A Market-Based Approach to Pricing With-Profits Guarantees

Abstract

ABSTRACT This paper addresses one of the fundamental issues faced by offices in the transacting of with-profits business, namely, the provision of equity-related performance along with maturity guarantees that increase over the lifetime of the policy. The approach commonly followed of using capital to cover the office's investment mismatch risk is considered from an individual policy viewpoint, and, through stochastic modelling, the degree of security represented by different reserve levels identified. An alternative approach using derivatives to provide similar levels of security is then presented and the range of policy proceeds resulting from the two methods compared. While it is recognised that the latter approach may have limited application in practice, the ideas presented could form the basis of a new approach to pricing guarantees under with-profits business that would be consistent with the pricing of current derivative-backed guaranteed products.