Benchmarked Risk Minimizing Hedging Strategies for Life Insurance Policies

Abstract

Traditional life insurance policies offer no equity investment opportunities for the premium paid, and suffer from low returns over the long insurance terms. Modern equity-linked insurance policies offer equity investment opportunities exposed to equity market risk. To combine the low-risk of traditional policies with the high returns offered by equity-linked policies, we consider insurance policies under the benchmark approach (BA), where the policyholders' funds are invested in the growth-optimal portfolio and the locally risk-free savings account. Under the BA, life insurance policies can be delivered at their minimal costs, lower than the classical actuarial theory predicts. Due to unhedgeable mortality risk, life insurance policies cannot be fully hedged. In this case benchmarked risk-minimization can be applied to obtain hedging strategies with minimally fluctuating pro fit and loss processes, where the fluctuations can further be reduced through diversification.

Keywords: benchmark approach, benchmarked risk minimization, life insurance, mortality model

JEL Classification: G13, G22