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Optimal Asset Allocation and Technical Efficiency in European Non-Life

Insurance Companies

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Optimal Asset Allocation and Technical Efficiency in

European Non-Life Insurance Companies

Abstract

Most previews studies investigate optimal asset allocation that maximizes shareholders‟ expected
utility. But, in addition to the maximization of shareholders' expected utility, the optimal assets
allocation plays additional key roles to insure the insurance company's survival such as building
necessary reserves to deal with claims payments. So, illiquidity, excessive risk and inadequate
returns have a negative influence on shareholders‟ behavior as well as on customers‟ behavior.
Furthermore, the mismanagement of asset allocation by an insurance company will increase
excessively its probability of insolvency, this will push the decision maker to increase premium
rates and as a consequence the company will lose its competitiveness in the market. This study is
original; it intended to investigate the optimal asset allocation of European non-life insurance
companies that maximizes technical efficiency. The definition of our objective function is based
on the directional output distance function. Two metaheuritics has been used PSO and GA.
Achieved results show that proportion allocated to the “alternative investment with high-risk high-
return” is in average lower then these founded in previous studies. However, the percentage
allocated to the “risk-free assets” is in average different from zero. Thus, the obtained investment
portfolio is relatively more diversified between available assets compared to this proposed in
previous studies. This can be explained by the implicit paying attention for competitiveness,
survival and long term profitability when one maximizes technical efficiency. So, any insurance
company has to pay more attentions to the presence of different stakeholders and resolves the
conflicts of interest between different stakeholders.
Keywords: Technical efficiency, survival, Asset allocation, PSO, GA, Directional output distance
function, Non-life insurance companies.
JEL codes: C63; C67; G11; G22; L21; L23

Bilel JARRAYA

1
 1. Introduction

Usually, researchers rely on operational research methods to investigate available observed

information of firms or stocks, and supporting managers in making optimal financial
decisions. There are many research works use operational research methods to study optimal
asset allocation in insurance companies (Yu et al (2010)). When, the insurance company
allocates optimally its assets, this enables it to improve both its solvency and competitiveness.
Most previews studies investigate optimal asset allocation that maximizes shareholders‟
expected utility. But, in addition to the maximization of shareholders' expected utility, the
optimal assets allocation plays additional key roles to insure the insurance company's survival
such as building necessary reserves to deal with claims payments. So, illiquidity, excessive
risk or inadequate returns all of them have a negative influence on shareholders‟ behavior as
well as on customers‟ behavior. Furthermore, the mismanagement of asset allocation by an
insurance company will increase excessively its probability of insolvency, this will push the
decision maker to increase premium rates and as a consequence the company will lose its
competitiveness in the market.

Usually shareholders and other stakeholders of a same company have conflicted objectives
and perspectives. Shareholders have interest to the short-term profits and the officer takes all
responsibilities in bankruptcy or insolvency cases. However other stakeholders, especially
customers, have interest to competitiveness, productivity and efficiency of the insurance
company because these insure its solvency, its survival and long-term returns. So in addition
to the maximization of shareholders' expected utility, the insurance company has to ensure its
competitiveness essentially by maximizing productivity. With more precision an insurance
company should maximize its technical efficiency by producing the maximum desirable
outputs with the minimum quantities of inputs and undesirable outputs.

The main contribution of this paper is in seeking optimal asset allocation while maximizing
technical efficiency, while referring to the production process of insurance companies, instead
of maximizing shareholders' expected utility. So in this paper, we propose a methodology to
investigate the optimal asset allocation of European non-life insurance companies based on
technical efficiency. First we simulate assets in which the insurer can invest. Second we
specify the objective function that must be used to maximize technical efficiency. So, we use
the general functional form of the directional output distance function proposed by Färe et al.

2
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(2005). This function allows a complete characterization of the production process (Färe et al.
(2005); Hachicha and Jarraya (2010); Jarraya and Bouri (2013) and Jarraya (2014)). Then, to
search the optimal asset allocation, that optimizes our objective we will use two
Metaheuristics namely: Genetic algorithm and Particle Swarm optimization algorithm. The
first one is classified among the oldest and most known algorithms. By cons the second
algorithm is one of the newest techniques within the family of evolutionary optimization
algorithms. We apply our model on a sample of 175 non-life insurance companies dispersed
in nine European countries over the period 2002-2008.

Our research is structured as follows. In the next section we survey some related works
focused on asset allocation issues in insurance companies. Section 3 illustrates our
methodology. Section 4 describes dataset, variable definitions, simulated assets and empirical
results. Finally, section 5 closes the chapter with some concluding remarks.

1. Literature Review

1.1. Asset Allocation in Insurance Industry

Asset allocation represents an important and delicate issue in insurance industry. Most
previous studies focused on the insurance industry designate available funds for investment
by capital or surplus. In this paper we investigate the optimal investment of this surplus in
European non-life insurance companies. Mayers and Read (2001) suggest that a highest level
of surplus represents a guarantee for policyholders. But, on the other hand, these authors
emphasized the high costs related to this surplus, as well as, the competitive premiums are
influenced by total surplus requirements and their allocation. So, in a competitive market the
mismanagement of asset allocation will increase excessively the probability of insolvency,
this will push the insurer to increase premium rates and as a consequence the insurance
company will lose its competitiveness position in the market.

The asset allocation issue in insurance companies is treated in the literature by two principal
approaches. The appearance of mean-variance analysis by Markovitz (1952) represents the
cornerstone of this first approach followed by many literature extensions. This approach aims
principally to generate an efficient frontier in a risk-return space. This frontier is constructed
by most efficient portfolios in which investors have to invest. This approach has provided a
birth of extension for previous studies interested by the liability side of financial institutions

3 Bilel JARRAYA
(Chiu and Li 2006; Craft, 2005, Sharpe and Tint 1990). Brennan et al. (1997) have noting that
a miss-definition of utility function represents the most striking drawback of this approach. In
the other hand Merton (1971) represents the pioneer of the second approach of building an
optimal portfolio of investment. The literature extension of this approach considers the asset
allocation problem as stochastic and the solutions are illustrated by Hamilton-Jacobi-Bellman
partial differential equations (Yu et al. (2010)). Mayers and Read (2001) have stated that
surplus returns known a significant magnitude in the net income of the insurance company, in
addition a substantial change have influenced the financial investment regulation. As a
consequence of these presented changes the authors have recommended the reinvestigation of
the asset allocation issue in insurance industry to provide more appropriate solutions for the
decision makers.

