Summary

In this chapter we describe financial options embedded in insurance contracts, focusing in particular on the most straightforward options which appear as guaranteed minimum death and maturity options in equity-linked life insurance policies effected by a single premium. We investigate pricing, valuation and risk management for these guarantees, performing our analysis under the Black–Scholes–Merton framework described in Chapter 13.

Introduction

The guaranteed minimum payments under an equity-linked contract usually represent a relatively minor aspect of the total payout under the policy, because the guarantees are designed to apply only in the most extreme situation of very poor returns on the policyholders' funds. Nevertheless, these guarantees are not negligible – failure to manage the risk from apparently innocuous guarantees has led to significant financial problems for some insurers.

In Chapter 12 we described profit testing of equity-linked contracts with guarantees, where the only risk management involved was a passive strategy of holding capital reserves in case the experience is adverse – or, even worse, holding no capital in the expectation that the guarantee will never apply. However, in the case when the equity-linked contract incorporates financial guarantees that are essentially the same as the financial options discussed in Chapter 13, we can use the more sophisticated techniques of Chapter 13 to price and manage the risks associated with the guarantees.