Chapter 23 Cost of guarantees and options

Question 1

How do insurer’s meet the cost of the liability created by the investment guarantee? (1)

What methods are available to price the costs of the guarantee? (2)

Answer 1

Insurer’s meet the cost of the additional liability created by the guaranteed by

charging an extra premium to reflect the extra sums it may need to pay due to the guarantee biting
To determing the extra premium to charge, the insurer can use

option pricing techniques
stochastic simulation

Question 2

Describe the general principle behind option pricing techniques to calc the extra premium for an investment guarantee (1)

Give examples of options which can be used to meet the different investment guarantees insurers may offer (6)

Answer 2

Option pricing/market valuation techniques assess the extra premium by

looking at market price of derivative/option insurer could use to mitigate risk
Options which can be used to mitigate the following investment guarantees

guaranteed maturity value
European style put option on investment funds at an exercise price = maturity guarantee
guaranteed surrender value
similar American style put option/series of puts with different exercise prices which match guaranteed surrender values
guaranteed annuity rate
call option on bonds that are needed to ensure guarantee is met
ie at exercise price which generated the required fixed rate of return
can also be mirrored by option to swop floating rate returns at the option date for fixed returns sufficient to meet guaranteed annuity option