The most recent research work which has investigated with an explicit and simple manner the
asset allocation issue in non-life insurance industry is that of Yu et al. (2010). These authors
use a simulation model for building assets' prices data. In this work a new evolutionary
algorithm has been developed allowing seeking the optimal asset in a dynamic environment
while maximizing shareholders' expected utility. Noting also that Kahane and Nye (1975) and
Cummins et al. (1981) are the pioneers in the issue of asset allocation in insurance companies
and they have investigated this problem for a single period. In the other hand, Browne (1995)
is the leading of exploring this issue of asset allocation in a dynamic framework. He has
shown in its study an optimal investment strategy must involve a fixed amount invested in
risky asset whatever the surplus amount. By against the results of Hipp and Plum (2000) show
that optimal amount invested in risky assets should be based on the current surplus. The
model of these authors is extended by the paper of Liu and Yang (2004) by taking account of
risk-free asset. Mayers and Read (2001) has proposed the model characterization as a
principal reason for divergence of results between Hipp and Plum (2000) and Browne (1995).

The maximization of shareholders‟ expected utility is the sole objective that has attracted the
most of previous research works focused on asset allocation issue in insurance industry. For
more information on asset allocation and portfolio optimization problems with Metaheuristics
one can refers to Jarraya (2013). As shareholders are generally risk-averse, the focus on utility
maximization can be a destruction source of other objectives such as productivity,
competitiveness and solvency. So we shouldn't limit our researches to this objective providing
only the shareholders satisfaction but we must investigate the asset allocation issue while

4 Bilel JARRAYA
taking account of objective of other stakeholders. In this paper we will try to seek the optimal
asset allocation allowing the maximization of insurance companies‟ efficiency. Like previous
research works in our study will be based on metaheuristic optimization algorithms to find the
optimum asset allocation allowing maximization of efficiency for non-life insurance
companies. The next paragraph is a theoretical survey of metaheuristic optimization
techniques.

1.2. Metaheuristics Optimization Techniques

Solving optimization problems became a central topic in several research areas. Making
decision problems that can be formalized as an optimization problem is growing rapidly.
There are many deterministic methods which make possible to resolve some types of
optimization problems in a finished time period. Among the most known methods: the linear
programming Schrijver (1998), the quadratic programming and the Newton method Nocedal
and Al. (1999), the dynamic programming Bertsekas (2000), the Simplex method Nelder and
Al. (1965) and the gradient method Avriel (2003). In practice the posed problems are more
complex and require too much time to be resolved by these deterministic methods. So,
researchers usually resort to the stochastic optimization algorithms, such as the
Metaheuristics, which make it possible to find an approached solution, in a reasonable time.

Metaheuristics are a family of stochastic algorithms intended for the resolution of the
optimization problems. Their key advantage is the adaptability to a great number of problems
without significant changes in their algorithms. Their capacity to optimize a problem with
minimum information is weakened, because these algorithms cannot offer any guarantee for
the optimality of the best found solution. However, from experts' point of view, that cannot be
an inevitable disadvantage, since, in practice, it is always preferable to found quickly an
approximate optimum that an exact value found in too much of time. Meta-heuristics have
usually an iterative behavior. The same pattern is repeated during the optimization until a
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stopping criterion, specified at the beginning, is met.

The most known Metaheuristic optimization techniques can be divided into two most used
approaches: Evolutionary algorithms and Algorithms based on swarm intelligence. Fraser
(1957) is the pioneer of evolutionary algorithms. They represent a family of research
algorithms inspired from species' biological evolution, such as: natural selection, mutation,
reproduction, and recombination. An evolutionary algorithm has usually three key operators:
5
selection operator, crossover operator and mutation operator. Using these operators in the
evolutionary algorithm has favored the emergence of four different approaches Bäck et al.
(1997). First the Evolutionary Strategy (ES) represents a family of Metaheuristic
optimization, inspired from evolution theory. This model was originally proposed by
Rechenberg (1965), it is the first genuine Metaheuristic and the first evolutionary algorithm.
Second the Evolutionary programming (EP) introduced by Fogel et al. (1966) and aims to
create a Finite-state machine by successions of crossover and mutations. This Metaheuristic
serves to predict future events based on previous observations. Noting that, Finite-state
machine is a fundamental tool in computer programs. Third the Genetic Algorithm (GA)
stochastic search techniques and theoretical foundations were established by Holland (1975).
They are inspired from Darwin theory: the natural evolution of living species. There are two
mechanisms allowing evolve living species: natural selection and reproduction. Natural
selection favors the most adapted population individuals to their environment. The selection is
followed by reproduction, performed by crossovers and mutations within individuals' genes.
Thus, two parents intersect and transmit some of their genetic heritage to their offspring. In
addition some individuals' genes could mutate during the reproductive phase. The
combination of these two mechanisms leads to a more adapted population to its environment.
Genetic algorithms were conceived as an optimization method to resolve problems with
discrete and continuous variables (Holland (1973); Goldberg (1989); Holland (1992)).

In their canonical version, Genetic Algorithms suffer most often of slow convergence or
premature problems. To overcome these drawbacks several improvements have been
proposed such as: organic operators, elitist strategy, etc. Michalewicz (1996). Finally the
Genetic Programming (GP) that represents an alternative of genetic algorithms, designed to
manipulate programs and implement an automatic learning model Koza (1992). The programs
are usually coded by trees that can be viewed as bit strings of variable length. Most techniques
and results of genetic algorithms can also be applied to genetic programming.

The second approach of Metaheuristics and the most recent is that of Algorithms based on
swarm intelligence. Collective intelligence refers to communities' cognitive abilities resulting
from multiple interactions between community members also called agents. From a simple
behavior, agents could perform complex tasks owing a fundamental mechanism known
synergy. Under particular conditions, created synergy through collaboration between
individuals emerges some opportunities of representation, creation and learning better than
Bilel JARRAYA
6
isolated individuals. The collective intelligence forms are various according to community
types and members that met. Collective systems are more or less sophisticated. Noting that,
human societies do not obey to rules as mechanical like other natural systems, such as animal
world.

