Pricing in Incomplete Markets

38 Pages Posted: 2 Jun 2011

See all articles by Antoon Pelsser

Antoon Pelsser

Maastricht University; Netspar

Date Written: May 30, 2011


For life insurance companies and pension funds, it is always the case in practice that not all of the risks in their books can be hedged. Hence, the standard Black-Scholes methodology cannot be applied in this situation. This paper discusses and compares several methods that have been proposed in the literature in recent years: the Cost-of-Capital method (the current insurance-industry standard), Good Deal Bound pricing, and pricing under Model Ambiguity. Although each of these methods has a very different economic starting point, we show that all three converge for small time-steps to the same limit. This convergence provides a basis for comparing the different parameters used by the three methods. From this comparison we conclude that the current cost-of-capital of 6% used by the industry and the European insurance supervisor (EIOPA) is too low, since it is not in line with the values implied by the Good Deal Bound and Model Ambiguity methods. A cost-of-capital of 12% is needed to bring the method in line with the other two methods.

Keywords: incomplete market, cost-of-capital, good deal bound, model ambiguity

JEL Classification: D81, G12, G22, G23

Suggested Citation

Pelsser, Antoon A. J., Pricing in Incomplete Markets (May 30, 2011). Available at SSRN: or

Antoon A. J. Pelsser (Contact Author)

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD

HOME PAGE: http://

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE

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