Practical valuation of long-term guarantees in inactive financial markets

In this paper we address certain issues in the valuation of long-term (insurance) guarantees from a practical point of view. These issues arise, because markets are incomplete or inactive. We provide a general, arbitrage-free valuation approach in this context and discuss the following topics in more detail: extrapolation of interest rates, treatment of interest rate spreads and counter-cyclical measures in distorted markets. By deriving solutions from a practitioner’s point of view this paper aims to contribute to an effective regulation under Solvency II. Moreover, we hope to provide a starting point for an in-depth academic analysis of these problems.