Collective intelligence is seen principally in social insects (ants, bees...) and animals in
movement (migrating birds, fish schools). Therefore, several algorithms based on collective
intelligence phenomenon have been introduced, such as ant colonies and particle swarm
(Hoffmeyer (1994); Ramos et al. (2005); Nickabadi et al. (2011); Wang et al (2011); Soares et
al. (2012); Wang et al. (2013); Liu et al. (2013); …).

Ant colony algorithms are born from a simple observation. Insects, particularly ants, solve
naturally complex problems. The principal factor that facilitates this behavior is that ants
communicate with each other indirectly owing to deposit of chemicals substances called
pheromones. This indirect communication type is called stigmergy.

According Goss et al. (1989) if an obstacle is introduced in ants path, they will all tend, after a
research phase, to follow the shortest way between nest and obstacle. They are more attracted
to the area where the pheromone substance rate is highest. Ants that passed by food source
and arrived too quickly to the nest are those that have taken the shorter way. Therefore, the
pheromone quantity in this way will be more important than the longer distance. Thereby,
eventually the shortest way has a greater probability to be used by all ants than other ways.

First algorithms inspired from this analogy were proposed by Colorni et al. (1992) and Dorigo
et al. (1996) to resolve problem of business traveler. In these algorithms each solution is
considered as an ant moving in the search space. Ants mark better solutions and take account
of previous markings to optimize their research. Ant colony algorithms use an implicit
probability distribution to perform the transition between iterations. In their adapted version to
combinatorial problems these algorithms use an iterative construction of solutions.

Particulate Swarm Optimization is a Metaheuristic proposed by Kennedy et al. (1995). This

method inspired from animals social behavior in their moving in swarms. The most used
example is the behavior of fish school (Wilson (1975) and ReynoldsBilel
(1987)). Indeed, these
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animals are characterized by a movement dynamics relatively complex, while individually
each one has a limited intelligence and local knowledge focused on its position in the swarm.
Thereby, each individual has knowledge only of the position and speed of its nearest

7
neighbors. It therefore uses not only its own memory, but also local information of nearest
neighbors to decide its own movement. Simple rules, such as "go in same speed as others",
"moving in the same direction" or "stay close neighbors" are among key behaviors that
maintain cohesion of the swarm and allow the implementation of complex and adaptive
collectives behaviors. The swarm's global intelligence is a direct consequence of local
interactions between different particles. Therefore, system performance as whole is greater
than the performance sum of its different parts.

The particle swarm optimization is inspired from these socio-psychological behaviors by

Kennedy et al. (1995). Potential solutions of the optimization problem are presented by
particles swarm that flies over search space to seek the global optimum. Particle‟s movement
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is influenced by three components:

 Physical component: the particle follows the current movement direction.

 Cognitive component: the particle moves towards the best place by which it has already
past.
 Social component: the particle relies on congener‟s experience, and thus move towards
the best already reached area by its neighbors.

A point's quality in the search space is determined by the objective function value at this
point. It is possible in some cases a particle moves out of the search space. In these cases it
could have a positive feedback amplification which leads to a system divergence. To
overcome this problem, Eberhart et al. (1996) propose to introduce the maximum velocity as a
new parameter, which allows controlling the system's explosion. A study of the PSO behavior
according the maximum velocity is available in Fan et al. (2001).

In addition, a particle confinement strategy can be established. This strategy can bring back a
particle moved away from the search space to inside of it. Then, several methods can be
employed:

 The particle is left outside the search space without assess of its objective function.
Thus, it can't attract other particles outside the search space.
 The particle is stopped at the border and the corresponding components of velocity are
canceled.
 The particle bounces on the border, but the corresponding velocity components are
multiplied by a random coefficient fired from  1,0 .

8
In the next section we develop our methodology.

2. Model

This section includes three parts. In the first part, is allocated to present our model design. In
the second part, based on the directional output distance function, we set up the objective
function which will be optimized. The last part is conserved to present the used Metaheuristic
algorithms to optimize this objective function and providing the optimal asset allocation that
maximize efficiency of the European non-life insurance companies.

2.1. Model Design

Our modeling is divided into two principal steps. First step we specify the technology frontier
T by using the directional output distance function. So based on the stochastic estimation
method we assess the parameters of the technology frontier, the inefficiency scores and the
error term. In the second step, we specify the objective function from which we investigate
the optimal asset allocation that minimizes technical inefficiency. So, we express technology
frontier just function of available funds for investment and other variables will be replaced by
their observed values. In the following figure we will present a simplified illustration our
model in a two axes plan. The abscissa axe represents the undesirable output and the ordinate
axe symbolizes the desirable output. Bilel JARRAYA

[Insert Figure 1]

In this figure A represents an observed insurance company with the coordinate (bA , YA). Were
YA and bA are the observed quantities of desirable and undesirable outputs, respectively, of this
company. μ is the inefficiency score attributed to this company regarding to the technology
frontier T. After an investigation of the optimal asset allocation that maximizes technical
efficiency, based on the available funds for investment, the insurance company will remove
from point A to the point A’. In this new point the insurance company keeps the same quantity
of undesirable output (as well as for input) and only the quantity of desirable output will be
enhanced. So the new place A’ will be closer to the technology frontier and obviously the
insurance company will be technically more efficient μ> μ’.

9
 2.2. Technology frontier

To model the insurance companies‟ production process and measure their technical efficiency
we use the directional output distance function. We assume there are k  1,2,..., K insurance

companies which use a vector of inputs x  ( x1 , x2 ...xn )  

N

to produce a vector of

desirable outputs y  ( y1 , y2 ... ym )  M and a vector of undesirable outputs

b  (b1 , b2 ...bh )   . The production possibility set under a technology (T ) is defined as

H

the set of all feasible inputs, desirable outputs and undesirable outputs vectors:

T  ( x, y, b) : x   , y   , b   , x can produce( y, b)
N M H
(1)

the directional output distance function allows a complete characterization of above defined
technology (1) in presence of undesirable outputs. This function seeks simultaneously the
maximum technologically feasible expansion of desirable outputs and the maximum possible

contraction of both inputs and undesirable outputs. Let g  ( g x , g y , g b ) , g x  

N

,

g y   and g b   denote the directional vector that define these possible expansions
M H

and contractions. The directional output distance function can be defined as follows:

D( x, y, b; g x , g y , g b )  max : ( x   g x , y  g y , b  g b )  T  (2)

