Distributionally Robust Optimization

of Moments subject to Partial Ambiguity

Yunshen Yang
Joint work with Qihe Tang

24th International Congress on Insurance: Mathematics and Economics (IME)

July 2021

Yunshen Yang IME Presentation July 2021 1 / 23

Outline

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 2 / 23

Outline for section 1

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 3 / 23

Example of Model Uncertainty

Let X be a risk variable; e.g., the magnitude of an earthquake, the

total loss of an insurance company, the credit quality index of a firm,
the mortality, ...
Let h(x) be a deterministic function and E [h(X )] is the quantity we
care about; e.g., the expected loss, the ruin probability, ...

Yunshen Yang IME Presentation July 2021 4 / 23

Example of Model Uncertainty

Let X be a risk variable; e.g., the magnitude of an earthquake, the

total loss of an insurance company, the credit quality index of a firm,
the mortality, ...
Let h(x) be a deterministic function and E [h(X )] is the quantity we
care about; e.g., the expected loss, the ruin probability, ...

Question: Do we know the true distribution of X ?

Ambiguity: the uncertainty of probability distribution

Yunshen Yang IME Presentation July 2021 4 / 23

Model Uncertainty

The estimation errors in underlying models can cause

Dramatically erroneous portfolio decisions
Underestimation of the risks
Violation of solvency constraints

How to produce a robust estimate/decision?

Yunshen Yang IME Presentation July 2021 5 / 23

Model Uncertainty

The estimation errors in underlying models can cause

Dramatically erroneous portfolio decisions
Underestimation of the risks
Violation of solvency constraints

How to produce a robust estimate/decision?

Distributionally Robust Optimization (DRO)

Yunshen Yang IME Presentation July 2021 5 / 23

Distributionally Robust Optimization

The three C’s to produce a robust estimation:

Construct an ambiguity set B of probability distributions

Consider every distribution in the ambiguity set
Conclude the worst scenario

sup E [h(X )]
F ∈B

Yunshen Yang IME Presentation July 2021 6 / 23

Outline for section 2

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 7 / 23

DRO

A good ambiguity set should be both broad and prudent

The method we followed uses an ambiguity ball:

Br (Fn ) = {F : D(F , Fn ) ≤ r }

with radius r and D(·, ·) is a statistical divergence

Then the DRO problem is

sup E [h(X )] , ,
F ∈Br (Fn )

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Over-conservativeness

Estimates and realized confidence levels are unnecessarily too high:

How to alleviate the over-conservetiveness issue?
In practice, there are different scenarios:
existing vs. new business
regular region vs. extreme region
age groups below 85 vs. above 85
Is it fair to treat all scenarios equally?

Yunshen Yang IME Presentation July 2021 9 / 23

Outline for section 3

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 10 / 23

Model Formulation

Consider the ordinary scenario 0 and the ambiguity scenario 1

Introduce a scenario indicator I with distribution

FI = (1 − q) δ0 + qδ1

where q = P(I = 1)
Y is the risk in scenario 0 with abundant data
Z is the risk in scenario 1 suffering from data scarcity
I is independent of the pair (Y , Z )

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Two-fold Ambiguity

The overall risk is

X = (1 − I ) Y + IZ
E [X p ] = (1 − q)E [Y p ] + qE [Z p ]

The ambiguity exists in both I and Z (or q and E [h (Z )]), and thus is
two-fold

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Two-fold ambiguity

Our DRO problem is

sup E [X p ] ,
X : FI ×FZ ∈Br (FIn ×FZN )

where

Br (FIn × FZN ) = {FI × FZ : W (FI × FZ , FIn × FZN ) ≤ r } ,

and
n o
W (FV1 , FV2 ) = inf (EΠ [d(V1 , V2 )p ])1/p : ΠV1 = FV1 , ΠV2 = FV2
Π

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Disentanglement

Carefully disentangle the ambiguity into the two folds:

W (FI × FZ , FIn × FZN ) ≤ r ⇐⇒ |q − qn | + W (FZ , FZN )p ≤ r p

Intuition:
The total ambiguity is fixed and should be allocated to q and FZ
Relatively unworthy to increase q when p are large.

