Valuation of the Minimum Guaranteed Return Embedded in Life Insurance Products

Knut Aase and Svein-Arne Persson

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: Consider a traditional life insurance contract paid with a single premium. In addition to mortality factors, the relationship between the fixed amount of benefit and the single premium depends on the interest rate (calculation rate). The calculation rate can be interpreted as the average rate the insurance company must earn on its investment in the insurance period to fulfill its future obligations. In many countries the traditional life insurance products include a fixed percentage guarantee on each year's return. This annual guarantee comes in addition to the fixed benefit. Furthermore, no extra premium is charged for this guarantee. In this article we present a model for the valuation of life insurance contracts including a guaranteed minimum return. The model is based on the notion of no arbitrage opportunities from the theories of financial economics. Numerical examples indicate that these guarantees may have substantial market values.

This paper was presented at the Financial Institutions Center's May 1996 conference on "

Date: 1996-05
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