Utility-Consistent Valuation Schemes for the Own Risk and Solvency Assessment of Life Insurance Companies
Asia-Pacific Journal of Risk and Insurance
27 Pages Posted: 17 Oct 2017 Last revised: 4 Aug 2020
Date Written: October 16, 2017
In this paper, we construct new valuation schemes for the liabilities and economic capital of insurance companies. Specifically, we first build a valuation framework based on SAHARA utility functions, and second we construct a framework based on the cumulative prospect theory that incorporates the SAHARA utility function as a value function. The process used for assessing a life insurance company's own funds consists in replacing the market-consistent parametrization with a utility-consistent parametrization that accounts for the risk aversion of the market and the long-term duration of the company's commitments. Our illustrations show that this approach leads to a lower value of the own risk and solvency assessment, or ORSA, overall solvency needs and to a lower volatility of own funds. The SAHARA-CPT framework has the advantage over a pure SAHARA framework that it considers a precautionary overweighting of extreme events, as a tradeoff for additional model complexity.
Keywords: Expected Utility Theory, Cumulative Prospect Theory, ORSA, Market-Consistent, Fair Value, Best Estimate of Liabilities, Overall Solvency Needs, Own Funds, SAHARA-CPT.
JEL Classification: G22, C14
Suggested Citation: Suggested Citation