MARKET VALUE MARGIN VIA MEAN–VARIANCE HEDGING

Andreas Tsanakas, Mario V. Wüthrich and Aleš Černý

ASTIN Bulletin, 2013, vol. 43, issue 3, 301-322

Abstract: We use mean–variance hedging in discrete time in order to value an insurance liability. The prediction of the insurance liability is decomposed into claims development results, that is, yearly deteriorations in its conditional expected values until the liability is finally settled. We assume the existence of a tradeable derivative with binary pay-off written on the claims development result and available in each development period. General valuation formulas are stated and, under additional assumptions, these valuation formulas simplify to resemble familiar regulatory cost-of-capital-based formulas. However, adoption of the mean–variance framework improves upon the regulatory approach by allowing for potential calibration to observed market prices, inclusion of other tradeable assets, and consistent extension to multiple periods. Furthermore, it is shown that the hedging strategy can also lead to increased capital efficiency.

Date: 2013
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