Market-Consistent Valuation of Insurance Liabilities by Cost of Capital

Abstract

This paper investigates market-consistent valuation of insurance liabilities in the context of Solvency II among others and to some extent IFRS 4. We propose an explicit and consistent framework for the valuation of insurance liabilities which incorporates the Solvency II approach as a special case. The proposed framework is based on replication over multiple (one-year) time periods by a periodically updated portfolio of assets with reliable market prices, allowing for “limited liability” in the sense that the replication can in general not always be continued. The asset portfolio consists of two parts: (1) assets whose market price defi nes the value of the insurance liabilities, and (2) capital funds used to cover risk which cannot be replicated. The capital funds give rise to capital costs; the main exogenous input in the framework is the condition on when the investment of the capital funds is acceptable. We investigate existence of the value and show that the exact calculation of the value has to be done recursively backwards in time, starting at the end of the lifetime of the insurance liabilities. We derive upper bounds on the value and, for the special case of replication by risk-free one-year zero-coupon bonds, explicit recursive formulas for calculating the value. In the paper, we only partially consider the question of the uniqueness of the value. Valuation in Solvency II and IFRS 4 is based on representing the value as a sum of a “best estimate” and a “risk margin”. In our framework, it turns out that this split is not natural. Nonetheless, we show that a split can be constructed as a simplifi cation, and that it provides an upper bound on the value under suitable conditions. We illustrate the general results by explicitly calculating the value for a simple example.