Insurance: Mathematics and Economics 59 (2014) 300–310

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Insurance: Mathematics and Economics

journal homepage: www.elsevier.com/locate/ime

Mean–variance asset–liability management with asset correlation

risk and insurance liabilities
Mei Choi Chiu a,∗ , Hoi Ying Wong b
a
Department of Mathematics & Information Technology, Hong Kong Institute of Education, Tai Po, N.T., Hong Kong
b
Department of Statistics, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong

article info abstract

Article history: Consider an insurer who invests in the financial market where correlations among risky asset returns are
Received July 2014 randomly changing over time. The insurer who faces the risk of paying stochastic insurance claims needs
Received in revised form to manage her asset and liability by taking into account of the correlation risk. This paper investigates
September 2014
the impact of correlation risk to the optimal asset–liability management (ALM) of an insurer. We employ
Accepted 7 October 2014
Available online 24 October 2014
the Wishart process to model the stochastic covariance matrix of risky asset returns. The insurer aims
to minimize the variance of the terminal wealth given an expected terminal wealth subject to the
Keywords:
risk of paying out random liabilities of compound Poisson process. This ALM problem then becomes a
Asset–liability management linear–quadratic stochastic optimal control problem with stochastic volatilities, stochastic correlations
Correlation risk and jumps. The recognition of an affine form in the solution process enables us to derive the explicit
Wishart process closed-form solution to the optimal ALM portfolio policy, obtain the efficient frontier, and identify the
BSDE condition that the solution is well behaved.
Mean–variance criteria © 2014 Elsevier B.V. All rights reserved.

1. Introduction
The Markowitz (1952) mean–variance (MV) portfolio selection
is not only the building block of the modern portfolio theory but
also useful in asset–liability management (ALM). Chiu and Li (2006)
apply the MV concept to manage the surplus level of a firm in
a continuous-time economy. Their approach is based on the ad-
vanced techniques developed by Li and Ng (2000), and Zhou and Li
(2000). Then, there are many extensions along this line of research.
Examples in dynamic MV-ALM include, but are not limited to, the
situation of regime-switching economy (Chen et al., 2008), nu-
merical methods for solutions under different market constraints
(Wang and Forsyth, 2011), the insurer’s problem with cointegrated
assets and insurance liabilities (Chiu and Wong, 2012), the case of
endogenous liabilities (Yao et al., 2013), the management of coin-
tegrated assets and a diffusion liability (Chiu and Wong, 2013a),
among others.
The motivations for considering MV criterion are that it is the
most well-known concept in portfolio management, and it can be
linked to ruin probability minimization, which is the fundamental
∗
Corresponding author.
E-mail addresses: mcchiu@ied.edu.hk (M.C. Chiu), hywong@cuhk.edu.hk
(H.Y. Wong).
http://dx.doi.org/10.1016/j.insmatheco.2014.10.003
0167-6687/© 2014 Elsevier B.V. All rights reserved.
concern of most insurers and the public. The ruin probability mea-
sures the likelihood that the insurer’s wealth goes to negative. This
probability is parallel to the safety-first problem considered by Roy
(1952), who proposes to minimize the ruin probability subject to
a target mean wealth level, see Chiu et al. (2012) for further de-
tails. Chiu and Li (2009) mathematically prove that the surrogate
safety-first problem can be subsumed into the MV problem in the
sense that the safety-first optimal solution is an optimal solution
of the MV problem with a certain target mean. The original version
of the safety-first problem is, however, ill-posed (Chiu and Wong,
2012). A stable optimal solution can only be obtained by imposing
some boundedness constraints. Therefore, the solution of the MV-
ALM problem can be regarded as a reasonable approximation to the
corresponding ruin probability minimization problem subject to a
positive expected wealth level. An alternative ALM approach max-
imizes the expected utility function on the insurer’s wealth (Chiu
and Wong, 2013b). However, we leave it for a separate paper.
We consider correlation risk in the ALM problem not only be-
cause such an investigation has not previously been conducted,
but also because empirical results strongly suggest stochastic cor-
relations. Examples of empirical evidence can be found in Lon-
gin and Solnik (1995), Ball and Torous (2000), Ledoit et al. (2003),
Ang and Chen (2002), Barndorff-Nielsen and Shephard (2004),
Moskowitz (2003) and many others. Gourieroux (2006) advocates
the Wishart process of Bru (1991) to model financial assets move-
ments. Gourieroux et al. (2009) provide a thorough analysis of
 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310
how the Wishart process can be used to model the evolution of
the stochastic covariance matrix. They show that the Wishart pro-
cess becomes the Heston (1993) stochastic volatility model in the
one-dimensional case. Christoffersen et al. (2009) improve the op-
tion pricing accuracy by a multiple Heston model while Gourier-
oux et al. (2009) show that the multiple Heston model is a special
case of the Wishart model. Gourieroux and Sufana (2010) then use
the Wishart model to develop an option pricing framework. In fact
the Wishart model is also useful for currency (Leung et al., 2013a),
commodity (Chiu et al., 2014) and interest rate derivatives (Leung
et al., 2013b).
Due to the randomness of the asset volatilities and correla-
tions, there are many important contributions on portfolio the-
ory with stochastic volatility and/or stochastic correlations. Chacko
and Viceira (2005) maximize the expected utility for asset allo-
cation between a risk-free asset and a risky asset following the
Heston model. Cerny and Kallsen (2008) derive the optimal MV
strategy between a risk-free asset and a risky asset with stochas-
tic volatility. Drawing from the properties of the Wishart process
and optimal portfolio solutions, Buraschi et al. (2010) consider a
stochastic covariance matrix among risky assets and derive an ex-
plicit optimal portfolio policy by maximizing the expected power
utility function. Chiu and Wong (2014) solve the MV portfolio prob-
lem with the Wishart process and deduce a condition under which
the MV portfolio problem admits a stable solution.
However, the use of Wishart process in ALM is yet to be con-
sidered in this paper. The challenge of solving the ALM problem
of an insurer with the Wishart covariance process is that the in-
surer’s wealth process consists of stochastic covariance matrix and
jumps simultaneously. Thus, it corresponds to a jump–diffusion
wealth process with stochastic volatilities and correlations. We at-
tack the problem using techniques of backward stochastic differ-
ential equation (BSDE). The BSDE framework helps to get around
the non-separability problem associated with the MV criterion. The
trade-off is that we have to solve a system of BSDEs, which is more
sophisticated than the single BSDE considered by Chiu and Wong
(2014). Our approach is greatly inspired by the works of Lim and
Zhou (2002) and Lim (2004), but the major difference is that their
approaches only work for bounded random parameters. However,
the Wishart covariance matrix process is unbounded so that we
extend the framework of Chiu and Wong (2012, 2013a) to prove
uniqueness of the optimal ALM policy upon existence.
As a result, this paper offers the closed-form solution to the
MV-ALM problem with correlation risk and a condition for stable
(no-blow-up) solutions. This condition implies that the optimal
ALM policy is well-behaved and stable if the leverage effect is not
significant, where the leverage effect is reflected by the correlation
between asset returns and their covariance matrix. In an economic
regime with a high leverage effect, the optimal ALM strategy is
stable only for a finite investment horizon, which depends on the
model parameters.
The remainder of the paper is organized as follows. Section 2
defines the market and insurance liability process and introduces
the MV-ALM problem. We then convert the original MV-ALM
problem into a system of BSDEs in Section 3, where we show the
uniqueness of the solution to the BSDE upon existence. Explicit
solutions and the condition for a stable solution are derived in
Section 4. Section 5 demonstrates the empirical use of the results
using numerical examples. We provide our conclusion in Section 6.
2. Problem formulation
2.1. The financial market
We adopt the financial market setting of Chiu and Wong (2014),
where n + 1 assets are traded continuously within the time horizon
301
[0, T ]. These assets are labeled by Si , i = 0, 1, 2 . . . , n with S0
being risk-free. Among them, the risk-free asset S0 (t ) satisfies the
ordinary differential equation (ODE):
dS0 (t ) = r (t )S0 (t )dt , S0 (0) = s0 > 0, (1)
where r (t ) is the continuous deterministic risk-free rate. The
vector of risky asset prices S (t ) = (S1 (t ), . . . , Sn (t ))′ satisfies the
vector-valued stochastic differential equation (SDE):
µ(Σ (t ), t ) dt + Σ 1/2 (t ) dBt ,
dS (t ) = IS (t ) 
 
