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Risk-Adjusted Return

for

Insurance Based Models

Tatiana Solcà

ETH Zürich under the supervision of

Prof. Dr. P. Embrechts and Dr. U. Schmock

Spring 2000

Ai miei genitori:

per avermi dato la possibilita’

di raggiungere questo traguardo.

Acknowledgements

to work in this very interesting field.

I am very grateful to Dr. Uwe Schmock for his helpful suggestions and sup-

port. He always managed to find time to discuss problems related to my

work.

Next I would like to thank Francesco for his encouragement, constant support

and patience.

Let me finally thank all my friends and schoolmates for their advice and all-

round help during this work. In particular, I thank Nicola for his pleasant and

constructive “pineletters” and “talks” from Paris, Giacomo and Andrea for

answering my tedious questions concerning LATEX and Carlo for the pleasant

time spent working in the computer room.

v

Contents

Acknowledgements v

1 Introduction 1

2 Preliminaries 3

2.1 Risk and Risk Measures . . . . . . . . . . . . . . . . . . . . . 3

2.1.1 Notation and properties . . . . . . . . . . . . . . . . . 3

2.1.2 The tail conditional expectation . . . . . . . . . . . . . 4

2.2 Convergence of random variables . . . . . . . . . . . . . . . . 5

2.3 Stationary process and ergodic theorem . . . . . . . . . . . . . 6

2.4 Properties of weak convergence . . . . . . . . . . . . . . . . . 8

2.5 The model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2.5.1 The idea and the notation . . . . . . . . . . . . . . . . 9

2.5.2 The different variants of the model . . . . . . . . . . . 11

3 Expected shortfall 13

3.1 The asymptotical limit of upper bounds . . . . . . . . . . . . 15

3.2 The n-dimensional model . . . . . . . . . . . . . . . . . . . . . 24

3.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

4 Standard deviation 33

4.1 The simplest cases: n = 1 and n = 2 . . . . . . . . . . . . . . 34

4.2 The general case . . . . . . . . . . . . . . . . . . . . . . . . . 42

4.3 The second variant of the model . . . . . . . . . . . . . . . . . 43

4.4 The third variant of the model . . . . . . . . . . . . . . . . . . 49

5 Capital allocation 53

5.1 Covariance principle . . . . . . . . . . . . . . . . . . . . . . . 53

5.2 Expected-shortfall principle . . . . . . . . . . . . . . . . . . . 60

vii

viii CONTENTS

Chapter 1

Introduction

actuarial techniques for measuring risk and for assessing profitable areas of

business. Its management is faced continually with the task of reconciling

the conflicting interests of policyholders and shareholders. The former are

interested in strong financial strength, while the latter are more concerned

with a return on equity that is commensurate with the risk inherent in their

investment. In order to satisfy these needs, the management selects profitable

business and limits the company’s risk.

Obviously, an insurance company’s liabilities cannot be entirely foreseen.

If companies are to maintain a high degree of financial security, they must

efficiently manage asset and liability portfolios, as well as understand and

keep control of the underlying risks.

One difficulty is that an insurance company faces many different types of

risk, and they are not at all easy to model. For a thorough understanding of

them it is essential to have quantitative models, but even though there are

many different measures of risk, up to today, none of them can be considered

the “best”.

In this paper, we focus on the kinds of risks which can be represented

by random variables. In particular, we analyze a model denoting the risk

portfolio of an insurance company. We suppose that the management steers

the company by choosing the numbers of independent risks so as to improve

the overall expected risk-adjusted return, defined as the expected return

divided by the assigned risk capital.

In other words, with respect to the defined model, we try to determine if

an optimal portfolio exists. For these purposes, we organized this paper in

four parts.

In Chapter 2, we first develop some approaches to measuring risk by con-

sidering the statement of axioms on a risk measure done by Artzner et al.,

1

2 CHAPTER 1. INTRODUCTION

introduce some basic concepts of probability theory (like convergence of ran-

dom variables and ergodic theorem), which will be seen to be useful for our

purpose.

Then, in Section 2.5, we give a description of the model considered in this

whole work and we indicate which methods will be used to measure risk. In

more detail, we suppose that the whole profit R of an insurance company

consisting of n units can be denoted by the sum of the stochastic gains Ri

of every unit i ∈ {1, . . . , n}. Ri is defined as the revenues minus the costs

and the losses in the form illustrated in (2.3). Then we will analyze this

model using the expected shortfall risk measure, the coherent risk measure

suggested by Artzner et al. (1998) and, later, by means of the standard

deviation risk measure, which is very popular in practice.

In Chapter 3 we discuss the model using the expected shortfall for quan-

tifying risk. We will estimate the performance of the company examining

the expected risk-adjusted return r, i.e., r = E[R]/ρ(R), where ρ denotes

the risk measure. In fact, the company’s aim will be to invest its resources

optimally and maximize r. We therefore will try to determine an optimal

portfolio by choosing the values of N1 , . . . , Nn , which denote the number of

contracts of the respective business units 1, . . . , n, such that a maximum for

r is attained. In particular, we focus on a proposition which shows the exis-

tence of the limit of the upper bounds for the expected risk-adjusted return

r.

