Pricing European Options on Deferred Insurance

Jonathan Ziveyi (), Craig Blackburn () and Michael Sherris ()
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Jonathan Ziveyi: School of Risk and Actuarial Studies, University of New South Wales
Craig Blackburn: School of Risk and Actuarial Studies and ARC Centre of Excellence in Population Ageing Research, Australian School of Business, University of New South Wales
Michael Sherris: School of Risk and Actuarial Studies and ARC Centre of Excellence in Population Ageing Research, Australian School of Business, University of New South Wales

No 201202, Working Papers from ARC Centre of Excellence in Population Ageing Research (CEPAR), Australian School of Business, University of New South Wales

Abstract: This paper considers the pricing of European call options written on pure endowment and deferred life annuity contracts, also known as guaranteed annuity options. These contracts provide a guarantee value at maturity of the option. The contract valuation is dependent on stochastic interest rate and mortality processes. We assume single-factor stochastic squareroot processes for both interest rate and mortality intensity, with mortality being a timeinhomogeneous process. We then derive the pricing partial differential equation (PDE) and the corresponding transition density PDE for options written on deferred contracts. The general solution of the pricing PDE is derived as a function of the transition density function. We solve the transition density PDE by first transforming it to a system of characteristic PDEs using Laplace transform techniques and then applying the method of characteristics. Once an explicit expression for the density function is found, we then use sparse grid quadrature techniques to generate European call option prices on deferred insurance products. This approach can easily be generalised to other contracts which are driven by similar stochastic processes presented in this paper. We test the sensitivity of the option prices by varying independent parameters in our model. As option maturity increases, the corresponding option prices significantly increase. The effect of miss-pricing the guaranteed annuity value is analysed, as is the benefit of replacing the whole-life annuity with a term annuity to remove volatility of the old age population.

Keywords: Mortality risk; Deferred insurance products; European options; Laplace Transforms (search for similar items in EconPapers)
JEL-codes: C63 G12 G13 G22 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2012-02
New Economics Papers: this item is included in nep-ias
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