The Benefit of Life Insurance Contracts with Capped Index Participation When Stock Prices are Subject to Jump Risk

Abstract

We analyze the benefit to the insured of newly traded, innovative life insurance contracts. On a sequence of yearly reference days, the insured can choose between a guaranteed return (linked to the insurer's asset result) and a capped index participation. The cap is adjusted at the beginning of each year such that both alternatives have the same value and the option to select is costless (product structuring condition). We point out that this condition cannot always be met. If the guaranteed return exceeds the upper bound of the capped index participation, the insurer can make a side profit. We show that a rather low insurance result also implies a rather low stock exposure, even if the insured opts for the index participation. Concerning the impact of the index dynamics, we emphasize that it is important to distinguish between jump and diffusion risk. The amount of (downward) jump risk reduces the cap rates but its overall impact on the expected utility is ambiguous. Finally, we show that the optimal decision strategy of a CRRA investor implies an index selection even if it is unfairly priced such that the insurer indeed makes a side profit.

Keywords: Derivatives, Life Insurance, Capped Index Participation, Monthly Summed Cap, Select Products

JEL Classification: G13, G22