Stochastics

An International Journal of Probability and Stochastic Processes

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A bivariate Markov modulated intensity model:

applications to insurance and credit risk modelling

Anubha Goel & Aparna Mehra

To cite this article: Anubha Goel & Aparna Mehra (2021) A bivariate Markov modulated intensity
model: applications to insurance and credit risk modelling, Stochastics, 93:4, 555-574, DOI:
10.1080/17442508.2020.1760866

To link to this article: https://doi.org/10.1080/17442508.2020.1760866

Published online: 13 May 2020.

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STOCHASTICS
2021, VOL. 93, NO. 4, 555–574
https://doi.org/10.1080/17442508.2020.1760866

A bivariate Markov modulated intensity model: applications

to insurance and credit risk modelling
Anubha Goel and Aparna Mehra

Department of Mathematics, Indian Institute of Technology Delhi, New Delhi, India

ABSTRACT ARTICLE HISTORY

A class of analytically tractable bivariate Markov modulated point Received 19 March 2019
process is presented in this article. The intensities of the bivariate Accepted 22 April 2020
jump process are assumed to be driven by a correlated Markov mod- KEYWORDS
ulated jump-diffusion processes with dependence among the jumps Continuous time Markov
being modelled using a copula. Following the martingale method, chain; regime-switching;
the closed form expressions for the Laplace transforms and moments jump-diffusion process;
of the joint process are derived. The proposed model is capable of copula; credit risk; insurance
addressing a variety of problems in the financial world. To exhibit the
applicability of the proposed model, the premium of credit default
swaps (CDS) with counterparty risk and the probability of surren-
dering an insurance contract are obtained. The sensitivity of the
premium of CDS and surrender probability with respect to various
parameters of the model is also demonstrated.

1. Introduction
Poisson process, due to its simplicity and mathematical tractability, has long been a classical
modelling tool to address various problems in financial mathematics. For instance, in an
intensity-based framework of credit risk, the default of an obligor is defined as the first
jump time of a Poisson process [25]. In insurance, Poisson process has a long history of
being used to model the arrivals of claims. However, empirical evidences suggests that the
Poisson process is not an appropriate process to model the claim arrivals or occurrence of
default [17]. Therefore, many generalizations of the Poisson process have been proposed
in the literature. One such generalization is the doubly stochastic Poisson process (also
known as Cox process).
A Cox process considers the intensity of the counting process not only to be time vary-
ing but also allows it to be driven by a stochastic process. The processes has an ability to
account for the time varying hazard function and over dispersion observed in the default
data. Although, there are infinitely many choices of stochastic processes to model the inten-
sity process, yet, one needs a mathematically tractable process so as to analytically derive
the important statistics like Laplace transforms and moments of the counting process.
Another desirable quality in the stochastic process for applications in financial modelling
is the mean reversion. One such class of stochastic processes is the class of affine processes

CONTACT Anubha Goel anubha.goel1@gmail.com

© 2020 Informa UK Limited, trading as Taylor & Francis Group
556 A. GOEL AND A. MEHRA

which have widely been used to model short-term interest rates for pricing the zero coupon
bond.
A learning from the sub-prime financial crisis of 2008 is not to ignore the significance of
correlations of events in the financial markets across breadth. It is important to analyze and
quantify dependence among the arrival of events. In credit risk modelling, the major con-
cern of a financial institution is the occurrence of disproportionately many joint defaults of
different counter-parties over a fixed time horizon. Hence, default correlation is at the heart
of the problem of pricing credit derivatives written on a portfolio of credit risky assets (like,
the collateralized debt obligations (CDOs)). The most important task in the pricing of the
counterparty credit risk of a CDS is to model the default intensities and default correlation
between the protection seller and reference entity. In insurance, one might be interested
in modelling the losses occurring in many different lines of business or the dependence
in the frequencies of losses of different types. Various techniques have been used in the
literature to model such a dependence among features, namely conditional independence
approach, copula approach, multivariate intensity-based models or common shock mod-
elling approach. A natural approach to modelling this dependence is to assume that all
losses can be related to a series of underlying and independent shock processes. In com-
mon shock modelling approach, the common shocks might be natural catastrophes for an
insurance problem or they can be external economic events (e.g. political news, global or
local recessions) that affect all the firms in the market in respect of credit risk.
In recent years, enormous growth is observed in the applications of regime-switching
models to a variety of problems in finance. Regime-switching models present an inter-
esting idea that the economy itself is not in a particular state but is subject to regular
yet unpredictable in time states called regimes. These states of the economy affect the
prices of different financial securities. For instance, the credit default probability is strongly
influenced by the state of the economy; it decreases during the economic expansion, and
increases in economic recession due to reduced earnings making it difficult to meet the
obligations.
In this article, we propose a class of mathematically tractable bivariate counting pro-
cesses whose intensities are assumed to follow Markov modulated jump-augmented CIR
model. The effect of the common shock on the intensities is in the form of a jump in the
intensities and dependence among the jump sizes is modelled by a copula whose param-
eter is assumed to be dependent on the driving regime-switching process. The proposed
bivariate counting process can be applied to various problems in credit risk and insurance
for modelling events such as joint defaults or claim arrivals. The closed form expressions
for distributional properties of the proposed process such as moments, joint Laplace trans-
form of the intensity process have been derived. The applicability of the proposed model
is demonstrated in the valuation of a credit default swap (CDS) with counterparty risk.
Furthermore, in the context of life insurance, following the idea of Russo et al. [37], the
surrender probability is obtained assuming the dependence among the surrender intensity
and interest rate. Finally, numerical illustrations are also presented.
The organization of the paper is as follows. Section 2 presents the related literature and
discusses the major contribution of the article. Section 3 introduces the bivariate counting
process in a regime-switching framework. Section 4 gives the distribution properties of the
proposed model such as the joint Laplace transforms and moments of the intensity process.
Section 5 discusses the application of the proposed models in the fields of credit risk and
 STOCHASTICS 557

insurance along with the numerical illustrations. Section 6 concludes the paper with future
work.

