Implicit Options in Life Insurance : Valuation and Risk Management

Participating life insurance contracts typically contain various types of implicit options. These implicit options can be very valuable and can thus represent a sig-nificant risk to the insurance companies issuing these contracts in case of in-sufficient risk management. Options can get especially risky through the inter-action with other options included in the contracts, which further makes an evaluation more complex. This article gives a comprehensive overview and clas-sification of implicit options in participating life insurance contracts and the cor-responding relevant literature. It further points out the potential problems particu-larly associated with the valuation of rights to early exercise due to policyholders’ exercise behavior. The risk potential of the interaction of implicit options is ex-hibited with numerical examples by means of a life insurance contract that in-cludes common implicit options, i.e., guaranteed interest rate, stochastic annual surplus participation, paid-up and resumption options. Valuation is conducted us-ing risk-neutral valuation, a concept that implicitly assumes the implementation of risk management measures such as hedging strategies.