Life Insurance Contracts with Embedded Options

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Abstract
This article presents a model for the fair valuation of a large class of insurance and pension liabilities. Life insurance companies and pension funds often issue policies/contracts with embedded options such as minimum return guarantees and bonus and surrender options. Until recently, most companies have neglected the proper valuation and risk management of these contingent claims. Recent recommendations from FASB and IASC have forced companies to revise their policies; the common theme in the recommended new accounting standards is the application of market or fair valuation principles throughout the balance sheet. In order to implement mark‐to‐market accounting, financial models are needed. The author presents a model of this type, discusses its implementation, and illustrates its potential usefulness with numerical examples. He concludes that minimum return guarantees can become very valuable, insolvency risk can be significant in realistic scenarios, and effective regulatory intervention rules can be of significant value to policyholders.

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