Research On The Pricing And Risk Of The Embedded Options And Life Insurance Policies

In the present actuarial practice, traditional actuarial method has being used in policy pricing. However, the various policy options, including the guaranteed interest rate, dividend rights, right of rescission, investment account switch rights, irregular premium rights, are not evaluated, and not even being considered in the ratemaking process. The value of the policy and the embedded options (a variety of different policies because of various embedded options) being the important component of the policy, are always a black box to policyholders and insurance companies. At present, the international accounting standards and China’s insurance accounting standards require insurance companies to price policy and its embedded options based on fair value. If the insurance company reasonably split the policy value and its components with fair pricing, it is not only more fair to the insurer and the policy holders, but also formed different policies, just like blocks building, by which realize product innovation, which also represents the general trend of current financial products pricing.Applying option pricing method to price the policy and its intrinsic value is recognized as the only consistent pricing method with fair value both theoretically and practical. This paper thinks the embedded option value should be different by different ways of policy split, which means sequences exist during calculation of embedded option value of the policy; in addition, we should review the interrelationship among embedded options when interest rate changes, in order to eliminate or make the selection in product design; thirdly, the opposite investment decisions will be made by interest driven from either insurer or policy holders. Being implicit premise, the insurer is usually regarded as the investment decision-maker in former researches; while this paper puts forward two pricing models formed by two kinds of investment decision-making method, and gives comparison.To solve the above problem, this paper has designed a model covering variety types of policy. The policies are divided into10kinds, depending on the types of their embedded options, so that the embedded option value can be calculated under a unified framework, other problems can also be solved in this unified model. For the convenience of comparison, this model makes the calculation by using option pricing method and the traditional actuarial method. Both interest rate sensitive surrender rate model and the static termination rate model are used in the traditional actuarial method, not only to model the policy holder’s microscopic behavior, but also to establish the macroscopic model of experience surrender rate.The conclusion of this research shows:first, the calculation sequence has significant effect in the value of different embedded options, with different influence ratio in the policy value. The same embedded option has different value in different policy, showing different embedded option value do exist because of different combination of embedded options; second, under different age of the insured, the importance of rescission right and the right to receive dividends in the policy differentiates, there is a trade-off existed between these two rights; third, the investment option of the insured has a high value in the policy with guaranteed interest rate, which cannot be ignored, while with the absence of guaranteed interest rate, the investment option value is negative, showing the guaranteed interest rate influences the right of investment option. While providing the policy holder with the right of investment decision or account switch option, we should pay a high attention to ensure the encouragement function of interest rate on high risk preference; fourth, in the total dividend circumstance, the embedded option value and its proportion in policy value was increased, the embedded option influence in total dividend policy, such as investment linked insurance, should be highly considered; fifth, the value of compensation policy is higher under the traditional actuarial method comparing with option pricing method, showing it may be unfair for the policy holder in current situation, currently in use of the policy value may not be fair to the policy holder; sixth, comparing two cancellation rate model under the traditional actuarial method, because it considers the most important influence factor about spread rate, the policy value and termination value of the right of denunciation is higher in dynamic surrender rate model comparing static model.