Optimal (Re)insurance Contract Design

Part II: CVaR Minimization and Extentions

C HENGGUO W ENG

Department of Statistics and Actuarial Science

University of Waterloo

READI Research Workshop - Module 2

Feb 22, 2019

C. Weng (c2weng@uwaterloo.ca) – p. 1/20

 Outline

• Section II-1. Optimal Quota-Share and Stop-Loss Reinsurance

• Section II-2. General Optimal Reinsurance under CVaR

Minimization

• Section II-3. Optimal Reinsurance under Expectile

• Section II-3. Empirical Reinsurance Models

C. Weng (c2weng@uwaterloo.ca) – p. 2/20

 • Section II-1.
Optimal Quota-Share and
Stop-Loss Reinsurance

C. Weng (c2weng@uwaterloo.ca) – p. 3/20

 Section II-1. Optimal Reinsurance with Expectile
Optimal Quota-Share and Stop-Loss Reinsurance
• Objective:
 Analyze optimal reinsurance for two most common reinsurance contracts:
4 quota-share and stop-loss
 As many as seventeen reinsurance premium principles are investigated.
• Problems Formulation:
Criterion Optimal Quota-Share Optimal Stop-Loss
n o n o
VaR-opt: min VaRα (TIqs ; c) min VaRα (TIsl ; d)
c∈[0,1] d∈[0,∞)
n o n o
CTE-opt: min CTEα (TIqs ; c) min CTEα (TIsl ; d)
c∈[0,1] d∈[0,∞)

 Reduces to one-parameter minimization problem.

C. Weng (c2weng@uwaterloo.ca) – p. 4/20

 Section II-1. Optimal Reinsurance with Expectile
Optimal Quota-Share and Stop-Loss Reinsurance (Con’t)
• Main Results:

 For some cases, we formally establish the sufficient and necessary (or just
sufficient) conditions for the existence of the nontrivial optimal reinsurance.

 Highlights the critical role of the reinsurance premium principles

4 depending on the chosen premium principles, optimal quota-share and
stop-loss reinsurance may or may not exist.

C. Weng (c2weng@uwaterloo.ca) – p. 5/20

 • Section II-2.
General Optimal Reinsurance
under CVaR Minimization

C. Weng (c2weng@uwaterloo.ca) – p. 6/20

 Section II-2. General Optimal Reinsurance under CVaR Minimization
Unbinding constraint
• Objective:
 Analyze the optimality of the general reinsurance, rather than restricting to a
special class of the ceded loss functions.
• Problems
 Formulation:  

 min CTEα (Tf ) = CTEα X − f (X) + (1 + θ)E[f (X)]
 f

′
(P0 ) s.t. 0 ≤ f (x) ≤ x for x ≥ 0



 0 ≤ (1 + θ)E[f (X)] ≤ π.

• Assume E[X 2 ] < ∞. Thus, we only need to focus on space

L2 := L2 ([0, ∞), B([0, ∞)), Pr), and formulate the model as follows:
  
 min CTEα (Tf ) = CTEα X − f (X) + (1 + θ)E[f (X)]
(P0 ) f
 s.t. f ∈ Q ≡ Q ∩ Q .
f π

 Qf := {f ∈ L2 : 0 ≤ f (x) ≤ x for x ≥ 0}.

 Qπ := {f ∈ L2 : 0 ≤ (1 + θ)E[f (X)] ≤ π}.

C. Weng (c2weng@uwaterloo.ca) – p. 7/20

 Section II-2. General Optimal Reinsurance under CVaR Minimization
Mathematical Technique
• Given α ∈ (0, 1), define the mapping Gα (ξ, f ) : R × L2 7→ R s.t.
 
1 
Gα (ξ, f ) = ξ + E X − f (X) + (1 + θ)E[f (X)] − ξ .
1−α +

• Applying Rockafellar and Uryasev (2002) yields:

(ξ ∗ , f ∗ ) ∈ arg min(ξ,f )∈R×Q Gα (ξ, f )

if and only if
f ∗ ∈ arg minf ∈Q CTEα (Tf ), ξ ∗ ∈ arg minξ∈R Gα (ξ, f ∗ ).

• (P0 ) can be reformulated as:

   
min Gα (ξ, f ) = ξ + α1 E X − f + (1 + θ)E[f ] − ξ


(PT ) (ξ,f )∈R×Qf +

f ∈ Qπ .

 s.t.

