Guarantees in With-Profit and Unitized With-Profit Life Insurance Contracts: Fair Valuation Problem in Presence of the Default Option

The purpose of the article is to apply contingent claim theory to the valuation of the type of participating life insurance policies commonly sold in the UK. The article extends the techniques developed by Haberman, Ballotta, and Wang (2003) to allow for the default option. The default option is a feature of the design of these policies, which recognizes that the insurance company's liability is limited by the market value of the reference portfolio of assets underlying the policies that have been sold. The valuation approach is based on the classical contingent claim pricing “machinery,” underpinned by Monte Carlo techniques for the computation of fair values. The article addresses in particular the issue of a fair contract design for a complex type of participating policy and analyzes in detail the feasible set of policy design parameters that would lead to a fair contract and the trade‐offs between these parameters.     

Analysis of Participating Life Insurance Contracts: A Unification Approach

Fair pricing of embedded options in life insurance contracts is usually conducted by using risk‐neutral valuation. This pricing framework assumes a perfect hedging strategy, which insurance companies can hardly pursue in practice. In this article, we extend the risk‐neutral valuation concept with a risk measurement approach. We accomplish this by first calibrating contract parameters that lead to the same market value using risk‐neutral valuation. We then measure the resulting risk assuming that insurers do not follow perfect hedging strategies. As the relevant risk measure, we use lower partial moments, comparing shortfall probability, expected shortfall, and downside variance. We show that even when contracts have the same market value, the insurance company's risk can vary widely, a finding that allows us to identify key risk drivers for participating life insurance contracts.     

A note on value relevance of mark-to-market values of energy contracts under EITF Issue No. 98-10

This paper examines whether marked-to-market values of energy trading assets and liabilities of companies that enter into energy contracts are related to market value of equity. The Emerging Issues Task Force of the Financial Accounting Standards Board ruled in November 2002 to ban the use of mark-to-market accounting for energy contracts out of concern that fair values can be easily inflated. We find that the excess of fair value over original value of energy trading assets and energy trading liabilities is not relevant for valuation. It may be inferred that fair values which are subject to management estimates and not verifiable are poor signals of worth and performance (Watts, R., 2003. Conservatism in accounting Part I: Explanations and implications. Accounting Horizons 17, 207–221).     

Life insurance in a contingent claim framework: Pricing and regulatory implications

In this paper we develop a contingent claim model to evaluate the equity and liabilities of a life insurance company. The limited liability of shareholders is explicitly modelled. We focus on a specific type of life insurance policy—namely, the profit-sharing policy. In this policy, the policyholder is entitled to a guaranteed interest rate and a percentage of the company's yearly financial revenues. The implicit equilibrium interest rate and profit-sharing ratio are derived and analyzed. We finally discuss regulatory measures frequently encountered in the life insurance business such as rate ceilings, capital ratios, and asset restrictions.     

Fair valuation of insurance liabilities via mean-variance hedging in a multi-period setting

A general class of fair valuations which are both market-consistent (mark-to-market for any hedgeable part of a claim) and actuarial (mark-to-model for any claim that is independent of financial market evolutions) was introduced in Dhaene et al. [Insurance: Mathematics & Economics, 76, 14–27 (2017)] in a single period framework. In particular, the authors considered mean-variance hedge-based (MVHB) valuations where fair valuations of insurance liabilities are expressed in terms of mean-variance hedges and actuarial valuations. In this paper, we generalize this MVHB approach to a multi-period dynamic investment setting. We show that the classes of fair valuations and MVHB valuations are equivalent in this generalized setting. We derive tractable formulas for the fair valuation of equity-linked contracts and show how the actuarial part of their MVHB valuation decomposes into a diversifiable and a non-diversifiable component.     

