A utility- and CPT-based comparison of life insurance contracts with guarantees

Abstract

Abstract Some recent literature studies whether contracts including financial guarantees can be preferred by a utility-maximizing investor. The main result for contracts exposed solely to financial risk (e.g. Doskeland and Nordahl, 2008; Dichtl and Drobetz, 2011) is that expected utility theory (EUT) fails to interpret demand for guarantees, while cumulative prospect theory (CPT) is able to support the demand. While the development of the financial market has a significant impact on the portfolio choice, some other non-financial risk might play an important role too. In the present paper, we take life insurance products as an example, where the long term nature of these contracts places a special emphasis on the uncertain lifetime of the investor. We incorporate the mortality risk and investigate its effect on the attractiveness of contracts offering minimum interest rate guarantees to EUT- and CPT-investors. For this purpose, we introduce two approaches for the consideration of multiple risk sources within CPT. We illustrate the theoretical framework with numerous simulations and our numerical results show that a long-term risk-averse EUT-investor prefers products with guarantees.