Fair valuation of life insurance liabilities: The impact of interest rate guarantees, surrender options, and bonus policies

The paper analyzes one of the most common life insurance products - the so- called participating (or with profits) policy. This type of contract stands in contrast to unit-linked (UL) products in th at interest is credited to the policy periodically according to some mechan ism which smoothes past returns on the life insurance company's (LIC) asset s. As is the case for Ln products, the participating policies are typically equipped with an interest rate guarantee and possibly also an option to su rrender (sell-back) the policy to the LIC before maturity. The paper shows that the typical participating policy can be decomposed int o a risk free bond element, a bonus option, and a surrender option. A dynam ic model is constructed in which these elements can be valued separately us ing contingent claims analysis. The impact of various bonus policies and va rious levels of the guaranteed interest rate is analyzed numerically. We fi nd that values of participating policies are highly sensitive to the bonus policy, that surrender options can be quite valuable, and that LIC solvency can be quickly jeopardized if earning opportunities deteriorate in a situa tion where bonus reserves are low and promised returns are high. (C) 2000 E lsevier Science B.V. All rights reserved. MSG: IM10: IE01.