Yunshen Yang IME Presentation July 2021 14 / 23

Disentanglement

Carefully disentangle the ambiguity into the two folds:

W (FI × FZ , FIn × FZN ) ≤ r ⇐⇒ |q − qn | + W (FZ , FZN )p ≤ r p

Intuition:
The total ambiguity is fixed and should be allocated to q and FZ
Relatively unworthy to increase q when p are large.

Now we have the DRO problem with two layers:

( )
sup (1 − q) E [h (Y )] + q sup E [h (Z )]
q∈[qn− ,qn+ ] FZ ∈B (FZN )

where [qn− , qn+ ] can incorporate prior beliefs

Yunshen Yang IME Presentation July 2021 14 / 23

Outline for section 4

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 15 / 23

Inner and Outer Optimization

Applying existing results to the inner optimization, we have

sup E [Z p ] = ( + kZN kLp )p

FZ ∈B (FZN )

It remains to solve the outer optimization

n  p o
sup (1 − q) C0p + q (r p − |q − qn |)1/p + C1 ,
q∈[qn− ,qn+ ]

where
C0 = kY kLp and C1 = kZN kLp

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Robust Estimates
When C0 ≤ C1 ,

(1 − qn )C0p + qn (r + C1 )p , when r ≤ r∗

p
sup E [X ] =
X : FI ×FZ ∈Br (FIn ×FZN )
(1 − q∗ )C0p + q∗ (∗ + C1 )p , when r > r∗

r∗ = r¯ ∨ 0 with r¯ the unique solution r to

−C0p + (r + C1 )p−1 r (1 − qn r −p ) + C1 = 0

q∗ = q̄n ∧ qn+ with q̄n the unique solution q to

 p
− C0p + (r p + qn − q)1/p + C1
 p−1 1−p
− q (r p + qn − q)1/p + C1 (r p + qn − q) p = 0

∗ = (r p + qn − q∗ )1/p
Yunshen Yang IME Presentation July 2021 17 / 23
Outline for section 5

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 18 / 23

Optimal Allocation
Allocation of the ambiguity (p=1) Allocation of the ambiguity (p=3)

0.100
The optimal q* The optimal q*
0.104

The upper bound q+n The upper bound q+n

0.098
0.102

0.096
0.100

0.094
q*

q*
0.098

0.092
0.096

0.090
0.094

0.088
0.00 0.01 0.02 0.03 0.04 0.05 0.00 0.05 0.10 0.15 0.20 0.25

r r

Figure: p = 1 Figure: p = 3

Figure: Optimal Allocation of the two methods when Y = |W | with W ∼ N (2, 1)

and Z is a Pareto (Type I) distribution with a scale parameter 4 and a tail index
10, P(X = 1) = 0.1

Yunshen Yang IME Presentation July 2021 19 / 23

Coverage-based Experiment

Given that the convergence theorems are too conservative to be

applicable, we use hold-out method to select the radius for different
methods to achieve 95% confidence.
p coverage (new) coverage (old) MAD (new) MAD (old)
1 0.91 1.00 1.5341e − 02 4.2786e − 02
2 0.97 1.00 1.1080e − 01 2.2022e − 01
3 0.99 1.00 6.9571e − 01 1.1608e + 00
4 0.99 1.00 4.5756e + 00 6.2976e + 00
Table: Coverage-based performance of the two methods when Y = |W | with
W ∼ N(2, 1) and Z is a Pareto (Type I) distribution with a scale parameter 4 and
a tail index 10,P(X = 1) = 0.1

Yunshen Yang IME Presentation July 2021 20 / 23

Outline for section 6

1 Model Uncertainty and Ambiguity

2 Distributionally Robust Optimization (DRO)

3 Model Formulation

4 Main Result

5 Numerical Studies

6 Conclusion

Yunshen Yang IME Presentation July 2021 21 / 23

Conclusion

Derive a closed-form estimation for the moment of a risk under partial

ambiguity
Alleviate the conservativeness of previous methods

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Future Works

Apply DRO to address the ambiguity issue in practical problems

Portfolio investment
Pricing in incomplete markets
For these problems where tail risks present and matters, our idea of
partial ambiguity becomes relevant

Yunshen Yang IME Presentation July 2021 23 / 23

Future Works

Apply DRO to address the ambiguity issue in practical problems

Portfolio investment
Pricing in incomplete markets
For these problems where tail risks present and matters, our idea of
partial ambiguity becomes relevant

Thank You!
Stay Healthy :)

Yunshen Yang IME Presentation July 2021 23 / 23