The solution says the "main risk to the company is that at the point of exercise the value of the backing assets will be insufficient to meet the guarantee". Please explain. Also, the solution says "the cost of the option for each stochastic simulation is any excess of the present value of the guaranteed annuity payments over the lump sum benefits multiplied by the assumed probability of exercise at that age". Is this saying that the annuity payment is calculated at the guaranteed annuity rate say 6% for a given lump sum and the annuity payment is also calculated at simulated annuity rates for the same given lump sum and then the difference in the annuity payments between the guaranteed annuity rate and the simulated rate gives the cost? Please explain.
The predominant uncertainty to the organisation is that at the moment of execution the price of the supporting investments will be less than the cost of what has been promised.
main risk to the company is that at the point of exercise the value of the backing assets will be insufficient to meet the guarantee
Thanks. Please advise if my understanding of the second part is correct (where I am using an example of 6%).
Yes. We work out how much annuity could be bought with the maturity proceeds at the guaranteed rate 6%. We then value this annuity at the projected interest rate at maturity, say 4%. The cost of the guarantee is then the projected cost of this annuity at 4% less the cost at 6%.
