Market based tools for managing the life insurance company

In this paper we present an approach to market based valuation of life insurance policies, in the spirit of the NUMAT proposed by Hans Bühlmann (2002) in an editorial in the ASTIN Bulletin. We have experienced the valuation method for more than one decade, both as a pricing procedure applied to policy portfolios of leading insurance companies, and by including the valuation principles into several actuarial teaching activities. Our interest is mainly focused here on participating policies that in Italy are characterized by contractually binding profit sharing rules. The problem of the fair valuation of the liabilities generated to the insurer by these contracts can be conveniently addressed using the methods of contingent claims pricing. These allow to price correctly the options embedded into the policies and to implement consistent plans of asset-liability management. The approach also provides a market based measurement of the value of business in force for outstanding policy portfolios and consistent assessments of the financial risk based capitals. 1 A NUMAT system from Italy In line with the suggestions expressed by Hans Bühlmann in the proposal of the NUMAT approach (Bühlmann, 2002) and also in the discussion of the article by Aase and Persson (Bühlmann, 2003a), we describe here our experience in applying and teaching the financial approach in valuation of life insurance policies in Italy. Our approach has been focused on two main issues: – providing a mark-to-market (fair) valuation of the outstanding liabilities of an insurance company, jointly with the appropriate measures of sensitivity to financial risk factors, e.g. interest rate risk, that are essential for implementing a consistent plan of asset-liability management; – derive a more reliable measure of the value embedded in business in force (VBIF), including a mark-to-market valuation of the financial options embedded into the policies. It is worth mentioning that when applied to a single policy at the issue date the approach also provides a fair methodology for profit testing. Another important byproduct is the derivation of the financial components of the risk based capital of the outstanding portfolio. This is typically done by properly stressing the risk factors of the valuation model and then repeating the pricing procedure under the “worst case scenario”.