Deep Least Squares Monte Carlo methods for the valuation of variable annuities with guarantees

Abstract: In general, the pricing of variable annuities with guarantees can be done by solving the corresponding optimal stochastic control problem if the contract withdrawal strategy is assumed to be optimal. This is typically solved as a dynamic programming problem using deterministic grid methods, which become computationally infeasible for more than a few state variables. In such situations, one needs to rely on simulation methods. The least-squares Monte Carlo (LSMC) method has become a popular simulation method for solving optimal stochastic control problems in quantitative finance over the last decades. In principle, the LSMC, originally developed for pricing Bermudan options, cannot be used directly for pricing variable annuities without simplifying assumptions because the underlying state variables are affected by the control decisions. This paper presents modifications of the LSMC algorithm that makes the pricing of general variable annuities feasible. For numerical illustrations, the pricing of variable annuities with guaranteed minimum withdrawal benefit under optimal withdrawal strategies is obtained with and without stochastic interest rates, using either polynomial regression or neural network regression in the LSMC algorithm. We found that the classical polynomial LSMC can give very accurate prices, at the cost of manual feature engineering, and with a standard deviation of the estimator that increases greatly when interest rates are made stochastic. By contrast, neural network LSMC gives slightly less accurate prices, requires more training time, but does not require manual feature engineering, and making interest rates stochastic makes no visible difference to its accuracy, suggesting a more stable and robust pricing performance of deep LSMC for higher-dimensional pricing problems.