The Risk Management of Minimum Return Guarantees

Contracts paying a guaranteed minimum rate of return and a fraction of a positive excess rate, whichis specified relative to a benchmark portfolio, are closely related to unit-linked life-insurance productsand can be considered as alternatives to direct investment in the underlying benchmark. They containan embedded power option, and the key issue is the tractable and realistic hedging of this option,in order to rigorously justify valuation by arbitrage arguments and prevent the guarantees frombecoming uncontrollable liabilities to the issuer. We show how to determine the contract parametersconservatively and implement robust risk-management strategies.

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Authors:	Mahayni, Antje ; Schlögl, Erik
Institutions:	Verband der Hochschullehrer für Betriebswirtschaft
Published in:	BuR - Business Research BuR ; Volume 1, Issue 1, May 2008, 55-76
Subject:	Risikomanagement \| risk management \| Lebensversicherung \| Betriebliche Altersversorgung \| Benchmark

1 Introduction
2 The Embedded Power Option
3 Hedging and Model Uncertainty
4 Static Hedging
4.1 Hedging with standard options
4.2 Bounds on contract parameters implied by market prices
5 Conservative contract specification based on a robust dynamic hedge
5.1 Robust hedging
5.2 Improving the price bounds
6 Conclusion
References

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