We propose a modelling framework for risk-neutral stochastic processes nested in a real-world stochastic process. The framework is important for insurers that deal with the valuation of embedded options and in particular at future points in time. We make use of the class of State Space Hidden Markov models for modelling the joint behaviour of the parameters of a risk-neutral model and the dynamics of option market instruments. This modelling concept enables us to perform non-linear estimation, forecasting and robust calibration. The proposed method is applied to the Heston model for which we find highly satisfactory results. We use the estimated Heston model to compute the required capital of an insurance company under Solvency II and we find large differences compared to a basic calibration method.

Heston, nested simulations, risk-neutral valuation, robust calibration, solvency II, State Space Hidden Markov
Ortec Finance, Rotterdam, The Netherlands
Applied Mathematical Finance
Centrum Wiskunde & Informatica, Amsterdam, The Netherlands

Singor, S.N, Boer, A, Alberts, J.S.C, & Oosterlee, C.W. (2017). On the modelling of nested risk-neutral stochastic processes with applications in insurance. Applied Mathematical Finance, 24(4), 302–336. doi:10.1080/1350486X.2017.1378583