Analysis of Participating Life Insurance Contracts : a Unification Approach

Fair pricing of embedded options in life insurance contracts is usually conducted by using risk-neutral valuation. This pricing framework assumes a perfect hedging strategy, which insurance companies can hardly pursue in practice. In this paper, we extend the risk-neutral valuation concept with a risk measurement approach. We accomplish this by first calibrating contract parameters that lead to the same market value using risk-neutral valuation. We then measure the resulting risk assuming that insurers do not follow perfect hedging strategies. As the relevant risk measure, we use lower partial moments, comparing shortfall probability, expected shortfall, and downside variance. We show that even when contracts have the same market value, the insurance company’s risk can vary widely, a finding that allows us to identify key risk drivers for participating life insurance contracts.