2. Literature review
Jarrow and Turnbull [25] modelled the default time of the underlying firm as the first jump
time of a Poisson process. In insurance setting, in order to obtain the ruin probability, the
claim arrival rate in the surplus process has been modelled by a homogeneous Poisson
process. However, a Poisson process is often unrealistic since the intensity of occurrence
of events (default or claim arrival) is not necessarily a constant. A natural extension of the
basic Poisson model is to allow for deterministically time-varying intensities. Duffie and
Singleton [17] considered that the default intensity is not a constant but a function of time.
In other words, the conditional probability of default in a small time interval t, given
no default till time t, is λ(t)t. Lando [28] proposed a doubly stochastic Poisson process
(also known as a Cox process) assuming that the default intensity is not a deterministic
function of time but driven by a stochastic process. He assumed that the default inten-
sity is affected by a set of market variables and macroeconomic factors. Duffie et al. [18]
considered an affine jump-diffusion model which covers various other models proposed
in the literature such as the Vasicek model [43]) and Cox-Ingersoll-Roll (CIR) model [8].
Björk and Grandell [4] and Albrecher and Asmussen [1] also considered the claim arrival
process to be a doubly stochastic Poisson process. Dassios and Jang [9] derived the price
of catastrophe reinsurance contracts and derivatives under the assumption that the claims
arrive according to a doubly stochastic Poisson process. Later, Biffis [3] and Schrager [39]
extended the idea of Lando [28] by considering the affine intensity to obtain the survival
probability. These processes have been applied to life-insurance modelling, and recently
extended to non-life insurance framework.
The reduced-form contagion models are popular models for describing dependence
among defaults of a number of firms [26,44], and hence in modelling the portfolio losses.
Typically two approaches are followed to model the dependence, the top down approach
and the bottom up approach. In a top down approach, the loss in the portfolio is modelled
directly without any specific reference to the individual constituents of the portfolio. For
instance, Davis and Lo [11] modelled the loss in the portfolio by considering the arrival of
defaults by a piece-wise deterministic Markov process and each default causes some loss in
the portfolio. Arnsdorf and Halperin [2] considered the non-linear death process to model
the arrivals of defaults in the portfolio. Errais et al. [19] studied the problem of portfolio
credit risk by considering a family of point process whose intensity is assumed to be driven
by affine jump-diffusion process.
On the other hand, the bottom up approach models the default of each constituent
and then loss in the portfolio is obtained by considering the dependence among the
constituents [16,23,26]. The dependence is modelled by mainly four approaches namely
the copula approach, the common shock modelling approach, the interacting intensity
approach and the conditional independence approach. In the copula approach the dis-
tribution of the joint defaults is obtained by coupling the marginal default probabilities
using copulas [7,24,29,38]. The common shock models are based on the idea that a firm’s
default is driven by exogenous events, for example, policy events, natural catastrophes
558 A. GOEL AND A. MEHRA

events, etc. Therefore, simultaneous defaults may occur under the common shock mod-
els [6,15,22,30,32]. In the interacting intensity models, the dependence between defaults is
introduced via the interactions between default intensities. For instance, the default inten-
sity of one firm may change due to default of other firms in the portfolio thus capturing the
clustering of defaults phenomenon [11–13,20,26,44,45]. In the conditional independence
approach, the default intensity of a constituent is assumed to be driven by a common set of
macroeconomic factors and conditional on the process governing macroeconomic factors,
the defaults of the constituents are independent [16,27,31,34].
In the direction of regime-switching models, Siu [41] proposed a jump-augmented
Vasicek model for bond valuation in a Markov regime-switching framework. Liang and
Wang [31] proposed a common Poisson shock model in a Markov regime-switching frame-
work to price kth-to-default basket default swaps. Shen and Siu [40] studied the problem of
pricing bond options under Hull-White model in a regime-switching framework. Bo et al.
[5] considered the problem of finding the default probability under the assumption that
the asset dynamics are driven by a regime-switching reflected stochastic processes. Dong
et al. [14] proposed a Markovian regime switching shot noise process and studied its appli-
cations in bond pricing and insurance. Recently, Pasricha and Dharmaraja [35] studied a
Markov modulated mean-reverting affine jump-diffusion process with contagion effects
and demonstrated its application in pricing of CDOs.
Contribution: From the above literature, we observe that the shot-noise processes pro-
vide a better fit and describe historical data very well as compared to affine jump-diffusion
models proposed in [16] in the field of credit risk as demonstrated in Gaspar and Schmidt
[21]. Building on this empirical observation Dong et al. [13,15] proposed regime-switching
shot noise models to model the correlated defaults. However, in both articles, the authors
considered pure jump intensities in contrast to the combination of affine framework and
shot noise process proposed in [21]. As a consequence, the trajectory between the two suc-
cessive jumps in the intensity process is a deterministic process which is not close to reality
since one observes a certain degree of external noises and risks that are persistently driv-
ing the market as compared to short lived shocks modelled by the jump processes. On the
other hand, the article by Dong et al. [14] considered the intensity process to be a Markov
modulated jump-diffusion modification of Vasicek model which results in the possibility
of the intensity process becoming negative. However, the default probability in the con-
text of credit risk or surrender intensity in the context of insurance cannot take negative
values.
Motivated by the above discussion, we observe that the models in Dong et al. [13,15] can
be extended to incorporate the additional diffusion term or one can extend the framework
of Dong et al. [14] to make the intensity process a positive process by using a CIR type
intensity. By introducing the diffusion term in [13,15], one can distinguish and capture the
short-lived risk factors (jump term) and long-lasting effects (diffusion term) more accu-
rately. In this article, we consider the second scenario while the first idea can be a future
research work. Since our idea is not limited to the field of credit risk, we consider affine
framework which is famous among practitioners in other fields such as insurance. The
contribution of this article is a theoretical model which considers the regime-switching
framework of a multi-dimensional affine jump-diffusion models with dependence mod-
elled using a copula. The proposed model is both analytically tractable and capable to
model the effect of economic regimes and dependence among the entities under study.
 STOCHASTICS 559

The proposed model is an amalgamation of the Markov regime-switching model by Dong

et al. [14] and the jump-diffusion intensity model by Ma and Kim [33].

