Out-of-Model Adjustments of Variable Annuities

Abstract

This paper studies the model risk of the Black-Scholes (BS) model in pricing and risk-managing variable annuities motivated by its wide usage in the insurance industry. Specifically, we derive a model-free decomposition of the no-arbitrage price of the variable annuity into the BS model price in conjunction with three out-of-model adjustment terms. This sheds light on all risk drivers behind the product, that is, spot price, realized volatility, future smile, and sub-optimal withdrawal. We further investigate the efficacy of the BS-based hedging strategy given the market diverges from the model assumptions. We disclose that the spot price risk can always be eliminated by the strategy and the hedger's cumulative P&L exhibits gradual slippage and instantaneous leakage. We finally show that the pricing, risk and hedging models can be separated from each other in managing the risks of variable annuities.

Keywords: Valuation Adjustment, Variable Annuities, Model Risk

JEL Classification: G22, C14, C63