An economic scenario generator for embedded derivatives in South Africa

  • Alexis Levendis
  • Eben Maré
Keywords: Heston-Hull-White, stochastic volatility, stochastic interest rates, stochastic mortality, GMMB, GMDB, pricing, hedging


It is well known that interest rate risk is a dominating factor when pricing long-dated contingent claims. The Heston stochastic volatility model fails to capture this risk as the model assumes a constant interest rate throughout the life of the claim. To overcome this, the risk-free interest rate can be modelled by a Hull-White short rate process and can be combined with the Heston stochastic volatility model to form the so-called Heston-Hull-White model. The Heston-Hull-White model allows for correlation between the equity and interest rate processes, a component that is important when pricing long-dated contingent claims. In this paper, we apply the Heston-Hull-White model to price Guaranteed Minimum Maturity Benefits (GMMBs) and Guaranteed Minimum Death Benefits (GMDBs) offered in the life insurance industry in South Africa. We propose a further extension by including stochastic mortality rates based on either a continuous-time Cox-Ingersoll-Ross short rate process or a discrete-time AR(1)-ARCH(1) model. Our findings suggest that stochastic interest rates are the dominating factor when reserving for GMMB and GMDB products. Furthermore, a delta-hedging strategy can help reduce the variability of embedded derivative liabilities.


Journal Identifiers

eISSN: 1680-2179