Endowment assurance products-effectiveness of riskminimizing 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.