C. Weng (c2weng@uwaterloo.ca) – p. 8/20

 Section II-2. General Optimal Reinsurance under CVaR Minimization
Unbinding Constraint: Main Results
• Assumption: α(1 + θ) ≤ 1
 
1
• Notation: dα = inf{d : Pr[X > d] ≤ α}, dθ = inf d : Pr[X > d] ≤
1+θ
• Solutions are discussed in the following three cases:
 case 1: π ≤ πα , where πα ≡ (1 + θ)E[(X − dα )+ ]
4 a class of solutions are identified, including the stop-loss.
 case 2: πα ≤ π ≤ πθ , where πθ ≡ (1 + θ)E[(X − dθ )+ ]
4 the stop-loss reinsurance f ∗ = (x − d∗ )+ s.t. (1 + θ)E[f ∗ ] = π is optimal.
 case 3: πθ ≤ π .
4 the stop-loss reinsurance f ∗ = (x − dθ )+ s.t. (1 + θ)E[f ∗ ] = πθ is optimal.
• If X were a continuous random variable, then stop-loss reinsurance
f ∗ = (x − d∗ )+ s.t. (1 + θ)E[f ∗ ] = min{π, πθ } is optimal

C. Weng (c2weng@uwaterloo.ca) – p. 9/20

 Binding constraint
• Objective:
 Analyze the efficient frontier of the reinsurance selection.
• Problems
 Formulation:  

 min CTEα (Tf ) = CTEα X − f (X) + (1 + θ)E[f (X)]
 f ∈L2

(Q0 ) s.t. 0 ≤ f (x) ≤ x for x ≥ 0



 (1 + θ)E[f (X)] = π.

 the insurer’s net risk of insuring risk X: Γ(f ) = Tf − p0

 the expected profit for the insurer:
b(f ) = −E[Γ(f ∗ )] = p0 − E[X] − θ E[f ].

 frontier:
n  o
CTEα (Γ(fπ∗ )), b(fπ∗ ) : π ∈ (0, πX ) ,

where πX = (1 + θ)E[X] and fπ∗ denotes the solution corresponding to the

binding premium budget π ∈ (0, πX ).

C. Weng (c2weng@uwaterloo.ca) – p. 10/20

 Binding Constraint: Efficient Frontier
• Solution to Q0 :
stop-loss reinsurance f ∗ = (X − d∗ )+ with (1 + θ)E[f ∗ ] = π.
• An example: 100

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C. Weng (c2weng@uwaterloo.ca) – p. 11/20

Figure 1: Risk reward under optimal reinsurance arrangement

 • Section II-3.
Optimal Reinsurance under
Expectile

C. Weng (c2weng@uwaterloo.ca) – p. 12/20

 Section II-3. Optimal Reinsurance with Expectile
Model Setup

• Recall the insurer’s total risk: Tf (X) = Rf (X) + Π(f (X)), where
Rf (X) = X − f (X).

• We adopt a risk margin evaluation framework:

 
Risk margin = δ × ϕ Tf (X) − E[Tf (X)] , (1)

where δ > 0 is a constant and ϕ is a risk measure used to quantify the gap between
the total risk exposure Tf (X) and its actuarial reserve E[Tf (X)].

• The liability of the insurer:

 
Lf (X) = E[Tf (X)] + δ × E Tf (X) − E[Tf (X)]; α (2)

C. Weng (c2weng@uwaterloo.ca) – p. 13/20

 Section II-3. Optimal Reinsurance with Expectile
Model Setup

• The liability of the insurer:

 
Lf (X) = E[Tf (X)] + δ × E Tf (X) − E[Tf (X)]; α (3)

• The optimal reinsurance model:


 min Lf (X),
f ∈F
(4)
 s.t. Π(f (X)) ≤ π,

where

F = {0 ≤ f (x) ≤ x : both Rf (x) and f (x) are increasing in x} . (5)

C. Weng (c2weng@uwaterloo.ca) – p. 14/20

 Section II-3. Optimal Reinsurance with Expectile
Model Setup

• Consider premium principles satisfying the following three conditions:

 C1 (Law invariance): Π(Y ) depends only on the distributional law FY (·) of Y ;

 C2 (Risk loading property): Π(Y ) ≥ E[Y ] for any loss random variable Y ;

 C3 (Preserving the convex order): Π(Y ) ≤ Π(Z) for any loss random variables
Y and Z with Y ≤cx Z, i.e. E[h(Y )] ≤ E[h(Z)] for all convex function h, for
which the corresponding expectations exist.

• P = {Premium principle Π : Π satisfies the conditions C1, C2 and C3}.

