Pricing unit-linked insurance with guaranteed benefit

M. Iqbal, F. Novkaniza, and M. Novita

Citation: AIP Conference Proceedings 1862, 030139 (2017); doi: 10.1063/1.4991243

View online: https://doi.org/10.1063/1.4991243
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Published by the American Institute of Physics

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 Pricing Unit-Linked Insurance with Guaranteed Benefit
M. Iqbal, F. Novkanizaa) , and M. Novita

Department of Mathematics, Faculty of Mathematics and Natural Sciences (FMIPA),

Universitas Indonesia, Depok 16424, Indonesia
a)
Corresponding author: fevi.novkaniza@sci.ui.ac.id

Abstract. Unit-linked insurance is an investment-linked insurance, that is, the given benefit is the premium investment out-
come. Recently, the most widely marketed insurance in the industry is unit-linked insurance with guaranteed benefit. With
guaranteed benefit applied, the insurance benefits form is similar to the payoff form of European call option. Thereby, pric-
ing European call option is involved in pricing unit-linked insurance with guaranteed benefit. The dynamics of investment
outcome is assumed to follow stochastic interest rate. Hence, change of measure methods is used in pricing unit-linked
insurance. The discount factor with stochastic interest rate needs to be modified as well to be zero coupon bond price.
Eventually, the insurance premium is calculated by equivalence principle with guaranteed benefit and insurance period
explicitly given.

INTRODUCTION

The innovation in insurance business has been continuously developed. An example of the innovation is investing
the insurance premium to an investment instrument such as stocks or bonds. Some of the investment outcomes are
taken by the insurance company as investment profit and the rest of it is remain invested in order to supply customer’s
benefit. Insurance product which allocated some of the premium on investment is called unit-linked insurance [1].
The purpose of adding guaranteed benefit is to cover customer investment risk, although at the same time would
increase company operational risk. One solution to reduce the company operational risk is to determine the value of
premium equal to the value of claim estimation which will make no loss occurred to the company. The determination
of premium is called pricing. Pricing of unit-linked insurance calculates the probability of company’s liability for
a policy that being invested in particular investment instrument. Company’s liability for a policy is the unit-linked
insurance benefit. Hence, in pricing, it is mandatory to analyze the characteristic of the benefit. Because of the unit-
linked insurance benefit is protection benefit plus investment benefit (if exist), then the unit-linked insurance benefits
form is similar to the European call option payoff [2].
Pricing unit-linked insurance with periodic premium and constant interest rate had been discussed in [2] as well as
pricing model with stochastic interest rate and single premium in [3]. Pricing model with periodic premium and the
stochastic interest rate was discussed in [4]. Pricing technique using least square monte carlo and bivariate model was
discussed in [5] and [6] respectively. Journal that has been mentioned discussed pricing unit-linked insurance using
geometric Brownian motion for the investment performance.
The main reference in this paper is analytical pricing unit-linked insurance with European call option by stochastic
interest rate and investment in stocks followed 2-factor diffusion process [1]. Zero coupon bond with face value of 1 is
used as discount factor and stock price movement assumed to be correlated with bond price movement. The difference
between this paper and the main reference paper is that the stochastic interest rate movement follow Merton model
[7]. Although it was not discussed about the movement of stochastic interest rate in the main reference paper.
The value of guaranteed benefit in this paper is determined by the possibility of guaranteed benefit that often
used in real world unit-linked insurance. Afterward, premium is calculated using known value of guaranteed benefit,
stochastic interest rate historical data and stock price historical data. Therefore, interest rate and stock price could be
predicted and premium could be calculated.

International Symposium on Current Progress in Mathematics and Sciences 2016 (ISCPMS 2016)
AIP Conf. Proc. 1862, 030139-1–030139-8; doi: 10.1063/1.4991243
Published by AIP Publishing. 978-0-7354-1536-2/$30.00

030139-1
 METHODS
In this section will be explained the method of determining unit-linked insurance pricing formula by modeling
investment price and equivalence principle.

