Risk-neutral valuation of participating life insurance contracts

The valuation of life insurance contracts using concepts from financial mathematics has recently attracted considerable interest in academia as well as among practitioners. In this paper, we will investigate the valuation of participating contracts, which are characterized by embedded interest rate guarantees and some bonus distribution rules. We will model these under the specific regulatory framework in Germany; however, our analysis can be applied to any insurance market with cliquet-style guarantees. We will present a framework, in which different kinds of guarantees or options can be analyzed separately. Also, the practical implementation of such models is discussed. We use two different numerical approaches to derive fair parameter settings of such contracts and price the embedded options. The sensitivity of the contract value with respect to multiple parameters is studied. In particular, we find that life insurers offer interest rate guarantees below their risk-neutral value. Furthermore, the financial strength of an insurance company considerably affects the value of a contract. (c) 2006 Elsevier B.V. All rights reserved.