IS (t ) = Diag(S ), t ∈ [0, T ], 1 ≤ i, j ≤ n (2)
where Bt is a standard n-dimensional Brownian motion, the
function  µ(Σ (t ), t ) is a vector of possibly state-dependent
appreciation rates, and Σ 1/2 (t ) is the positive square root of the
covariance matrix Σ (t ).
The risky asset dynamics in (2) is the classical Black–Scholes
model for a deterministic Σ (t ). However, we not only permit
variances, diagonal elements of Σ (t ), to be stochastic but also
its off-diagonal elements. We do this by modeling the covariance
matrix through the continuous-time Wishart diffusion process
as suggested in Gourieroux et al. (2009), Gourieroux and Sufana
(2010), Buraschi et al. (2010) and Chiu and Wong (2014).
Two approaches are possible. The first one directly assumes
the covariance matrix itself to follow the Wishart process and
µ(Σ (t ), t ) = r1 + Σ (t )β(t ). This is the situation of deterministic

market price of covariance risk (DMPCR) and is consistent with the
consideration of Cerny and Kallsen (2008) in a single risky asset
case. The second approach assumes the precision matrix Σ −1 (t )
to follow the Wishart process and  µ(Σ (t ), t ) = r1 + µ(t ), where
µ(t ) is deterministic. This refers to the market with a deterministic
risk premium (DRP). Chiu and Wong (2014) illustrate possible
statistical procedures to determine whether DMPCR or DRP should
be used for a given financial data set. Our interest is, however, to
derive solutions for both situations.
Let g : Rn+×n → Rn+×n be a bijection onto the space of n-dimen-
sional positive definite matrices Rn+×n . The covariance matrix Σ (t )
satisfies the matrix-valued SDE:
Σ (t ) = g (Λ(t )), (3)
dΛ(t ) = γ QQ ′ + M Λ(t ) + Λ(t )M ′ dt
 
+ Λ1/2 (t )dWt Q + Q ′ dWt′ Λ1/2 (t ), Λ(0) = Λ0 ,
where γ is a positive constant, Q is an n × n invertible constant ma-
trix, M is an n × n diagonalizable constant matrix with nonnegative
eigenvalues, and Wt is a standard n × n matrix Brownian motion.
The matrix stochastic process {Λ(t )} in (3) is the Wishart pro-
cess. If g (Λ(t )) = Λ(t ) (g (Λ(t )) = Λ−1 (t )), then the covari-
ance (precision) matrix follows the Wishart process. The constant
matrix M with nonnegative eigenvalues characterizes the persis-
tence, or approximately speaking the mean reversion, to ensure
the stationarity of Λ(t ). When M is singular, process (3) resembles
the continuous-time cointegration model of Chiu and Wong (2011)
so that cointegration exists among elements of the covariance
matrix. The invertible matrix Q determines the long-term equilib-
rium of the Wishart process Λ(t ) as γ QQ ′ and controls the vari-
ance–covariance among elements in Λ(t ). The constant γ > n − 1
ensures Λ(t ) is positive and follows the Wishart distribution for all
t ∈ (0, T ] (Bru, 1991).
We allow the vector of asset returns and its covariance matrix
to be correlated with correlation vector ρ . Following Da Fonseca
et al. (2007), Buraschi et al. (2010) and Chiu and Wong (2014), we
make the following model specification,
Bt = Wt ρ + Zt 1 − ρ ′ ρ,

where Zt is an n-dimensional Wiener process independent of Wt
and ρ = (ρ1 , . . . , ρn )′ , is a correlation column vector such that
∥ρ∥ < 1. All the Wiener processes, Bit , Ztj and Wtkℓ are defined on a
fixed filtered complete probability space (Ω , F , P , Ft ≥0 ).
302 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310

2.2. Insurer’s wealth and random liabilities (P(Y )) min Var(Y (T )) s.t. E[Y (T )] = Y ,
u(·)

The classical risk model describes an insurer’s wealth process as u(·) ∈ L2G ([0, T ], Rn ), (3) and (8).
Y (t ) = Y0 + C (t ) − L(t ), (4) The space L2G ([0, T ], Rn ) represents the set of all Rn -valued
where Y0 is the initial wealth, C (t ) is the non-negative accumulated GT -measurable random variables with finite second moments. We
say A(t ) ∈ L2G ([0, T ], Rn×n ) if it is an Gt -adapted n × n matrix-
insurance premium and L(t ) represents accumulated random pay-  
T
tr A(s)A(s)′ ds < ∞, where
 
ments for insurance claims or liability. The insurance liability fol- valued process such that E 0
lows a compound Poisson process,
tr(·) is the trace of a square matrix. The optimal solution u∗ of
Nt (P(Y )) is an efficient portfolio with expected final wealth Y , and the
point (Var(Y (T ))|u∗ , Y ) is an efficient point.√

L(t ) = zi , L(0) = 0, (5) The set of all efficient
i =1 points forms the efficient frontier in the ( Var(Y (T )), Y ) space
defined by Markowitz (1952).
where {Nt , 0 ≤ t ≤ T } is the Poisson process with intensity ν(t ),
and zi are independent and identically distributed positive random
variables with finite second moments for i = 1, 2, . . . , and inde- 3. Backward stochastic differential equation
pendent of Nt .
The risk model (4) ignores the fact that insurers usually partic- Using the Lagrangian method, the optimal solution of (P(Y )) can
ipate in the financial market, (Hipp and Plum, 2000). Consider that be derived through a max–min problem:
the insurer invests in the financial market with stochastic covari- max min Var(Y (T )) − λ(E[Y (T )] − Y ), (9)
ance as described in Section 2.1. For a simple mathematical setup, λ∈R u∈U
we assume a zero insurance premium, C (t ) ≡ 0, for the moment U = {u(·) ∈ L2G ([0, T ], Rn ) : (3) and (8) hold true}.
but the situation of positive premium will be fully addressed in Sec-
tion 4.2. This approach essentially moves the expectation constraint to the
Let ui (t ) be the capital invested in asset i and Ni (t ) be the num- objective function of the optimization problem. We, however, have
ber of units of asset i in the portfolio of the insurer. An insurer’s to solve the additional outermost maximization problem. Thus, the
wealth level at time t is derivation for the solution of (9) involves two steps. The first step
solves the internal minimization problem in terms of the Lagrange
m m
  multiplier λ. The second step determines the optimal value of λ for
Y (t ) = ui ( t ) = Ni (t )Si (t ), Y (0) = Y0 . (6)
the external maximization problem.
i=0 i =0