Investment Price Model

According to Hurlimann [1], only some of premium would be invested that is α · P, with 0 < α ≤ 1. Investment
done through stocks with assumption no dividend and no transaction cost. To find stock investment outcome, stock
unit bought in each period is accumulated, and then all the units multiplied by recent stock price. Stock investment
outcome by time t can be declared as equation below.
!
1 1 1
H(T ) = α · P · + + ... + · S (T )
S (0) S (1) S (T − 1)
T −1
X S (T )
= α·P· (1)
t=0
S (t)

H(t) : investment outcome at t

P : premium
α : investment portion
S (t) : stock price at t
In fact, stock price changes in real time meaning that it is difficult to predict. Hence, stock price is a stochastic
process. In this paper, stock price movement and zero coupon bond price movement are assumed to follow Hurlimann
model [1] and Merton model [7] respectively, which is

q
dS (t) = r(t)S (t)dt + σ s S (t)ρdW1 (t) + σ s S (t) 1 − ρ2 dW2 (t)
dB(t, T ) = r(t)B(t, T )dt − g(T − t)B(t, T )dW1 (t)

r(t) : stochastic interest rate at t

σs : stock price volatility
ρ : correlation between stock price and stochastic interest rate
g : bond price volatility
B(t, T ) : zero coupon bond price at t which matures at T with face value of 1
W1 (t) and W2 (t) : independent standard Brownian motion
Explicit form of stock price can be determined using Ito’s lemma on function ln S (t), that is
Z t !
1 2
q
S (t) = S (0) · exp r(u) du − σ s t + σ s ρW1 (t) + σ s 1 − ρ W2 (t)
2 (2)
0 2
Therefore, explicit form of stock price is found in (2).
As explained in introduction, the calculation of European call option price is involved in the calculation of unit-
linked insurance benefit present value. In the next step, the calculation of European call option is analyzed with
investment model according to Equation (2).

Calculation of European Call Option

Option price fluctuates as well as stock price and bond price, hence, option price is a stochastic process. By having
u(t) such that process f (t)/u(t) is martingale, then f (0) can be found [8]. Consider option price at t is f (t) = Ct , to
determine the present option price, which is C0 , it is needed to know the numeraire such that option price relative to
the numeraire (Ct /u(t)) would be martingale.
Since option price Ct was assumed
R t depends on stock
 Rprice which
 follow stochastic interest rate, hence, the accu-
 t
mulation function is u(t) = exp 0 r(u) du . If Ct · exp − 0 r(u) du is martingale, then option price C0 can be found.
However, process Ct movement is unknown except at payoff (T ) which is CT = max(H(T )−G, 0) while H(T ) is defined

030139-2
by (1) and G is its strike price. On H(T ), the only random variable is S (T )/S (t), therefore option
 R price process
 CT has
T
the same movement with S (T )/S (t). To analyze the martingale behavior, process CT · exp − 0 r(u) du is inspected
whether it has drifted or not, since martingale process has no drift. Meanwhile, equation of process S (T )/S (t), t < T
is needed in order to find the equation of process CT . Below is shown the equation of process S (T )/S (t) by (2).
! !
S (T ) S (T )
q
d = · r(T )dt + σ s ρdW1 (t) + σ s 1 − ρ2 dW2 (t) (3)
S (t) S (t)
Process (S (T )/S (t))/u(T ), t < T has no drift, hence it is a martingale process. By the martingale behavior, option
price C0 can be found in equation below.

" #
C0 CT
= E
u(0) u(T )
" Z T ! #
C0 = E exp − r(u) du max(H(T ) − G, 0)
0

By defining an indicator variable,

(
1, H(T ) − G ≥ 0
ε=
0, H(T ) − G < 0
We have,

" Z T ! #
C0 = E exp − r(u) du (H(T )ε − Gε)
0
T −1 " Z t ! #
1
X q
= α · P · E exp − r(u) du − σ2s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ2 (W2 (T ) − W2 (t)) ε
t=0 0 2
" Z T ! #
−E exp − r(u) du Gε (4)
0

The reader could see (4) is difficult to be solved, hence, another numeraire is needed to be found which would
make the calculation of option price C0 easier.
Next step is analyzing the calculation of option price C0 using numeraire which brings process Ct forward to
time T , that is u(t) = B(t, T ). Since the form of process Ct only known at T or CT , hence the martingale behavior is
checked on CT /u(T ) = CT /B(T, T ) by inspecting whether the stochastic differential equation of (S (T )/S (t))/B(T, T )
has a drift or not. Using Ito’s lemma, below equation is obtained.
! !
S (T )/S (t) S (T )/S (t)
q
d = σ s ρdW1 (t) + σ s 1 − ρ2 dW2 (t)
B(T, T ) B(T, T )
The process (S (T )/S (t))/B(T, T ) has no drift which indicates that it is a martingale process. Using zero coupon
bond numeraire, option price can be solved as below.

