Option Valuation in Life Insurance

Ekaterina Avershina

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Master's Thesis from the year 2004 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 2 ...

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Master's Thesis from the year 2004 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 2 (B), LMU Munich (Seminar for Insurance Studies), language: English, abstract: The capital forming life insurance appears currently to be in a very vulnerable state. It was usually an attractive investment opportunity with stable returns comparable to other investment opportunities. In 2000-2002 it was difficult for the life insurance companies to overcome the consequences of the stock market crises, the losses of the insurance companies were enormous. Today there is another challenge for the insurance companies to overcome - the end of the tax privilege starting in 2005. These events bring our attention to the problem of profit sharing. In this paper I show that the changes in the tax law related to the life insurance profits in Germany lead to an increased competition for new customers in 2004 by paying maximum possible bonus rates and to the drastic decrease of it in 2005 which will force the insurers to look for alternative methods to attract new customers like implicit options embedded in the insurance contracts. Such options are liabilities to the issuer, they also constitute a potential danger to the company's solvency. Therefore, they should be properly valued. Historically that has not been done which turned out to be a disaster for some companies. In the first chapter of this work I introduce the mechanism of profit sharing, its legal framework, the changes in the tax law crucial for the insurance companies and my own model describing how the insurer actually chooses the bonus rate of the insurance contract. Furthermore, the predictions about bonus rates in 2005 and its signification for the options will be made. The second chapter is devoted to the definition, classification and the examples of the most common implicit options on the German life insurance market. The third chapter shows the most common models of the valuation of interest rate and asset options. The tree models will be described particularly in detail. The fourth chapter is dedicated to the models of valuation of the non-European options in life insurance contracts.