In Chapter 4 we repeat the same approaches using the standard deviation

risk measure. In this case we concentrate on the optimization problem defined

in (4.2), i.e., we will try to determine the optimal number of contracts of every

unit i ∈ {1, . . . , n} in order to maximize E[R]/C subject to the constraint

ρ(R) ≤ C, where C denotes the capital the company wants to invest. We

will examine three different variants of the model defined in Section 2.5 and

we will show that this optimization problem has a solution for every variant.

In Chapter 5 we consider two different capital allocation principles, name-

ly the covariance principle and the expected shortfall principle. We will

calculate the covariance principle for ̺(R) = −E[R] + κ σ(R) with κ > 0,

and for two variants of the model R considered in Chapter 4. Moreover, for

simplicity we consider a company consisting only of two units, but the same

results can be computed in a similar way for the general case, too, and we

calculate E[Ri | R ≤ c] for the multivariate normal case.

In the Appendix we briefly recall some useful technical rules to calculate

the expected shortfall.

Chapter 2

Preliminaries

It is not easy to define risk, and we will avoid attempting to give an exact

definition. Nevertheless in a recent paper, Artzner et al. (1998) have come

up with an appropriate description of what risk actually is. In this paper,

we consider risk related to the variability of the future value of a position

due to uncertain events. Therefore, we treat those kinds of risks which can

be represented by random variables, and which indicate the possible future

values of positions.

Let Ω be the set of possible states of nature, and assume it is finite. By

a random variable X we denote the final net worth of a position for each

element of Ω. Let G be the set of all risk, i.e., the set of all real valued

functions on Ω. Remark that G can be identified with Rn , where n = card(Ω).

Then the real number ρ(X) can be interpreted, when positive, as the

minimum extra cash to add to the risky position X, or when negative, as the

cash amount that can be subtracted from the position.

We now consider some properties for a risk measure ρ defined on G listed

in the form of axioms.

For all X ∈ G and all real numbers α: ρ(X + αr) = ρ(X) − α,

where r is the rate of return on a reference riskless investment.

3

4 CHAPTER 2. PRELIMINARIES

Axiom (Subadditivity).

For all X1 , X2 ∈ G: ρ(X1 + X2 ) ≤ ρ(X1 ) + ρ(X2 ).

Axiom (Positive homogeneity).

For all λ ≥ 0 and all X ∈ G: ρ(λX) = λρ(X).

Axiom (Monotonicity).

For all X and Y ∈ G with X ≤ Y : ρ(Y ) ≤ ρ(X).

Axiom (Relevance).

For all X ∈ G with X ≤ 0 and X = 0: ρ(X) ≥ 0.

Remarks.

• Translation invariance means that adding (resp. subtracting) the sure

initial amount α to (from) the initial position, and investing it in the

reference instrument (with rate of return r) the risk measure only de-

creases (resp. increases) by α.

• Subadditivity reflects the diversification of portfolios and ensures that

the risk measure behaves reasonably when adding two positions; we

can say: “a merger does not create extra risk”.

sets, but we won’t treat this topic (for more details see Artzner et al. (1998)).

We are interested in the following definition then we argue that any risk

measure which is to be used to effectively regulate or manage risks satisfies

these axioms.

Definition 2.2. A risk measure satisfying the four axioms of translation

invariance, subadditivity, positive homogeneity and monotonicity is called

coherent.

In their paper Artzner et al. suggest a specific coherent measure called

tail conditional expectation and in the following chapter we will study the

model of a portfolio using this risk measure.

risk

In practice there are various methods of measuring risk, and these axioms

are not restrictive enough to specify a unique risk measure. The choice of

precisely which measure to use should be made on the basis of additional

considerations.

2.2. CONVERGENCE OF RANDOM VARIABLES 5

which, under some assumptions, is the least expensive among those which

are coherent and accepted by regulators 1 since they are more conservative

than the value-at-risk measurement. Managers and regulators are primarily

interested in setting “minimal requirements” or a maximal limit on the po-

tential losses. With a shortfall approach, one can answer the question “how

bad is bad?” by measuring the negative of the average future net worth X

of a position, given that X is below the quantile c ≤ 0, i.e.,

In the following sections we will focus on definitions and theorems, which

will be useful later for our purposes.

Definition 2.3. Let X1 , X2 , . . . and X be real-valued random variables on

some probability space (Ω, F, P ). We say:

n→∞

r

ii) {Xn }n∈N converges to X in r-th mean (−→) for r > 0 if

n→∞

E | Xnr | < ∞ for all n and E( | Xn − X | r ) −−→ 0,

P

iii) {Xn }n∈N converges to X in probability (−→) if for every ε > 0

n→∞

P ( | Xn − X | > ε) −−→ 0 .