Creating Customer Value in Participating Life Insurance

The value of a life insurance contract may differ depending on whether it is looked at from the customer's point of view or that of the insurance company. We assume that the insurer is able to replicate the life insurance contract's cash flows via assets traded on the capital market and can hence apply risk‐neutral valuation techniques. The policyholder, on the other hand, will take risk preferences and diversification opportunities into account when placing a value on that same contract. Customer value is represented by policyholder willingness to pay and depends on the contract parameters, that is, the guaranteed interest rate and the annual and terminal surplus participation rate. The aim of this article is to analyze and compare these two perspectives. In particular, we identify contract parameter combinations that—while keeping the contract value fixed for the insurer—maximize customer value. In addition, we derive explicit expressions for a selection of specific cases. Our results suggest that a customer segmentation in this sense, that is, based on the different ways customers evaluate life insurance contracts and embedded investment guarantees while ensuring fair values, is worthwhile for insurance companies as doing so can result in substantial increases in policyholder willingness to pay.     

The Value of Deposit Insurance in the Presence of Interest Rate and Credit Risk

In this paper we employ the theory of the term structure of interest rates and the pricing of interest contingent contracts to determine the fair value of insurance for depository institutions. The balance sheet of a bank is taken to consist of long and short positions in various fixed income securities. Deposit insurance for the bank is a put option on the value of the assets. The value of deposits, assets, the implied exercise price of the put and the value of the put are all determined simultaneously as part of the same valuation solution. The approach is developed initially for a single‐state term structure. It is extended to incorporate credit risk on bank assets.
The most important policy implication is that for a bank whose assets are longer term than its liabilities and whose borrowers are not excessively leveraged the properly calculated, risk‐adjusted deposit insurance premia are increasing functions of the level of interest rates. Sensitivity analyses also treat such factors as the bank's deposit to asset ratio, duration gap, interest volatility, the volatility of assets backing the bank loans, and the bank's borrowers' debt to equity ratio.     

保险公司负债公允价值的评估

保险公司的资产与负债按照财务报告或风险管理的要求要用公允价值来表示其价值。保险公司负债主要由各种类型的保险合同组成。尽管金融产品的交易非常活跃,市场价格可以相对容易地获得,但像保险合同这样缺乏交易市场,并且风险是非系统化的金融产品的公允价值的计算却十分困难。通过分层次的方法可以有效地评估金融工具的公允价值,其中评估保险公司负债的公允价值最常用的方法是现值法。现值法中包含了直接法与间接法两种本质上等价的方法。本文对这两种方法分别作了分析,并提出了在评估保险公司负债的公允价值时需要考虑的一些现实问题。     

Fair valuation of cliquet-style return guarantees in (homogeneous and) heterogeneous life insurance portfolios

Participating life insurance contracts allow the policyholder to participate in the annual return of a reference portfolio. Additionally, they are often equipped with an annual (cliquet-style) return guarantee. The current low interest rate environment has again refreshed the discussion on risk management and fair valuation of such embedded options. While this problem is typically discussed from the viewpoint of a single contract or a homogeneous* insurance portfolio, contracts are, in practice, managed within a heterogeneous insurance portfolio. Their valuation must then – unlike the case of asset portfolios – take account of portfolio effects: Their premiums are invested in the same reference portfolio; the contracts interact by a joint reserve, individual surrender options and joint default risk of the policy sponsor. Here, we discuss the impact of portfolio effects on the fair valuation of insurance contracts jointly managed in (homogeneous and) heterogeneous life insurance portfolios. First, in a rather general setting, including stochastic interest rates, we consider the case that otherwise homogeneous contracts interact due to the default risk of the policy sponsor. Second, and more importantly, we then also consider the case when policies are allowed to differ in further aspects like the guaranteed rate or time to maturity. We also provide an extensive numerical example for further analysis.     

A Finite Difference Approach to the Valuation of Path Dependent Life Insurance Liabilities

This paper sets up a model for the valuation of traditional participating life insurance policies. These claims are characterized by their explicit interest rate guarantees and by various embedded option elements, such as bonus and surrender options. Owing to the structure of these contracts, the theory of contingent claims pricing is a particularly well-suited framework for the analysis of their valuation.The eventual benefits (or pay-offs) from the contracts considered crucially depend on the history of returns on the insurance company's assets during the contract period. This path-dependence prohibits the derivation of closed-form valuation formulas but we demonstrate that the dimensionality of the problem can be reduced to allow for the development and implementation of a finite difference algorithm for fast and accurate numerical evaluation of the contracts. We also demonstrate how the fundamental financial model can be extended to allow for mortality risk and we provide a wide range of numerical pricing results.     

