Fair valuation of insurance liability cash-flow streams in continuous time

Fair valuation of insurance liability cash-flow streams in continuous time

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We investigate fair (market-consistent and actuarial) valuation of insurance liability cash-flow streams in continuous time. We first consider one-period hedge-based valuations, where in the first step, an optimal dynamic hedge for the liability is set up, based on the assets traded in the market and a quadratic hedging objective, while in the second step, the remaining part of the claim is valuated via an actuarial valuation. Then, we extend this approach to a multi-period setting by backward iterations for a given discrete-time step h, and consider the continuous-time limit for h à 0. We derive a partial differential equation for the valuation operator which satisfies the continuous-time limit of the multi-period, discrete-time iterations and prove that this valuation operator is actuarial and market consistent. We show that our continuous-time fair valuation operator has a natural decomposition into the best estimate of the liability and a risk margin. The dynamic hedging strategy associated with the continuous-time fair valuation operator is also established. Finally, the valuation operator and the hedging strategy allow us to study the dynamics of the net asset value of the insurer. Our results can be useful for understanding the valuation concepts in Solvency II and IFRS 17.

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