3. The model description

3.1. Regime-switching framework
Consider a finite time horizon T > 0 and assume that the filtered probability space
(, F , Ft , P)0≤t≤T models the uncertainty in the economy. Let E denotes the expecta-
tion operator with respect to the risk neutral measure P. We assume that the state of the
economy is evolving over time according to a continuous-time homogeneous irreducible,
observable Markov chain X = {X(t), t ≥ 0} with a finite state space. Without loss of gen-
erality, assume that the state space of X is the set of unit vectors E = {e1 , e2 , . . . , eN }, ei =
(0, . . . , 0, 1, 0, . . . , 0)∗ ∈ RN , where ∗ denotes the transpose of a vector or a matrix. In other
words, the state of the economy or the business cycle can be in one of the N possible states.
Let the transition rates be given by

P(X(t + t) = j | X(t) = k) = λkj t + o(t), k = j

N
where λkj ≥ 0, k = j, j=1 λkj = 0. Let Q = [λkj ]j,k∈X denotes the infinitesimal generator
matrix of the Markov chain X. Let HX := {HX (t), t ≥ 0} be the natural filtration generated
by the Markov chain X. We have the following canonical semi-martingale decomposition
(adopted by Elliott et al. [46]) of the Markov chain
 t
X(t) = X(0) + Q∗ X(s) ds + L(t) (1)
0

where {L(t), t ≥ 0} is an RN valued, (HX , P)-martingale. AssumeN ·, · denotes the

Euclidean scalar product in R , i.e. for any x, y ∈ R , x, y = j=1 xj yj .
N N

3.2. The proposed Markov modulated bivariate process

Consider a bivariate real-valued Markov modulated doubly stochastic Poisson process
{(N (1) (t), N (2) (t)), t ≥ 0} with non-negative intensity processes assumed to be driven by
the following jump-diffusion process, for i = 1, 2,
⎛ ⎞
  (i)
M(t)
dλ(i) (t) = δ (i) (η(i) (t) − λ(i) (t)) dt + σ (i) (t) λ(i) (t) dW (i) (t) + d ⎝ Yj ⎠ (2)
j=1

where λ(i) (0) is the initial intensity at time t = 0, δ (i) is the constant mean-reverting rate
of the intensity process and η(i) (t) is the mean-reverting level and assumed to be depen-
dent on the state of the economy, i.e. η(i) (t) := η(i) (t, X(t)) = η(i) , X(t) with η(i) :=
(i) (i) (i) (i)
(η1 , η2 , . . . , ηN ), and ηj > 0 for each j = 1, 2, . . . , N. Here, W(i) := {W (i) (t), t ≥ 0}
denotes a standard Brownian motion and σ (i) (t) is the volatility of intensity diffusion and
is assumed to be driven by X(t), i.e. σ (i) (t) := σ (i) (t, X(t)) = σ (i) , X(t) where σ (i) :=
(i) (i) (i) (i)
(σ1 , σ2 , . . . , σN ) with σj > 0 for each j = 1, 2, . . . , N. The process {M(t), t ≥ 0}, is
560 A. GOEL AND A. MEHRA

assumed to be a Poisson process with intensity ρ(t) where ρ(t) := ρ(t, X(t)) = ρ, X(t)
with ρ := (ρ1 , ρ2 , . . . , ρN ) and ρj > 0 for each j = 1, 2, . . . , N. This process reflects the
jumps growing out of systematic events such as financial crisis, and affects the intensities
(i)
of both the processes. For i = 1, 2, the sequence of random variables {Yk }, k = 1, 2, . . .
represent the magnitudes of jumps in the ith intensity process due to the kth jump of the
(i)
process M(t). The random variables Yk are assumed to be i.i.d. with distribution function
F (i) (·). The dependence among the jump sizes in two intensity processes is modelled by
a time varying copula C(·, ·, θ(t)) where the parameter θ (t) of the copula is assumed to
be dependent on the state of the economy. We assume that θ (t) := θ (t, X(t)) = θ, X(t)
with θ := (θ1 , θ2 , . . . , θN ). More precisely, if X(t) = ej , then the dependence among the
jump sizes, i.e. (Yj(1) , Yj(2) ) are modelled by the copula C(·, ·, θj ).
We assume that {Yk(1) }k=1,2,... , {Yk(2) }k=1,2,... , {M(t), t ≥ 0}, {W (1) (t), t ≥ 0} and
{W (2) (t), t ≥ 0} are independent of each other. Furthermore, we assume {M(t), t ≥ 0} and
{X, t ≥ 0} do not jump at the same time. The compensator of the process {N (i) (t), t ≥
0}, i = 1, 2 is given by
 t
(i)

t = λ(i)
u du.
0
The infinitesimal generator1 of the process (λ(1) , λ(2) ,
(1) ,
(2) , t, X) using the copula C
is given by
Af (λ(1) , λ(2) ,
(1) ,
(2) , t, X)

∂f  (i) ∂f 
2 2
∂f
= + λ (i)
− δ (i) (λ(i) − η(i) (t)) (i)
∂t i=1
∂
i=1
∂λ


2
1 ∂ 2f
σ (i) (t)λ(i) (t) + f(λ(1) , λ(2) ,
(1) ,
(2) , t), Q∗ X
2
+
i=1
2 ∂λ(i) ∂λ(i)
 ∞ ∞

+ ρ(t) f (λ(1) + y1 , λ(2) + y2 ,

(1) ,
(2) , t, X)
0 0

− f (λ(1) , λ(2) ,
(1) ,
(2) , t, X) dC(F (1) (y1 ), F (2) (y2 ), θ (t)), (3)

where
f(λ(1) , λ(2) ,
(1) ,
(2) , t)
= (f (λ(1) , λ(2) ,
(1) ,
(2) , t, e1 ), . . . , f (λ(1) , λ(2) ,
(1) ,
(2) , t, en ))∗ .
The function f ∈ (A), the domain of the infinitesimal generator which consists of func-
tions f (λ1 , λ2 ,
1 ,
2 , t, X) such that it is differentiable with respect to each of the argument
λ1 , λ2 ,
1 ,
2 , t and X for their all possible values and satisfies the following conditions
 ∞  ∞


 ρ(t) f (λ(1) + y1 , λ(2) + y2 ,
(1) ,
(2) , t, X)

0 0
 

− f (λ , λ ,
,
, t, X) dC(F (y1 ), F (y2 ), θ (t)) < ∞.
(1) (2) (1) (2) (1) (2)
 STOCHASTICS 561

4. Distributional properties of the proposed model

In this section, we derive the main results of this article, i.e. joint Laplace transforms and
moments of the bivariate intensity process following the piecewise deterministic Markov
processes theory [10].

