Cost of Capital and Surrender Options for Guaranteed Return Life Insurance Contracts

The opacity of traditional accounting systems for insurance companies is well known. This was confirmed recently by unexpected repercussions of stock market and interest rates movements on the financial strength of many insurance companies. To improve transparency, new valuation standards are initiated by regulators or by professional bodies such as actuaries or accountants. Whether the purpose is pricing or risk management, the new standards are all based on a market consistent framework where assets and liabilities are valued at market value. Traditionally the pricing and the risk capital assessment are treated separately. In this thesis we build a unifying valuation framework where these two components can not be dissociated. To reflect the incompleteness of insurance markets and the limited access to equity capital, we introduce the notion of cost of capital. We analyse the impact of the cost of capital on the valuation of life insurance contracts with guarantees. In the last part of this thesis we focus on surrender options that represent today one of the most obscure risk for life insurers. We present models where the pricing can be precisely performed, but we also discuss certain aspects of policyholder’s behaviour. 1 Acknowledgement I would like to thank the supervisors of my master’s thesis, Prof. Damir Filipovíc for his valuable comments and for his availability, Prof. Paul Embrechts for useful discussions and Jon Bardola who supported me with the necessary time of work and also encouraged me in the selection of this practical topic.