 The class P is a rather general class of premium principles. It includes the
expected value principle, Wang’s principle, the Dutch principle, the standard
deviation principle, among many others.

C. Weng (c2weng@uwaterloo.ca) – p. 15/20

 Section II-3. Optimal Reinsurance with Expectile
Optimal Solution
• For 0 ≤ a ≤ b ≤ m ≤ ∞, we define a two-layer function h(x) for x ≥ 0 as

h(x) = ha,b,m (x) = x − (x − a)+ + (x − b)+ − (x − m)+ (6)




 x, for 0 ≤ x < a,

for a ≤ x < b,

 a,
=


 x − (b − a), for b ≤ x < m,


 m − (b − a), for x ≥ m.

• We will show in Theorem 3.1 that a two-layer ceded loss function of form
ha,b,m (x) solves problem (4). To do so, we consider condition
  
Rha,b,m (X) − ER
 
E (X − m)+ = E ha,b,m (7)
+

with ERha,b,m denoting the α-expectile of Rha,b,m (X) = X − ha,b,m (X), and
define
n o
F0 = ha,b,m : 0 ≤ a ≤ b = a + ER ha,b,m ≤ m ≤ ∞ and m satisfies (7) . (8)
C. Weng (c2weng@uwaterloo.ca) – p. 16/20
 Section II-3. Optimal Reinsurance with Expectile
Optimal Solution
• For a given premium principle Π ∈ P and reinsurance premium budget π > 0,
denote

G = {f ∈ F : Π(f (X)) ≤ π} , (9)

and G0 = {f ∈ F0 : Π(f (X)) ≤ π} , where F and F0 are defined in (5) and (8),
respectively.
• Theorem 3.1 For any premium principle Π ∈ P and reinsurance premium budget
π > 0,

min Lf (X) = min Lha,b,m (X).

f ∈G ha,b,m ∈G0

C. Weng (c2weng@uwaterloo.ca) – p. 17/20

 Section II-3. Optimal Reinsurance with Expectile
Optimal Solution
• Basic idea behind the proof:
 The optimal reinsurance model: minf ∈F Lf (X), s.t. Π(f (X)) ≤ π.
 Recall Tf (X) = Rf (X) + Π(f (X)) with Rf (X) = X − f (X). Thus,

Tf (X) − E [Tf (X)] = Rf (X) − E[Rf (X)]

and  
Lf (X) = E[Tf (X)] + δ × E Tf (X) − E[Tf (X)]; α
 
= E[Rf (X)] + Π(f (X)) + δ × E Rf (X) − E[Rf (X)]; α

 Idea: Given a ceded loss function f ∈ F, we construct a function ha,b,m of the

form (6) such that the value of the blue part remains the same and the red part
becomes smaller, heavily relied on the following lemma:
Lemma 3.1 Consider two real-valued functions f1 and f2 defined on R with
E[f1 (Y )] = E[f2 (Y )]. Then, f2 (Y ) ≤cx f1 (Y ) whenever f1 up-crosses f2 .

4 f1 is said to up-cross f2 at x0 ∈ R if f1 (x) ≤ f2 (x) for x < x0 and

f1 (x) ≥ f2 (x) for x > x0 .
C. Weng (c2weng@uwaterloo.ca) – p. 18/20
 Section II-3. Optimal Reinsurance with Expectile
Optimal Solution

• Furthermore, with an additional mild condition on the premium principle Π, we

will show that a one-layer reinsurance is optimal for problem (4).

• Define a one-layer ceded loss function Id,m (x) for x ≥ 0 with parameters
0 ≤ d ≤ m ≤ ∞ as

 0, for 0 ≤ x < d,


Id,m (x) = (x − d)+ − (x − m)+ = x − d, for d ≤ x < m, (10)


m − d, for x ≥ m,


and denote
n o
F1 = Id,m ∈ F0 : 0 ≤ ER
Id,m =d≤m≤∞ . (11)

C. Weng (c2weng@uwaterloo.ca) – p. 19/20

 Section II-3. Optimal Reinsurance with Expectile

• Theorem 3.2 If Π ∈ P satisfies the translation invariance property or if Π is the

expected value principle, then

min Lf (X) = min LId,m (X),

f ∈G Id,m ∈G1

where G is given in (9), and G1 = {f ∈ F1 : Π(f (X)) ≤ π} with F1 defined in

(11).

• We recall that a premium principle Π is said to satisfy the translation invariance

property if it satisfies Π(Y + c) = Π(Y ) + c for any loss random variable Y and
constant c.

C. Weng (c2weng@uwaterloo.ca) – p. 20/20