Analysis of VIX-linked fee incentives in variable annuities via continuous-time Markov chain approximation

TL;DR

This paper develops a continuous-time Markov chain approach to price variable annuities with VIX-linked fees under various stochastic volatility models, analyzing optimal surrender strategies and their robustness to volatility changes.

Contribution

It introduces an efficient Markov chain approximation method for pricing VAs with complex fee structures and provides a recursive algorithm for optimal surrender decision-making.

Findings

VIX-linked fees increase the robustness of surrender strategies to volatility fluctuations.

The Markov chain approximation yields accurate VA pricing under multiple stochastic volatility models.

Optimal surrender strategies can be effectively approximated with closed-form matrix expressions.

Abstract

We consider the pricing of variable annuities (VAs) with general fee structures under popular stochastic volatility models such as Heston, Hull-White, Scott, $\alpha$-Hypergeometric, $3/2$, and $4/2$ models. In particular, we analyze the impact of different VIX-linked fee structures on the optimal surrender strategy of a VA contract with guaranteed minimum maturity benefit (GMMB). Under the assumption that the VA contract can be surrendered before maturity, the pricing of a VA contract corresponds to an optimal stopping problem with an unbounded, time-dependent, and discontinuous payoff function. We develop efficient algorithms for the pricing of VA contracts using a two-layer continuous-time Markov chain approximation for the fund value process. When the contract is kept until maturity and under a general fee structure, we show that the value of the contract can be approximated by a closed-form matrix expression. We also provide a quick and simple way to determine the value of early surrenders via a recursive algorithm and give an easy procedure to approximate the optimal surrender surface. We show numerically that the optimal surrender strategy is more robust to changes in the volatility of the account value when the fee is linked to the VIX index.