Analysis Of Changes In Interest Rates On The Embedded Value Of Life Insurance Companies

Classical embedded valuation techniques have been developed from properly and precisely measuring the performance of life insurance and widely used in the Asset-Liability Management for insurance companies to manage the interest rate risks and so on. This trend has then converged with the solvency test. As the practical application of interest rate management, it is of importance to build a financial accounting report for modeling the financial market and eliminating the defects derived from the deterministic risk-adjusted discount rates in evaluating the Embedded Value in terms of a full balance sheet approach considering the specific conditions of the liabilities of life company policies especially for the non-traditional ones.Motivated by the modeling, this paper attempts to introduce the stochastic discounting deflator, comparing with the traditionally well-known discounting approach in actuary, under the arbitrage-free principle and advance a market-consistent valuation method for both assets and liabilities of life company. Then, we will calculate, under the foundation of the stochastic discounting, the risk bearing capital for both the technical risk and financial risk for individual life policies with embedded options terms of the contracts and obtain the market-consistent embedded value for life company and its volatility generated by the mark interest rates.Based on a combination of financial economics and corporate finance, a method of investment portfolio is conducted and the results shows that the market-consistent embedded value is sensitive to the interest rates but with a natural way of hedging the option in our example. Moreover, the stochastic deflating, which is equivalent to the risk-neutral pricing measures, is shown as the key to model the market states and avoid the defect out of the traditional deterministically risk-adjusted discounting rates; it is more accurate to do a sensitivity test for the interest rates based on the marked-consistent embedded valuation using the stochastic deflating.