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Unhedgeable Risk
Roger J.A. Laeven
www.fee.uva.nl/ke/laeven
University of Amsterdam
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Background [2]
This paper solves simultaneously both the optimal dividend problem and the optimal
investment problem.
• In doing so, we distinguish between hedgeable risks (financial risks) and unhedgeable
risks (pure insurance risks).
• The asset portfolio can be chosen so as to replicate the financial risks (hedgeable part)
of the liability portfolio. The insurance company may decide to deviate from the
replicating portfolio in order to benefit from excess returns, but at the cost of increased
risk.
• The pricing of unhedgeable insurance risk can also be embedded in our framework.
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Outline
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The model: a stylized insurance company [1]
• We assume that there is competition in the insurance market and that m is exogenously
given and not a control variable.
• The factor α is a control variable. If α=0, then one only invests in risk-free bonds. For
α>0, one takes more risk. For α=1 the asset portfolio is equal to the so-called
replicating portfolio which replicates exactly the financial risks (hedgeable part) of the
liability portfolio.
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The model: a stylized insurance company [2]
The surplus S of the insurance company is given by the difference in value between assets
and liabilities:
To simplify further analysis of the surplus process, we substitute β =(α-1) and we replace the
two diffusion terms by a single diffusion term which has the same law:
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The model: a stylized insurance company [3]
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Optimal policies
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Example [1]
Parameter specification:
Parameter Value
µM 5.25 (million)
σM 25.4 (million)
m 0.525 (million)
σI 4.60 (million)
M 25.0%
c 5.00%
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Example [2]
30%
25%
Optimal Investment Policy
20%
15%
10%
5%
0%
0 2 4 6 8 10 12 14
Initial Surplus
Beyond an initial surplus of 12.44 million, a maximum risk strategy should be followed.
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Example [3]
Expected value of the discounted dividends under the optimal investment and optimal
dividend policy as a function of the initial surplus
40
35
30
25
Value Function
20
15
10
0
0 5 10 15 20 25 30
Initial Surplus
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The pricing of insurance risk
• The expected value of the discounted dividends turns out to be decreasing in σI.
• The sensitivity of the expected value of the discounted dividends with respect to σI can
be interpreted as the marginal price of insurance risk.
• The marginal price of insurance risk is such that the shareholders are indifferent
between bearing an additional unit of insurance risk (as measured by σI) while receiving
an immediate dividend payout equal to the marginal price of insurance risk, and not
bearing the additional unit of insurance risk.
• Alternatively, one may determine the increase of the profit margin m that offsets the
decrease of the expected value of the discounted dividends when an additional unit of
insurance risk (as measured by σI) is borne.
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Example revisited
40
35
30
25 4
Value Function
4.6
20 5
6
15 7
10
0
0 5 10 15 20 25 30 35
Initial Surplus
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Time of bankruptcy
• Because the optimal dividend policy is a barrier strategy, the (modified) surplus process
is a Brownian Motion with a reflecting barrier and an absorbing barrier.
• For such a process, the Laplace transform of the time of absorption (i.e., bankruptcy)
can be calculated analytically.
• The distribution function of τ can be useful in calibrating the model. In particular, it may
be used to infer the dividend discount rate, c.
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Conclusions
• We have solved both the optimal dividend policy problem and the optimal investment
policy problem simultaneously.
• We obtained analytical expressions for the optimal policies, as a function of the initial
surplus.
• The framework lends itself to infer the price of insurance risk that shareholders want the
insurer to charge.
• Further research: more sophisticated models for the assets and liabilities, and
stochastic interest rate modelling.
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Some References
Asmussen, Søren & Michael Taksar (1997). “Controlled diffusion models for optimal dividend pay-out,”
Insurance: Mathematics and Economics 20, 1-15.
Borch, Karl (1967). “The theory of risk,” Journal of the Royal Statistical Society B 29, 432-452.
Borch, Karl (1969). “The capital structure of a firm,” Swedish Journal of Economics 71, 1-13.
Bühlmann, Hans (1970). Mathematical Methods in Risk Theory, Berlin: Springer Verlag.
Cox, D.R. & H.D. Miller (1965). The Theory of Stochastic Processes, London: Chapman and Hall.
De Finetti, Bruno (1957). “Su un'impostazione alternativa dell teoria colletiva del rischio,” Transactions of the
15th International Congress of Actuaries 2, 433-443.
Gerber, Hans U. (1972). “Games of economic survival with discrete- and continuous-income processes,”
Operations Research 20, 37-45.
Gerber, Hans U. (1979). An Introduction to Mathematical Risk Theory, Huebner Foundation Monograph 8,
Illinois: Homewood.
Højgaard, Bjarne & Michael Taksar (1999). “Controlling risk exposure and dividends payout schemes:
insurance company example,” Mathematical Finance 9, 153-182.
Markowitz, Harry M. (1952). “Portfolio selection,” Journal of Finance 7, 77-91.
Markowitz, Harry M. (1970). Portfolio Selection: Efficient Diversification of Investments, 2nd edn., first edition
1959, New York: Wiley.
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