Investment strategies and risk management for participating life insurance contracts

Transcription

1 1/20 Investment strategies and risk for participating life insurance contracts and Steven Haberman Cass Business School AFIR Colloquium Munich, September 2009

2 2/20 & Motivation Motivation New supervisory framework for the (life) insurance industry: IASB Insurance Project EU Solvency II Review Basic concepts consistent valuation of A & L Target Capital Focus directed especially on Fair valuation : what is it? How to carry out the program? modelling Identification of embedded options: the default option & safety loading

3 3/20 Aims and objectives Motivation of financial risk induced by a participating contract with minimum guarantee Consiglio et al. (2006): reference portfolio structuring by means of non linear programming using the Wilkie model Bernard et al. (2006): investment strategies for the corresponding safety loading in a market set up á la Merton (1974)

4 3/20 Aims and objectives Motivation of financial risk induced by a participating contract with minimum guarantee Consiglio et al. (2006): reference portfolio structuring by means of non linear programming using the Wilkie model Bernard et al. (2006): investment strategies for the corresponding safety loading in a market set up á la Merton (1974) (Static) allocation approach minimization Chosen risk measure : volatility of the guaranteed benefit with respect to prespecified target

5 3/20 Aims and objectives Motivation of financial risk induced by a participating contract with minimum guarantee Consiglio et al. (2006): reference portfolio structuring by means of non linear programming using the Wilkie model Bernard et al. (2006): investment strategies for the corresponding safety loading in a market set up á la Merton (1974) (Static) allocation approach minimization Chosen risk measure : volatility of the guaranteed benefit with respect to prespecified target Analysis of market consistent value of embedded options and safety loading probability of default and Solvency II capital requirements robustness of the approach

6 4/20 1 The Participating contract Design Embedded options Safety loading 2 The reference portfolio 3 The market model 4 5

7 5/20 The Participating Contract The Participating Contract Starting time: t = 0; maturity: T = 20 years Single premium: π 0 Reference fund: F(t) Leverage coefficient: θ such that π 0 = θf(0) Embedded options Reversionary bonus

8 5/20 The Participating Contract The Participating Contract Embedded options Reversionary bonus Starting time: t = 0; maturity: T = 20 years Single premium: π 0 Reference fund: F(t) Leverage coefficient: θ such that π 0 = θf(0) Benefit at maturity: Guaranteed component: π(t) Discretionary component (terminal bonus): R(T) = (θf(t) π(t)) + Terminal bonus rate: γ

9 6/20 The fair pricing condition The Participating Contract Embedded options Reversionary bonus Benefit paid IF company solvent at T overall liability: π(t) + γr(t) D(T) where D(T) = (π(t) F(T)) + payoff of the Default Option No arbitrage condition: π 0 = V π (0) + γv R (0) V D (0)

10 6/20 The fair pricing condition The Participating Contract Embedded options Reversionary bonus Benefit paid IF company solvent at T overall liability: where π(t) + γr(t) D(T) D(T) = (π(t) F(T)) + payoff of the Default Option No arbitrage condition: π 0 = V π (0) + γv R (0) V D (0) π 0 + V D (0) = V π (0) + γv R (0) Price of the Default Option: additional premium to gain insurance against possible default Safety Loading V D (0) = ϕπ 0

11 7/20 The design of the guaranteed component π (t) = π (t 1) (1 + r π (t)) t = 1,2,...,T The Participating Contract Embedded options Reversionary bonus

12 7/20 The design of the guaranteed component The Participating Contract Embedded options Reversionary bonus π (t) = π (t 1) (1 + r π (t)) t = 1,2,...,T { ( )} r π (t) = max r G, β F(t) F(t n+1) n n F(t 1) F(t n) r G is the minimum guarantee β (0,1) is the participation rate n = min(t, τ), where τ is the length of the smoothing period

13 7/20 The design of the guaranteed component The Participating Contract Embedded options Reversionary bonus π (t) = π (t 1) (1 + r π (t)) t = 1,2,...,T { ( )} r π (t) = max r G, β F(t) F(t n+1) n n F(t 1) F(t n) r G is the minimum guarantee β (0,1) is the participation rate n = min(t, τ), where τ is the length of the smoothing period ( r π (t) = r G + β ) + n F(t i ) n i=1 F(t i 1 ) (β + r G) Sequence of Asian call options + risk free bond (No closed formulae for the price of the embedded options)