4.1. Joint laplace transform

In order to derive the joint Laplace transforms of (λ(1) , λ(2) ) and (
(1) ,
(2) ), we first find
the following expectation.

V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x)
(1) (T)−ξ
(2) (T)−Kλ(1) (T)−ψλ(2) (T)
= E(e−γ
| λ(1) (t), λ(2) (t), X(t) = x).

The following theorem leads to the key result of this paper, i.e. joint Laplace transform
of V.
Define the following variables

δ (1) + Kσj(1) − m(1)
2

m(1) + 2γ σj(1) , m(2) + 2ξ σj(2) , a(1)

2 2 j
= δ (1)2 = δ (2)2 = ,
j j j
δ (1) + Kσj(1) + m(1)
2
j
(2)2 (2)
δ (2) + ψσj − mj
a(2)
j =
(2)2 (2)
δ (2) + ψσj + mj

Theorem 4.1: Assuming some suitable integrability conditions, we have the following

V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x)
(1) (t)−ξ
(2) (t)−A (1) (t)−A (2) (t)
= e−γ
1 (t,T),xλ 2 (t,T),xλ (t, T)1, x, (4)

where

A1 (t, T) = (A1 (t, T, e1 ), A1 (t, T, e2 ), . . . , A1 (t, T, eN ))∗ ,

A2 (t, T) = (A2 (t, T, e1 ), A2 (t, T, e2 ), . . . , A2 (t, T, eN ))∗ ,

and for j = 1, 2, . . . , N, we have

(1)
(1) (1) mj (t−T) (1)
aj (δ (1) + mj ) e − (δ (1) − mj )
A1 (t, T, ej ) = (1)
(5)
mj (t−T)
σj(1) (1 − a(1)
2
j e )
(2)
mj (t−T)
a(2)
j (δ
(2) + m(2) ) e
j − (δ (2) − m(2)
j )
A2 (t, T, ej ) = (2)
(6)
(2)2 (2) mj (t−T)
σj (1 − aj e )

and (t, T) is a fundamental matrix of the following matrix-valued system of linear ODEs
d(t, T)
+ (t, T)(t, T) = 0, (T, T) = 1, (7)
dt
562 A. GOEL AND A. MEHRA

with (t, T) = Q + diag(G(t)) and 1 = (1, 1, . . . , 1)∗ . Here, diag(G(t)) represent a N × N

diagonal matrix whose jth diagonal entry, Gj (t) is given by

(1) (2)
Gj (t) = −δ (1) ηj A1 (t, T, ej ) − δ (2) ηj A2 (t, T, ej )
 ∞ ∞

+ ρj e−A1 (t,T,ej )y1 −A2 (t,T,ej )y2 − 1
0 0
(1)
× dC(F (y1 ), F (2) (y2 ), θi ), j = 1, . . . , N. (8)

Proof: Proof of the theorem is given in Appendix. 

Corollary 4.2: The joint Laplace transforms of the vectors (λ(1) (t), λ(2) (t)) and (
(1) (t),

(2) (t)) can easily be obtained by substituting ξ = γ = 0 in Theorem 4.1 and by substituting
K = ψ = 0 in Theorem 4.1, respectively. Therefore, we have

(1) (2)

E e−γ
(T)−ξ
(T) | λ(1) (t), λ(2) (t), X(t) = ej
(1) (t)−ξ
(2) (t)−Ã (1) (t)−Ã (2) (t)
= e−γ
1 (t,T,ej )λ 2 (t,T,ej )λ (t, T)1, x, (9)

where
(1)
mj (T−t)
2γ (e − 1) (1) (1)2
Ã1 (t, T, ej ) = = δ (1) + 2γ σj
2
(1)
, mj
(1) mj (T−t) (1)
(δ 1 + mj )(e − 1) + 2mj
(2)
mj (T−t)
2ξ(e − 1) (2) (2)2
Ã2 (t, T, ej ) = = δ (2) + 2ξ σj
2
(2)
, mj
mj (T−t)
(δ 2 + m(2)
j )(e − 1) + 2m(2)
j

Similarly,

(1) (2)

E e−Kλ (T)−ψλ (T) | λ(1) (t), λ(2) (t), X(t) = ej
(1) (t)−Ā (2) (t)
= e−Ā1 (t,T,ej )λ 2 (t,T,ej )λ (t, T)1, x, (10)

where
(1) (T−t)
2Kδ (1) e−δ
Ā1 (t, T, ej ) =
(1)2 (1) (T−t)
Kσj (1 − eδ ) + 2δ (1)
(2) (T−t)
2ψδ (2) e−δ
Ā2 (t, T, ej ) =
ψσj(2) (1 − eδ
2 (2) (T−t)
) + 2δ (2)

and (t, T) is a fundamental matrix of the following matrix-valued system of linear ODEs
given in Equation (7).
 STOCHASTICS 563

5. Moments, covariance and linear correlation

The marginal and the joint moments of λ(1) (t) and λ(2) (t) can be derived by differentiating
the Laplace transforms of λ(1) (t) and λ(2) (t), respectively. In this section, we derive the
first- and second-order moments of λ(1) (t) and λ(2) (t), thereby obtaining their marginal
expectation, joint expectation, variance and hence the correlation function.

Proposition 5.1 (Expectation): The conditional expectation of the process λ(1) (t) given
λ(1) (0) is given by

 (1)
E λ(1) (t) | λ(1) (0) = −e−δ t λ(1) (0) + φ1 (0, t), X(0), (11)

where
d((0, t)1)
φ1 (0, t) = lim .
K→0 dK
and the conditional expectation of the process λ(2) (t) given λ(2) (0) at time t = 0 is given by

 (2)
E λ(2) (t) | λ(2) (0) = −e−δ t λ(2) (0) + φ2 (0, t), X(0), (12)

where
d((0, t)1)
φ2 (0, t) = lim .
ψ→0 dψ

Proof: Setting ψ = 0 in (10), we have

(1)
 (1)
E e−Kλ (t) | λ(1) (0) = e−Ā1 (0,t,ej )λ (0) (0, t)1, x.

