infonet-economy

Common features in life insurance contracts are an interest rate guarantee and policyholder participation in the returns of insurers' reference portfolio, which can be of substantial value. The aim of this paper is to analyze the model risk involved in pricing and risk assessment that arises from the process specification of the reference portfolio. This is, in general, the most important source of model risk and is analyzed by comparing results from the standard Black-Scholes setting with a Lévy-type model based on a Normal Inverse Gaussian process. We focus on the dependence of the insurer's insolvency risk associated with fair contracts on the specification of the underlying asset process using lower partial moments. We show that a misspecification of the underlying stochastic asset model may not only result in serious mispricing, but also lead to an inadequate assessment of insurers' shortfall risk. Model risk can thus imply substantial solvency risk for insurance companies.