" #
C0 CT
= E
u(0) u(T )
T −1 " Z T ! #
1
X q
C0 = α · P · E B(0, T ) · exp r(u) du − σ2s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ (W2 (T ) − W2 (t)) ε
2

t=0 t 2
−E [B(0, T ) · G · ε] (5)

030139-3
 Equation (5) is hard to be solved as well. Notice that option price C0 can be determined by two different numeraires,
which are accumulation function of stochastic interest rate and zero coupon bond. The difference of numeraire cause
difference of probability measure [9]. Defined probability measure Q for the accumulation function of stochastic
interest rate numeraire and probability measure QT for the zero coupon bond which matures at T numeraire. Change
of measure technique requires Radon-Nikodym derivative which is shown below.

T −1 " Z t ! #
1 2
X q
α · P · EQ exp − r(u) du − σ s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ (W2 (T ) − W2 (t)) ε
2

t=0 0 2
" Z T ! #
−EQ exp − r(u) du · G · ε =
0
T −1 " Z T ! #
1
X q
α · P · EQT B(0, T ) · exp r(u) du − σ2s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ2 (W2 (T ) − W2 (t)) ε
t=0 t 2
−EQT [B(0, T ) · G · ε] (6)

By (6) we have
" Z t !# " Z T !#
EQ exp − r(u) du = EQT B(0, T ) exp r(u) du
0 t

and
" Z T !#
EQ exp − r(u) du = EQT [B(0, T )]
0

According to Radon-Nikodym derivative, we have below equation.

 R 
T
dQ T exp − 0
r(u) du
= (7)
dQ B(0, T )
By the Radon-Nikodym derivative was determined, the option price equation in (5) can be simplified by changing
the measure. On the equation below, option price measure is changed from Q to QT and Qt according to Radon-
Nikodym derivative in (7).

T −1 " ! #
1
X q
C0 = α·P·B(0, t)·EQt exp − σ2s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ (W2 (T ) − W2 (t)) ε −B(0, T )·G·EQT [ε]
2

t=0
2
∗
To simplify further, probability measure Qt is constructed by defining Radon-Nikodym derivative as below.
∗
1 T 2
Z T Z T
dQt
Z q !
= exp − σ s dt + σ s ρ dW1 (t) + σ s 1 − ρ dW2 (t)
2
dQt 2 t t t

Therefore we have,
T −1
X
C0 = α · P · B(0, t) · EQt∗ [ε] − B(0, T ) · G · EQT [ε] (8)
t=0

Equation (8) result in simple calculation of the option price. The next step is to determine the bound value when
the indicator variable ε value changes. As defined, ε has a value of 1 as H(T ) ≥ G and has a value of 0 as H(T ) < G.
Meanwhile, H(T ) ≥ G is obtained when
T −1 Z T !
1
X q
α·P· exp r(u) du − σ2s (T − t) + σ s ρ(W1 (T ) − W1 (t)) + σ s 1 − ρ (W2 (T ) − W2 (t)) ≥ G
2 (9)
t=0 t 2

030139-4
 Since σ s (Wk (T ) − Wk (t)) ∼ N(0, σ2s (T − t)), hence the variance of σ s (Wk (T ) − Wk (t)) is σ2s (T − t) or notated by σ2t .
If σ s (Wk (T ) − Wk (t)) = σt Uk in (9) is substituted with Uk ∼ N(0, 1), k = 1, 2 and U1 , U2 i.i.d, we have
T −1 Z T !!
1
X q
α·P· exp r(u) du − σ2t + σt ρU1 + 1− ρ2 U 2 ≥G (10)
t=0 t 2
From (10), it can be concluded that ε has a value of 1 for every Uk which satisfied. To make the measure equal,
∗ t∗
the expectation on Qt will be solved using QT measure by analyzing the distribution of WkQ (t) on QT . According to
t∗
Girsanov theorem, W1Q (t) can be expressed as
t∗ t
dW1Q (t) = dW1Q (t) + σ s ρdt
Because Qt and QT measure have the same distribution, therefore under QT measure,
t∗ t∗  
σ s (W1Q (T ) − W1Q (t)) ∼ N σ2s ρ(T − t), σ2s (T − t)
and
∗ ∗
q !
t t
σ s (W2Q (T ) − W2Q (t)) ∼ N σ2s 1− ρ2 (T − t), σ2s (T − t) .