We assume that g  ( g x , g y , g b )  (1,1,1) which provides the same weight to inputs, desirable

outputs and undesirable outputs. The directional output distance function takes zero value for
efficient company insurance. Otherwise this function will be strictly greater than zero and in
this case the insurance company is classified inefficient. Following Chambers et al. (1996,
1998) the directional output distance function should satisfy many properties. The well known
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important property is the translation property expressed as follows:
 
D( x, y, b; g x , g y , g b )    D( x  g x , y  g y , b  g b ; g x , g y , g b )   (4)

The development of our model will be based on a quadratic functional form of the directional
output distance function. As a reference we will use Färe et al. (2005) to parameterize this
function:

10
 N M N N M M
D( x, y, b; g x , g y , g b , t , )   0    n xn    m y m  1 / 2  nn' xn xn '  1 / 2  mm ' y m y m '
n 1 m 1 n 1 n '1 m 1 m '1
N M H N H M H H H
   mn y m xn   h bh    nh xn bh    mh y m bh  1 / 2 hh'bh bh '
n 1 m 1 h 1 n 1 h 1 m 1 h 1 h 1 h '1
N M H
  1t  1 / 2 2 t 2   n tx n   m ty m    h tbh (5)
n 1 m 1 h 1

 Symmetric restrictions
 nn'   n'n n  n'
 mm'   m'm m  m'
 hh'   h 'h h  h' (6)
 Mathematical constraint defined from the translation property
N H M

      
n 1
n
h 1
h
m1
m 1

M N H

  mn    nn'    nh  0
m1 n 1 h 1
 n  1,...., N

M N H Bilel JARRAYA
  mm'   mn mh  0
m1 n 1 h 1
 m  1,...., M

M N H

mh    nh   hh'  0
m1 n 1 h 1
 h  1,...., H

M N H

    
m 1
m
n 1
n
h 1
h 0 (7)

Where   ( ,  ,  ,  ,  ,  , ,  , , ,  ) is the parameters vector which should be

calculated. These parameters can be computed via either linear programming (LP) proposed
by Aigner and Chu‟s (1968) or stochastic frontier techniques suggested by Aigner, Lovell and
Schmidt (1977) and Meeusen and Vanden-Broek (1977). The last approach has some
advantages over the first (LP). The most known advantages is the suitable processing of
stochastic shocks and random error, in addition the econometric approach allows testing
several statistical assumptions. In our model this stochastic approach can be specified as
follows:

11

Dtk ( xtk , Stk , btk ; g x , g y , g b , t , )   tk  0 (8)
iid
Noting that  tk  tk  tk where the error term is expressed as follows tk  N (0, 2 ) and the
iid
one sided error term tk  N (0, 2 ) expresses the technical inefficiency.

In a second step we specify the objective function from which we seek the optimal asset
allocation allowing the minimization of technical inefficiency. So we express estimated
k
directional output distance function just with surplus S t , and the other variables will be
replaced by their estimated or observed (parameters or variables respectively) values:
 
Dtk ( xtk , Stk , btk , t ,ˆ)  Dtk (Stk ,ˆ) (9)
Finally we have to search the optimal asset allocation that minimizes the average of technical
inefficiency for our sample of European non-life insurance companies, expressed as follows:

1 K 1 T k k ˆ
  Dt (St , )
K k 1 T t 1
(10) s.t.

L 5
S kt   P1lt Z1lt   Pjt Z jt l  1,...,15 and 1  L  15
l 1 j 2

Where Z jt and Pjt represent the quantities and unit‟s price, respectively, of asset j at time t .

On the other hand Z 1lt and P1lt represent the quantities and unit price, respectively, of a bond

with l year maturity at time t . Bilel JARRAYA

2.3. Optimal Asset Allocation

To find the optimal asset allocation while maximizing technical efficiency we need to use a
metaheuristic optimization algorithm. In this work we use two algorithms PSO and GA to
seek the optimal asset allocation for European nonlife insurance companies. The first
algorithm it's among Algorithms based on swarm intelligence, it's newly developed and
judged the most efficient in its results. The second algorithm forms part of evolutionary
algorithms, it's ranked among the oldest algorithms and it's the most famous in the field of
Metaheuristics. However, before starting the description of processes linked to each one of
these two algorithms we have to present the simulated assets in which insurance companies
can invest.

12
 2.3.1. Assets Definitions

Like Yu et al. (2010) we propose five asset types in which each insurer can invest, such as
stock index, three alternative investments and bonds knowing that maturity years, of this last
asset, range from one to fifteen years.

Noting dW the differential vector of five wiener processes:


dW  dWr dWs dWAI hh dWAI ll dWAI hl '
(11)
Where dWr represents the process of one year spot rate (r), dWs the process of the stock

index return, dWAI hh , dWAI ll and dWAI hl the alternative investment (AI ) processes
characterized respectively by high-risk high-return (hh) , low-risk low-return (ll ) and high-

risk low-return (hl ) . We use the correlation matrix R proposed by Yu et al. (2010) to estimate
these wiener processes (see Appendix 1).

2.3.1.1. Bond markets

To simulate one-year spot interest rate we use the model proposed by Cox et al. (1985) also
called CIR process. This model assumes that the instantaneous interest rate follows the
stochastic differential equation:

drt  a(b  r )dt   r r dWt (12)

Where a(b  r ) is a drift factor that ensures the mean reversion of the spot interest rate, a is a

positive parameter that represents the speed of adjustment, b denotes the long term level of

the spot interest rate and  r r represents the standard deviation factor.

According to Cox et al. (1985) we obtain the bond prices at time t as follows:

P(r, t , T )  A(t , T )e rB(t ,T ) (13)

Where
2 ab
(T t )( b  )
  2
A(t , T )   2e 2
 (b   )(e  ( T t )
 1)  2
  (14)
 
B(t , T )  
2(e (T t )  1) (b   )(e (T t )  1)  2  (15)
  b²  2 ² (16)

13
 2.3.1.2. The stock index

Like Yu et al. (2010) we suppose that the stock index behavior is a continuous time stochastic Bilel J
process. This process follows an interest rate adjusted geometric Brownian motion:

dS
 (r  rs )dt   S dWt (17)
S
Where dS is the change in the market index‟ prices, rs represents the risk premium and  S
denotes the index price volatility.