D

iv) {Xn }n∈N converges to X in distribution (−→) if

n→∞

P (Xn ≤ x) −−→ P (X ≤ x)

1

A regulator is a supervisor who takes into account the unfavorable states when allowing

a risky position.

6 CHAPTER 2. PRELIMINARIES

a.s. P D

i) Xn −→ X =⇒ Xn −→ X =⇒ Xn −→ X ,

r P D

ii) Xn −→ X =⇒ Xn −→ X =⇒ Xn −→ X.

Theorem 2.4 (Lebesgue bounded convergence theorem). Consider a

a.s.

sequence {Xn }n∈N of variables with Xn −→ X. If there is a random variable

Y such that E | Y | < ∞ and | Xn | ≤ Y for all n, then

n→∞

E[Xn ] −−→ E[X] .

Remark. It is appropriate to specify that by the convergence in r-th mean

the values r = 1 and r = 2 are of most use. Therefore, in these cases, we

write, respectively

1

i) Xn −→ X in mean, instead of Xn −→ X,

2

ii) Xn −→ X in mean square, instead of Xn −→ X.

Definition 2.5. A real-valued process X1 , X2 , . . . is called stationary if for

every x1 , . . . , xn ∈ R and integer k > 0

Definition 2.6. A transformation T : Ω → Ω will be called measurable if

for all A ∈ F: T −1 (A) = {ω ∈ Ω | T (ω) ∈ A} ∈ F.

Definition 2.7. A measurable transformation T : Ω → Ω will be called

measure-preserving if for all A ∈ F: P (T −1 (A)) = P (A).

Let T be a measure-preserving transformation on (Ω, F, P ).

Definition 2.8. A set A ∈ F is called invariant if T −1 (A) = A.

We denote by J the set of all invariant A ∈ F. Note that J is a σ-field.

2.3. STATIONARY PROCESS AND ERGODIC THEOREM 7

formation on (Ω, F, P ). Then for any random variable X such that E|X| <

∞:

n−1

1

lim X(T k (ω)) = E[X | J ] a.s. and in mean.

n→∞ n

k=0

on (Ω, F, P ). Then for any random variable X such that E|X| < ∞:

n−1

1

lim X(T k (ω)) = E[X] a.s. and in mean.

n→∞ n

k=0

can be applied to the original stationary process X1 , X2 , . . . by considering a

shift transformation T , i.e., if x = (x0 , x1 , . . . ) is a real sequence of values of

the stationary process then T x = (x1 , x2 , . . . ). For more details see Grimmet

and Stirzaker (1992). The corresponding form of the ergodic theorem for

stationary processes is:

X2 , . . . be a stationary process such that E|X1 | < ∞, then

n

1

lim Xk = E[X|J ] a.s. and in mean.

n→∞ n

k=1

the corresponding version of the ergodic theorem.

A stationary process is said to be ergodic if P {(X0 , X1 , . . . ) ∈ A} = 0 or 1,

whenever A is shift-invariant, i.e., A is invariant with respect to the shift-

operator T .

8 CHAPTER 2. PRELIMINARIES

Remark. Let {Xn }n∈N0 be a real-valued stationary process. Then the follow-

ing conditions are equivalent:

(c) limn→∞ n1 nj=1 φ(Xj , Xj+1 , . . . ) = E[φ(X0 , X1 , . . . )], for every measur-

able function φ of real sequences, provided the expectation exists,

(d) limn→∞ n1 nj=1 φ(Xj , . . . , Xj+k ) = E[φ(X0 , . . . , Xk )], for every k ∈ N0

and every measurable function φ of k + 1 variables, provided the ex-

pectation exists.

For more details see Karlin and Taylor (1975), Chapter 9.5.

So, since a stationary process X1 , X2 , . . . is ergodic if every shift-invariant

event has probability zero or one, if J has this zero-one property, of course

the average converges to E[X1 ]. Hence, we restrict ourselves to:

If X1 , X2 , . . . is a stationary ergodic process such that E|X1 | < ∞, then

n

1

lim Xk = E[X1 ] a.s. and in mean.

n→∞ n

k=1

Let S be a metric space and S the Borel σ-field in S, i.e., S is the smallest

σ-field containing all the open sets. Let Cb (S) be the set of all bounded

continuous real functions f on S, and P be a probability measure on S, i.e.,

a nonnegative, countably additive set function with P (S) = 1.

w

We say that {Pn }n∈N converges weakly to P (Pn −→ P ) if for all f ∈ Cb (S):

f dPn −→ f dP .

S S

called a P-continuity set.

