Outlining a practical approach to price and hedge minimum rate of return guarantees embedded in recurring - contribution life insurance contracts

Abstract

This dissertation tackles the current life insurance industry challenge to price and hedge minimum rate of return guarantees (MRRG) embedded in recurring-contribution life insurance contracts in a practical manner. The key contribution to the literature is to outline a practical approach to quantify and project the impact of dynamic hedging strategies for such options. MRRGs are typically very long-dated and as a result the validity of using typical financial economics options pricing models under incomplete market conditions remains a debate. However, life insurers need robust, practical solutions to assist them to manage market risk exposures for day-to-day solvency and income statement management. Literature specific to the topic of MRRG pricing and hedging over recurring-contribution life insurance products is sparse but Schrager and Pelssers’ significant contribution (Schrager and Pelsser 2004) provided a basis on which this dissertation was built. Schrager and Pelsser show these options to be analogous to Asian options written over a stochastically-weighted average of the underlying unit fund price. This dissertation demonstrates the effects of stochastic interest rates on MRRGs increase with maturity, as shown by Schrager and Pelsser. Consequentially, users should be aware of the effect and limitations of their choice of interest rate model when pricing MRRGs. Sensitivities for the various maturity terms of MRRG benefits are shown and provide readers with insight into the factors driving the dynamics of such options. A simple dynamic hedging program is outlined and projected under real-world evolutions on a daily basis, thus allowing the effectiveness of the hedging program to be tested.