Differentiating with respect to K, we get

(1)

dE e−Kλ (t) | λ(1) (0) (1)
−4δ (1) e−δ t λ(1) (0)
2
(1)
= e−Ā1 (0,t,ej )λ (0)
dK (1) 2 (1)
(Kσj (1 − eδ (t) ) + 2δ (1) )2
 
−Ā1 (0,t,ej )λ(1) (0) d((0, t)1)
× (0, t)1, x + e , X(0)
dK
(1)
−4δ (1) e−δ t λ(1) (0)
2
(1)

= E e−Kλ (t) | λ(1) (0)
(Kσj(1) (1 − eδ (t) ) + 2δ (1) )2
2 (1)

 
−Ā1 (0,t,ej )λ(1) (0) d((0, t)1)
+e , X(0) .
dK
(1)
Taking K = 0, and observing that E(e−Kλ (t) | λ(1) (0)) = 1 when K = 0, we get the
requisite result.
Similarly, setting K = 0 in (10) and then differentiating the Laplace transform of λ(2) (t)
with respect to ψ at ψ = 0 yields the conditional expectation of λ(2) (t) given λ(2) (0)
in (12). 
564 A. GOEL AND A. MEHRA

Proposition 5.2 (Conditional joint expectation): The conditional joint expectation of

λ(1) (t) and λ(2) (t) given λ(1) (0) and λ(2) (0) is given by

 (1) (2) (1)
E λ(1) (t)λ(2) (t) | λ(1) (0), λ(2) (0) = e−(δ +δ )t λ(1) (0)λ(2) (0) − e−δ t λ(1) (0)
(2) t
× φ2 (0, t), X(0) − e−δ λ(2) (0)φ1 (0, t), X(0)
+ φ21 (0, t), X(0),

where
∂ 2 ((0, t)1)
φ21 (0, t) = lim .
ψ,K→0 ∂ψ∂K

Proof: From (10), we have

(1) (2)
 (1) (2)
E e−Kλ (t)−ψλ (t) | λ(1) (0), λ(2) (0) = e−Ā1 (0,t,ej )λ (0)−Ā2 (0,t,ej )λ (0) (0, t)1, x.

Differentiating first with respect to K and then with respect to ψ, we have

(1) (2)

∂ 2 E e−Kλ (t) e−ψλ (t) | λ(1) (0), λ(2) (0)
∂ψ∂K
(1)2 (1) t (2) t
e−δ λ(1) (0) −4δ (2) e−δ λ(2) (0)
2
−4δ
= ×
(1)2 (1) (t) (2)2 (2) (t)
(Kσj (1 − eδ ) + 2δ (1) )2 (ψσj (1 − eδ ) + 2δ (2) )2
(1) (0)−Ā (2) (0)
× e−Ā1 (0,t,ej )λ 2 (0,t,ej )λ (0, t)1, x
(1)2 −δ (1) t  
4δ e λ(1) (0) −Ā1 (0,t,ej )λ(1) (0)−Ā2 (0,t,ej )λ(2) (0) ∂((0, t)1)
− e ,x
(Kσj
(1)2
(1 − eδ
(1) (t)
) + 2δ (1) )2 ∂ψ
(2) t  
4δ (2) e−δ λ(2) (0)
2
−Ā1 (0,t,ej )λ(1) (0)−Ā2 (0,t,ej )λ(2) (0) ∂((0, t)1)
− e ,x
(ψσj
(2)2
(1 − eδ
(2) (t)
) + 2δ (2) )2 ∂K
 
(1) (0)−Ā (2) (0) ∂ 2 ((0, t)1)
+ e−Ā1 (0,t,ej )λ 2 (0,t,ej )λ ,x .
∂ψ∂K
Setting K = ψ = 0, we get the desired result. 

Proposition 5.3 (Variance): The conditional variance of the process λ(1) (t) given λ(1) (0) is
given by

Var(λ(1) (t) | λ(1) (0))

(1) t (1)2 (1) (t)
e−δ λ(1) (0)σj (1 − eδ )
= + φ11 (0, t)1, x − (φ1 (0, t)1, x)2 .
(2δ (1) )
where
∂ 2 ((0, t)1)
φ11 (0, t) = lim .
K→0 ∂K∂K
 STOCHASTICS 565

and the conditional variance of the process λ(2) (t) given λ(2) (0) is given by
(2) t (2)2 (2) (t)
(2) (2)
e−δ λ(2) (0)σj (1 − eδ )
Var(λ (t) | λ (0)) = + φ22 (0, t)1, x
(2δ (2) )
− (φ2 (0, t)1, x)2 . (13)
where
∂ 2 ((0, t)1)
φ22 (0, t) = lim .
ψ→0 ∂ψ∂ψ
Proof: Consider

(1)
 (1)
E e−Kλ (t) | λ(1) (0) = e−Ā1 (0,t,ej )λ (0) (0, t)1, x.

If we differentiate above Equation with respect to K twice, we get

(1)

E (λ(1) (t))2 e−Kλ (t) | λ(1) (0)
⎛ ⎞2
(1) 2 −δ (1) t (1)
−4δ e λ (0) ⎠ e−Ā1 (0,t,ej )λ(1) (0)
=⎝
(1)2 (1)
(Kσj (1 − eδ (t) ) + 2δ (1) )2
(1) t (1)2 (1) (t)
−4δ (1) e−δ λ(1) (0)σj (1 − eδ
2
)
× (0, t)1, x +
(1)2 (1) (t)
(Kσj (1 − eδ ) + 2δ (1) )3
(1)
× e−Ā1 (0,t,ej )λ (0) (0, t)1, x
⎛ ⎞
−4δ (1)2 e−δ (1) t λ(1) (0)
+ 2⎝ ⎠ e−Ā1 (0,t,ej )λ(1) (0)
(1)2 (1)
(Kσj (1 − eδ (t) ) + 2δ (1) )2
(1) (0)
× φ1 (0, t)1, x + e−Ā1 (0,t,ej )λ φ11 (0, t)1, x.
Setting K = 0 we have

 (1) (1) (1) 2

(1) 2 −2δ (1) t (1)2

(1)
e−δ t λ(1) (0)σj (1 − eδ (t) )
E (λ (t)) | λ (0) = e λ (0) +
(2δ (1) )
(1) t
− 2 e−δ λ(1) (0)φ1 (0, t)1, x + φ11 (0, t)1, x.
Using E((λ(1) (t)) | λ(1) (0)), we can get the desired result.
Similarly, we can find E((λ(2) (t))2 | λ(2) (0)) and hence the variance. 