t∗ t∗ t∗ t∗
If we substitute σ s (W1Q (T ) − W1Q (t)) = σt (U1 + σt ρ) and σ s (W2Q (T ) − W2Q (t)) = σt (U2 + σt 1 − ρ2 ) from (9),
p
∗
with U1 , U2 i.i.d N(0, 1), the condition which make ε under measure Qt or notated by εt , has a value of 1 is shown
below.
T −1 Z T !
1
X q
α·P· exp r(u) du − σ2t + σt (ρU1 + 1 − ρ2 U2 + σt ) ≥ G
t=0 t 2
Therefore indicator variable ε can be declared as

1, ρU1 + p1 − ρ2 U2 ≥ d
( p
ε=
0, ρU1 + 1 − ρ2 U2 < d
and

1, ρU1 + p1 − ρ2 U2 ≥ d − σt
( p
εt =
0, ρU1 + 1 − ρ2 U2 < d − σt
with d satisfied
T −1 Z T !
X 1 2
α·P· exp r(u) du − σt + σt d = G
t=0 t 2
Option price formula with ρ > 0 is shown below.

T −1
X
C0 = α · P · B(0, t) · EQT [εt ] − G · EQT [ε]
t=0
T −1
X Z ∞ Z ∞ Z ∞ Z ∞
= α · P · B(0, t) · d−σt −
√
1−ρ2 ·U2
f (u1 ) f (u2 ) du1 du2 − B(0, T ) · G · d−
√
1−ρ2 ·U2
f (u1 ) f (u2 ) du1 du2
t=0 −∞ ρ −∞ ρ

030139-5
 Meanwhile, option price formula with ρ < 0 is expressed below.

√ √
d−σt − 1−ρ2 ·U2 d− 1−ρ2 ·U2
T −1 Z ∞ Z Z ∞ Z
X ρ ρ
C0 = α · P · B(0, t) · f (u1 ) f (u2 ) du1 du2 − B(0, T ) · G · f (u1 ) f (u2 ) du1 du2
t=0 −∞ −∞ −∞ −∞

f (uk ) is probability density function of random variable Uk . The reader could see that formula of option price
can be determined through Black-Scholes model [10], with adjustment on the stochastic interest and the Brownian
motion.
Option price formula that was obtained will be used in calculation of present value of unit-linked insurance benefit
which will be discussed in the next section. The only numerical method that needed to be used is bisection method
in finding indicator variable ε (since it is a root of polynomial equation), meanwhile the other equation is just direct
calculation.

Pricing Unit-Linked Insurance with Guaranteed Benefit

Because of the benefit max(H(k), G) = max(H(k) − G, 0) + G has a similar form with European call option payoff
form, which is max(H(k), G), hence, we could find the mathematical model for present value of unit-linked insurance
benefit on below equation.
n
X
A x:n = [C0 (H(k), G) + G · B(0, k)] Pr(K x = k) + [C0 (H(n), G) + G · B(0, n)] Pr(K x > n) (11)
k=1

A x:n : actuarial present value

K x = k : person die at age x + k
x : insured age
n : insurance period
The concept of premium payment in this paper is still the same with conventional insurance because the only
difference between the two insurances is just its benefit model.
The expected present value of annuity äx:n is calculated
 using stochastic interest rate, hence the discount factor of
Rk
the annuity need to be changed to vk = exp − 0 r(t) dt . ä x:n can be expressed on below equation.
n−1
X
ä x:n = B(0, k) · k p x
k=0

k px : probability of a person aged x still alive in the next k year(s)

Substitute A x:n from (11) to equivalence principle so that we have the formula of unit-linked insurance with
guaranteed benefit.
n
X
ä x:n · P = [C0 (H(k), G) + G · B(0, k)] Pr(K x = k) + [C0 (H(n), G) + G · B(0, n)] Pr(K x > n). (12)
k=1

Therefore premium can be found through (12) using numerical methods such as trapezoidal rule in solving the
integrals and bisection method in finding the indicator variable ε.

RESULTS
In this section will be shown result of premium simulation using formula that was obtained in the previous section.
Premium is simulated according to 2011 Indonesian mortality table released by Asosiasi Asuransi Jiwa Indonesia
(AAJI) and interest rate r(0) based on Jakarta Inter-Bank Offered Rate (JIBOR) on April 1st 2016, that is r(0) = 0.049.
Guaranteed benefit assumed to be Rp100,000,000.00 with premium investment portion in amount of 75% of annual
premium of 30 years old male insured. Below is the result of premium simulation.

030139-6
 FIGURE 1. Premium simulation result.

TABLE 1. Premium comparison.