The portfolio u(t ) = (u1 (t ), u2 (t ), . . . , un (t ))′ is said to be admis- 3.1. The unconstrained minimization problem
(t ) is a non-anticipating
sible if u
T  and Ft -adapted process that sat-
isfies E 0
u(τ )′ u(τ )dτ < ∞. Consider the internal unconstrained minimization problem:
Note that u(t ) is not a self-financing strategy due to the interim min Var(Y (T )) − λ(E[Y (T )] − Y ).
random insurance payment dL(t ). Specifically, the budget equation
u∈U

of the insurer’s wealth is (Hipp and Plum, 2000; Yang and Zhang, A property of the variance shows that
2005),  2 
λ λ2

n n Var(Y (T )) − λ(E[Y (T )] − Y ) = E Y (T ) − Y+ − .
2 4
 
dY (t ) = Ni (t )dSi (t ) + Si (t )dNi (t )
i=0 i=0
Once the following problem,
n
(P1 (c )) E[(Y (T ) − c )2 ],

= Ni (t )dSi (t ) − dL(t ). min
u∈U
i=0
can be solved for any constant c, the internal unconstrained mini-
i=0 Si (t )dNi (t ) from the
n
Here, the insurer draws an amount of mization problem in (9) attains a solution by setting c = Y + λ/2
portfolio to finance an insurance claim dL. Therefore, in (P1 (c )).

dSi (t )
m
Theorem 3.1. If there exist a solution triple (P , η1 , σ1 ) ∈ L∞
G ([0, T ],

dY (t ) = ui (t ) − zdNt . (7)
i =0
Si ( t ) R) × L2G ([0, T ], Rn ) × L2G ([0, T ], Rn×n ) that satisfies the backward
stochastic differential equation (BSDE):
Applying Itô’s lemma and Eqs. (1) and (2), the wealth process is
 
given by  −1/2 (η (
2
t ) + σ1 (t )′ ρ) 
1
dP (t ) = 
Σ µ(Σ , t ) +  − 2r (t )
dY (t ) = r (t )Y (t ) + u(t )′ µ(Σ (t ), t ) dt P (t )
  
(8)
+ u(t )′ Σ 1/2 (t )dBt − zdNt , Y (0) = Y0 , × P (t ) dt + η1 (t )′ dBt + tr(σ1 (t )dWt ),
P (T ) = 1, P (t ) > 0, t ∈ [0, T ], (10)
where µ(Σ (t ), t ) =  µ(Σ (t ), t ) − r (t )1 and z has the same dis-
tribution with zj . Define H := {Ht }t ≥0 the filtration generated by a solution triple (R, η2 , σ2 ) ∈ L∞
G ([0, T ], R) × LG ([0, T ], R ) ×
2 n

Nt augmented by the P -null sets. Let G be the filtration {Gt }t ≥0 L2G ([0, T ], Rn×n ) to the BSDE,
where Gt := Ft ∨ Ht , the smallest filtration containing F and
H. Note that Gt can be regarded as the information available to

the investor at time t. Define the compensated Poisson process dR(t ) = −R(t )r (t ) + P (t )z (t )ν(t )
t
Mt := Nt − 0 ν(s)ds, which is a G-martingale. ′
η1 (t ) + σ1 (t )′ ρ

Yet, we properly define the MV-ALM problem in an optimiza- −1/2
+ Σ µ(Σ , t ) +
tion form as follows. P (t )
 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310 303

Σ 1/2 (η1 + σ1 ′ ρ)
  
× R(t )Σ −1/2 µ(Σ , t ) + η2 (t ) + σ2 (t )′ ρ + 2u′ µ +
 
dt YP
P
1/2
′ Rµ + Σ (η2 + σ2 ′ ρ)
  
+ η2 (t )′ dBt + tr(σ2 (t )dWt ), (11) + 2u P + u Σ u dt
′
R(T ) = 0, P
{· · · }dWti,j + {· · · }dMt

a solution triple (H , η3 , σ3 ) ∈ L∞ + {· · · }dBt +
G ([0, T ], R) × LG ([0, T ], R ) ×
2 n
i ,j
L2G ([0, T ], Rn×n ) to the BSDE,
= (u − u ) Σ (u − u∗ )P dt + {· · · }dBt
∗ ′
 
  ′
R(t )σ1 (t )′ {· · · }dWti,j + {· · · }dMt ,

dH (t ) = −P (t )z 2 (t )ν(t ) − P (t )tr σ2 (t ) − + (14)
P (t ) i,j
 
R(t )σ1 (t )′ where

× (I − ρρ ) σ2 (t ) −
′
dt
P (t ) Σ 1/2 (η1 + σ1 ′ ρ)
 
u∗ (t , Y) = −Σ (t )−1 µ(Σ , t ) + Y (t )
+ η3 (t )′ dBt + tr(σ3 (t )dWt ), (12) P (t )
H (T ) = 0, Rµ(Σ , t ) + Σ 1/2 (η2 + σ2 ′ ρ)

+ .
where I is an identity matrix, then the problem (P1 (c )) has an optimal P
feedback control As the stochastic processes Bt , Wt and Mt are local martingales,

Σ 1/2 (t )(η1 (t ) + σ1 (t )′ ρ)
 there exists an increasing sequence of stopping time {τi } such that
u∗ (t , Y(t )) = −Σ (t )−1 µ(Σ , t ) + τi ↑ T as i → ∞ and
P (t )  2 
R(t )µ(Σ , t ) + Σ 1/2 (t )(η2 (t ) + σ2 (t )′ ρ) R(T ∧ τi )
 
× Y(t ) + , E P (T ∧ τi ) Y(T ∧ τi ) + + E[H (T ∧ τi )]
P (t ) P (T ∧ τi )
 2 
R(0)
T 
where Y(t ) = Y (t ) − ce − t r (s)ds . Furthermore, the corresponding = E P (0) Y(0) + + E[H (0)]
P (0)
 2
R(0)
optimal value of the objective function is P (0) Y(0) + P (0) +H (0).
 T ∧τi
∥Σ 1/2 (t )(u(t ) − u∗ (t ))∥2 P (t )dt .
T
Proof. Define Y(t ) = Y (t )− ce − t r (s)ds . Then, the dynamic of Y(t ) +E (15)
0
can be derived by Itô’s lemma.
R(t )
T Because of the uniform boundedness of P (t ), R(t ), P (t ) and H (t ),
dY(t ) = dY (t ) − r (t )ce− 0 r (s)ds dt (we will prove it later), and E[supt ∈[0,T ] |Y2 (t )|2 ] < +∞, the first
= r (t )Y(t ) + u(t )′ µ(Σ , t ) dt + u(t )′ Σ 1/2 (t )dBt
    2 
R(T )
line of Eq. (15) becomes E P (T ) Y(T ) + P (T )
+ E[H (T )] when
− zdNt , (13)
T i tends to infinity by the Dominated Convergence Theorem. Mean-
with Y(0) = Y0 − ce− 0 r (s)ds and Y(T ) = Y (T ) − c.
T
while, the integral of Eq. (15) becomes E 0 (u(t ) − u∗ (t ))′ Σ (t )
Hence, the optimization problem can be simplified as (u(t ) − u∗ (t ))P (t )dt, followed from the Monotone Convergence
Theorem. Hence, it is eligible for us to write
min E[Y(T )2 ]
u(·)  2 
R(T )

s.t. u(·) ∈ LGT ([0, T ], R ),
2 n
E P (T ) Y(T ) + + E[H (T )]
P (T )
T
Y(0) = Y0 − ce− 0 r (s)ds ,
(3) and (13).
 2 
R(0)

