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Identification and Pricing of the Embedded Option in a Supplementary Disability Insurance

In recent years it has become clear that in order to make a fair estimate of the solvency of a pension fund or an insurance company, the liabilities in the balance sheet have to be reported at market price. For nominal claims the expected cash flows can simply be discounted using the term structure of interest rates. If, however, the claim is index-linked, then the value of the cash flows will be uncertain and in general behave like a cash flow that can be replicated by the payoff of some (still to be identified) option. This paper describes a supplementary disability insurance carried by the ABP insurance group. It will identify the option resulting from the indexation promise embedded in the disability insurance and subsequently value this promise.