The recipients of the 2003 Witt Award were Steven Boyce and Richard Ippolito for “The Cost of Pension Insurance,” The Journal of Risk and Insurance, Vol. 69, No. 2. (June 2002), pp. 121-170.
This article estimates the cost of the federal pension insurance program. Pension insurance claims have an important market-risk component, which means that the cost of the exposure cannot be estimated by discounting future claims by the risk-free rate. Moreover, owing to the complexity of the insurance contract, its price cannot be estimated with known options formulas without introducing an error of non-quantifiable magnitude. To circumvent these problems, we model the insurance program in its full complexity and use a Monte Carlo method. By hedging the exposure with a dynamic premium policy that offloads the market risk to the insureds, one can calculate the risk-free, or actuarial, cost of that policy. One can also characterize the nature of the subsidy and its structure across insured plans. Finally, we provide an estimate of the implicit cost of the hedge function that taxpayers currently are providing for zero remuneration. The model shows that simple contingent claims models of pension insurance result in a price that is about triple the true market cost of the insurance, and that pension insurance models that ignore market risk understate the cost by half. The solution demonstrates the broad characteristics that might characterize a credible private-sector version of pension insurance.