= E P (0) Y(0) + + E[H (0)]
It is clear that the dynamic of Y(t ) is same as Y (t ) with different P (0)
initial values. By Itô’s lemma, we have  T

d(Y ) = 2r Y + 2Yu µ + u Σ u dt + 2Yu Σ

2 2 ′ ′ ′ ′ 1/2 +E ∥Σ 1/2 (t )(u(t ) − u∗ (t ))∥2 P (t )dt
 
dBt
0
+ z 2 − 2Y2 z dNt ,
 
and the results follow. 
and Although Theorem 3.1 gives the optimal feedback control of
  
R
2 the unconstrained minimization problem if the BSDEs (10)–(12)
d P Y+ + H = d(P Y2 ) + 2d(RY) + d(R2 P −1 ) + dH all have solution triples, it provides neither an explicit expression
P
to the solution of those BSDEs nor the optimal control u∗ (t , Y (t )).
Σ 1/2 (η1 + σ1 ′ ρ) Further analysis on the system of BSDEs is required to derive
 
= µ+ Y (P , η1 , σ1 ), (R, η2 , σ2 ) and (H , η3 , σ3 ).
P
Rµ + Σ 1/2 (η2 + σ2 ′ ρ)
′
+ Σ −1 3.2. Uniqueness of the solutions to the BSDEs
P
Σ 1/2 (η1 + σ1 ′ ρ) Although BSDEs (10)–(12) are nonlinear, the special structure
 
× µ+ Y of the Wishart process allows us to derive closed-form and explicit
P solutions to them using an exponential affine form. The uniqueness
Rµ + Σ 1/2 (η2 + σ2 ′ ρ)

of the solution is investigated by incorporating the Wishart process
+ P (3) into the BSDE to form a forward BSDE (FBSDE). Thus, the
P
304 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310

decoupled FBSDE theory developed by Zhang (2006) can be applied shows that
to prove the uniqueness. Specifically, the forward SDE of the Λ(t )   T   
s
−r (τ )dτ
R(t ) = −P (t )E z (s)ν(s)ds Gt ,

in (3) and the BSDEs (10) and (11) constitute three decoupled 
 e t

FBSDEs. Although proving the uniqueness of the BSDEs (10) or (11) 

 t
alone could be difficult due to the unbounded stochastic process R (22)
η2 (t ) = η1 (t ),
Λ(t ) appearing in the BSDE, the theory of FBSDE gets around this 

 P
problem by drawing information from the SDE (3).  R
σ2 (t ) = σ1 (t ).


Specifically, the BSDE (10) also appears in Chiu and Wong P
(2014) and they have already shown its uniqueness results. For the
As the random variables, z (t ), ν(t ), Wt and Bt are independent,
sick of self-contained paper, we state their result here.
T
  
s
e t −r (τ )dτ z (s)ν(s)ds Gt
 
E
Proposition 3.1 (Chiu and Wong, 2014). If there exists a solution to t
the BSDE (10), then that solution is unique.  T
s
e t −r (τ )dτ E[z (s)]E[ν(s)]ds. 

=
The following existence and uniqueness results for the remain- t
ing two BSDEs are new.
Proposition 3.2. If there exists a unique solution to the BSDE (10),
Theorem 3.2. If there exists a unique solution to the BSDE (10), then then there exists a unique solution to the BSDE (12) such that
there exists a unique solution to the BSDE (11) such that  T
H (t ) = E P (s)z 2 (s)ν(s)|Gt ds.
 
 T s (23)
R(t ) = −P (t ) e t −r (τ )dτ E[z (s)]E[ν(s)]ds, (16) t

t
Proof. By Theorem 3.2, the BSDE (12) reduces to
R
η2 (t ) = η1 (t ), (17) dH (t ) = −P (t )z 2 (t )ν(t )dt + η3 (t )′ dBt + tr(σ3 (t )dWt ).
P
t
R Hence, H (t ) + 0 P (s)z 2 (s)ν(s)dt is a P -martingale. According to
σ2 (t ) = σ1 (t ). (18) Pardoux and Peng (1990), the martingality ensures the uniqueness.
P T 
Using H (T ) = 0, H (t ) = t E P (s)z 2 (s)µ(s)|Gt ds. 


Proof. Consider the forward SDE (3) and the BSDE Note that H (t ) is a non-negative function. Since η3 (t ) and σ3 (t )
are not required in the optimal policy nor the efficient frontier,
ξ ′ Σ −1/2 µ + µ′ Σ −1/2
Ur + z ν +  V ρ dt
 
U = 
d we omit the discussion on it. Theorem 3.2 not only shows the
ξ ′ dBt + tr(
+ V dWt ), U (T ) = 0.
 (19) existence and uniqueness of the BSDE (11) but also offers a closed-
form explicit solution upon knowing the solution of BSED (10).
It is clear that the decoupled FBSDE, (3) and (19), satisfies all Proposition 3.2 gives the expectation representation for H in terms
the technical conditions in Theorem 1 of Zhang (2006), so the of the solution of BSDE (10), (P , η1 , σ1 ). However, we will see
solution of (19) is unique if the exists. Now, consider U = shortly that the efficient frontier needs an explicit expression of
 solution
H (t ), which is rather involved. Thus, we derive its closed-form
 s 
t r (τ )dτ
T
−E e− z (s)ν(s)ds Gt . Then, we have U (T ) = 0 and

t solution in a later section.
∂U
dU = dt + 0n×1 dBt + tr(0n×n dWt ) 3.3. The optimal ALM strategy
∂t
= (Ur (t ) + z (t )ν(t )) dt + 0n×1 dBt + tr(0n×n dWt ) Once the BSDE (10) admits a solution, the original MV-ALM
= Ur (t ) + z (t )ν(t ) + 0n×1 Σ −1/2 µ + µ′ Σ −1/2 0n×n ρ dt problem (P (Y )) can be solved by substituting c = Y + λ∗ /2 into
 
(P1 (c )). Specifically, the optimal control of (P1 (c )) is given by the
+ 0n×1 dBt + tr(0n×n dWt ).
u∗c in Theorem 3.1, where c = Y + λ∗ /2 and λ∗ ∈ R maximizes the
It is clear that outermost maximization problem of (9), which is
R(0) λ2
 2
T
 
P (0) Y(0) + + H (0) −
  s
t r (τ )dτ z (s)ν(s)ds Gt
−

U = −E e P (0)


 4
t
(20)
λ R(0) λ2
   2
ξ = 0n×1
T
= P (0) Y0 − Y + e− 0 r (s)ds + + H (0) − .