2.5. THE MODEL 9

probability measures on (S, S). These five conditions are equal:

w

i) Pn −→ P ,

ii) lim supn→∞ S f dPn = S f dP , for all bounded uniformly continuous

functions f : S → R,

2.5.1 The idea and the notation

The aim of this work is to study a model for the portfolio of an insurance

company by means of two different risk measures which take the whole profit

of the company into consideration. We investigate some possible risk port-

folios, which are directly dependent on the number of the contracts to be

stipulated and on the expected losses, so as to determine, if possible, the

optimal number of contracts in order to maximize the profit. Hence, we are

going to assume that an insurance company consists of n organizational units

or business segments. The whole profit of the company (positive value means

gain, negative value means loss) will be denoted by

n

R= Ri , (2.2)

i=1

with Ri describing the stochastic gain of the unit i during a fixed time period

(usually one year). Moreover, we suppose that for every unit i ∈ {1, . . . , n}

Ni

Ri = νi Ni − Xi,j − Yi Ni (2.3)

j=1

where:

10 CHAPTER 2. PRELIMINARIES

number of contracts of the insurance company,

• {Xi,j }j∈N is a sequence of random variables for i ∈ {1, . . . , n}: Xi,j

represents

Ni the loss associated with the risk in the j-th contract of unit

i and j=1 Xi,j is the total (annual) claim amount of unit i,

• Yi is a random variable which represents, for one contract of unit i,

a safety loading needed to obviate both the possible approximation

error in the calculation of the optimal premium and unforeseeable,

catastrophic events.

Therefore, we will examine how to determine an optimal portfolio, which

guarantees a maximal profit. We will discuss this problem for two risk mea-

sures: the expected shortfall, the coherent risk measure suggested by Artzner

et al. (1998), and the standard deviation, which is very popular in practice.

We will analyze the portfolio by means of a risk adjusted performance mea-

surement, this means that we compute the return in the way commonly called

RORAC (return on risk adjusted capital). In particular, considering any risk

measure ρ and provided that ρ(R) = 0, we define the expected risk-adjusted

return for a risk R as

E[R]

r(R, ρ) = . (2.4)

ρ(R)

In practice, the company tries hard to improve its results and this means that

its aim is to maximize r. Therefore, we will try to determine the optimal

value for the numbers of contracts Ni of every unit i ∈ {1, . . . , n}, such that

this maximum is attained.

We now introduce our running examples of risk measure. We start con-

sidering the expected shortfall defined by

ρ(R) = E[−R | R ≤ c] with c ≤ 0 . (2.5)

The expected shortfall is an alternative risk measure to the quantile which

overcomes some of the theorical deficiencies of the latter. In particular, this

risk measure gives some information about the size of potential losses, given

that a loss bigger than c has occurred.

Then, the same consideration will be repeated using the standard devia-

tion risk measure defined by

ρ(R) = −E[R] + κ σ(R), (2.6)

where κ > 0 is some positiveconstant and σ(R) denotes the standard devi-

ation operator, i.e., σ(R) = Var(R).

2.5. THE MODEL 11

In Chapter 4 we will examine the expected risk-adjusted return for a risk

R considering the standard deviation risk measure. In particular, we will

study three different variants of the model representing the whole profit of a

company consisting of n units, previously defined as

n

Ni

R= νi Ni − Xi,j − Yi Ni . (2.7)

i=1 j=1

Moreover, we make the following assumptions, which are valid through all of

Chapter 4.

• {Xi,j }j∈N , for all i ∈ {1, . . . , n}, are sequences of independent iden-

tically distributed (i.i.d.) random variables, with Xi,j having a finite

mean denoted by µi , i.e,

µi = E[Xi,j ] for all i ∈ {1, . . . , n} and j ∈ N,

µ̃i = E[Yi ] for all i ∈ {1, . . . , n},

• all the sequences {Xi,j }j∈N , with i ∈ {1, . . . , n}, and the random vari-

ables Y1 , . . . , Yn are independent.

Remark. In Chapter 3, we will examine the above-defined model with the

aid of the expected shortfall as risk measure, but for the moment we do

not need such strong assumptions. In fact it is not necessary to require

that {Xi,j }j∈N are sequences of i.i.d. random variables, but rather we will

prove some statements for which it is enough to assume the existence of real

constants µ1 , . . . , µn such that, for all i ∈ {1, . . . , n},

N

1 N →∞

Xi,j −−−→ µi in mean.

N j=1

assumptions, there are different variants depending on the choice of the dis-

tributions of the random variables and on the nature of the parameters Ni

for i ∈ {1, . . . , n}.

Then, in Chapter 4 we will examine three different cases which result

from (2.7) if we choose Ni for i ∈ {1, . . . , n} in different ways. In particular,

we consider the Ni ’s first as positive integers, then as Poisson-distributed

random variables and, finally, as the sum of both.

12 CHAPTER 2. PRELIMINARIES

i

with Ni a positive integer for all i ∈ {1, . . . , n},

i

with Ni ∼ POIS(λi ), λi > 0 for all i ∈ {1, . . . , n},

i

with Ni = Ni + Ni , where Ni are positive integers and Nipois are

fix pois fix

for all i ∈ {1, . . . , n}.

Chapter 3

shortfall risk measure

In this chapter, we will examine the portfolio of a company, analyze the profit

represented by the model previously described, and consider the expected

shortfall as an aid to quantifying risk.

