Implicit Options in Life Insurance Contracts: Valuation and Risk Management

Most life insurance policies are replete with implicit (also called embedded) options that can be of significant value. In the past, many of these options were offered free of charge, which was partly because traditional actuarial methods were not capable of appropriately pricing the options. When British Equitable Life had to stop taking new business in 2000 due to improper hedging of provided options, concern over embedded options intensified, especially regarding the appropriate pricing of implicit options and the conduct of risk management. These concerns are also reflected in recent regulatory processes (see Solvency II, Swiss Solvency Test, IFRS), where financial reporting now requires a determination of the market value of liabilities, and thus implicit options at fair value. However, fair valuation requires an appropriate financial valuation model. Increasingly, actuaries are cooperating with financial economists in order to cope with this challenge. The fair valuation approach thus has an impact on the design of life insurance contracts and other related aspects. Alternatively, facets such as managerial behavior will have an influence on the claim structure and thus on fair valuation and the insolvency risk of the insurer. The aim of our research project is to analyze aspects related to the fair valuation of implicit options that have a substantial impact, particularly the measuring and managing of risk and the impact of corporate taxes.