On the risk of insurance liabilities: Debunking some common pitfalls

This article develops a life insurance liabilities valuation model that debunks some pitfalls commonly encountered in the insurance industry. Using a contingent claim based methodology, a fairly simple closed-form solution for the pricing of life insurance liabilities is obtained. Because it accounts for stochastic interest rates, default risk, and bonus schemes, this model produces more accurate interest rate elasticity and duration measures. The effective duration of life insurance liabilities is shown to be significantly different from the traditional Macaulay duration measure. For reasonable sets of parameters, equity is shown to resemble a short straddle even though we do not rely on the traditional explanations to achieve such a result. Immunization implications are considered.