A Finite Difference Approach to the Valuation of Path Dependent Life Insurance Liabilities

Anders Grosen (), Bjarke Jensen () and Peter Løchte Jørgensen
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Anders Grosen: Department of Finance, Aarhus School of Business, Postal: Fuglesangs Allé 4, 8210 Aarhus V, Denmark
Bjarke Jensen: SEB Fixed Income Research, Postal: Landmærket 10, 1119 Copenhagen K, Denmark
Peter Løchte Jørgensen: Department of Management, Postal: Aarhus University, Bldg. 350, 8000 Aarhus C, Denmark

No 01-5, Finance Working Papers from University of Aarhus, Aarhus School of Business, Department of Business Studies

Abstract: This paper sets up a model for the valuation of traditional participating life insurance policies. These claims are characterized by their explicit interest rate guarantees and by various embedded option elements, such as bonus and surrender options. Owing to the structure of these contracts, the theory of contingent claims pricing is a particularly well-suited framework for the analysis of their valuation. The eventual benefits (or pay-offs) from the contracts onsidered crucially depend on the history of returns on the insurance company’s assets during the contract period. This path-dependence prohibits the derivation of closed-form valuation formulas but we demonstrate that the dimensionality of the problem can be reduced to allow for the development and implementation of a finite difference algorithm for fast and accurate numerical evaluation of the contracts. We also demonstrate how the fundamental financial model can be extended to allow for mortality risk and we provide a wide range of numerical pricing results.

Date: Written 2001-02-27
Note: Later published in The Geneva Papers on Risk and Insurance Theory, vol. 26, 2001, p. 57-84.
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