Replicating portfolio

In the valuation of a life insurance company, the actuary considers a series of future uncertain cashflows (including incoming premiums and outgoing claims, for example) and attempts to put a value on these cashflows. There are many ways of calculating such a value (such as a net premium valuation), but these approaches are often arbitrary in that the interest rate chosen for discounting is itself rather arbitrarily chosen.

One possible approach, and one that is gaining increasing attention, is the use of "replicating portfolios" or "hedge portfolios". The theory is that we can choose a portfolio of assets (fixed interest bonds, zero coupon bonds, index-linked bonds, etc.) whose cashflows are identical to the magnitude and the timing of the cashflows to be valued.

For example, to value a set of annual cashflows as follows: 2, 2, 2, 50, 2, 2, 102, you could buy a seven year bond with a 2% dividend, and a four year zero-coupon bond with a maturity value of 48. The cost of those two instruments might be 145 (the cost of buying the replicating portfolio) - and therefore the value of the cashflows is taken to be 145.

It should be clear that the advantages of a replicating portfolio approach include:
* an arbitrary discount rate is not required
* the term structure of interest rates is automatically taken into account.

For additional information on economic valuations and replicating portfolios can be found here: [http://swissre.com/pws/research%20publications/risk%20and%20expertise/technical%20publishing/the%20economics%20of%20insurance.html The Economics of Insurance]