The Purpose of the Firm,Valuation, and the Management of Intangibles

This article provides a different way of thinking about, and responding to, four important issues that confront most public companies. First, in articulating the overarching corporate purpose, the author suggests a middle ground between shareholder value maximization and stakeholder theory that aims to achieve the end result of value maximization while taking a “holistic” view that meets most of the demands of stakeholder advocates. As described by the author, there are four critical steps for management and boards in creating such companies: (1) communicating a vision of the company and its purpose to employees as well as investors (and other key outsiders); (2) organizing to survive and prosper through efficiency and innovation; (3) working continuously to develop win‐win relationships with stakeholders and other companies; and (4) taking care of the environment and future generations. Second, in thinking about the corporate purpose and how to evaluate success in achieving it, managements and boards need a valuation model that provides a clear and insightful connection between long‐term corporate performance and market valuation, and how both might be expected to change as the firm matures. A strong case is presented for the life‐cycle valuation model, widely used by money management organizations, in which a company's projected cash flows reflect an expected “fade” in both economic returns on capital and reinvestment rates. The potential uses of this model are illustrated using lifecycle corporate performance data for 3M during the past 50 years. Third, in an effort to capture the value of innovation and investment in intangible assets, the author presents an alternative to the accounting approach of capitalizing and amortizing such assets that attempts to capture their expected future benefits by using more favorable forecasts of long‐term fade rates. Fourth, the author shows how incorporating Life‐cycle Reviews for each of a company's business units as part of its Integrated Reporting could improve management's resource allocation decisions, help build a shareholder base of long‐term investors, and provide management with the support and confidence to resist Wall Street's excessive emphasis on quarterly earnings.     

Pricing Double-Trigger Reinsurance Contracts: Financial Versus Actuarial Approach

This article discusses various approaches to pricing double‐trigger reinsurance contracts—a new type of contract that has emerged in the area of ‘‘alternative risk transfer.’’ The potential coverage from this type of contract depends on both underwriting and financial risk. We determine the reinsurer's reservation price if it wants to retain the firm's same safety level after signing the contract, in which case the contract typically must be backed by large amounts of equity capital (if equity capital is the risk management measure to be taken). We contrast the financial insurance pricing models with an actuarial pricing model that has as its objective no lessening of the reinsurance company's expected profits and no worsening of its safety level. We show that actuarial pricing can lead the reinsurer into a trap that results in the failure to close reinsurance contracts that would have a positive net present value because typical actuarial pricing dictates the type of risk management measure that must be taken, namely, the insertion of additional capital. Additionally, this type of pricing structure forces the reinsurance buyer to provide this safety capital as a debtholder. Finally, we discuss conditions leading to a market for double‐trigger reinsurance contracts.     

The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. The aim of this article is to study this effect on competitive equity–premium combinations while considering a framework with policyholders and equity holders where guaranty fund charges are volume‐based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one‐period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence, adverse incentives may arise with regard to the overall security level of the industry.     

The Gap between the Theory and Practice of Corporate Valuation: Survey of European Experts

The valuation of companies or their assets is at the heart of most financing and investment decisions. Over the last five decades, academics have developed several simple and sophisticated models for corporate valuation. Yet valuation estimates of a firm or its assets appear to vary widely among practitioners. It is unclear whether these differences arise from practitioners' use of different valuation models or from differences in their assumptions about the inputs used in those models. To provide some insights into this issue, the authors recently surveyed 365 European finance practitioners with CFAs or equivalent professional degrees. They find that almost all survey respondents use the Discounted Cash Flow (DCF) model (along with some version of Relative Valuation that relies on the use of “comparables”). But the estimation methods of such practitioners for almost all inputs in the DCF model, including beta, the equity market risk premium, leverage, cost of debt, and terminal value, vary widely. This can be a serious problem because even small differences in inputs can cause huge variations in valuations. Such differences arise primarily because theory provides little guidance on how to estimate parameters, leaving practitioners to make their own assumptions and judgments. In sum, the authors' findings suggest that the process of estimating valuation parameters can be as important as the choice of the valuation model itself, and requires the serious attention of academics and practitioners. The authors recommend that key valuation parameter estimates be disclosed in financial and valuation reports. Their findings are also relevant to policy makers because the concept of “fair value” plays such a central role in post‐crisis regulation.     

