When developing new insurance products, important parameters must be set regarding the pricing of such products. For one, it is important to determine which investment fee covers the cost of return guarantees for a unit-linked product. Furthermore, the financial risks of a product must be efficiently hedged with available financial instruments.
A recent approach, which combines both of these elements, is the so-called replicating portfolio method. In this case, insurance products are replicated by liquid financial instruments. To achieve this goal, it is important to mimic all cash flows of a product (premiums, costs, guaranteed payments, profit-sharing) with available financial instruments (bonds, interest derivatives, etc.). As a result, it becomes possible to convert an insurance product (or insurance portfolio) to an equivalent portfolio of financial instruments. This approach has two advantages:
- The replicating portfolio gives investors a well-defined benchmark with which to compare the return on their investments;
- The replicating portfolio is a practical tool for product development, pricing and risk management objectives. An embedded option in an insurance product can, for example, often be replicated with a derivate (for example, a swaption) with an actual market price. This information can then be used to determine a good hedge for the embedded option, and the costs involved with this hedge.
The components that are required for such calculations (such as market value liabilities and economic scenarios) are standard features in the ALM model for insurers. Accordingly, ALS Life can also be employed succesfully for product development objectives.