14 8/20 model Reference Portfolio: equity & bonds S(t) P(t,T) F(t) = αf(t 1) + (1 α)f(t 1) S(t 1) P(t 1,T) }{{}}{{} equity bond Model (simplified) Equity Geometric Brownian motion ds (t) = µs (t)dt + σs (t)dw (t) Interest rates Hull and White model dr (t) = κ (a (t) r (t))dt + vdz (t) Equity and interest rate are correlated

15 9/20 allocation strategy How to fix α? Idea: stabilize the expected guaranteed benefit due at maturity, with respect to prespecified target prespecified optimality criterion Strategy Implementation Results 3 Results 4 Results 5

16 9/20 allocation strategy Strategy Implementation Results 3 Results 4 Results 5 How to fix α? Idea: stabilize the expected guaranteed benefit due at maturity, with respect to prespecified target prespecified optimality criterion Prespecified Target t. = π 0 (1 + r G (1 + h)) T h = spread representing the policyholder participation in the asset returns

17 9/20 allocation strategy Strategy Implementation Results 3 Results 4 Results 5 How to fix α? Idea: stabilize the expected guaranteed benefit due at maturity, with respect to prespecified target prespecified optimality criterion Prespecified Target t. = π 0 (1 + r G (1 + h)) T h = spread representing the policyholder participation in the asset returns Optimality Criterion: MINIMIZE volatility of guaranteed benefit with respect to the target min α E [(π (T) t) 2] 1/2

18 9/20 allocation strategy Strategy Implementation Results 3 Results 4 Results 5 How to fix α? Idea: stabilize the expected guaranteed benefit due at maturity, with respect to prespecified target prespecified optimality criterion Prespecified Target t. = π 0 (1 + r G (1 + h)) T h = spread representing the policyholder participation in the asset returns Optimality Criterion: MINIMIZE volatility of guaranteed benefit with respect to the target min α E [(π (T) t) 2] 1/2 = minα [Var [π (T)] + (E[π (T)] t) 2] 1/2

19 10/20 Implementation Strategy Implementation Results 3 Results 4 Results 5 Monte Carlo simulation 1 Solve numerically the given optimization problem α 2 Obtain the corresponding no-arbitrage prices of the embedded options V π (0),V R (0),V D (0) 3 Derive the fair terminal bonus rate γ γ = (π 0 + V D (0) V π (0))/V R (0) 4 Calculate the safety loading ϕ ϕ = V D (0)/π 0 5 Compute the corresponding solvency indices

20 11/20 Results: Case 1 Strategy Implementation Results 3 Results 4 Results 5 Parameter set model Equity µ = 10% p.a. σ = 20% p.a. Interest rate r 0 = 4.5% v = % κ = % λ = ρ = 0.2 Policy design β = 70% θ = 90% r G = 4% h=70% F (0) = 100 τ = 3 years T = 20 years Prices β α V π (0) V R (0) V D (0) γ % ϕ % ϕ (α = 100%; β = 70%) = 53.79%

21 12/20 Solvency indices Strategy Implementation Results 3 Results 4 Results 5 A = insurer total assets available s.t. measures A(0) = F(0) + V D (0) P (π(t) > A(T)) TVaR of the solvency index s(t) = RBC(t+1) RBC(t) A(t) RBC(t) = A(t) }{{} P P (π(1) > A(1)) V π (t) γv R (t) }{{} ˆP Bearing Capital (FOPI 2006)

22 Probability of Default Strategy Implementation Results 3 Results 4 Results 5 P(π(T)>A(T)) a) Alternative investment strategy for the safety loading V D (0) β c) Probability of default in 1 year from inception V D only 6 x P(π(1)>A(1)) Probability of default at maturity P(π(T)>A(T)) b) Alternative investment strategies for the available funds β α = 0 α * α =1 1 13/ β