Without loss of generality and, in order to simplify the following cal-

culations, we start by examining a one-dimensional model. This means we

assume that an insurance company consists of only one business unit. Hence,

we denote the whole profit by

N

R(N ) = νN − Xj − Y N, (3.1)

j=1

Y is a random variable having finite mean µ̃ and N is some positive integer.

Recall that it is assumed that Y and the sequence {Xj }j∈N are independent,

and that we still do not require any particular properties for the process

{Xj }j∈N . Moreover, we assume ν − µ − µ̃ > 0, i.e., the company chooses a

premium income rate greater than the expected losses.

In order to estimate the performance of the company, we consider the

expected risk-adjusted return for the risk R(N ) which, in this case, can be

represented by

E R(N )

rN = , c ≤ 0, (3.2)

E − R(N ) | R(N ) ≤ c

13

14 CHAPTER 3. EXPECTED SHORTFALL

More generally, in Section 3.2 we will take the same approach considering

an n-dimensional model

n

Ni

R(N1 , . . . , Nn ) = νi Ni − Xi,j − Yi Ni (3.3)

i=1 j=1

Now, we begin with the following lemma which is valid in general for any

risk represented by a random variable R ∈ L1 (Ω, F, P ).

Lemma 3.1. Let R be an integrable random variable on a probability space

(Ω, F, P ), this means R ∈ L1 (Ω, F, P ), and let c0 denote the infimum of the

support of the distribution of R, i.e., c0 = inf {c ∈ R | P (R ≤ c) > 0}.

Then the map

(c0 , ∞) ∋ c −→ E[−R | R ≤ c]

is non-increasing.

Proof. First, we consider E[−R | R ≤ c]. This conditional expectation is

defined by

E − R 1{R≤c}

E[−R | R ≤ c] = .

P [R ≤ c]

Then we consider any constants c1 , c2 ∈ (c0 , ∞) such that c1 < c2 .

Given that, since {R ≤ c1 } and {c1 < R ≤ c2 } are disjoint, it holds that

we can write:

E[−R | R ≤ c2 ]

E[−R | R ≤ c1 ] P [R ≤ c1 ] + E[−R | c1 < R ≤ c2 ] P [c1 < R ≤ c2 ]

= .

P [R ≤ c2 ]

Then, in order to prove the monotony, it suffices to show that

E[−R | R ≤ c2 ] ≤ E[−R | R ≤ c1 ] .

i) If P (c1 < R ≤ c2 ) = 0, then it holds that 1{R≤c2 } = 1{R≤c1 } P -a.s.

and P (R ≤ c1 ) = P (R ≤ c2 ). Therefore, it follows that

E[−R 1{R≤c2 } ] E[−R 1{R≤c1 } ]

E[−R | R ≤ c2 ] = = = E[−R | R ≤ c1 ] .

P [R ≤ c2 ] P [R ≤ c1 ]

3.1. THE ASYMPTOTICAL LIMIT OF UPPER BOUNDS 15

E[−R | R ≤ c2 ]

E[−R | R ≤ c1 ] P [R ≤ c1 ] + E[−R | c1 < R ≤ c2 ] P [c1 < R ≤ c2 ]

=

P [R ≤ c2 ]

=

P [R ≤ c2 ]

E[−R | c1 < R ≤ c2 ] P [c1 < R ≤ c2 ]

+

P [R ≤ c2 ]

= E[−R | R ≤ c1 ]

P [c1 < R ≤ c2 ]

+ E[−R | c1 < R ≤ c2 ] − E[−R | R ≤ c1 ]

P [R ≤ c2 ]

−c2 ≤···<−c1 ≥−c1

0<···≤1

<0

< E[−R | R ≤ c1 ] .

In this section we focus on the portfolio of a company represented by the

model defined in (3.1). In particular, we will study the expected risk-adjusted

return rN for the risk R(N ). The main question is whether it is possible

to find a maximal value for rN thereby determining an optimal value for

N such that this maximum is attained. We will show that the limit of

the upper bounds for the expected risk-adjusted return exists under quite

general conditions. We also derive an explicit formula for the limit. Recall

that, considering the expected shortfall risk measure, rN is defined by (3.2).

Now, for any c ≤ 0 we can write

E[R(N )]

E R(N )

rN = = R(N ) NR(N ) .

E − R(N ) | R(N ) ≤ c E − N | N ≤ Nc

Therefore, if we define

N

1

RN = ν − Xj − Y, (3.4)

N j=1

ν − µ − µ̃

rN = c

. (3.5)

E − RN | RN ≤ N

16 CHAPTER 3. EXPECTED SHORTFALL

N process and Y be a inte-

1

grable random variable. Let RN = ν − N j=1 Xj − Y and assume that a

real constant µ exists such that

N

1 N →∞

Xj −−−→ µ in mean .

N j=1

N →∞

E[RN | RN ≤ 0] −−−→ E[ν − µ − Y | ν − µ − Y ≤ 0] .

Lemma 3.3. Let RN be defined as above and assume that a real constant

µ exists such that

N

1 N →∞

Xj −−−→ µ in mean.