2.3.1.3. Alternative investment markets

The price process of the three proposed alternative investments supposed to be geometric
Brownian motions like Yu et al. (2010):

dAI ij
  AI ij dt   AI ij dWt i   l,h  and j   l,h  (18)
AI ij
Where  AI ij and  AI ij denote, respectively, expected return and standard deviation of the

alternative investment prices characterized by a risk i and a return j .

2.3.2. Particle Swarm Optimization Algorithm

Kennedy and Eberhart (1995) develop a parallel evolutionary algorithm based on the social
behavior metaphor called particle swarm optimization (PSO). Kennedy et al., (2001)
Represents a reference exploring social and computational paradigms of PSO.

Like evolutionary algorithms an initial population is defined for the PSO algorithm. This
population is composed by a set of random candidate solutions called particles. A defined
number of particles are considered as a population P(t ) at the generation t . Each particle i

characterized by a position yti and a velocity vti . In each generation t all particles are evaluated
and the non-dominated particles are archived in the external repository, while dominated
particles are removed. In the next step, the position and the velocity of each particle are
updated by equations similar to the following:

vti1  w.vti  c1.r1.( Pt i  yti )  c2 .r2 .( Rth  yti ) (19)

y i
t 1  y v
i
t
i
t 1 (20)

Where w called inertia coefficient that controls previous history impact of velocities, it can

14
taken large or small value for the global or local search respectively (Mendes et al. (2004),
Elbeltagi et al. (2005) and Jung and Karney (2006)). The two constants c1 and c2 are

positive, r1 and r2 are uniform random values in the range 0, 1 . Rth is a particle solution

chosen from the repository in each iteration t and guides the movement of particles toward
optimum. Pt i represents the most excellent position vector of particle i , in a first time is set
equal to the initial position corresponding to this particle. The iterative process of the PSO
technique can be resumed in a five steps as follows:

1- An initial population of particles is generated. For each particle is attributed a position

y 0i and a velocity v0i . The current position of each one is recorded as P0i . The best value

of P0i is chosen as R0h that will be saved.

2- Then new positions will be generated for particles using the two equations (19) and
(20) presented above.
3- The objective function is evaluated for each new particle‟s position. The objective
function is evaluated for each newest position of particle i. if this particle has achieved

a better position its previews Pt i value will be replaced by the current value yti 1 .

4- Similarly to the first step the Rth value must be updated from the new stored values of

Pt i1 . So if Rth  Rth1 nothing will change, otherwise the Rth will be replaced by the new

value Rth1 .
5- The steps 2, 3 and 4 are repeated until the number of iterations reaches a
predetermined value.

2.3.3. Genetic Algorithm

The concept of „survival of the fittest‟, developed by Darwin (Davis, 1991), represents the
corner stone of genetic algorithms. These algorithms are inspired from the natural law of
evolution. The key idea of this law is that species most suited to their environment and which
have the best fitness, will dominate the world. According to Maturana and Nauann (1977) and
Goldberg (1989) genetic algorithms inspired from biological principles allow the fitness
improvement of a chromosomes population and providing the set of solutions linked to an
optimization problem. For an appropriate use of genetic algorithms, Chang (1998) suggest the
transformation of any optimization problem into parameters appropriated to this problem. The

15
optimization goal is to find the most appropriate combination of these parameters to achieve
the optimality (minimum or maximum). The iterative steps of the genetic algorithm can be
resumed in the following steps:

1- Generate an initial population of solutions. The elements building these solutions

represent the decision variables. These latter are symbolized by the proportions of total
investments allocated to five types of asset. The number of our decision variables is
nineteen (since maturity years of bonds range from one to fifteen years).
2- In this selection step a proportion of individuals are extracted from the last generated
population. Indeed, a fitness evaluation, based on the defined objective function, is
applied on each individual in the existing population. The best solutions have more
chance to be selected.
3- In this step a set of genetic operators (crossover, mutation, regrouping, colonization-
extinction and migration) are applied on the selected individuals to generate a new
population. The most known and used operators are crossover and mutation. Each new
off-spring is produced by at least a pair of "parent" solutions selected from extracted
individuals in the previous step. This new produced child share many characteristics
like its parent. This process continues until the appropriate population size is achieved.
4- Checking the termination criterion is reached. If this condition is satisfied the
generation process will be stopped, otherwise the steps two and three will be repeated
until the termination condition is satisfied.

3. Empirical Implications Bilel JARRAYA

3.1. Dataset

To validate empirically our model we use a sample of 175non-life insurance companies

dispersed in nine European countries (United-Kingdom, Sweden, Denmark, Belgium,
Netherlands, French, Spain, Italy and Germany). In constructing our sample, we first use a list
and information of European non-life insurance companies published in the “Thomson ONE
Banker” database. Then we establish needed information of our sample referring to annual
reports published by non-life insurance companies in their official websites.

16
 3.2. Inputs-Outputs Definitions

The definition of inputs and outputs is a key step in efficiency investigation. A poor definition
of these quantities may lead to misleading or meaningless results. This problem is particularly
keen in the service sector, where most outputs are intangible and some basic input's data are
not publicly available, such as the employees' number or the worked hours. In this part we
specify the followed approach to define inputs and outputs in the European non-life insurance
Bilel JARRAYA
companies.

Let beginning by the definition of inputs. There is a well-known agreement about the
definitions of these variables in most previous studies focused on efficiency issue in the
insurance industry (Cummins et al., 2004). So we will use four inputs namely: operating
k k k
expenses ( x1t ) , equity capital and reserves ( x2t ) , financial debt capital ( x3t ) and technical
k
provisions ( x4t ) as inputs. Where the Net operating expenses are used as a proxy to business
services, labor force, used materials and products distribution. The Equity capital and reserves
involve any balance sheet item linked with shareholders‟ capital or reserves (minority
interests, participating rights capital…). The Debt capital illustrates all funds borrowed from
creditors. Finally, the technical provisions take account of both loss and unearned premium
reserves.

In the other hand, previous studies have been labeled by an acute divergence concerning the
suitable definition of outputs. There are two main approaches to specify outputs in insurance
industry: the intermediation or asset approach and the value added approach also called
production approach. In the first one, the insurance company is considered as a pure financial
intermediary. In a first step it receives funds from policyholders, paying out claims and all
other additional loads. Then the remaining funds are invested in capital markets. Cummins
and Weiss (2000) affirm that this approach is inappropriate to specify outputs for insurance
industry and especially for non-life insurance companies. The second approach is considered,
by many authors as the most suitable to specify outputs for studying efficiency issue in
insurance industry (Berger et al., 1999; Cummins and Weiss, 2000). This approach considers
output as significant if it contributes a substantial added value, as judged using
operating cost allocations (Berger et al., 2000). In this approach we distinguish
between three principal services provided by non-life insurance companies: risk-

17
pooling and risk-bearing, financial services and intermediation. The total investment is
considered as the best proxy for intermediation function. While the best proxy for the two
remaining services, is the net incurred claims plus additions to reserves (Eling and Luhnen
(2009)).