23 14/20 Strategy Implementation Results 3 Results 4 Results 5 Base case: β = 70%; ϕ = 1.67% Probability of Default t = 1 (F, φ) (α*, α*) 1.98% 0.02% (α*, 100%) 2.08% 0.02% A α* 1.98% - 100% 43.11% -

24 14/20 Strategy Implementation Results 3 Results 4 Results 5 Base case: β = 70%; ϕ = 1.67% Probability of Default t = 1 (F, φ) (α*, α*) 1.98% 0.02% (α*, 100%) 2.08% 0.02% A α* 1.98% - 100% 43.11% - Expected severity t = 1 AAA BBB 8% 7% 9% 7.5%

25 14/20 Base case: β = 70%; ϕ = 1.67% Probability of Default t = 1 (F, φ) (α*, α*) 1.98% 0.02% Expected severity t = 1 AAA BBB 8% 7% Strategy Implementation Results 3 Results 4 Results 5 (α*, 100%) 2.08% 0.02% 9% 7.5% A α* 1.98% % 43.11% (β = 50%; ϕ = 7.88%; α ) = (0.04%;15%;12%) (β = 90%; ϕ = 0.32%; α ) = (0.54%;20%;14%)

26 15/20 Bearing Capital Strategy Implementation Results α = 0 α * α = 1 β = 0.3 AAA AA A BBB BB B x% β = 0.7 α = 0 α * α = β = 0.5 α = 0 α * α = 1 AAA AA A BBB BB B x% β = 0.9 α = 0 α * α = 1 Results Results AAA AA A BBB BB B x% AAA AA A BBB BB B x%

27 16/20 Increasing the target: h = 90% Optimal asset allocation h = 70% h = 90 % α* Strategy Implementation Results 3 Results 4 Results β

28 16/20 φ Increasing the target: h = 90% Optimal asset allocation h = 70% h = 90 % Safety loading h = 70% h = 90% α* β β Strategy Implementation Results 3 Results 4 Results 5

29 16/20 φ Increasing the target: h = 90% Optimal asset allocation h = 70% h = 90 % Safety loading h = 70% h = 90% α* Strategy Implementation x β h = 70% α = 0 α * α = β Results 3 4 Results 4 3 Results β

30 16/20 φ Increasing the target: h = 90% Optimal asset allocation h = 70% h = 90 % Safety loading h = 70% h = 90% α* Strategy Implementation x β h = 70% α = 0 α * α = β h = 90% α = 0 α * α =1 Results Results 4 Results 5 3 P(π(1)>A(1)) β β

31 17/20 Stress testing ST Aim: to assess the robustness of the proposed asset allocation Adverse (extreme) movement at t = 1 year equity volatility interest rates σ = +10%, i.e. σ ST = 30% at t = 1 r = 1%, i.e. r ST (1) = r(1) 1% F invested optimally; alternative strategies for the Safety Loading

32 18/20 Probability of Default ST Base case: β = 70%, P (π (1) > A (1)) = 0.02% Investment P (π (1) > A(1)) % strategy a) σ = +10% b) r (1) = 1% β α α = 0 α α = 1 α = 0 α α =

33 18/20 Probability of Default ST Base case: β = 70%, P (π (1) > A (1)) = 0.02% Investment P (π (1) > A(1)) % strategy a) σ = +10% b) r (1) = 1% β α α = 0 α α = 1 α = 0 α α = Expected severity σ r(1) β AAA BBB AAA BBB % 27% 29% 24% % 15% 29% 22% % 17% 48% 40%

34 Bearing Capital β = 0.3 Base case σ r 1 b) α * β = 0.5 Base case σ r AAA AA A BBB BB B x% 0.05 AAA AA A BBB BB B x% ST β = 0.7 Base case σ r β = 0.9 Base case σ r /20 AAA AA A BBB BB B x% AAA AA A BBB BB B x%

35 20/20 s allocation strategy aimed at risk of participating life insurance minimum guarantee reversionary bonus terminal bonus Impact on capital requirements Results consistent with regulatory requirements imposed by Solvency II regime Optimal value of the design parameter β Results are robust under stress testing Work in progress: further investigation of approach robustness via scenario generation