Under Expected Utility Theory (EUT) and its behavioural counterpart Cumulative Prospect Theory (CPT), the demand for interest rate guarantees of cliquet style cannot be explained. The reason is that both theories solely focus on the terminal payoff a contract offers and hence completely ignore the stabilizing effect of interest rate guarantees throughout the course of the investment. Recognizing this, recent research has proposed Multi Cumulative Prospect Theory (MCPT) as an approach that extends regular CPT to also include interim value changes of a contract in the policyholder's valuation. We find that under CPT investor preferences, the direct investment yields the highest utility as compared to simple and complex guarantee forms. In contrast to previous findings under MCPT, we show that cliquet style guarantees can only outperform simpler guarantee forms or a direct investment when the investor puts his main emphasis on the subjective utility of the interim changes. As soon as the influence of the terminal value on the subjective utility increases to a certain level, the cliquet style guarantee will be dominated by other products.
Participating life insurance contracts are common products in Europe. Their savings component typically exhibits an interest rate guarantee in combination with a surplus participation mechanism. Together, these two features constitute an embedded option. The purpose of this article is to show how an insurance company can maximize policyholder utility by setting the level of the interest rate guarantee in line with his preferences. We develop a general model of life insurance, taking stochastic interest rates, early default and regular premium payments into account. Furthermore, we assume that equity holders receive risk adequate returns on their initial equity contribution. Our findings show that the optimal level for the interest rate guarantee is far below the maximum value typically set by the supervisory authorities.
In this paper, we comprehensively analyze open-end funds dedicated to investing in U.S. senior life settlements. We begin by explaining their business model and the roles of institutions involved in the transactions of such funds. Next, we conduct the first empirical analysis of life settlement fund return distributions as well as a performance measurement, including a comparison to other asset classes. Since the funds contained in our dataset cover a large fraction of this relatively young segment of the capital markets, representative conclusions can be derived. Even though the empirical results suggest that life settlement funds offer attractive returns paired with low volatility and are virtually uncorrelated with other asset classes, we find latent risk factors such as liquidity, longevity and valuation risks. Since these risks did generally not materialize in the past and are hence largely not reflected by the historical data, they cannot be captured by classical performance measures. Thus, caution is advised in order not to overestimate the performance of this asset class.
We analyse the prevailing valuation practices in the settlement industry based on a sample of eleven funds that cover a large fraction of the current market. The most striking result is that a majority of asset managers seems to substantially overvalue their portfolios relative to the prices of recently closed comparable transactions. Drawing on market-consistent estimates with regard to medical underwriting, it is possible to trace back the observed discrepancies to inadequately low model inputs for life expectancies and discount rates. The consequences are a dissimilar treatment of investor groups in open-end fund structures as well as an unduly high compensation for managers and third parties. To address this predicament, we suggest defining life settlements as level 2 assets in the fair value hierarchy of IFRS 13, improving transparency and disclosure requirements, and developing new incentive compatible fee structures.