V = 0n×n 2 P (0) 4
(24)
is the unique solution to (19). Suppose that there exists a unique
solution to the BSDE (10), (P , η1 , σ1 ). Applying Itô’s lemma to RP −1 To derive λ , it is useful to point out that (24) is a quadratic
∗
T
deduces that function of λ with the coefficient of λ2 being 14 e−2 0 r (s)ds P (0) − 14 .
The maximum value of a quadratic function is uniquely obtained
d(RP −1 ) = RP −1 r + z ν + P −1 η2′ − RP −2 η1′ Σ −1 µ
  
if the coefficient of the second-order term is negative, as shown in
+ µ′ Σ −1/2 P −1 σ2′ − RP −2 σ1′ ρ dt the next section for two specific stochastic correlation models.
  
T
+ P −1 η2′ − RP −2 η1′ dBt 0 r (s)ds > P (0), then
 
Proposition 3.3. If e2

+ tr P −1 σ2 − RP −2 σ1 dWt
    
R(0)
T T
(21) 2P (0)e− 0 r (s)ds Y0 − Y e − 0 r (s)ds + P (0)
λ∗ = and
with terminal condition R(T )P T = 0. Hence, the bijective map: (25)
T
P (0)e−2 0 r (s)ds −1
(RP −1 , P −1 η2 − RP −2 η1 , P −1 σ2 − RP −2 σ1 ) = (
U ,
ξ,
V) |λ∗ | < ∞.
 
 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310 305

The proof of Proposition 3.3 is trivial. It remains for us to prove K̇ + K (M − 2Q ′ ρ b′ ) + (M − 2Q ′ ρ b′ )′ K
the inequality in Proposition 3.3, which is fully addressed in the + KQ ′ 4ρρ ′ − 2I QK + bb′ = 0n×n ,
following section. K (T ; b, T ) = 0n×n


Ȧ + tr γ QQ ′ K = 0
  
4. Explicit solutions . (32)
A(T ; b, T ) = 0

As mentioned in Section 2, we consider two possible financial Applying Itô’s lemma to the proposed solution form of P (t ) in (27)
market situations: deterministic market price of covariance risk with respect to the dynamic of Λ(t ) in (3) and definition of K and
(DMPCR) and deterministic risk premium (DRP). We now proceed A in (32), we have
to derive explicit closed-form solutions to these two cases based
∂P
 
+ LΛ P dt + tr Λ1/2 dWt Q + Q ′ dWt′ Λ1/2 D P ,
  
on the BSDE framework developed in Section 3. In other words, we dP =
have to solve the BSDE (10), BSDE (11) and E[P (s)|Gt ] for the two ∂t
market situations. (33)
In the DMPCR economy, we recall that g (Λ(t )) = Λ(t ) and γ QQ ′ + M Λ + ΛM ′ D P + 2ΛD Q ′ Q D P ,
  
LΛ P = tr
µ(Σ (t ), t ) = r1 + Σ (t )β in (3) for a deterministic β ; whereas in

∂
the DRP economy, g (Λ(t )) = Λ−1 (t ) and  µ(Σ (t ), t ) = r1 + µ(t ) where Dij := ∂ Λ . The diffusion term of P in (33) is calculated as
ij
in (3) for a deterministic µ(t ). The following auxiliary variable follows.
enables us to present our theoretical results in a precise and
Λ1/2 dWt Q + Q ′ dWt′ Λ1/2 D P
  
concise manner. tr
= −P tr Λ dWt QK − P tr Q dWt′ Λ1/2 K
 1/2   ′ 
Λ (µ̃(Σ (t ), t ) − r1) = β(t ),
 −1

= −P tr QK Λ1/2 dWt − P tr K ′ Λ1/2 dWt Q
   
for the DMPCR economy;
b(t ) = (26)
µ̃(Σ (t ), t ) − r1 = µ(t ),

= −P tr QK Λ1/2 dWt − P tr QK Λ1/2 dWt
   
for the DRP economy.
= tr −2PQK Λ1/2 dWt ,
 
(34)
Theorem 4.1. Under either the DMPCR or the DRP economy, the where the last equality holds because of the property of the tr(·)
solutions of BSDEs (10) and (11) are given by operator and the symmetry of K and Λ1/2 . We further calculate the
T drift term of the dynamic in (33) as follows.
P (t ) = e t 2r (s)ds exp {−tr (K (t ; b, T )Λ(t )) − A(t ; b, T )} ,
∂P
 
 T s + LΛ P
R(t ) = −P (t ) e t −r (τ )dτ E[z (s)]E[ν(s)]ds ∂t
t
= P −2r − tr K̇ Λ − Ȧ − tr( γ QQ ′ + M Λ + ΛM ′ K
    
η1 (t ) = η2 (t ) = 0n×1 ,
− 2ΛKQ ′ QK )

σ1 (t ) = −2PQK (t ; b, T )Λ1/2 (t ),
= P − Ȧ + tr γ QQ ′ K − 2r
   
 T  (27)
s
σ2 (t ) = −σ1 (t ) e t −r (τ )dτ E[z (s)]E[ν(s)]ds,
− tr Λ K̇ + KM + M ′ K − 2KQ ′ QK
  
t
= P −tr Λ 2KQ ρ b′ + 2(Q ρ b′ )′ K
  
where b is defined in (26),
− 4KQ ′ ρρ ′ QK − bb′ − 2r
 
K (t ; b, T ) = R2 (τ )R1 (τ )−1 (28)  
2QK Λ1/2 P )′ ρ 
2
 1/2 (
with τ = T − t , R1 (τ ), R2 (τ ) ∈ C ([0, T ], R ), and the square n×n
=P  Λ b −
 − 2r
matrices R1 (τ ) and R2 (τ ) being the solution of the associated linear P 
system of ODEs in the interval [0, T ]:  
(2QK Λ1/2 P )′ ρ 
2
 −1/2
d
 
R1

2Q ρ b′ − M Q ′ (2I − 4ρρ ′ )Q
 
R1
= P Σ
 µ(Σ , t ) −  − 2r .
 (35)
= (29) P
dτ R2 bb′ (M − 2Q ρ b′ )′ R2
It is clear that P (T ) = 1 and P (t ) > 0 for all t ∈ [0, T ] if the so-
R1 (0) = I , R2 (0) = 0n×n .
lution form (27) is applied. By comparing the coefficients in BSDE
In particular, if b is a constant vector, then the solution of (29) is (10) and (33), it is easy to verify that the solution form in (27) is
expressed in terms of the matrix exponential function in the following indeed a solution triple of (10).
way. The matrix ODE of K in (32) is essentially the matrix Riccati
equation that admits the closed-form solution as shown in the the-
R1 (τ ) 2Q ρ b′ − M Q ′ (2I − 4ρρ ′ )Q
    
= exp τ orem, see Abou-Kandil et al. (2003). Given the solution form of K ,
R2 (τ ) bb′ (M − 2Q ρ b′ )′ the result for A follows trivially.
  Therefore, we show that the BSDE (10) has the solution triple
In
× . (30) (P , η1 , σ1 ) as shown in the theorem once R1 (τ ) is invertible. By
0n×n
Proposition 3.1, the BSDE (10) has a unique solution under such a
In addition, condition. Hence, Theorem 3.2 provides the unique solution tripe
(R, η2 , σ2 ) to BSDE (11) once R1 (τ ) is invertible. 
T
  
