Liability Driven Investments with a Link to Behavioral Finance

Ludwig Brummer, Markus Wahl and Rudi Zagst

Chapter 11 in Innovations in Insurance, Risk- and Asset Management:Proceedings of the Innovations in Insurance, Risk- and Asset Management Conference, 2018, pp 275-311 from World Scientific Publishing Co. Pte. Ltd.

Abstract: Liability driven investment (LDI) strategies that take stochastic liabilities into account have become increasingly important for insurance companies and pension funds due to market developments such as low interest rates, high volatility and changes in regulatory requirements. We consider stochastic liabilities in a portfolio optimization framework and include aspects from behavioral finance, in particular cumulative prospect theory (CPT). We study LDI strategies with extended preference structures and probability distortion and derive analytical solutions for a CPT portfolio optimization problem in an LDI context. Within a case study, we compare the optimal investment strategies to existing LDI approaches within traditional frameworks such as the partial surplus optimization presented in [1] and the funding ratio optimization in an expected utility framework as introduced in [2].

Keywords: Insurance; Actuarial Science; Risk Measure; Reinsurance; Copula; Replicating Portfolio; Bayesian Finance; Risk Classification; Stochastic Dominance; Dynamic Hedging; Autoregressive Hidden Markov Models; Exchange-Traded Funds; Uncertainty Quantification; Fixed Income; Stochastic Processes for Finance (search for similar items in EconPapers)
JEL-codes: G22 G32 (search for similar items in EconPapers)
Date: 2018
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