Remark: We can easily obtain the correlation function using the conditional joint expec-
tation, marginal expectation and the variances as follows
Corr(λ(1) (t), λ(2) (t))
     
E λ(1) (t)λ(2) (t) | λ(1) (0), λ(2) (0) − E λ(1) (t) | λ(1) (0) E λ(1) (t) | λ(1) (0)
=      .
Var λ(1) (t) | λ(1) (0) Var λ(2) (t) | λ(2) (0)
566 A. GOEL AND A. MEHRA

6. Applications of the proposed model

In this section, we present the applications of the proposed model in the fields of credit risk
modelling and insurance modelling to obtain respectively the

(i) fair spread of a CDS with counterparty risk, and

(ii) surrender probability taking into account that the stochastic intensity driving the
decision of surrender is dependent on the interest rate.

We also carry out sensitivity analysis with respect to the model parameters. In the
numerical illustrations, we consider Farlie–Gumbel–Morgenstern (FGM). The FGM cop-
ula belongs to the family of Archimedean copula and have been widely used to study the
associations and efficiency of non-parametric procedures [42]. The FGM copula is defined
as follows

C(u, v) = uv + θ uv(1 − u)(1 − v), u, v ∈ [0, 1], θ ∈ [−1, 1].

Further, we assume that the marginal distribution functions are given by

F (1) (x) = 1 − e−αx , x > 0, α > 0

F (2) (y) = 1 − e−βy , y > 0, β > 0.

The resulting joint distribution is given by

F(x, y) = C(F (1) (x), F (2) (y))

= 1 − e−αx − e−βy + (1 + θ) e−αx−βy − θ e−αx−2βy − θ e−2α−βy
+ θ e−2αx−2βy .

In this article, our main focus is on developing a theoretical framework, the calibration
to the market data such as CDS spreads is in our future research basket. To calibrate the
parameters of the CIR intensity model, one approach could be using generating functions
as proposed in [36]. In this article, we just perform sensitivity analysis in order to gain
insights into role of various parameters without doing any calibration.

6.1. Pricing CDS with counterparty risk

A CDS is an agreement between two parties to provide an insurance against a default by
the third party also known as reference entity. The buyer of a CDS obtains the right to
sell the bond issued by the reference entity at its par value to the seller of CDS in case of
default by the reference entity. The buyer makes periodic payments to the seller to acquire
this right until the maturity of the contract or default by the reference party. However,
there is a possibility that the reference entity and the seller of CDS both default at the same
time. We shall be considering this scenario and capture the dependence between the default
intensities of the reference entity and CDS seller to obtain the fair spread of the CDS with
a counterparty risk.
Let T be the maturity time of CDS and t0 < t1 < · · · < tM = T be the premium pay-
ments date. Let R denotes the recovery rate and r be the risk free interest rate which is
 STOCHASTICS 567

assumed to be a constant in [0, T]. Assume that the default intensity processes of the ref-
erence entity λ(re) and CDS seller λ(s) follow the proposed bivariate Markov modulated
model. Further, λ(b) denotes the default intensity of the buyer and is assumed to follow one
dimension counterpart of the proposed Markov modulated model and is assumed to be
independent of the default intensities of the seller and reference entity.
Assume that e(re),(s) (0, tk−1 , tk ) denotes the present value (PV) of a deterministic payoff
of 1$ that is paid at the date tk if the reference entity defaults in (tk−1 , tk ] and the protection
seller survives upto tk . Then, it is given by

e(re),(s) (0, tk−1 , tk )

  t t   
t
−rtk − 0 k−1 λ(re) (u) du − 0 k λ(re) (u) du − 0 k λ(s) (u) du (re) (s)
=E e e −e e | λ (0), λ (0)

(re) (s) (s) (s)
= e−rtk E e−
(tk−1 )−
(tk−1 ) e−(
(tk )−
(tk−1 ))
(re) (s)

− e−
(tk )−
(tk ) | λ(re) (0), λ(s) (0) (14)
t t
where
(re) (t) = 0 λ(re) (u) du and
(s) (t) = 0 λ(s) (u) du. Therefore, the CDS premium
c obtained using the expressions for joint and marginal Laplace transforms is given by
M (re),(s)
k=1 e (0, tk−1 , tk )
c = (1 − R) 
.
M −rtk E e−
(b) (tk ) | λ(b) (0)
k=1 (tk − tk−1 ) e

Now, we illustrate the model to observe the effect of regime-switching framework. For
performing the sensitivity analysis and comparison, value of only one parameter is changed
at one time while the value of the other parameters are kept same as that in the base case
recorded in Table 1. In the table, we have used [a; b] to represent the values of parameters
where a, b represent the values of variable in regime 1 and regime 2, respectively. We show
the results for the parameters of reference entity. A similar behaviour can be observed with
respect to the parameters of the protection seller. We calculate the CDS premium assuming
the number of regimes to be 2 (i.e. N = 2). Table 2 gives the CDS premium with 1 year
maturity, one with regimes and the other without regime. It is observed that CDS premium
are robust with respect to the FGM copula parameter θ showing that the premium is not
susceptible to changes in value of θ. A notable difference is observed between the premiums
when N = 1 and N = 2, thereby indicating a considerable effect of regime-switching on
CDS pricing.

Table 1. Values of the parameters in the base case.

Parameters Values Parameters Values Parameters Values
λ(rc) (0) 0.5 λ(s) (0) 0.1 λ(b) (0) 0.02
δ (rc) 0.2 δ (s) 0.1 δ (b) 0.3
η(rc) (t) [0.5; 0.8] η(s) (t) [0.2; 0.6] η(b) (t) [0.06; 0.4]
σ (rc) (t) [0.2; 0.5] σ (s) (t) [0.1; 0.8] σ (b) (t) [0.02; 0.1]
α(t) [10; 5] β(t) [5; 10] γ (t) [15; 10]
ρ(t)  [2; 5]  θ(t) [0.1; 0.6] X(0) 1
−1 1
Q N 2
2 −2
568 A. GOEL AND A. MEHRA

Table 2. CDS Rates against θ in regime-switching

framework (N = 2) and no regime framework (N = 1).
θ N=1 N=2
−1 0.3591 0.3907
−0.5 0.3598 0.3909
0 0.3604 0.3911
0.5 0.3610 0.3914
1 0.3617 0.3916

Figure 1. CDS premium against mean reverting level and mean reverting rate of reference entity. (a)
CDS premium against mean reverting level η(rc) of reference entity and (b) CDS premium against mean
reverting rate δ (rc) of the reference entity.

