Recently, considerable publicity is drawn to life-insurance policies with Guaranteed Annuity Options (GAOs). Equitable, a large British insurance office, had to close for new business as a portfolio of old insurance policies with GAOs became an uncontrollable liability. In this paper we want to propose a hedging methodology that can help insurance companies to avoid such problems in the future. We derive a market value for the GAO using martingale modelling techniques. Furthermore, we show how to construct a static replicating portfolio of vanilla interest rate swaptions that replicates the GAO. Finally, we illustrate with historical UK interest rate data from the period 1980 until 2000 that the static replicating portfolio would have been extremely effective as a hedge against the interest rate risk involved in the GAO, that the static replicating portfolio would have been considerably cheaper than up-front reserving and also that the replicating portfolio would have provided a much better level of protection than an up-front reserve.

Paper: pelsser.pdf

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