IDEAS home Printed from https://ideas.repec.org/a/bpj/apjrin/v1y2005i1n2.html
   My bibliography  Save this article

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

Author

Listed:
  • Chang Shih-Chieh Bill

    (National Chengchi University, Taiwan)

  • Tsai Chenghsien

    (National Chengchi University, Taiwan)

  • Hung Li-Chuan

    (Nan Shan Life Insurance Co., Ltd., Taiwan)

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.

Suggested Citation

  • Chang Shih-Chieh Bill & Tsai Chenghsien & Hung Li-Chuan, 2005. "Incorporating Foreign Equities in the Optimal Asset Allocation of an Insurer with the Consideration for Background Risks: Models and Numerical Illustrations," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 1(1), pages 1-22, June.
    • Handle: RePEc:bpj:apjrin:v:1:y:2005:i:1:n:2
    DOI: 10.2202/2153-3792.1001
    as

    Download full text from publisher

    File URL: https://doi.org/10.2202/2153-3792.1001
    Download Restriction: For access to full text, subscription to the journal or payment for the individual article is required.
    File URL: https://libkey.io/10.2202/2153-3792.1001?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    2. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    3. John Y. Campbell & Luis M. Viceira & Joshua S. White, 2003. "Foreign Currency for Long-Term Investors," Economic Journal, Royal Economic Society, vol. 113(486), pages 1-25, March.
    4. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    5. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 627-627, November.
    6. Monoyios, Michael, 2004. "Option pricing with transaction costs using a Markov chain approximation," Journal of Economic Dynamics and Control, Elsevier, vol. 28(5), pages 889-913, February.
    7. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
    8. Michael J. Brennan & Yihong Xia, 2000. "Stochastic Interest Rates and the Bond-Stock Mix," Review of Finance, European Finance Association, vol. 4(2), pages 197-210.
    9. Canner, Niko & Mankiw, N Gregory & Weil, David N, 1997. "An Asset Allocation Puzzle," American Economic Review, American Economic Association, vol. 87(1), pages 181-191, March.
    10. Menoncin, Francesco, 2002. "Optimal portfolio and background risk: an exact and an approximated solution," Insurance: Mathematics and Economics, Elsevier, vol. 31(2), pages 249-265, October.
    11. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 25(2), pages 65-86.
    12. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
    13. M. J. Brennan, 1998. "The Role of Learning in Dynamic Portfolio Decisions," Review of Finance, European Finance Association, vol. 1(3), pages 295-306.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    2. Jakub W. Jurek & Luis M. Viceira, 2011. "Optimal Value and Growth Tilts in Long-Horizon Portfolios," Review of Finance, European Finance Association, vol. 15(1), pages 29-74.
    3. Bilel Jarraya & Abdelfettah Bouri, 2013. "A Theoretical Assessment on Optimal Asset Allocations in Insurance Industry," International Journal of Finance & Banking Studies, Center for the Strategic Studies in Business and Finance, vol. 2(4), pages 30-44, October.
    4. Brennan, Michael J. & Xia, Yihong, 2000. "Dynamic Asset Allocation under Inflation," University of California at Los Angeles, Anderson Graduate School of Management qt8p95456t, Anderson Graduate School of Management, UCLA.
    5. Munk, Claus & Sorensen, Carsten & Nygaard Vinther, Tina, 2004. "Dynamic asset allocation under mean-reverting returns, stochastic interest rates, and inflation uncertainty: Are popular recommendations consistent with rational behavior?," International Review of Economics & Finance, Elsevier, vol. 13(2), pages 141-166.
    6. John Y. Campbell & Yeung Lewis Chanb & M. Viceira, 2013. "A multivariate model of strategic asset allocation," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part II, chapter 39, pages 809-848, World Scientific Publishing Co. Pte. Ltd..
    7. Lin, Wen-chang & Lu, Jin-ray, 2012. "Risky asset allocation and consumption rule in the presence of background risk and insurance markets," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 150-158.
    8. Larsen, Linda Sandris & Munk, Claus, 2012. "The costs of suboptimal dynamic asset allocation: General results and applications to interest rate risk, stock volatility risk, and growth/value tilts," Journal of Economic Dynamics and Control, Elsevier, vol. 36(2), pages 266-293.
    9. Penaranda, Francisco, 2007. "Portfolio choice beyond the traditional approach," LSE Research Online Documents on Economics 24481, London School of Economics and Political Science, LSE Library.
    10. Michael J. Brennan & Yihong Xia, 2002. "Dynamic Asset Allocation under Inflation," Journal of Finance, American Finance Association, vol. 57(3), pages 1201-1238, June.
    11. Escobar, Marcos & Ferrando, Sebastian & Rubtsov, Alexey, 2016. "Portfolio choice with stochastic interest rates and learning about stock return predictability," International Review of Economics & Finance, Elsevier, vol. 41(C), pages 347-370.
    12. Ahmad Telfah, "undated". "" Do Financial Planners Take Financial Crashes In Their Advice: Dynamic Asset Allocation Under Thick Tails And Fast Volatility Updating," API-Working Paper Series 0604, Arab Planning Institute - Kuwait, Information Center.
    13. Björn Bick & Holger Kraft & Claus Munk, 2013. "Solving Constrained Consumption-Investment Problems by Simulation of Artificial Market Strategies," Management Science, INFORMS, vol. 59(2), pages 485-503, June.
    14. Kaminski, Kathryn M. & Lo, Andrew W., 2014. "When do stop-loss rules stop losses?," Journal of Financial Markets, Elsevier, vol. 18(C), pages 234-254.
    15. Li, Kai, 2019. "Portfolio selection with inflation-linked bonds and indexation lags," Journal of Economic Dynamics and Control, Elsevier, vol. 107(C), pages 1-1.
    16. Constantin Mellios, 2007. "Interest rate options valuation under incomplete information," Annals of Operations Research, Springer, vol. 151(1), pages 99-117, April.
    17. Suresh M. Sundaresan, 2000. "Continuous‐Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, August.
    18. O. S. Rozanova & G. S. Kambarbaeva, 2015. "Optimal strategies of investment in a linear stochastic model of market," Papers 1501.07124, arXiv.org.
    19. Mkaouar, Farid & Prigent, Jean-Luc & Abid, Ilyes, 2017. "Long-term investment with stochastic interest and inflation rates: The need for inflation-indexed bonds," Economic Modelling, Elsevier, vol. 67(C), pages 228-247.
    20. Munk, Claus, 2015. "Financial Asset Pricing Theory," OUP Catalogue, Oxford University Press, number 9780198716457.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bpj:apjrin:v:1:y:2005:i:1:n:2. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Peter Golla (email available below). General contact details of provider: https://www.degruyter.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.