Figure 1(a,b) present the variation of the CDS premium with respect to mean-reverting
level and mean reverting rate of reference entity, respectively. The CDS premium increases
with respect to increase in mean-reverting level but are almost robust with respect to the
mean-reverting rate. This behaviour is expected since increase in mean-reverting level
increases the probability of default.
Figure 2(a) gives the variation of CDS premium with respect to the volatility term
in the intensity process of reference entity. From Figure 2(b), we observe that increas-
ing the β results in an downward shift in the CDS premium. This is intuitive since
a higher value of β results in decreased jump size (since mean jump size is recipro-
cal of β) in the intensity of default of the reference entity hence decreases the occur-
rence of a default event. Similar behaviour is observed with respect to β in regime and
no-regime scenario, however, there is significant difference between the CDS premium
in regime and no-regime case thus confirming the importance of considering regime
framework.
From the above sensitivity analysis, we observe that the CDS premium has a diverse
dependence structure on the various parameters in the intensity process. CDS premi-
ums may be modestly monotonic or stable with respect to different parameters. Further,
we observe a significant difference in premiums in two cases namely regime-switching
framework and no-regime framework.
 STOCHASTICS 569

Figure 2. CDS premium against volatility and external jump size parameter of reference entity. (a)
CDS premium against volatility of the diffusion component in intensity of reference entity and (b) CDS
premium against parameter of external jump size β for reference entity.

6.2. Surrender modelling in life insurance

The Solvency II regulations, came into execution from 1st January 2016, laid down the cap-
ital requirements for insurance companies. Under Article 26 of this regulation, the dynamic
policy holder’s behaviour have to be considered by insurance undertakings to evaluate
the best estimate of liabilities (BEL). Recently, Russo et al. [37] considered intensity-based
models (Vasicek and Cox–Ingersoll–Ross) to derive the closed-form solution of the pol-
icyholder’s probability of surrendering the policy. They assumed that interest rates and
surrendering are dependent and the mortality rates are independent of interest rates and
surrendering. In this application, we follow the similar approach but in a regime-switching
framework to take into account the effect of various states of economy. For performing
the sensitivity analysis and comparison, the parameter values for the proposed bivariate
process are assumed to be same as that considered in the base case recorded in Table 1.
Suppose an insurance company holds a portfolio of endowment life insurance contracts
each starting at time T0 and maturity time T. We do not assume any other embedded
options in the contract like minimum guaranteed option or extended coverage option.
Assume that the policyholder pays a one time premium at time T0 to the insurer and
receives a fixed amount C̄ at maturity time if the insured is alive and continues to hold
the policy till maturity or receives the benefits of surrendering the policy before maturity
or otherwise the nominee receives the death benefits.
Let the interest rate r(t) and surrender intensity δ(t) follow the proposed bivariate
Markov modulated process. Let μx (t) denotes the stochastic force of mortality of an indi-
vidual aged x years, then the probability that an individual aged x dies in the time interval
(t, T) is given by
T
qx (t) = 1 − E(e− t μx (s) ds
).
We assume that the mortality rate μx (t) is independent of r(t) and δ(t). Let T0 = t1 <
t2 < · · · < tn = T be the n time points at which the payments are paid by insurer in case
of surrender or death of the policyholder. Let N(ti ) denote the number of contracts that are
in force and and C̄(ti ) denote the benefit amount to be paid by insurer at ti , i = 1, 2, . . . , n.
To evaluate the best estimate of liabilities, we need to project portfolio cash flows into the
570 A. GOEL AND A. MEHRA

Table 3. Best estimate of liabilities (values in Dollars).

Maturity (in years) model with regime-switching model without regime-switching
16 69248709.22 81923825.39
17 69248677.55 81923386.62
18 69248662.72 81923108.29
19 69248655.77 81922931.96
20 69248652.54 81922821.27

future. Clearly, we have the following

N(ti ) = N(ti−1 )[1 − qx (ti−1 , ti ) − g(ti−1 , ti )],

where g(ti−1 , ti ) is the probability to surrender the contract between ti−1 and ti and
qx (ti−1 , ti ) is the probability of death between ti−1 and ti . Therefore, using no-arbitrage
principle, BEL at time T0 is given by


n−1
 
BEL(T0 ) = P(T0 , ti ) C̄(ti )N(ti−1 )qx (ti−1 , ti ) + C̄(ti )N(ti−1 )g(ti−1 , ti )
i=1

+ P(T0 , tn )C̄(tn )N(tn )

where the dependence between the surrender intensity and interest rate is taken into
account while evaluating BEL and
 ti
− r(s) ds
P(T0 , ti ) = E(e T0 ).

Therefore, BEL can be obtained using the Laplace transforms of the proposed model.
Now, we implement the model to observe the effect of the regime-switching framework
to estimate BEL. The parameters considered in the base case are given similar to given in
Table 1 where the variables corresponding to reference entity and seller now corresponds
to the interest rate and surrender intensity. We assume a portfolio of endowment policies
composed by 1000 contracts that expire in T years. Each contract is related to individuals
aged 40 at the start date. The mortality rates are taken from the last column of Table 1 in
Russo et al. [37]. We consider the case in which the policyholder pays a single premium
with a fixed benefit amount C = 100,000$. The estimates of BEL are reported in Table 3. We
observe that a higher amount of reserves (BEL) is required in regime-switching framework.
Hence, we can conclude that the state of the economy affects the interest rates which in turn
affects the surrender rates and hence cash flows of the insurer.

7. Conclusions
This article proposes a bivariate doubly stochastic Poisson process in a Markov regime-
switching framework. The intensities of the two processes are assumed to follow a jump-
diffusion process with dependence among the jump sizes being modelled by FGM copula.
Few important distributional properties of the integrated intensity process such as joint
Laplace transform, expectation, variance, and correlation are derived following the mar-
tingale method. The proposed model is a generalization to various models in the literature
 STOCHASTICS 571

and is capable to address various problems in the field of credit risk and insurance. As an
application of the proposed model, the pricing of CDS with counterparty risk and obtain-
ing the best estimates of liabilities in life insurance are discussed. The future work could
be to study the calibration of the proposed model to the real data and hence analyzing its
application to various other directions.