In practice, insurance companies search to minimize claims. However, when considering net
incurred claims plus additions to reserves as output, this latter must be maximized in
efficiency analysis. This paradox represents the main drawback of this approach. To resolve
this problem, in this chapter, we use the directional output distance function technique. So this
output will be considered as undesirable output and will be minimized. Thus, in our efficiency
k
analysis, the total investment (surplus) express the desirable output noted ( S t ) and net
k
incurred claims plus additions to reserves represents undesirable output noted (bt ) .

Table 1 presents descriptive statistics, the mean and the standard deviation, of each above
defined variable by country over the period 2002-2008.

[Insert Table 1] Bilel JARRAYA

3.3. Results and interpretations

This subsection illustrates our principal achieved results and their interpretations. It contains
three parts.

3.3.1. Frontier Estimation

As previously mentioned, we use the maximum likelihood technique for the estimation of the
directional output distance function, and the one-sided error term is supposed to be
independently and identically distributed. Table 2 presents estimated parameters of the
technology frontier. The result of the one-sided generalized likelihood ratio test is LR=987.
From an econometric point of view this result indicates that the model is statistically
significant. In other hand from an economic point of view this result confirms the importance
of technical inefficiency effects. From the same table we show that first order estimated
coefficients of inputs and outputs have the expected values regarding economic behavior. The
estimated parameters of the stochastic directional output distance function validate that most
of the maximum likelihood coefficients are statistically significant. The majority of variables
are significant at the 1 to 10% levels. Using the estimated parameters in Table 2, we verify

18
that resulting directional output distance function ensures the convexity conditions on inputs
and concavity conditions on outputs for most observations.
[Insert Table 2]

3.3.2. Inefficiency scores before asset allocation

Country-specific technical inefficiency is estimated for each country in each year over the
period 2002-2008. From table 3, we show that inefficiency scores of European non-life
insurance companies are on average waiting of 43.02%. This implies that insurance
companies operating around the net-puts average values have the potential to increase total
investment (desirable output), and simultaneously decrease the quantities of net incurred
claims plus additions to reserves (undesirable output) and inputs by about 43%. The most
efficient non-life insurance system is that of Belgium with an average score inefficiency of
22.21%. However, the most inefficient non-life insurance system is that of Sweden with an
average score inefficiency of 51.63%. So the non-life insurance system of Belgium and
Sweden have to increase total investment and simultaneously decrease the net incurred claims
plus addition to reserves and all inputs by about 22.21% and 51.63%, respectively. The
European non-life insurance companies are invited to minimize incurred claims by revising
offered premium rates and ensure a severely records control of insured customers so as to
minimize asymmetric information. Also they are invited to put more funds for investment and
seek the optimal manner to allocate them.

[Insert Table 3] Bilel JARRAYA

3.3.3. Inefficiency scores after asset reallocation

Simulated assets have been used for seeking the optimal assets allocation allowing the
maximization of technical efficiency for European non-life insurance industry. The simulation
process is based on the correlations between these assets like in the work of Yu et al. (2010).
Achieved results by Genetic algorithm and Particle Swarm Optimization algorithm are
presented in the table 4. This table shows that the obtained results during the period 2002-
2008 are in average quite similar for both algorithms. For 2002, 2005 and 2006 the both
algorithms have reached the same optimal solution with negligible or inexistent differences.
The maximum of technical efficiency can be reached by European non life insurance
companies is 91.5%, 89.6% and 91.1%, respectively. Therefore, highly likely these points
represent relative global optima for the experimented scatter plot. By cons there is a slight

19
difference between results obtained by these two algorithms for the remaining years (2003,
2004, 2007 and 2008). So, the GA reaches, for those years, a local optimum very close to the
optimum achieved by the PSO algorithm. Maximum efficiency levels achieved by the latter
algorithm are 93.5%, 93.2%, 86.4% and 85.8% respectively to aforesaid years. However
efficiency levels achieved by the GA are 92.1%, 91.8%, 84.9% and 86%, respectively. Table
4 shows that the optimal asset allocation allowing the maximization of technical efficiency for
European non-life insurance companies. First, the PSO algorithm provides the following
average percentages of assets allocation for the period 2002-2008: 55.6% of surplus in stock
index, 13% in alternative investment with high-risk high-return, 11.3% in alternative
investment with low-risk low-return, 13.4% in alternative investment with high-risk low-
return and 5.8% in risk-free assets. In other hand, the average percentages provided by the GA
for the same period are as follows: 57.2% of surplus in stock index, 16.1% in alternative
investment with high-risk high-return, 9.1% in alternative investment with low-risk low-
return, 13.3% in alternative investment with high-risk low-return and 4.3% in risk-free assets.
So, the PSO algorithm offers an average of 32% as amelioration of technical efficiency after
assets reallocation. By cons, the GA achieves only 31.4% of amelioration on technical
efficiency. This slight difference is explained above, since the GA is stopped for some years
Bilel JARRAYA
in a relatively local optimum.

