Risk-Neutral Valuation: Challenges and Choices

These embedded options need to be valued in a market consistent way due to regulatory requirements (such as Solvency II, RBC, et all.) but equally important also from a risk management perspective. From a risk management perspective it is crucial to get a thorough insight into the sensitivity of these embedded options toward changes in (economic) variables and the impact on the overall financial and solvency position of these embedded options on the company going forward. Because of the complex pay-out structure of these embedded options, this presents quite a challenge.

Risk-neutral models

Valuation at market value implies that pricing models need to be used that replicate current prices of frequently traded instruments. There type of pricing models are called risk-neutral models. The valuation of embedded options with risk-neutral models is a challenge – for instance compared to standard derivatives – because more often than not they depend on multiple economic variables and are characterized by a rather complex pay-out structure. Even though it is challenging the risk-neutral pricing methodology is widely accepted and has become the pricing standard for embedded options in the insurance industry.

Since the recent financial crisis risk-neutral models increasingly take into account and incorporate the dynamics and patterns that can be observed in financial market data, thereby increasing the computational complexity. Next to that, insures would like to have a thorough understanding of the risks on the balance sheet (and risks stemming from the embedded options in the technical provisions in particular) which calls for advanced valuation models. This is becoming even more relevant in a number of (proposed) regulatory requirements, such as solvency capital frameworks (Solvency II, RBC, et all.) and the upcoming IFRS 17 framework that also requires insurers to value contracts consistent with current market information. This means more emphasis on well-established models and documentation.

In this document we highlight the most important challenges and choices in risk-neutral valuation. For each challenge we also highlight how we at Ortec Finance address these challenges with our state-of-the-art risk-neutral scenario generator.