paper is to analyze the effect of capital and risk transfer instruments (CRTIs) on afinancial group's risk situation. In this respect, we extend previous literature by accounting for the conglomerate discount on firm value, which is areduction in shareholder value due to diversification within the group. In general, CRTIs between parent and subsidiaries have asubstantial effect on the diversification of risks, economic capital requirements, and default risk, which we study in detail for different types of CRTIs, including intra-group retrocession and guarantees. One main finding is that diversification effects within the group are much lower when taking into account conglomerate discount effects. We believe this aspect to be an important issue in the ongoing discussion on group solvency regulation and enterprise risk managemen

Insurance Guaranty Schemes in a Contingent Claims Setting

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. This contribution summarizes the major findings of a working paper written by Schmeiser and Wagner (Working Papers on Risk Management and Insurance (IVW-HSG), No.80, 2010). The effect on competitive equity-premium combinations is studied while considering a framework with policyholders and equity holders where guaranty fund charges are volume-based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one-period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence adverse incentives may arise with regard to the overall security level of the industr

Price presentation and consumers' choice

Currently, regulatory authorities and consumers ask for more cost transparency with respect to financial product components. In life insurance, for instance, the premium for products should be split in its components: A premium for death benefits, the savings premium, the cost of an investment guarantee, and the administration costs. In this regard, it is important for insurance companies and regulators to know to what extent the way of presenting the prices of an offer affects consumer evaluation of the product. Based on a paper by Huber et al. (How do price presentation effects influence consumer choice? The case of life insurance products. Working paper, 2011) as presented at the annual meeting of Deutscher Verein für Versicherungswissenschaft in 2011, this article presents the effects of different forms of presenting the price of life insurance contract components and especially of investment guarantees on consumer evaluation of this product. This is done by means of an experimental study using a representative panel for Switzerland and by focusing on unit-linked life insurance products. The findings reveal that, contrary to consumer products, there is no effect of price bundling and price optic on consumer evaluation and purchase intention for life insurance products. However, there is a significant moderating effect of consumer experience with insurance products on this relationshi

Enterprise risk management in financial groups: analysis of risk concentration and default risk

In financial groups, enterprise risk management is becoming increasingly important in controlling and managing the different independent legal entities in the group. The aim of this paper is to assess and relate risk concentration and joint default probabilities of the group's legal entities in order to achieve a more comprehensive picture of a financial group's risk situation. We further examine the impact of the type of dependence structure on results by comparing linear and nonlinear dependencies using different copula concepts under certain distributional assumptions. Our results show that even if financial groups with different dependence structures do have the same risk concentration factor, joint default probabilities of different sets of subsidiaries can vary tremendousl

Zur Integration heuristischer Managementstrategien in die Dynamische Finanzanalyse

Zusammenfassung: Die Dynamische Finanzanalyse (DFA) hat sich in den vergangenen Jahren zu einem wichtigen Instrument zur Analyse der Finanzlage eines Versicherungsunternehmens entwickelt. Trotz der zunehmenden Verbreitung der DFA in der Praxis und zahlreicher Abhandlungen in der wissenschaftlichen Literatur gibt es weiterhin Aspekte in der Implementierung der DFA, die bislang nicht im Fokus wissenschaftlicher Untersuchungen standen. Einer dieser Aspekte ist die Integration von Managementstrategien in DFA-Modelle. Das Ziel dieser Arbeit besteht darin, Managementstrategien in ein DFA-Modell zu integrieren und ihre Effekte auf die Rendite- und die Risikoposition eines Versicherers zu analysieren. Dabei erweitern wir die Ergebnisse aus Eling / Parnitzke / Schmeiser (2007) um zwei Modellvarianten und stellen diese Varianten im Rahmen einer neuen Beispielsimulation da

A performance analysis of participating life insurance contracts

Traditional life insurance products, in particular participating life insurance contracts, are often criticized. Their performance is often said to be poor compared to other investment alternatives. Interestingly, this perception appears to persist although very little research has been conducted into the performance of participating life insurance contracts. But are participating life insurance contracts actually bad for policyholders? We conduct a performance analysis based on contracts offered in the German market, in order to provide evidence to support decision making by policyholder

Investment guarantees in unit-linked life insurance from the customer perspective

Interest rate guarantees are a typical contract feature in unit-linked-life insurance products. As the financial crisis of 2007/2008 has shown, these guarantees can be of substantial value for policyholders since they ensure that at least a minimum amount will be paid back even if the mutual fund value falls below a specific guaranteed level. However, from the insurance company's view, these guarantees can be costly—especially in highly volatile markets—due to the required risk management measures which must be undertaken to secure the guarantees promised to the customers. Thus, the aim of this paper is to investigate whether customers really value these guarantees and if their willingness to pay (WTP) is sufficient to cover the guarantee costs. To elicit customer WTP, we use an online questionnaire and compare these results to the actual guarantee costs calculated with the Black and Scholes option pricing formula. One main finding is that even though most of the participants in the online questionnaire work in the financial industry, subjective prices are difficult to derive and are lower, on average, than the prices obtained using a financial pricing model. However, many participants are still willing to pay a substantially higher pric

Optimal rate classification for enhanced annuities

For a given premium, enhanced annuities pay higher pensions to policyholders with impaired health. Even though risk classification is a common concept in the insurance sector and should allow insurers to increase their profitability, enhanced annuities are rarely offered outside of the United Kingdom. The paper provides a general method of determining an optimal risk classification system for enhanced annuities that will maximize an insurance company's profits. The cost of risk classification, as well as that incurred when insureds are assigned to inappropriate risk classes (a chief component of underwriting risk), are explicitly considere

Portfolio management and retirement: what is the best arrangement for a family?

In comparing an immediate life annuity with a payout-equivalent investment fund payout plan (self-annuitization), research to date has focused mainly on shortfall probabilities of self-annuitization. As an exception, Schmeiser and Post (2005) propose a family strategy where the chances of self-annuitization (i.e., bequests) are taken into consideration as well. In such a family strategy, potential heirs must bear shortfall risks, but in return have a chance of receiving a bequest. This paper analyzes under which conditions heirs will be willing to agree to a family strategy. The idea of a family strategy is integrated into a realistically calibrated intertemporal expected utility framework, taking into account risks arising from stochastic life span, asset returns, and nontradable labor income. A family strategy is shown to be accepted for many parameter combinations, especially in families with low marginal tax rates, if the heirs are wealthy, or in a case where the retiree has an average population life expectancy. We also work out how family self-annuitization decisions interact with asset allocation, saving decisions, and labor income risk. Under realistic conditions our results support two explanations for the empirically observable low demand for annuities (the so-called annuity puzzle), namely intra-family risk sharing and high cost of market-annuitizatio