Interest Rate Tends to constant (a = 0) Constant (0.049)

Premium 73,164,236.87 36,863,193.52

In Fig. 1(a), reader could see that the bigger (smaller) interest rate drift (a), the cheaper (more expensive) premium
would be, this is because of the larger interest rate, the smaller discount factor, therefore the present value would
become smaller as well as the premium. Figure 1(b) shows the premium tends to increase along with interest rate
volatility (g). This implication corresponds to the fact that the bigger interest rate volatility, the bigger chance interest
rate would be lower than initial value or one can say that the bigger risk investor would face. Hence premium will
increase in cost of investment risk coverage. The same thing happened in Fig. 1(c), the bigger stock volatility σ s , the
more expensive premium. Thus conclude that the bigger investment volatility, the more expensive premium would be.
While in Fig. 1(d), reader could see the bigger correlation between interest rate and stock price (ρ), the premium
tends to be constant which is varied around its mean. It can be concluded the correlation between interest rate and
stock price has no impact on premium value.
The simulation also conclude that the existence of volatility in interest rate will impact the premium value in great
magnitude. To confirm the previous statement, following table shows premium comparison between constant interest
rate, which is 0.049, and tends to constant interest rate (a = 0) that has volatility. The result from the Table 1 confirm
the beginning statement of the paragraph and also corresponds to Fig. 1(b) which declared that premium would be
cheaper with constant interest rate. For sake of simplicity, the simulation just used one value in other parameter which
is 0.5, reader could check that the same behavior will be obtained if different values is used.

030139-7
 CONCLUSIONS
The formula for pricing unit-linked insurance can be found through these steps:

1. Construct European call option payoff formula and zero coupon bond price using stochastic interest rate model
from Merton [7], stock price model and investment model from Hurlimann [1].
2. By using Ito's lemma, it can be inspected whether option price process with stochastic interest rate discount
factor numeraire is a martingale or not. From known interest rate model, stock price model and investment
model, option price relative to stochastic interest rate discount factor turned out to be a martingale. Therefore,
option price formula can be found.
3. Afterward, option price formula is simplified by changing the measure. Change of measure technique is done
using Radon-Nikodym derivative, while Radon-Nikodym derivative is obtained by matching the formula of
option price with stochastic interest rate discount factor numeraire and with zero coupon bond price numeraire
as well.
4. Using bisection method, indicator variable bound value that causes investment outcome less than guaranteed
benefit is determined. Then put the bound value to the option price formula.
5. Option price formula is put in to the premium equation, which is equivalence principle, and change the discount
factor to zero coupon bond price. Eventually, premium can be solved using trapezoidal rule in solving integral
and bisection method in finding root of equation.

Change of interest rate drift, interest rate volatility and investment instrument volatility hold major contribution on the
premium value, meanwhile the correlation between interest rate and stock price has no impact on it.

SUGGESTION
This paper could be served as reference for further study by developing the interest rate model to be more complex
such as Vasicek model, Cos-Ingersoll-Ross model or Ho-Lee model. Insurance model could be developed as well such
as pension funds or multi-decrement insurance model. Therefore the calculation of benefit would no longer involve
calculation of European call option, but could be Asian call option or another derivative as well.

REFERENCES
1. W. Hürlimann, Astin Bull. 40, 631-653 (2010).
2. M. J. Brennan and E. S. Schwartz, J. Financ. Econ. 3, 195-213 (1976).
3. A. Bacinello and F. Ortu, ”Pricing guaranteed securities-linked life insurance under interest rate risk,” in 3rd
International AFIR Colloquium (1993), Vol. 4, pp. 35-55.
4. A. Kurz, ”Pricing of equity-linked life insurance policies with an asset value guarantees and periodic premiums,”
in 6th International AFIR Colloquium, Nürnberg, 1996.
5. A. Bacinello, in Encyclopedia of Quantitative Risk Assessment, edited by E. L. Mernick and B. S. Everitt (Wiley,
Chichester, 2008), pp. 637-642.
6. M. Costabile, M. Gaudenzi, I. Massabo, and A. Zanette, Insur. Math. Econ. 45, 286-295 (2009).
7. R. Merton, RAND J. Econ. 4, 141-183 (1973).
8. J. M. Harrison and D. Kreps, J. Econ. Theory 20, 381-408 (1979).
9. J. Hull, Options, Futures, and Other Derivatives: 8th Edition (Boston, Prentice Hall, 2012).
10. F. Black and M. Scholes, J. Polit. Econ. 81, 637-654 (1973).

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