Note
1. The infinitesimal generator A of a stochastic process Z(t) is defined by
E(f (Z(t + h), t + h)) − f (Z, t)
Af (Z, t) = lim ,
h→0 h
where f ∈ (A), the domain of the infinitesimal generator.

Disclosure statement
No potential conflict of interest was reported by the author(s).

ORCID
Anubha Goel http://orcid.org/0000-0002-2211-4936

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Appendix
Proof of Theorem 4.1: Write

V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x) = (V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, e1 ), . . . ,
V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, en ))∗ .
Hence,
(V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x) = V(λ(1) , λ(2) ,
(1) ,
(2) , t, T), x.
Considering the affine nature of the processes λ(1) and λ(2) , assume the following exponential affine
form
(1) (T)−ξ
(2) (T)−A (1) −A (2)
V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x) = e−γ
1 (t,T,x)λ 2 (t,T,x)λ D(t, T, x) (A1)
with terminal conditions A1 (T, T, x) = 1, K, A2 (T, T, x) = 1, ψ and D(T, T, x) = 1, x. Note
that the function V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x) is continuously differentiable with respect to t. Fur-
ther, we observe that V is twice continuously differentiable with respect to the variables λ(1) and λ(2) .
Write
A1 (t, T) = (A1 (t, T, e1 ), A1 (t, T, e2 ), . . . , A1 (t, T, eN ))∗ ,
A2 (t, T) = (A2 (t, T, e1 ), A2 (t, T, e2 ), . . . , A2 (t, T, eN ))∗ ,
D(t, T) = (D(t, T, e1 ), D(t, T, e2 ), . . . , D(t, T, en ))∗ .
Then, A1 (t, T, x) = A1 (t, T), x, A2 (t, T, x) = A2 (t, T), x, D(t, T, x) = D(t, T), x. Therefore,
applying infinitesimal generator given in Equation (3) to the function f = V(λ(1) , λ(2) ,
(1) ,
(2) , t,
T, x) given in Equation (A1), we have
 
dA1 (t, T, x) (1) dA2 (t, T, x) (2) 1 dD(t, T, x)
0= − λ − λ + V − γ λ(1) V − ξ λ(2) V
dt dt D dt
2

   2
1 (i)2
− δ (i) (η(i) (t) − λ(i) ) Ai (t, T, x)V + σ (t)λ(i) (t)A2i (t, T, x)V
2
i=1 i=1
 ∞ ∞

V
+ QD(t, T), x + V ρ(t) e−A1 (t,T,x)y1 −A2 (t,T,x)y2 − 1
D(t, T) 0 0

× dC(F (1) (y1 ), F (2) (y2 ), θ(t))

which can further be written as
 2
dD(t, T, x) 
0= + D(t, T, x) − δ (i) Ai (t, T, x)η(i) , x
dt
i=1
 
(1) dA1 (t, T, x) (1) 1 2 (1) 2
+λ − + δ A1 (t, T, x) − γ + A1 (t, T, x)σ , x
dt 2
574 A. GOEL AND A. MEHRA

 
dA2 (t, T, x) 1
+ λ(2) − + δ (2) A2 (t, T, x) − ξ + A22 (t, T, x)σ (2) , x2
dt 2
 ∞ ∞


−A1 (t,T,x)y1 −A2 (t,T,x)y2 (1) (2)
+ e − 1 ρ, x dC(F (y1 ), F (y2 ), θ(t)), x
0 0

+ QD(t, T), x.

Since the above equation is true for any value of λ(1) , λ(2) and x = ej , j = 1, 2, . . . , N, therefore the
coefficients of λ(1) , λ(2) and x must vanish. Hence, we have the following set of equations for j =
1, 2, . . . , N,
dA1 (t, T, ej ) 1
+ δ (1) A1 (t, T, ej ) − γ + A21 (t, T, ej )σj(1) = 0,
2
− A1 (T, T, ej ) = K (A2)
dt 2
dA2 (t, T, ej ) 1 (2)2
− + δ (2) A2 (t, T, ej ) − ξ + A22 (t, T, ej )σj = 0, A2 (T, T, ej ) = ψ (A3)
dt 2
and
 2
dD(t, T), x 
0= + D(t, T), x − δ (i) Ai (t, T), xη(i) , x
dt i=1
 
∞ ∞

−A1 (t,T),xy1 −A2 (t,T),xy2 (1) (2)
+ ρ, x e − 1 dC(F (y1 ), F (y2 ), θ(t)), x
0 0

+ QD(t, T), x, D(t, T) = 1 (A4)

which can further be written as
dD(t, T)
+ (t, T)D(t, T) = 0, D(T, T) = 1,
dt
where (t, T) = Q + diag(G(t)). Here diag(G(t)) is a N × N diagonal matrix with jth diagonal
entries Gj (t) given in Equation (8). It is easy to see that Equations (A2) and (A3) are actually Riccati
equations, which can be easily solved. The solutions are respectively given by (5) and (6). For solution
of Equation (A4), let (t, T) denotes the fundamental matrix of the following matrix-valued linear
ODEs:
d(t, T)
+ (t, T)(t, T) = 0, (T, T) = 1, (A5)
dt
Since (t, T) is continuous, we have a unique solution of the system of ODEs (A5) on [0, T]. Then,
D(t, T) = (t, T)1
and we have D(t, T, x) = (t, T)1, x.
Since the unknowns in V(λ(1) , λ(2) ,
(1) ,
(2) , t, T, x) are obtained by AV = 0, therefore, by
property of the infinitesimal generator, it is a martingale. In other words,
(1) (T)−ξ
(2) (T)−A (1) (T)−A (2) (T)
E(e−γ
1 (T,T,X(T))λ 2 (T,T,X(T))λ D(T, T, X(T)) | λ(1) (t), λ(2) (t), X(t) = x)
(1) (t)−ξ
(2) (t)−A (1) (t)−A (2) (t)
= e−γ
1 (t,T,x)λ 2 (t,T,x)λ D(t, T, x)
and hence the result in Equation (4) follows.