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IAI Actuarial Core Principles · Economic Modelling · Valuing benefit guarantees using simulation

For which purpose would an insurer most appropriately use real-world rather than risk-neutral scenarios?

Real-world scenarios suit estimating the distribution of guarantee costs for a 99.5th percentile capital requirement, because capital depends on realistic likelihoods of outcomes. Pricing, calibration to market option prices and hedging are done under the risk-neutral measure.

  1. ACalculating the market-consistent value of an embedded option for the balance sheet
  2. BCalibrating to observed swaption prices
  3. CEstimating the distribution of guarantee cost to set a 99.5th percentile capital requirementCorrect
  4. DChecking that discounted asset prices are martingales
  5. Deriving the price of a hedge from the replicating portfolio

Explanation

Capital requirements depend on the likely future distribution of outcomes, which needs realistic drifts and volatilities, i.e. real-world scenarios. The other options concern pricing by no-arbitrage, calibration to market prices, or martingale tests, all of which belong to the risk-neutral framework.

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