Quantitative Assessment of Common Practice Procedures in the Fair Evaluation of Embedded Options in Insurance Contracts

Abstract

This work analyses the common practice used to evaluate financial options written on with-profit policies issued by European insurance companies. In the last years regulators introduced, with the Solvency II directive, a risk neutral valuation framework for determining the fair value of assets and liabilities of insurance funds. A relevant aspect is how to deal with the estimation of sovereign credit and liquidity risk, that are important components in the valuation of the majority insurance funds, which are usually heavily invested in treasury bonds. The common practice is the adoption of the certainty equivalent approach (CEQ) for the market consistent evaluation of insurance liabilities, which results in a deterministic risk adjustment of the securities cash flows. In this paper, we propose an arbitrage free stochastic model for interest rate, credit and liquidity risks, that takes into account the dependences between different government bond issuers. We test the impact of the common practice against our proposed model, via Monte Carlo simulations. We conclude that in the estimation of options whose pay-off is determined by statutory accounting rules, which is often the case for traditional with-profit insurance products, the deterministic adjustment for risk of the securities cash flows is not appropriate, and that a more complete model such as the one described in this article is a viable and sensible alternative in the context of market consistent evaluations.