Bayesian multivariate regime-switching models and the impact of correlation structure misspecification in variable annuity pricing

ABSTRACT

We develop Bayesian multivariate regime-switching models for correlated assets, comparing three different ways to flexibly structure the correlation matrix. After developing the models, we examine their relative characteristics and performance, first in a straightforward asset simulation example, and later applied to a variable annuity product with guarantees. We find that the freedom allowed by the more flexible structures enables these models to more accurately reflect the actual asset dependence structure. We also show that the correlation structures inferred by the most commonly used (and simplest) model will result in significantly larger estimates of the cost of the annuity guarantees.