Pricing and hedging of guaranteed minimum benefits under regime-switching and stochastic mortality

Publication date: September 2016
Source:Insurance: Mathematics and Economics, Volume 70
Author(s): Katja Ignatieva, Andrew Song, Jonathan Ziveyi
This paper presents a novel framework for pricing and hedging of the Guaranteed Minimum Benefits (GMBs) embedded in variable annuity (VA) contracts whose underlying mutual fund dynamics evolve under the influence of the regime-switching model. Semi-closed form solutions for prices and Greeks (i.e. sensitivities of prices with respect to model parameters) of various GMBs under stochastic mortality are derived. Pricing and hedging is performed using an accurate, fast and efficient Fourier Space Time-stepping (FST) algorithm. The mortality component of the model is calibrated to the Australian male population. Sensitivity analysis is performed with respect to various parameters including guarantee levels, time to maturity, interest rates and volatilities. The hedge effectiveness is assessed by comparing profit-and-loss distributions for an unhedged, statically and semi-statically hedged portfolios. The results provide a comprehensive analysis on pricing and hedging the longevity risk, interest rate risk and equity risk for the GMBs embedded in VAs, and highlight the benefits to insurance providers who offer those products.