Comparing achieved results with those obtained by previous research works especially this of
Yu et al (2010). This paper seeks the best asset allocation allowing maximization of
shareholders‟ expected utility function while using a simulation approach like in our model.
The strike difference between this study and our model is the objective function since we
maximize technical efficiency of non-life insurance companies. In average Yu et al. (2010)
show that surplus of non life insurance companies must be allocated as follows: 39% of
surplus in stock index, 34.6% in alternative investment with high-risk high-return, 8.2% in
alternative investment with low-risk low-return, 18.2% in alternative investment with high-
risk low-return and 0% in risk-free assets. From a financial perspective, managers are the first
responsible of losses or bankruptcy events by cons shareholders seek short-term return. For
this reason we find a relatively great part of investment is allocated into “alternative
investment with high-risk high-return” and zero percent for “risk-free assets” when we are
interested by the shareholders utility function. In other hand, while maximizing technical
efficiency the average percentage founded for “alternative investment with high-risk high-

20
return” is 13% by the PSO algorithm and 5.8% for “risk-free assets”. So, the investment
portfolio is relatively more diversified between available assets. This can be explained by the
implicit paying attention for competitiveness, survival and long term profitability when one
maximizes technical efficiency.
Bilel JARRAYA
[Insert Table 4]

4. Conclusion

Optimal asset allocation is a key issue for any insurance company and it has a great influence
on its solvency and competitiveness. Most previous studies investigate optimal asset
allocation that maximizes shareholders‟ expected utility. But these studies have overlooked
the objectives of other stakeholders of the insurance company. So, illiquidity, excessive risk
or inadequate returns all of them have a negative influence on all stakeholders of the company
especially on the customers‟ behavior. Such risks can influence dramatically the company‟s
survival and the building of necessary reserves to deal with claims payments. Furthermore,
the mismanagement of asset allocation by an insurance company will increase excessively its
probability of insolvency, this will push the decision maker to increase premium rates and as a
consequence the company will lose its competitiveness in the market.

The suggested approach in this chapter attempts to seek the optimal asset allocation that
maximizes technical efficiency of the nonlife insurance company. So, the directional output
distance function has been used as an objective function. Two metaheuristics have been
applied in our model (PSO and GA) to find the optimal asset allocation allowing the
maximization of technical efficiency. Used sample includes 175 non-life insurance companies
dispersed in nine European countries over the period 2002-2008. The empirical application of
the model led us to the following results and recommendations. At the beginning, results
show that estimated production frontier is globally meaningful. Then, generated efficiency
scores implies that European nonlife insurance companies should decrease incurred claims by
revising offered premium rates. Also, they must increase the available funds for investment
and seeking the optimal manner to allocate them. In other hand, applying metaheuristics
algorithms to seek optimal proportions of asset allocation we find more diversified portfolio.
Indeed, the proportion allocated to the “alternative investment with high-risk high-return” is
in average lower then these founded in previous studies. However, the percentage allocated to
the “risk-free assets” is in average different from zero. Thus, the obtained investment

21 Bilel JARRAYA
portfolio is relatively more diversified between available assets compared to this proposed in
previous studies. This can be explained by the implicit paying attention for competitiveness,
survival and long term profitability when one maximizes technical efficiency. So, any
insurance company has to pay more attentions to the presence of different stakeholders and
resolves the conflicts of interest between different stakeholders.
Bilel JARRAYA

22
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Figure

T
Y

μ’
μ
YA’ A’
Bilel JARRAYA
YA
A

Bilel J
bA=bA’ b

Figure 1 : Optimal asset allocation and inefficiency scores

1
Table

Table 1 : Descriptive statistics of variables by country

U-K Swe Den Bel Neth Fr Sp Ita Ger
Inputs
Mean 315,31 49,486 30,696 333,797 77,809 929,481 99,313 102,698 108,893
( x1kt )
S.D. 314,439 37,202 28,651 239,581 106,833 1 141,03 81,007 108,16 105,809
Mean 752,539 2 778,86 54,779 629,632 Bilel
66,475JARRAYA
22 303,06 432,836 38,894 348,53
( x2kt )
S.D. 519,46 2 876,25 84,846 581,739 104,566 35 856,52 475,381 45,757 396,641
Mean 653,017 1 776,39 301,323 743,71 173,241 2 490,92 216,772 28,238 231,587
( x3kt )
S.D. 535,933 2 138,42 375,221 497,091 247,307 2 825,76 202,927 32,395 254,532
Mean 2 843,80 6 697,98 2 748,79 5 574,59 352,53 19 785,38 1 719,06 99,326 2 917,97
( x 4kt )
S.D. 1 682,70 6 162,97 4 929,02 5 318,41 461,597 26 257,70 2 165,05 127,004 3 757,28
Outputs
Mean 2 241,30 8 645,74 2 871,74 6 098,80 252,611 25 549,76 1 725,24 101,225 3 239,45
( y1kt )
S.D. 1 482,40 8 210,86 4 830,80 6 204,66 309,159 34 434,26 2 070,11 124,262 4 041,19
Mean 493,111 484,136 210,04 1 255,70 113,85 3 843,42 266,56 83,285 346,665
(btk )
S.D. 338,344 384,547 313,25 1 326,23 141,965 4 828,09 257,556 56,33 371,499
Notes: The table reports the mean and the cross-sectional standard deviation (SD) of each variable by
country. Different notations used in the table are defined as follows: x1= Operating expenses; x2= Equity
capital and reserves; x3= Financial debt capital; x4= Technical provisions; b = Incurred claims plus additions
to reserves; y1= Total investment (surplus). All variables are expressed on € million.

1
 Table 2 : Frontier estimation
Par. Par. Est. SD Par. Par. Est. SD
C α0 -1,25E+02 3,46E+01 X2*b χ21 8,86E-06 9,54E-17
X1 α1 8,42E-01 4,35E-05 X2*S ɣ12 2,91E-07 4,56E-19
X2 α2 1,48E-02 1,61E-08 X2*t ψ2 -8,68E-05 7,84E-10
X3 α3 7,20E-02 4,02E-06 X3*X3 α33 -8,39E-06 1,61E-14
X4 α4 4,90E-02 7,54E-08 X3*X4 α34 -6,88E-06 6,65E-16
B λ1 -3,56E-02 Bilel JARRAYA
2,66E-06 X3*b χ31 5,14E-05 2,41E-14
S β1 -5,79E-02 4,85E-08 X3*S ɣ13 4,67E-06 2,03E-16
t δ1 2,19E+01 8,63E+00 X3*t ψ3 -1,59E-02 1,25E-07
X1*X1 α11 2,63E-04 3,12E-12 b*b τ11 -2,57E-05 1,40E-14
X1*X2 α12 -1,49E-06 2,17E-16 X4*b χ41 1,93E-05 8,91E-17
X1*X3 α13 -2,24E-04 1,60E-13 S*b ⱷ11 -1,78E-05 7,21E-17
X1*X4 α14 -3,79E-06 6,29E-15 b*t Ф1 4,12E-04 1,39E-07
X1*b χ11 -7,16E-05 1,91E-13 X4*X4 α44 -6,79E-06 7,79E-18
X1*S ɣ11 1,25E-05 1,82E-15 X4*S ɣ14 2,28E-06 1,65E-18
X1*t ψ1 -2,73E-03 2,53E-06 X4*t ψ4 1,01E-02 3,48E-09
X2*X2 α22 -3,86E-07 1,54E-19 S*S β11 1,94E-06 4,61E-18
X2*X3 α23 3,32E-06 2,91E-17 S*t η1 -8,22E-03 2,28E-09
X2*X4 α24 -2,36E-06 4,32E-18 t*t δ11 -4,70E+00 5,15E-01
LR=987
Notes: This table presents the estimated parameters and the standard deviation for each one of the estimated
directional output distance function. Different notations used in the table are defined as follows: X1= Operating
expenses; X2= Equity capital and reserves; X3= Financial debt capital; X4= Technical provisions; b= Incurred
claims plus additions to reserves; S= Total investment (surplus); t= trend time variable that explains technical
progress; LR: the one-sided generalized likelihood ratio; Par.: estimated parameters.

