Incorporating Foreign Equities in the Optimal Asset Allocation of an Insurer with the Consideration for Background Risks: Models and Numerical Illustrations

Chang Shih-Chieh Bill, Tsai Chenghsien and Hung Li-Chuan
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Chang Shih-Chieh Bill: National Chengchi University, Taiwan
Tsai Chenghsien: National Chengchi University, Taiwan
Hung Li-Chuan: Nan Shan Life Insurance Co., Ltd., Taiwan

Asia-Pacific Journal of Risk and Insurance, 2005, vol. 1, issue 1, 22

Abstract: We analyzes the optimal asset allocation problem for life insurers that are required to cope with significant background risks originating from life insurance businesses among a set of stochastic investment opportunities including foreign equities. The insurer is assumed to maximize the expected discounted utility of its surplus over a time horizon, and the optimalization problem is formulated in a stochastic control framework. Our derivations show that the optimal portfolio can be characterized by three components: a risk-minimizing component, a risk aversion index coupled with the portfolio's performance index, and the component reflecting the diffusions of state variables. Since the explicit solutions cannot be derived due to the complexity of the model, we employ Markov chain approximation methods to obtain the optimal control solutions numerically. The model and numerical methods are then applied to a hypothetical insurer in a simplified setting as an illustrative example.

Keywords: foreign investment; background risk; asset allocation; stochastic control; Markov chain approximation; life insurance (search for similar items in EconPapers)
Date: 2005
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DOI: 10.2202/2153-3792.1001

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