A(t ; b, T ) = tr γ QQ ′ K (s; b, T ) ds . (31) Note that Theorem 4.1 only guarantees the existence of the
t solution under the condition that R1 (τ ) is invertible. In other
words, all elements in K do not explode in a finite time horizon.
Proof. Consider the system of ordinary differential equations In fact, the theory of matrix Riccati equation (MRE) shows that a
(ODEs): non-blow-up solution of K occurs if the matrix 2ρρ ′ − I is negative
306 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310

semidefinite and bb′ is positive semidefinite. It is clear that bb′ making the optimal ALM policy blow up. Insurers then need to
must be a positive semidefinite matrix-valued function. When K shorten the investment horizon for a stable solution. The empirical
is bounded, Proposition 3.1 ensures that the optimal control u∗c for study of Buraschi et al. (2010) documents that elements in Q ′ ρ are
the problem P1 (c ) is unique. In addition, as K ≡ 0 once bb′ ≡ 0, negative but ∥ρ∥2 is far less than 1/2. The blow-up situation seems
the comparison theorem of MRE in Abou-Kandil et al. (2003) shows unlikely to occur in practice.
that K (t ; b, T ) is positive semidefinite and is non-zero for a non- Although the optimal ALM policy has been obtained, the effi-
zero positive semidefinite bb′ . Hence, both tr(K (t )Σ −1 (t )) and cient frontier remains to be determined through the function H (t ).
A(t ; b, T ) in Theorem 4.1 are strictly positive real-valued functions, Determination of the efficient frontier is important for insurers
T
implying that P (0; T ) < e 0 r (t ) dt . By Proposition 3.3, the bounded who are interested in examining the ruin probability. Chiu and Li
Lagrange multiplier λ∗ is uniquely obtained. (2009) show that if the mean and variance of the efficient strat-
egy form a quadratic function, then the surrogate safety-first prob-
Proposition 4.1. If ρρ ′ − 21 I is negative semidefinite, then the MV- lem can be deduced through the efficient frontier. The surrogate
safety-first problem minimizes an upper bound of the ruin proba-
ALM problem P (Y ) under either DMPCR or DRP has the following
optimal trading strategy: bility. Thus, we have to prove the quadratic relationship between
the mean and variance for the efficient ALM policy. In fact, we find
u∗ (t ; T ) = Σ −1 (t ) µ(Σ , t ) − 2K (t ; b, T )Q ′ ρ
 
the closed-form solution of the efficient frontier.
 T  
s
× e− t r (τ )dτ E[z (s)]E[ν(s)]ds − Y (t )
t
4.1. Efficient frontier
T  s 
0 r (s)ds 0 r (τ )dτ E
 T 
P (0; T )e −
Y0 − 0 e −
[z (s)]E[ν(s)]ds − Y 
T
t r (s)ds  , We turn to develop the MV-ALM efficient frontier with correla-
+ e−  T
P (0; T )e−2 0 r (s)ds − 1 tion risk and insurance liability. After adopting the optimal control
provided in Theorem 3.1, the variance of terminal wealth, σY2(T ) ,
where b is defined in (26) and we highlight the dependency of the is obtained by substituting λ∗ into (24). Simple calculation shows
optimal policy on the investment horizon T . that
Proof. Given that ρρ ′ − 12 I is negative semidefinite, K is bounded
 T  s 2
0 r (s)ds 0 r (τ )dτ
T
Y −e Y0 + e− E[z (s)]E[ν(s)]ds
for all t < T and T > 0. Hence, P (t ) is uniquely obtained by Propo- 0
σY2(T ) =
sition 3.1. As K (t ; b, T ) is positive semidefinite for all t < T , λ∗ can T
0 r (s)ds
P −1 (0)e2 −1
be obtained via Proposition 3.3. The result follows by substituting
(P (t ), η1 (t ), σ1 (t )) and (R(t ), η2 (t ), σ2 (t )) in Theorem 4.1 into the + H (0), (36)
optimal control u∗c in Theorem 3.1, where c = Y + λ∗ /2.  where Y is the expected terminal wealth. Eq. (36) gives the rela-
The nonnegative semidefinite condition of ρρ − implies that ′ 1
I tionship between the expected terminal wealth and variance of the
√ 2
terminal wealth of efficient portfolios. From the expression of H (t )
∥ρ∥2 ≤ 1/2 or ∥ρ∥ ≤ 1/ 2 ≃ 0.707. In other words, market in (23), H (t ) should be positive. Hence, taking the square root to the
leverage does not go to an extreme zone. The empirical study of both sides of (36), which is a curve depicted on the plane of mean
Buraschi et al. (2010) reveals that the √ estimated value of ∥ρ∥ is and standard deviation, the efficient frontier is not a straight line.
far below the unstable threshold of 1/ 2. When leverage becomes Two special cases are worth mentioning: the absent of stochas-
extreme, the dynamic ALM policy could have the so-called Nirvana tic liability; and deterministic covariance matrix. When the
solution discussed by Kim and Omberg (1996), which requires the stochastic liability is absent, we mean that z (s) = ν(z ) = H (t ) =
insurer to consider a short investment horizon T depending on the 0. In such a situation, the efficient frontier on the mean-standard
market parameters. However, it is the nature of insurers that they deviation plane is a straight line, whose slope is called the price of
have to consider long-term horizon. To examine the effect of the risk:
investment horizon, a closed-form solution to K helps identify the  T
stable investment time interval. e2 0 r (s)ds
When ρρ ′ − 12 I is not negative semidefinite, the optimal port- −1
P (0)
folio policy in Proposition 4.1 is still true. However, it can blow 
up before the terminal time. To avoid this, insurers have to con-    T

sider a short-term investment so that the instability of the solu- = exp tr K (0; b, T )Λ(0) + γ QQ ′ K (s; b, T ) ds − 1,
tion occurs after the investment horizon. A practical approach can 0

be used to determine the investment horizon by computing the (37)

matrices R1 (T ) and R2 (T ) in (30) for solving K (0; β, T ), then nu-
where Λ = Σ −1 and b = µ for the case of DRP while Λ = Σ and
merically checking for the first time point τ0 that det(R1 (τ0 )) = 0.
b = β for the case of DMPCR. The solution of K is given in (28).
Hence, an investment horizon T could be chosen from the time
When the covariance matrix is deterministic, we mean that
interval (0, τ0 ). However, insurers, especially those offer life in-
Q ≡ 0n×n . Then,
surance plans, should manage their assets and insurance liabilities
T
with a long-term commitment in mind. Therefore, insurers are ad-

eM (s−t ) b(s)b(s)′ eM (s−t ) ds,
′
vised better not to invest in highly leveraged portfolio. K (t ; b, T ) =
t
The leverage effect is the finance terminology that refers to the
M′t
negative correlation between an asset’s return and its volatility. Λ(t ) = e Λ0 eMt ,
T
Similarly, the co-leverage effect reflects the negative correlation t 2r (τ )−b(τ ) Λ(τ )b(τ )dτ
′
P (t ) = e ,
between an asset’s return and the correlation between its return  T T
and volatility. Hence, the leverage and co-leverage effects are H (t ) = e s 2r (τ )−b(τ )′ Λ(τ )b(τ )dτ
E[z 2 (s)]E[ν(s)]ds.
collectively reflected by correlations between asset returns and t
their covariance matrix through the vector Q ′ ρ . Leverage effects
Substituting these into (36) deduces the efficient frontier to be
occur if all components in Q ′ ρ are negative. However, if all
components in Q ′ ρ become more negative, then 2Q ′ ρρ ′ Q − Q ′ Q , 1
σY2(T ) =
or equivalently ρρ ′ − I /2, is less likely to be negative semidefinite,
T
0 b(τ ) Λ(τ )b(τ )dτ
′
e −1
 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310 307

