Valuation and Risk Assessment of Participating Life Insurance in the Presence of Credit Risk

Abstract

In participating life insurance, management decisions regarding the asset composition can substantially impact the value of a policy from the policyholders’ perspective as well as the insurer’s risk situation. Due to the long-term guarantees often embedded in these contracts, life insurers typically invest a considerable portion of their capital in long-term assets such as corporate and government bonds. Besides interest rate risk, the value of these bond investments is thus particularly influenced by credit (spread) risk. Thus, the aim of this paper is to examine the impact of market risk associated with the asset composition on fair valuation and risk assessment with focus on credit risk and its interaction with equity risk and interest rate risk. Our analysis emphasizes the strong tradeoff between higher coupon payments of lower grade bond portfolios and the increased credit risk as well as the interaction between credit risk, interest rate risk, and equity risk arising from the stock investments.