Pricing a guaranteed annuity option under a stochastic correlation setting

Recent regulatory overhauls in North America and Europe require insurers the detailed revision of capital requirements across multiple insurance product domains. These cover unique challenges akin to guaranteed minimum benefits in variable annuities and risk correlations. This article addresses the urgent need to establish robust pricing methodologies for option-embedded guarantees. Our focus is on the pricing of a guaranteed annuity option (GAO), which offers investors with both growth prospects and downside protection. We propose a stochastic correlation framework to capture the dynamic dependence between financial and longevity risks. When the traditional Monte-Carlo method is used as a baseline, our change of probability measures approach not only generates accurate GAO values but also features a remarkably efficient computation. An analysis of the magnitude and direction of the impact of the model parameters on GAO prices is also presented. Both the theoretical and applied contributions of this article have central importance to insurers and regulators alike and to the concerted efforts in sustaining the insurance sector’s stability and consumer protection.