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1 Market-Consistent Valuation of Insurance Contracts Antoon Pelsser Professor of Actuarial Science University of Amsterdam & Netspar.

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Presentation on theme: "1 Market-Consistent Valuation of Insurance Contracts Antoon Pelsser Professor of Actuarial Science University of Amsterdam & Netspar."— Presentation transcript:

1 1 Market-Consistent Valuation of Insurance Contracts Antoon Pelsser Professor of Actuarial Science University of Amsterdam & Netspar

2 2 Outline Historical Roots: Actuarial & Finance Collapse of Equitable Life Market-Consistent Valuation New Directions for Actuaries

3 3 Historical Roots: Actuarial Life-insurance is oldest profession 1670s: Valuation of Annuities Complex calculations long before computer-age Actuarial education more art than science Deal with uncertainty via conservative deterministic assumptions Create extra buffers as a cushion for risk

4 4 Historical Roots: Actuarial (2) First half of 20 th century Investment portfolio of life-insurers mainly bonds Investment returns higher than base-rate Prudence to cover for actuarial risks Risk-sharing between insurer and policy- holder With-profits insurance policies

5 5 Historical Roots: Actuarial (3) Last quarter of 20th century Invest (aggressively) in stocks Higher return than bonds Unit-Linked insurance products Continue to use traditional actuarial methods Prudent base rate Profit-sharing Minimum return guarantees

6 6 Historical Roots: Finance Meanwhile in banking… 1950: Markowitz Mean-Variance optimisation 1970: Black-Scholes-Merton Derivative pricing via Delta-Hedging Completely different methodology of dealing with risk! Reduce risk via offsetting trading-positions 1980+: Development of risk-management and supervision in banking

7 7 Collapse of Equitable Life End of 1990s: Collapse of Equitable Life in UK Oldest life-insurance company (1762) Large life-insurance company Guaranteed Annuity Option (GAO) Mortality Guarantee (1950s table) Interest Rate Guarantee (8%) Significant change in both risk-factors from 1970 – 1999

8 8 Wake-Up Call for Actuaries Shock for actuaries as risk professionals Severe criticism in UK on the profession Morris Review of the Actuarial Profession Market risks are often larger than insurance risks Regulators push for Market-Consistent Valuation Denmark, Switzerland, UK, Netherlands Europe Solvency II IASB Accounting of Insurance Contracts

9 9 Market-Consistent Valuation MC value of Liabilities = Market value of Replicating Portfolio Discount cash flows with todays term structure of interest rates Calculate value of embedded options with arbitrage- free pricing Risk-neutral pricing Different from classical Embedded Value

10 10 New Directions for Actuaries Bring classical actuaries up-to-speed with modern financial economics Important steps have already been made Continuing improvement in the curriculum needed Change from risk observer to risk manager Reserve for the risk & wait… Change in attitude is not easy Use active risk management (for financial risks)

11 11 New Directions… (2) European Insurance Regulators are developing Solvency II, which is fully market-consistent based How to deal with Internal Models? New proposal from IASB is fully consistent with market-consistent principles No consensus (yet) on how to calculate the Market-Consistent value: Own Credit Rating Market Value Margin

12 12 New Directions… (3) Financial-economic pricing assumes complete market Every insurance contract can be replicated by financial instruments This is not true for insurance! Pricing rules in incomplete markets Mortality risk & trends Insurance risks (Irrational) Policyholder behaviour With-Profits contracts

13 13 New Directions… (4) Find pricing rules that are Consistent with arbitrage-free pricing for financial risks Extend for non-financial risks Utility-based approach seems promising Find practical rules-of-thumb This is currently a field of active academic research (1 mln grant from Netspar)


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