Measuring profitability of life insurance products under Solvency II (Q2066774)

In this paper, the authors introduce a method for measuring profitability of life insurance products in the light of Solvency II. Specifically, they focus on the complete probability distributions for the underlying random variables under a real-world probability measure and describe the profitability of the products from the perspective of shareholders. The consideration of the complete probability distributions provides a fuller picture of future profitability than the best estimates given by, say the expected values, and allows for incorporating extreme outcomes in the analysis of future profitability. The authors propose profit measures for insurance contracts over their entire lifetimes, which capture various sources of capital. Specifically, using the cost of capital for the whole projection period, the strain on shareholders attributed to the solvency capital requirement (SCR) under Solvency II is considered. An application to insurance products with interest rate guarantees is provided to illustrate the proposed profit measures. Their numerical results reveal feasibility and suitability of the proposed profit measures. Section 2 of the paper presents a general company set up based on a simplified economic balance sheet under Solvency II (Figure 1). The SCR is defined based on the own funds of the company, which comprise the shareholder capital, retained profits, present value of future profits. The solvency ratio is defined as the ratio of the own funds and the SCR. Section 3 introduces profit measures for insurance products from the perspective of shareholders. These profit measures are based on shareholders' cash flows. The projection of future cash flows is done via the real-world probability measure, and the paper is concerned with the complete probability distributions for the future cash flows instead of their expected values. The excess profit and the excess profit margin are introduced in Section 3.1, where the excess profit is defined as the difference between the present value of the shareholder cash flows and the present value of the cost of shareholder capital. The excess profit margin is defined as the excess profit per unit of the present value of the premiums paid by policyholders. The projection of a shareholder account is discussed in Section 3.2. The return on capital (ROC) is defined in Section 3.3. Section 4 presents the model set up, which includes the price dynamics of a financial market, the design of insurance products and the respective model companies. The financial market consists of a money market account, a portfolio of zero-coupon bonds and a share index. Section 4.1 describes the price dynamics. The interest rate is assumed to be stochastic and governed by the Hull-White model, where mean reversion in the interest rate is incorporated and an exponential affine form for the zero-coupon bond price is used. The price process of the share index is supposed to be governed by a geometric Brownian motion. It is assumed that the interest rate and the share index are correlated. The authors also suppose that the shareholder's fund is invested in the money market account only and that the policyholder's fund is invested in all the three assets. The dynamics for the policyholder's fund are presented. Three types of insurance products, namely the cliquet guarantee, the maturity guarantee, the unit-linked product, are discussed in Section 4.2. The projection of cash flows incorporating management rules is explained in Section 4.3. The numerical results for illustrating the application are presented in Section 5. The evaluation and comparison of model companies based on the proposed profit measures are considered in Section 5.1. Sensitivity analyses of some selected results with respect to the term structure of interest rates, the stock ratio and the target solvency ratio are provided in Section 5.2.