N j=1

schitz continuous function. Then, it holds that

N →∞

E Z f (RN ) −−−→ E Z f (ν − µ − Y ) .

constant K > 0 exists such that

E | Z | 1{ | Z | >K} ≤ ε .

| f (RN ) − f (ν − µ − Y ) | ≤ α | RN − ν − µ − Y | .

3.1. THE ASYMPTOTICAL LIMIT OF UPPER BOUNDS 17

Then,

E | Z f (RN ) − Z f (ν − µ − Y ) |

≤ E | Z | | f (RN ) − f (ν − µ − Y ) |

≤ E | Z | 1{ | Z | >K} | f (RN ) − f (ν − µ − Y ) |

≤ 2 sup|f |

+ E | Z | 1{ | Z | ≤K} | f (RN ) − f (ν − µ − Y ) |

≤K

≤ E | Z | 1{ | Z | >K} 2 sup|f | + K E | f (RN ) − f (ν − µ − Y ) |

≤ε ≤α |RN −(ν−µ−Y )|

N →∞

≤ 2 ε sup |f | + K α E | RN − ν − µ − Y | −−−→ 2 ε sup |f |

1 N

=| N j=1 Xj −µ|

N →∞

E | Z f (RN ) − Z f (ν − µ − Y ) | −−−→ 0 .

E RN 1{RN ≤0}

E[RN | RN ≤ 0] = . (3.6)

P [RN ≤ 0]

N

1

E RN 1{RN ≤0} = E ν − Xj − Y 1{RN ≤0} (3.7)

N j=1

N

1

= νP [RN ≤ 0] − E Xj 1{RN ≤0} − E Y 1{RN ≤0} .

N j=1

Since

N →∞

RN −−−→ ν − µ − Y in mean ,

and because the convergence in mean implicates the convergence in distrib-

ution, it holds that

N →∞

P (RN ≤ 0) −−−→ P (ν − µ − Y ≤ 0) .

18 CHAPTER 3. EXPECTED SHORTFALL

the one hand, that

N

1 N →∞

E Xj 1{RN ≤0} −−−→ µ P (ν − µ − Y ≤ 0) (3.8)

N j=1

N →∞

E Y 1{RN ≤0} −−−→ E[Y | ν − µ − Y ≤ 0] P (ν − µ − Y ≤ 0) . (3.9)

From N

1 N →∞

E Xj − µ −−−→ 0

N j=1

it follows that

N N

1 1

E Xj 1{RN ≤0} − µ 1{RN ≤0} = E Xj − µ 1{RN ≤0}

N j=1 N j=1

≤1

N

1 N →∞

≤E Xi − µ −−−→ 0 .

N j=1

N →∞ N →∞

N →∞

Figure 3.1, let fn and gn bounded continuous functions defined by

1 ,

if x ∈ (−∞, − n1 ] ,

fn (x) = −nx , if x ∈ (− n1 , 0) ,

0, if x ∈ [0, ∞) ,

and

1 ,

if x ∈ (−∞, 0] ,

gn (x) = 1 − nx , if x ∈ (0, n1 ) ,

if x ∈ [ n1 , ∞) .

0,

3.1. THE ASYMPTOTICAL LIMIT OF UPPER BOUNDS 19

fn (x) gn (x)

1 1

x 1 x

− n1 n

Figure 3.1: Continuous approximation of the indicator function 1(−∞,0] from be-

low by fn and from above by gn .

n n

E Z fn (RN ) ≤ E Z 1(−∞,0] ◦ RN ≤ E Z gn (RN ) . (3.10)

Z + − Z − with Z + = max{Z, 0} and Z − = max{−Z, 0}.

Then, considering the left and right side respectively of the inequality

(3.10) separately, since fn and gn are Lipschitz continuous functions, i.e.,

| fn (RN ) − fn (ν − µ − Y ) | ≤ n | RN − ν − µ − Y |

and analogously

| gn (RN ) − gn (ν − µ − Y ) | ≤ n | RN − ν − µ − Y | ,

N →∞

E Z fn (RN ) −−−→ E Z fn (ν − µ − Y )

and N →∞

E Z gn (RN ) −−−→ E Z gn (ν − µ − Y ) .

n→∞

Moreover, since fn (ν − µ − Y ) −−→ 1(−∞,0) ◦ (ν − µ − Y ) pointwise, from the

Lebesgue theorem 2.4 it follows that

n→∞

E Z fn (ν − µ − Y ) −−→ E Z 1(−∞,0) ◦ (ν − µ − Y )

20 CHAPTER 3. EXPECTED SHORTFALL

and analogously

n→∞

E Z gn (ν − µ − Y ) −−→ E Z 1(−∞,0] ◦ (ν − µ − Y ) .

E Z 1(−∞,0) ◦ (ν − µ − Y ) = E Z 1(−∞,0] ◦ (ν − µ − Y )

and Z = Y , respectively, i.e.,

N →∞

and

N →∞

E Y 1{RN ≤0} −−−→ E Y 1{ν−µ−Y ≤0}

= E[Y | ν − µ − Y ≤ 0] P (ν − µ − Y ≤ 0) .

