Introduction

This chapter gives an introduction to interest rate derivatives and their use in risk-management for life insurance companies. The first part of the chapter recalls the definitions of swap rates, swaps, swaptions and related products within a setting similar to the one studied in the previous chapters. Then we describe some pricing methods that have been proposed in the literature. There are a vast number of instruments available in the financial markets, and there exist many different models for the pricing of these instruments; see, for example, Brigo and Mercurio (2001), Musiela and Rutkowski (1997) and Rebonato (2002). Our treatment of this area is rather minimal, and our aim is simply to provide a brief introduction to certain developments that seem useful in an analysis of the risk faced by life insurance companies. The reader is therefore referred to the abovementioned references for a more detailed and systematic treatment of the basic theory.

We end the chapter by giving possible applications of these instruments in the area of risk management for a life insurance company facing insurance liabilities that cannot be hedged via bonds in the market due to the very long time horizon associated with the liabilities. Typically, insurance companies are faced by insurance liabilities that extend up to sixty years into the future, whereas the financial markets typically do not offer bonds that extend more than thirty years into the future.