Valuation of Universal Policies with a Smoothing Scheme: The Chinese Case

Abstract

Universal life insurance contracts, which usually have the so-called cliquet syle interest rate guarantees, are quite popular in China. These contracts often include other options such as the surrender option. This paper attempts to valuate these policies using the risk-neutral pricing method of financial mathematics. The framework in which the fair value of these policies is priced in a stochastic interest rate environment is presented. We analyze the guaranteed interest rate option and the surrender option separately. The values of embedded options are derived using the Least Square Monte Carlo approach. Using the calibrated parameters, we find out that the stochastic interest rate assumption affects the valuation considerably in comparison to the constant interest rate. Additionally, the volatility of assets and the smoothing mechanism are important for valuing the policyholder s' claim.