Modeling Life Insurance Liability at Fair Value: An Analysis of Embedded Options in With-Profit Policy

Life insurance contracts are often very complex financial products which embed interest rate guarantee and other implicit options. Focusing on the With-Profit life insurance policy in China, this paper presents a dynamic model to develop suitable fair valuation techniques for liability of this category contract. Unlike traditional actuarial valuation method, the model captures several essential elements of With-Profit policy, such as interest rate of return guarantee, annual bonus option and terminal bonus option. Based on the classical contingent claim pricing theory, Monte Carlo techniques are used to calculate the values of these options. The numerical results obtained show that the liability value of With-Profit policy is highly sensitive to changes in model parameters, especially for bonus strategy and interest rate of return guarantee.