Thus, to conclude,

N →∞

E[ν − µ − Y | ν − µ − Y ≤ 0] P (ν − µ − Y ≤ 0) ,

the statement in the proposition follows directly from the definition of the

conditional expectation.

Consequently, from Lemma 3.1 and from Proposition 3.2 we obtain the

limit of the upper bounds for the expected risk-adjusted return rN . In fact,

we also have

N →∞

rN −−−→ r∞ ,

N →∞

as RN −−−→ ν − µ − Y in mean and in law and hence

c

N →∞

P RN ≤ −−−→ P ν − µ − Y ≤ 0

N

and

N →∞

E RN 1RN ≤c/N −−−→ E (ν − µ − Y ) 1ν−µ−Y ≤0 .

3.1. THE ASYMPTOTICAL LIMIT OF UPPER BOUNDS 21

R(N ) = νN − j=1 Xj − Y N such that X1 , X2 , . . . is a real stationary

ergodic process having finite mean µ = E[X1 ], and P (ν − µ − Y = 0) = 0.

In fact, as a result of the Ergodic Theorem 2.14, it holds that

N

1 N →∞

Xj −−−→ µ a.s. and in mean.

N j=1

Therefore, the requirements of the Proposition 3.2 are satisfied and it follows

that, if N → ∞, the expected risk-adjusted return for R(N ) converges to

r∞ .

distributed random variables and by giving a numerical example.

Example 1. Assume that an insurance company consists of one business

unit, i.e., n = 1. Then we consider

N

R(N ) = νN − Xj − Y N.

j=1

Suppose that {Xj }j∈N is an i.i.d. sequence of random variables having normal

distribution and that Y is a normally distributed random variable indepen-

dent of the sequence {Xj }j∈N . In particular, we write

Xj ∼ N µ, σ 2 for all j ∈ N ,

Y ∼ N µ̃, σ̃ 2 .

Because of the particular properties of the normal distribution it holds that

N σ2

1

Xj ∼ N µ,

N j=1 N

and therefore

N

1 σ2

RN = ν − Xj − Y ∼ N ν − µ − µ̃, + σ̃ 2 .

N j=1 N

For more details see Johnson et al. (1994), Chapter 13, Section 3.

Based on RN , we can calculate the expected risk-adjusted return rN .

Given c ≤ 0, define

c/N − E[RN ] c/N − ν + µ + µ̃

cN = = .

Var(RN ) σ 2 /N + σ̃ 2

22 CHAPTER 3. EXPECTED SHORTFALL

E R(N )

rN =

E − R(N ) | R(N ) ≤ c

E[RN ]

=

E[−RN | RN ≤ c/N ]

ν − µ − µ̃

=

′ .

−ν + µ + µ̃ + σ 2 /N + σ̃ 2 log Φ (cN )

an integer. If c = 0, the above expression simplifies to

−cN

rN =

′ .

cN + log Φ (cN )

−ν + µ + µ̃

c∞ := lim cN = ,

N →∞ σ̃

hence

ν − µ − µ̃

r∞ = lim rN =

′

N →∞ −ν + µ + µ̃ + σ̃ log Φ (c∞ )

−c∞

=

′ .

c∞ + log Φ (c∞ )

ν = 5, µ = 1, µ̃ = 2, σ = 2, σ̃ = 1

In Figure 3.3, we can observe that the returns {rN }N ∈N converge to r∞

for any c ≤ 0, as asserted in Proposition 3.2 . In fact,

2 ∼

r∞ =

′ = 5.359 .

−2 + log Φ (−2)

3.1. THE ASYMPTOTICAL LIMIT OF UPPER BOUNDS 23

6

5

4

3

r

2

1

0

2 4 6 8 10

N

Figure 3.2: This figure shows the risk-adjusted returns rN of the form mentioned

above for the parameter values under the assumptions that parameter c = 0 (dot-

ted line), c = −1 (short-dashed line), c = −2 (dashed line), c = −5 (solid line),

respectively, and the limit r∞ (long-dashed line).

6

5

4

3

r

2

1

0

0 10 20 30 40 50

N

Figure 3.3: Plot of the same returns rN shown in Figure 3.2 for greater values

of N .

24 CHAPTER 3. EXPECTED SHORTFALL

The previous considerations are also valid for an n-dimensional model. In

fact, in general we can denote the whole profit of a company consisting of n

units by

N1

1

R(N1 , . . . , Nn ) = N1 ν1 − X1,j − Y1 + · · ·

N1 j=1

Nn

1

+ Nn νn − Xn,j − Yn ,

Nn j=1

where Ni are some positive integers for all i ∈ {1, . . . , n} and Y1 , . . . , Yn are

integrable random variables. Moreover, assume that real constants µ1 , . . . , µn

exist such that, for all i ∈ {1, . . . , n},

Ni

1 Ni →∞

Xi,j −− −→ µi in mean.