   T
2
T s where
× Y −e 0 r (s)ds Y0 + e− 0 r (τ )dτ E[z (s)]E[ν(s)]ds
LΛ Gt = tr (γ QQ ′ + M Λ + ΛM ′ )D Gt + 2ΛD QQ ′ D Gt ,
 
0 (42)
 T T
2r (τ )−b(τ )′ Λ(τ )b(τ )dτ ∂
+ e s E[z 2 (s)]E[ν(s)]ds. (38) and Dij := ∂(Λ )ij
. Substituting the exponential affine form and the
0
above formula into the left hand side of Eq. (42) yields that
Again, the form holds for both cases of DRP and DMPCR.
However, when the covariance matrix is stochastic and the
   
∂K (s, t ) ∂ A(s, t )
insurance liability is there, the problem is far more complicated. −tr Λ − Gt
In particular, H (t ) is needed to complete the explicit form of the ∂s ∂s
efficient frontier in (36).
− tr (γ QQ ′ + M Λ + ΛM ′ ) K (s, t ) Gt
 
Proposition 4.2. Under the financial market of (8) and (3) and the
+ tr 2Λ K (s, t )QQ ′ K (s, t ) Gt
 
insurance liability of (5), the function H (s) in (23) becomes,

T
∂
K ( s, t )
 T

H (s) = t 2r (τ )dτ −A(t ;b,T ) K (s, t )Λ(s) − 
A(s, t )} K (s, t )M + M ′ K ( s, t )
t
 
e exp{−tr  = G −tr +
s ∂s
× E[ν(t )]E[z 2 (t )]dt , (39)
 

where
− 2K (s, t )QQ K (s, t ) Λ
 ′


′ ′
K (s, t ) = e−M s e−Mt K (t ; b, T )−1 e−M t
 
∂
A(s, t )

+ tr γ QQ K (s, t )
′
= 0,
 
−
 t  −1 ∂s
−M τ ′ −M ′ τ
+2 e QQ e dτ e−Ms ,
s which equals the right hand side of Eq. (42). It thus verifies that the
  t 
exponential affine form satisfies the governing equation of (42). In
A(s, t ) = tr γ QQ
 ′ K (τ , t )dτ , addition, the boundary conditions on  K (t , t ) and 
A(t , t ) ensure that
Gt (t , Λ) = e−tr(K (t ;b,T )Λ(t )) . It remains to verify that
s

Λ = Σ −1 and b = µ for the case of DRP and Λ = Σ and b = β for  −1

t
the case of DMPCR. The solution of K is defined in (28). Indeed, H (0)
 
e−M τ QQ ′ e−M τ dτ
′s ′ ′
e −M e−Mt K (t ; b, T )−1 e−M t + 2 e−Ms
equals s
 T T
t 2r (τ )dτ −A(t ;b,T )
is the solutions of the ODEs (40). Let
K (0, t )Λ(0) − 
A(0, t )
  
e exp −tr 
0 
′ ′
× E[ν(t )]E[z (t )]dt . 2 f (s) = e−M s e−Mt K (t ; b, T )−1 e−M t

Proof. By the independent assumption among Bt , Wt , ν(t ) and

 t
−1
−M τ ′ −M ′ τ
z (t ), the H (t ) in (23) can be expressed as +2 e QQ e dτ e−Ms .
s
 T
H (s) = E[P (t )|Fs ]E[z 2 (t )]E[ν(t )]dt ′ t −1
′t
 
s
Hence, we have f (t ) = e−M e−Mt K (t ; b, T )−1 e−M e−Mt =
T K (t ; b, T ) and
 T
= e t 2r (τ )dτ −A(t ;b,T )

s ∂f
= −fM − M ′ f + 2fQQ ′ f .
× E [ exp {−tr (K (t ; b, T )Λ(t ))}| Gs ] E[ν(t )]E[z (t )]dt , 2
∂s
where Λ = Σ −1 and b = µ for the case of DRP and Λ = Σ and This concludes that f (s) is indeed the solution of (40). 
b = β for the case of DMPCR.
Consider the exponential affine form:
4.2. Positive insurance premium
Gt (s, Λ) = exp −tr 
K (s, t )Λ(s) − 
A(s, t ) ,
   

When a positive insurance premium rate is allowed  in (6), we

where K (s, t ) and 
A(s, t ) are the solution of the following differen-
only need to revise the wealth process to be dY (t ) = r (t )Y (t ) +
tial equations:
u(t )′ µ(Σ (t ), t ) dt + u(t )′ Σ 1/2 (t )dBt − zdNt + dC (t ). Let 
Y (t ) =

∂K (s, t )
s
t r (τ )dτ
T
+ K (s, t )M + M ′ K (s, t ) − 2
K (s, t )QQ ′
K (s, t ) = 0n×n , Y (t ) + t
e− dC (s). Itô’s lemma shows that
∂s
Y (t ) = r (t )
Y (t ) + u(t )′ µ(Σ (t ), t ) dt
 
d
K (t , t ) = K (t ; b, T );
 (40)
+ u(t )′ Σ 1/2 (t )dBt − zdNt ,
∂A(s, t )
+ tr γ QQ ′ K (s, t ) = 0,
   T 
∂s Y (0) = Y0 +

s
e− 0 r (τ )dτ dC (s),
A(t , t ) = 0. (41) 0

which is exactly the same as (8) except for the initial condition.
 
t
K ′ and the solution of (41) is tr γ QQ ′ s  K (τ , t )dτ .

Note that  K =
Therefore, all of the results including the optimal MVALM policy
Applying the Feynman–Kač formula to Gt (s, Λ) with respect to (3), and efficient frontier are applicable once Y0 is replaced by Y (0).
we obtain a partial differential equation governing Gt : The solution is equivalent to the case in which the insurer collects
∂ Gt a lump sum premium at the beginning of the investment with an
+ LΛ Gt = 0, Gt (t , Λ) = exp {−tr (K (t )Λ(t ))} , amount equal to the present value of all future premiums.
∂s
308 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310

MV Efficient Frontiers with T=1/4

14
Constant Risk Premium
Constant Market Price of Var–Co Risk
13
E[Y(T)]

12

11
0 0.5 1 1.5 2 2.5 3 3.5 4
σY(T)
MV Efficient Frontiers with T=1/2
16
Constant Risk Premium
15 Constant Market Price of Var–Co Risk
E[Y(T)]

14

13

12

11
0 0.5 1 1.5 2 2.5 3 3.5 4
σ
Y(T)
MV Efficient Frontiers with T=1
18
Constant Risk Premium
16 Constant Market Price of Var–Co Risk
E[Y(T)]

14

12

10
0 0.5 1 1.5 2 2.5 3 3.5 4
σY(T)

Fig. 1. MVALM efficient frontiers with different investment horizons.

