Valuing options and guarantees

Various issues surrounding options and guarantees have been discussed previously with regard to:

• contract design
• pricing
• reserving
• asset management

For options and guarantees, it is particularly important that the assumptions used are adjusted over time to reflect:

• the current state of the economy
  • as this can have a material impact on the size of the payoff from the option or guarantee
• changes in demographic factors such as health or marital status
  • as these can affect the likelihood of exercising the option
• changes in customer sophistication
  • as this can lead to a better understanding of the value of embedded options and guarantees

Liability hedging is often used to protect against the risks arising from options and guarantees embedded in insurance contracts and involves choosing assets that can be expected to perform in the same way as the liabilities.
Thus, immunisation is a simple example of liability hedging, where assets are matched to liabilities by term in order to eliminate interest rate risk.
Similarly, the purchase of OTC options for the investment bond considered previously would also be an example of liability hedging.
However, in practice, suitable traded assets may not exist that can match the liability cash flows exactly. For example, whilst immunisation can remove the interest rate risk from an annuity contract, it cannot hedge against longevity risk.