Exotic unit-linked life insurance contracts

This article integrates aspects of traditional insurance with advances in financial economics, yielding proper valuation and premium assessments of insurance benefits linked to various financial assets. Several new types of unit-linked life insurance contracts are discussed, with substantial potential for real-life applications. Compared to usual unit-linked products, these contracts offer added flexibility and/or altered exposure to financial risk for the insured and/or the insurer. The single premiums of these policies are calculated as expectations under a risk-adjusted probability measure (equivalent martingale measure), satisfying no-arbitrage conditions in financial markets.     

Corporate governance,SFAS 157 and cost of equity capital: evidence from US financial institutions

This study examines the association between fair value measurements and the cost of equity capital under different fair value valuation methods, and assesses the impact of corporate governance on this relationship for US financial firms. We find that firms’ cost of equity capital is negatively associated with more verifiable fair value assets and positively related to less verifiable fair value assets. Furthermore, the positive association between less verifiable fair value assets and the cost of equity capital is mitigated under better corporate governance. The differential impact between more and less verifiable assets becomes smaller for firms with stronger governance. Our findings contribute to the ongoing debate on fair value regulation by investigating the economic consequences of adopting Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) and the importance of audit committee financial expertise on fair value reporting. We also provide evidence on the importance of board independence, internal control strength, auditor industry specialists, and audit committee financial experts in fair value reporting.     

Insurance Guaranty Schemes in a Contingent Claims Setting

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. This contribution summarizes the major findings of a working paper written by Schmeiser and Wagner (Working Papers on Risk Management and Insurance (IVW-HSG), No. 80, 2010). The effect on competitive equity-premium combinations is studied while considering a framework with policyholders and equity holders where guaranty fund charges are volume-based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one-period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence adverse incentives may arise with regard to the overall security level of the industry.     

On accounting standards and fair valuation of life insurance and pension liabilities

The actuarial profession is increasingly teaming up with financial economists for a fruitful cooperation on the proper valuation of life insurance and pension (L&P) liabilities. This has been a natural consequence of a recent sharply increased focus on market values in financial reports of L&P companies from regulators, standard setters, the financial press, stakeholders, and others with an interest in the L&P business.

This article provides a financial economist's point of view on recent developments in relation to the fair valuation of L&P liabilities. The role of accounting standards and the background for the international harmonization in this field are first discussed. We then review and explain the concept of fair value and provide a general view on appropriate techniques for estimating fair values of L&P liabilities in accordance with the definition of the concept. The paper also contains a section which briefly reviews recent and quite innovative regulatory initiatives in relation to market value reporting in the Danish market for life and pension insurance.     

The impact of the institutional environment on the value relevance of fair values

Most prior studies attribute valuation discounts on certain fair valued assets to measurement error or bias. We argue that institutional differences across countries (e.g., information environment or market sophistication) affect investors’ ability to process and impound fair value information in their valuation. We predict that the impact of the institutional environment on value relevance is particularly pronounced for reported fair values of assets designated at fair value through profit or loss (hereafter, “FVO assets”), for which investor experience is lowest and complexity is highest. Using a global sample of IFRS banks, we find that FVO assets are generally less value relevant than held-for-trading assets (HFT) and available-for-sale assets (AFS). By partitioning countries into market- and bank-based economies to proxy for institutional differences, we find that the valuation discount on FVO assets is more pronounced in bank-based economies. Additional tests suggest that this valuation discount is attenuated by a richer firm-level information environment and the presence of institutional investors with fair value experience.