Keeping the number of risk neutral scenarios as low as possible
Keeping the number of risk neutral scenarios as low as possible. Life insurance products are often characterized by embedded options or guarantees that are contractually promised to the policy holder. The value of these options or guarantees depends heavily on the prevailing economic conditions. Think for instance of the level of the interest rate in case of profit-sharing options, or the return on investments in case of Unit-Linked products with a return guarantee. The value of these embedded options or guarantees is an integral part of the market value of insurance liabilities and a correct valuation is therefore essential.
The valuation of embedded options or guarantees in insurance liabilities is important for life insurers for reporting purposes and internal steering. And it has also gained much more attention because of Solvency II, the European wide regulatory regime for insurance companies, which has officially come into force at the beginning of this year. Due to the inherent uncertainty in the future pay-off structure of insurance contracts containing these embedded options or guarantees, risk-neutral valuation techniques need to be used to determine their current value.