Long-Dated Cash Flow Pricing in Pension Liabilities:

The Application of Good-Deal-Bound Approach

Qiaohui Liang

Abstract: The facts that pension insurers keep liabilities on their books for a very long time, and Solvency II requires pension valuation to be on a market-consistent base make evaluating pension liabilities properly a crucial content for both industry and regulatory. However, because of market incompleteness, neither interest rates with maturities beyond 30 years nor longevity-related assets could be traded in existing financial market. Pricing by replication fails in this case. Pension industry currently applies Cost-of-Capital method to fix this problem. But according to recent research, this method has insufficient economic justification and it may underestimate pension liabilities. This is a very serious problem for public security. The aim of my thesis is to adopt another pricing method in incomplete market, the Good-Deal-Bound approach, to deal with corresponding unhedgeable risks and price long-dated cash flows in pension liabilities. Moreover, a real numeral example of pension liability evaluation will also be discussed.

Keywords: Pension liabilities valuation; Good-Deal-Bound approach; term structure; mortality rate risk