A large-scale optimization model for replicating portfolios in the life insurance industry

Replicating portfolios have emerged as an important tool in the life insurance industry, used for the valuation of companies' liabilities. This paper describes the replicating portfolio (RP) model used to approximate life insurance liabilities in a large global insurance company. We describe the challenges presented by the latest solvency regimes in Europe and how the RP model enables this company to comply with the Swiss Solvency Test. The model minimizes the L1 error between the discounted life insurance liability cash flows and the discounted RP cash flows over a multiperiod time horizon for a broad range of different future economic scenarios. A numerical application of the RP model to empirical data sets demonstrates that the model delivers RPs that match the liabilities and perform well for economic capital calculations.