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.
Table of Contents
Introduction
The impact of the German Tax Raises on the Importance of Options
A. The Role of Bonus Payments in Capital Forming Life Insurance Contracts
B. A Model of Bonus Payments to attract New Customers
1. Legal Framework
2. Model
C. The influence of the change in law on the profit sharing in 2005
D. Numerical results
Implicit Options in Life Insurance
E. Options in Financial Theory
F. Implicit options
G. Classification of options in life insurance according to the risk type
1. Risk-free Options
2. Actuarial Risks
3. Financial Risks
H. Classification of the Most Common Options
1. Risk-free Options
2. Actuarial Options
3. Financial Options
Basic Models of Option Valuation.
I. Equity Option Models
1. Black-Scholes Model
2. Binomial Tree Model of Cox, Ross and Rubinstein
3. Risk neutral valuation
J. Interest Rate Option Models
1. Hull-White Model
Models of the Valuation of the American Options in Life Insurance
K. Tribinomial tree for the interest rate and asset process
L. Valuation of the Surrender Option in Capital Forming Life Insurance
1. The model
2. Numerical Results
M. Grosen-Jorgensen Approach
N. Longstaff and Schwartz Approach
Conclusion
Research Objectives and Key Topics
This master's thesis analyzes the valuation of implicit options in German life insurance contracts, particularly in the context of changing tax laws effective from 2005. It aims to determine how insurers adapt their bonus payment strategies in a competitive market and why the proper valuation of embedded options is essential for maintaining corporate solvency.
- The impact of tax legislative changes on German life insurance products.
- Mechanism and modeling of bonus payments as a marketing tool.
- Classification of implicit options based on actuarial and financial risk.
- Valuation models for American-style options using tree-based approaches.
- Sensitivity analysis of surrender options in capital-forming life insurance.
Excerpt from the Book
G. Classification of options in life insurance according to the risk type
The first group includes options that do not lead to additional risk for the insurer. The main feature of such options is that the exact conditions and consequences of a given right are not set in the contract. They will only be specified at the date when the option is exercised. At that time, the insurance company can take the situation into account and deny the change under certain circumstances, for example if the policyholder does not accept a higher premium or an additional medical examination. So there is no additional risk in this option. For example, the insurer can insist on an additional medical examination. That is why there is no need to ask for additional premium to include this option into the contract.
In contrast to risk-free options in life insurance there are two big groups of options that do lead to an additional risk for the insurer. In this case all conditions are set in the contract so that at the exercise date the insurer cannot change any of them. We can distinguish between two types of risk that options can bring along: actuarial and financial risk.
Summary of Chapters
Introduction: Outlines the challenges facing the capital-forming life insurance market in Germany due to the end of tax privileges and the resulting focus on implicit options.
The impact of the German Tax Raises on the Importance of Options: Explains the necessity of modeling bonus payments as an investment to attract new customers and how tax changes shift competitive focus.
Implicit Options in Life Insurance: Defines implicit options and classifies them into risk-free, actuarial, and financial categories based on their risk profiles for the insurer.
Basic Models of Option Valuation.: Introduces classical models including Black-Scholes and Binomial trees for equity and interest rate derivatives.
Models of the Valuation of the American Options in Life Insurance: Describes advanced tree-based modeling methods, specifically the tribinomial tree for estimating American options.
Conclusion: Synthesizes the findings, asserting that insurers must shift focus toward proper pricing of embedded options to avoid future liabilities.
Keywords
Life insurance, Option valuation, Implicit options, Bonus payments, Tax change 2005, Capital-forming insurance, Solvency, Actuarial risk, Financial risk, Surrender option, Hull-White model, Tribinomial tree, Risk-neutral valuation, Competitive market.
Frequently Asked Questions
What is the primary focus of this thesis?
The work examines how German life insurance companies manage and value implicit options within their contracts, especially in light of the 2005 tax law changes that reduced the attractiveness of traditional profit-sharing policies.
What are the main thematic fields?
The core themes include the economics of insurance bonus payments, the classification of contract-embedded options based on risk, and the application of financial mathematics to value these liabilities.
What is the central research question?
The research investigates how insurers can effectively price implicit options to remain competitive and solvent when traditional profit-sharing mechanisms (bonus payments) lose their effectiveness due to legislative shifts.
Which scientific methods are used?
The author utilizes standard option pricing theory, including Black-Scholes, Binomial trees, and advanced Tribinomial tree modeling, to conduct numerical analyses and sensitivity testing of insurance contract features.
What is covered in the main body of the work?
The main part covers the legal framework of profit sharing, the classification of various options, and detailed technical valuation methods for American options in life insurance settings.
Which keywords characterize this work?
The work is characterized by terms such as option valuation, implicit options, surrender options, and the impact of German tax regulations on life insurance strategy.
How does the tax change affect the bonus policy?
The 2005 tax reform forces insurers to decrease bonus rates because the tax-advantaged status of older contracts creates an intense, temporary competitive pressure that will fade, rendering current high bonus payments unsustainable.
What is the role of the "Tribinomial tree" in this study?
The tribinomial tree is used as a superior modeling tool that accounts for both interest rate and asset price processes simultaneously, allowing for more precise valuation of American options compared to simpler models.
- Arbeit zitieren
- Ekaterina Avershina (Autor:in), 2004, Option Valuation in Life Insurance, München, GRIN Verlag, https://www.grin.com/document/30754
