Endowment assurance products – effectiveness of risk-minimizing strategies under model risk

This paper analyzes and discusses the effects of model misspecification associated with both interest rate and mortality risk on the hedging decisions of insurance companies. We consider hedging strategies in different instruments (zero bonds) which are risk–(variance–)minimizing with respect to an assumed model. In this case, the associated expected costs and the variance of the costs are the same for all strategies. While the introduction of model risk, i.e. a deviation of assumed from true models, has the same effect on the expected costs, this is not true with respect to the variance. It turns out that the choice of hedging instruments has a crucial impact on the robustness of the strategies. In addition, the results of the paper can be used to emphasize the necessity to use a combined hedging model. In terms of robust hedging, a separate specification of interest rate model and mortality model is inconvenient, even in the case that interest rate and mortality are assumed to be independent.