TAILIEUCHUNG - Fair valuation of life insurance liabilities: The impact of interest rate guarantees, surrender options, and bonus policies

Our stylized model generates several empirical hypotheses about the insurance offer decision. Firms in industries where labor turnover rates are high do not tend to offer insurance. Premium rigidities will be most pronounced in such industries. Firms not offering insurance will tend to have lower health-cost variability and lower average expected health spending than firms offering insurance; for example, they have higher proportions of younger workers or are in industries where workers tend to be healthy. These firms need not have high within-firm variability of employee health costs as proposed by Bundorf (2002). Industries or markets with greater between-firm age and average employee income heterogeneity (rather than. | ELSEVIER Insurance Mathematics and Economics 26 2000 37-57 Fair valuation of life insurance liabilities The impact of interest rate guarantees surrender options and bonus policies Anders Grosena 1 Peter Lochte Jorgensenb a Department of Finance Aarhus School of Business DK-8210 Aarhus V Denmark b Department of Management University of Aarhus Bldg. 350 DK-8000 Aarhus C Denmark Received April 1999 received in revised form August 1999 Abstract The paper analyzes one of the most common life insurance products the so-called participating or with profits policy. This type of contract stands 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 UL 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 LIC 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 LIC solvency can be quickly jeopardized if earning opportunities deteriorate in a situation where bonus reserves are low and promised returns are high. 2000 Elsevier Science . All rights reserved. MSC IM10 IE01. KWD Participating Life Insurance Policies Embedded options Contingent claims valuation Bonus policy Surrender JEL classification G13 G22 G23 1. Introduction Embedded options pervade the wide range of products offered by pension funds and life insurance companies. Interest rate .

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