Schlögl, Erik; Mahayni, Antje:

The Risk Management of Minimum Return Guarantees

In: Business research : BuR ; official open acces journal of VHB, Verband der Hochschullehrer für Betriebswirtschaft e.V., Jg. 1 (2008), S. 55-76
Zeitschriftenaufsatz / Fach: Wirtschaftswissenschaften
Abstract:
We analyse contracts which pay out a guaranteed minimum rate of return
and a fraction of a positive excess rate, which is specied on the basis of a benchmark
portfolio. These contracts are closely related to unit{linked life{insurance/savings plan
products and can be considered as alternatives to a direct investment in the underlying
benchmark portfolio. The option embedded into the savings plan is in fact a power option,
and thus the specication of the \fair" contract parameters is closely related to well
known features of these nancial derivatives. The key issue, both in order to rigorously
justify valuation by arbitrage arguments and to prevent the guarantees from becoming
uncontrollable liabilities to the issuer, is the risk management of the embedded options
by a tractable and realistic hedging strategy. The long maturity of life{insurance products
makes it necessary to lift the Black/Scholes assumptions and consider an uncertain
volatility scenario, thus explicitly taking into account \model risk". In this context, we
show how to determine the contract parameters conservatively and implement robust risk
management strategies. This highlights the necessity of a careful choice of guarantees
which are granted to the insurance customer and suggests a new role for a type of \bonus
account" customary in many life{insurance contracts.

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