Hedging Endowment Assurance Products under Interest Rate and Mortality Risk

This paper analyzes how model misspecification associated with both interest rate and mortality risk influences hedging decisions of insurance companies. For this purpose, diverse risk management strategies which are risk–minimizing when model risk is ignored come into consideration. The effectiveness of these strategies is investigated by looking at the distribution of the resulting hedging errors under the combination of both sources of model risk. The analysis is based on endowment assurances which include an investment element together with a sum assured. Normally, the customer contributes periodic premiums. Compared to an upfront premium, this poses an additional risk to the insurance company. Since the premium payments stop in the case of an early death, it is not known today how many premium payments will be forthcoming. Theoretically, a loan corresponding to the present value of the expected delayed premium payments must be asked for by the insurance company in order to implement his hedging decisions. Therefore, we also consider how model risk affects this borrowing decision.