Fair Valuation of Cliquet-Style Return Guarantees in a Heterogeneous Life Insurance Portfolio

Abstract

In Europe, participating life insurance contracts are often equipped with a return guarantee. The current low interest rate environment has again refreshed the discussion on risk management and fair valuation of such embedded options. Typcially, this problem is discussed from the viewpoint of a single contract or a homogeneous insurance portfolio. In practice, however, insurance portfolios are heterogeneous. Rapidly changing conditions on interest rate markets have, for example, led to big differences in guarantee levels within an insurance portfolio. Contracts in an insurance portfolios can - unlike the case of asset portfolios - not be priced independently: Their premiums are invested in the same reference portfolio; the contracts interact by joint reserves and joint default risk of the policy sponsor. In this exposition, we discuss the fair valuation of individual insurance contracts with an annual (cliquet-style) return guarantee in a heterogeneous life insurance portfolio.