Table 3: Inefficiency scores by country

2002-
2002 2003 2004 2005 2006 2007 2008
2008
U-K 0,3831 0,4972 0,3632 0,3737 0,5772 0,3126 0,6646 0,4531
Swe 0,6894 0,5837 0,5028 0,5266 0,5787 0,3794 0,3537 0,5163
Den 0,3516 0,3525 0,4101 0,4433 0,4045 0,4300 0,4681 0,4086
Bilel JARRAYA
Bel 0,1279 0,0713 0,0772 0,2545 0,2962 0,2202 0,5071 0,2221
Den 0,3813 0,1784 0,2541 0,4062 0,3881 0,3817 0,3821 0,3388
Neth 0,6121 0,5171 0,5034 0,4599 0,4928 0,4851 0,3909 0,4944
Fr 0,4728 0,5187 0,5179 0,4271 0,4847 0,5116 0,4008 0,4762
Sp 0,2671 0,3836 0,6094 0,4502 0,5142 0,4711 0,5937 0,4699
Neth 0,5384 0,4186 0,5469 0,4809 0,4816 0,4897 0,4888 0,4921
Ita 0,6894 0,5837 0,5028 0,5266 0,5787 0,3794 0,3537 0,5163
Fr 0,3516 0,3525 0,4101 0,4433 0,4045 0,4300 0,4681 0,4086
Ger 0,1279 0,0713 0,0772 0,2545 0,2962 0,2202 0,5071 0,2221
Notes: This table reports a comparison of the average annual inefficiency scores for each country reported by
year and for all the studied period.

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 Table 4 : Optimization of the nonlife insurer’s asset allocation
Panel
PSO Algorithm
A:
Stock AIhh AIll AIlh Bond Ω Γ
2002 0,398 0,302 0,158 0,137 0,005 0,085 33,1%

2003 0,377 0.244 0,234 0,133 0,012 0,065 31,2%

2004 0,378 0,245 0,235 0,133 0.008 0,068 33,0%

2005 0,516 0,034 0,030 0,333Bilel JARRAYA

0,087 0,104 31,7%

2006 0,466 0,199 0,135 0,200 0,000 0,089 36,9%

2007 0,909 0,000 0,000 0,000 0,091 0,136 25,7%

2008 0,847 0,000 0,000 0,000 0,153 0,142 32,3%

02-08 0,556 0,130 0,113 0,134 0,058 0,098 32,0%

Panel
Genetic Algorithm
B:
Stock AIhh AIll AIlh Bond Ω Γ
2002 0,398 0,302 0,158 0,137 0,005 0,085 33,1%

2003 0,414 0,297 0,157 0,132 0,000 0,079 29,8%

2004 0,420 0,294 0,156 0,130 0,000 0,082 31,6%

2005 0,516 0,034 0,030 0,333 0,087 0,104 31,7%

2006 0,466 0,200 0,134 0,200 0,000 0,090 36,8%

2007 0,862 0,000 0,000 0,000 0,138 0,151 24,2%

2008 0,928 0,000 0,000 0,000 0,072 0,140 32,5%

02-08 0,572 0,161 0,091 0,133 0,043 0,104 31,4%

Notes: This table reports the proportions allocated for different assets and the new achieved inefficiency
scores while using Genetic Algorithm and Particle Swarm Optimization algorithm over the period 2002-2008.
Noting that AIhh: Alternative Investment with high-risk high-return; AIll: Alternative Investment with low-risk
low-return; AIhl: Alternative Investment with high-risk low-return; Ω: the annual average of the new
inefficiency score after assets reallocation; Γ: the won percentage of efficiency after assets reallocation.

3
*1st page

Optimal Asset Allocation and Technical Efficiency in

European Non-Life Insurance Companies

Bilel Jarrayaa Abdelfettah Bouri b

a
Ph D Student, Roud Aeroport FSEG, Sfax 3048, Tunisia
b
Professor, Roud Aeroport FSEG, Sfax 3048, Tunisia

Abstract

Most previews studies investigate optimal asset allocation that maximizes shareholders’ expected
utility. But, in addition to the maximization of shareholders' expected utility, the optimal assets
allocation plays additional key roles to insure the insurance company's survival such as building
necessary reserves to deal with claims payments. So, illiquidity, excessive risk and inadequate
returns have a negative influence on shareholders’ behavior as well as on customers’ behavior.
Furthermore, the mismanagement of asset allocation by an insurance company will increase
excessively its probability of insolvency, this will push the decision maker to increase premium
rates and as a consequence the company will lose its competitiveness in the market. This study is
original; it intended to investigate the optimal asset allocation of European non-life insurance
companies that maximizes technical efficiency. The definition of our objective function is based
on the directional output distance function. Two metaheuritics has been used PSO and GA.
Achieved results show that proportion allocated to the “alternative investment with high-risk high-
return” is in average lower then these founded in previous studies. However, the percentage
allocated to the “risk-free assets” is in average different from zero. Thus, the obtained investment
portfolio is relatively more diversified between available assets compared to this proposed in
previous studies. This can be explained by the implicit paying attention for competitiveness,
survival and long term profitability when one maximizes technical efficiency. So, any insurance
company has to pay more attentions to the presence of different stakeholders and resolves the
conflicts of interest between different stakeholders.
Keywords: Technical efficiency, survival, Asset allocation, PSO, GA, Directional output distance
function, Non-life insurance companies.
JEL codes: C63; C67; G11; G22; L21; L23

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