Chapter 35

Valuing Insurance Policies and Pension Obligations

Our final chapter in individual instrument valuation and simulation is focused on insurance policies and pension obligations, since insurance companies and pension funds make up a substantial proportion of the world’s financial institutions. To reiterate, our objective in reviewing valuation and simulation methodologies is to incorporate the insurance liabilities and pension liabilities in the Jarrow-Merton put option on the financial institution’s assets and liabilities. We want to use a consistent methodology to calculate this comprehensive measure of integrated interest rate risk, market risk, liquidity risk, foreign exchange risk, and credit risk.

This is particularly interesting to discuss for insurance and pension obligations because the links with what we have already covered are so strong and yet so few members of the financial community would acknowledge that that is the case. We hope that this chapter assists in narrowing this perception gap.

First, we start with life insurance policies and then move to pension obligations and property and casualty insurance.

LIFE INSURANCE: MORTALITY RATES VS. DEFAULT PROBABILITIES

The analogy between the mortality rate on a life insurance policy and the default probability on a bond of a particular issuer is very strong. Exhibit 35.1 shows annual mortality rates for a 50-year-old male (upper line) and 50-year-old female (lower line) taken from the U.S. Society of Actuaries ...

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