Table 1 Table 2
The averaged realized volatilities and correlation. The GMM estimates for the model under DRP.
Volatility of returns Volatility of correlation M Q µ
 ρ
S&P 500 0.0474 −0.149 0.114 0.706 0.494 0.0616 0.381
0.0412 0.070 −0.112 0.806 0.641 0.0114 0.392
Treasury 0.0312

5. Empirical illustration and numerical example Table 3

The GMM estimates for the model under DMPCR.

After deriving the optimal ALM policies for both cases of DRP
and DMPCR, we numerically demonstrate the efficient frontiers
for both cases. To investigate the effect of different market beliefs
on the rates of returns, we consider the optimal asset allocation
among the S&P 500 Index, the 30-year Treasury Bond Futures,
and the risk-free bank deposit. We use parameters estimated by
Buraschi et al. (2010), who apply the general method of moments
(GMM) to S&P 500 Index and 30-year Treasury Bond Futures
returns, sampled monthly in the period from January 1990 to
October 2003.
Table 1 presents the averaged realized volatilities and correla-
tion from the GMM estimation. Mathematically, the numbers im-
ply that
n
1
 (tj )
Σ solid line) and DMPCR (the dashed line). It can be seen that the
n j=1

0.04742 0.0412 × 0.0474 × 0.0312
 short investment horizon (3 months), the DMPCR setting seems of-
= , (43)
0.0412 × 0.0474 × 0.0312 0.03122
where tj is the jth sampling month and n is the total number of
months. Our numerical example thus takes Σ  (0) = 1 nj=1 Σ
 (tj ),

n
where 0 refers to the initial investment time. For the two-asset
model, parameters are required to define the Wishart process Λ.
For the model under DRP, parameters of the Wishart processes
are M , Q and vectors 
µ and ρ , where Σ = Λ−1 and 
µ = r1 + µ.
Table 2 summarizes the corresponding GMM estimates in Buraschi
et al. (2010) and we follow them to take γ = 10. Alternatively,
parameters for the model under DMPCR are M , Q , the vectors β
M Q β ρ
−1.122 0.747 0.160 0.083 4.612 −0.279
0.884 −0.888 −0.021 0.009 2.891 −0.247
and ρ where Σ = Λ and  µ = r1 + Σ β . Table 3 reports the GMM
estimates from Buraschi et al. (2010).
It is assumed that the risk-free asset is available in the market,
which derives the risk-free interest rate to be 3 and the initial
liability value is zero and the initial wealth level is 10. The random
claim payment z follows an exponential distribution with mean 21 .
The Poisson process Nt has intensity ν = 5.
After substituting the estimated parameters into the corre-
sponding models, the efficient frontiers are calculated through
(36). Fig. 1 plots the efficient frontiers of both cases of DRP (the
efficient frontiers vary across different investment horizons. For a
fering a better off between expected return and risk than the DRP
setting does. However, the DRP setting prevails for longer term in-
vestments (6 months and 1 year). We stress that the actual per-
formance of the optimal investment strategy should depend on
the correct choice of the model. Fig. 1 only ensures that different
model assumptions lead to very different results and the choice of
the model should be carefully made in practice. In fact, statistical
model selection criteria such as AIC and BIC may be useful in de-
termining a better model between the two market assumptions.
To have a closer look at each case of DRP and DMPCR, we pro-
duce Figs. 2 and 3 and examine the impact of the expected insur-
ance claim size to the efficient frontier. Both figures consistently
 M.C. Chiu, H.Y. Wong / Insurance: Mathematics and Economics 59 (2014) 300–310 309

Q
E[z]=1 Q/4
16
16 E[z]=1/2 Q/16
Q/256
E[z]=1/4
E[z]=1/16
15
15

14

E[Y(T)]
14
E[Y(T)]

13
13
12

12
11

11 0 5 10 15 20 25 30
σ Y(T)
0 1 2 3 4 5
σY(T)
Fig. 4. MV-ALM efficient frontiers under DMPCR model for different volatility of
volatility.
Fig. 2. MV-ALM efficient frontiers under DRP model for different mean of claim
size.
Q
12.6 Q/4
Q/16
E[z]=1 Q/256
16 E[z]=1/2 12.4
E[z]=1/4
E[z]=1/16 12.2
15

E[Y(T)]
12

14
11.8
E[Y(T)]

13 11.6

11.4
12
11.2
0.6 0.8 1 1.2 1.4 1.6 1.8 2
11 σY(T)

0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

σ
Fig. 5. MV-ALM efficient frontiers under DRP model for different volatility of
Y(T)
volatility.

Fig. 3. MV-ALM efficient frontiers under DMPCR model for different mean of claim
size.
show that the efficient frontier moves towards north-west when
the expected claim size decreases. It is reasonable because the less
the expected claim size the less risk the insurer is facing. Therefore,
a higher profit results for the same level of risk. However, these
plots ignore the potential income from offering insurance plans.
One of the major concern of this paper is the impact of stochas-
tic covariance on the trade-off between profit and risk. As we use
Wishart process to describe the movement of the positive defi-
nite stochastic covariance matrix, the parameter matrix Q takes
the role as volatility matrix of the covariance matrix. Fig. 4 plots the
efficient frontier under DMPCR with different Q . It can be seen that
the efficient frontier changes quite substantially with Q . Therefore,
the trade-off between profit and risk is quite sensitive to the fluc-
tuation of variances and covariances if we use the DMPCR setting.
In contrast, Fig. 5 shows that the efficient frontier is almost
insensitive to Q under DPR. Therefore, the DPR economy offers a
more robust strategy to insurers. The partial empirical analysis by
Chiu and Wong (2014) reveals that financial data seems in favor
of the DPR setting. Certainly, a comprehensive empirical study is
worth considering as a future possible research.
6. Conclusion
One of the insurers’ major concerns is the optimal policy to
manage their investment assets and insurance claim payments.
This paper investigates the situation of a financial market with
stochastic covariance risk. We derive the explicit closed-form
solution to the optimal feedback ALM policy using the BSDE
framework and the corresponding MV-efficient frontier. We also
offer a condition under which the solution is stable and bounded.
This condition is related to the strength of leverage effects in the
financial market. The economic implication is that strong leverage
effects discourage insurers to participant into the financial market
because the optimal ALM policy is unstable for a long-term
investment while insurers plan their investment with a long-term
commitment in mind. The aggregate leverage effect, including both
the leverage and co-leverage effects, summarized by the parameter
vector Q ′ ρ is regarded as strong if ∥ρ∥2 > 1/2. The deduced MV-
efficient frontier is useful to deduce the surrogate safety-first ALM
policy. We however refer interesting audiences to the paper by
Chiu and Li (2009) for this application.
Acknowledgments
M.C. Chiu acknowledges the support by Research Grant Council
of Hong Kong with ECS Project Number: 809913. H.Y. Wong
acknowledges the support by Research Grant Council of Hong Kong
with GRF Project Number: 403511.
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