Ni j=1

Then we define

R(N1 , . . . , Nn )

R̃(N1 , . . . , Nn ) =

N1 + · · · + N n

and we obtain that the expected risk-adjusted return for all c ≤ 0 can be

written as

E R(N1 , . . . , Nn )

r(N1 , . . . , Nn ) =

E − R(N1 , . . . , Nn ) | R(N1 , . . . , Nn ) ≤ c

E R(N1 ,...,Nn )

= N1 +···+Nn

E −R(N 1 ,...,Nn ) R(N1 ,...,Nn )

N1 +···+Nn N1 +···+Nn

≤ c

N1 +···+Nn

E R̃(N1 , . . . , Nn )

= .

c

E − R̃(N1 , . . . , Nn )R̃(N1 , . . . , Nn ) ≤ N1 +···+Nn

Ni

−→ ti exists, for all i = 1, . . . , n .

N1 + · · · + N n

3.2. THE N -DIMENSIONAL MODEL 25

n

n

(t1 , . . . , tn ) ∈ [0, 1] and ti = 1 (3.11)

i=1

and that

n

N1 ,...,Nn →∞

R̃(N1 , . . . , Nn ) −−−−−−−→ R̃∞ (t) := ti (νi − µi − Yi ) in mean,

i=1

P R̃∞ (t) = 0 = 0,

it holds that

N ,...,Nn →∞

E[R̃(N1 , . . . , Nn ) | R̃(N1 , . . . , Nn ) ≤ 0] −−1−−−−−→ E R̃∞ (t) | R̃∞ (t) ≤ 0 .

Note that this is the same statement we arrived at (3.2) for the simplest

model. For this reason, we omit the proof in this case, because it suffices to

adapt the arguments considered there.

Analogously, as before, we obtain that the limit of the upper bounds

exists and will be denoted by

N ,...,Nn →∞

r N1 , . . . , Nn −−1−−−−−→ r∞ t1 , . . . , tn , (3.12)

where

n

i=1 ti (νi− µi − µ̃i )

r∞ t1 , . . . , tn = .

E − R̃∞ (t1 , . . . tn ) | R̃∞ (t1 , . . . tn ) ≤ 0

We can observe that the limit of the upper bounds obtained for the

n-

dimensional model is directly

dependent on (t1 , . . . tn ). If P R̃∞ (t) = 0 = 0

for every t = (t1 , . . . , tn satisfying (3.11), then (3.12) holds for

all these t and

it makes sense to determine the maximum of r∞ t1 , . . . , tn for (t1 , . . . , tn )

satisfying (3.11). In fact, if r∞ is upper semi-continuous, then this maximum

is attained by t∗1 , . . . , t∗n , which can be calculated through

n

∗ ∗ i=1 ti (νi − µi − µ̃i )

(t1 , . . . , tn ) = argmax .

(t1 ,...,tn ) E − R̃∞ (t1 , . . . tn ) | R̃∞ (t1 , . . . tn ) ≤ 0

ti ∈[0,1]

Note that, if Y1 , . . . , Yn are

independent with continuous distribution func-

tions, then P R̃∞ (t) = 0 = 0 certainly holds for all (t1 , . . . , tn ) satisfying

(3.11).

26 CHAPTER 3. EXPECTED SHORTFALL

units, i.e., n = 2. Then

N1

N2

R(N1 , N2 ) = ν1 N1 − X1,j − Y1 N1 + ν2 N2 − X2,j − Y2 N2 .

j=1 j=1

Assume that Xi,j ∼ N µi , σi2 ) and Yi ∼ N µ̃i , σ̃i2 ) for all i ∈ {1, 2} and

j ∈ N. Furthermore, assume that all the random variables are independent.

For simplicity, we denote µ̂i = νi − µi − µ̃i for i ∈ {1, 2},

µ̂ = N1 µ̂1 + N2 µ̂2

and

σ̂ 2 = N1 σ12 + N12 σ̃12 + N2 σ22 + N22 σ̃22 .

Then we have

R(N1 , N2 ) ∼ N µ̂, σ̂ 2 .

Using (A.3) as in the previous example, we obtain for c ≤ 0

E[R(N1 , N2 )]

r(N1 , N2 ) =

E[−R(N1 , N2 ) | R(N1 , N2 ) ≤ c]

µ̂

=

′ .

−µ̂ + σ̂ log Φ (c − µ̂)/σ̂

N1 N ,N2 →∞

−−1−− −→ t exists.

N 1 + N2

Then

µ̂ N ,N2 →∞

−−1−− −→ t µ̂1 + (1 − t) µ̂2

N1 + N2

and

σ̂ N ,N2 →∞

−−1−− −→ t2 σ̃12 + (1 − t)2 σ̃22 .

N1 + N 2

Hence

N ,N →∞

r(N1 , N2 ) −−1−−

2

−→ r∞ (t) ,

with

t µ̂1 + (1 − t) µ̂2

r∞ (t) =

′

−c(t)

=

′

,

c(t) + log Φ c(t)

3.2. THE N -DIMENSIONAL MODEL 27

where

t µ̂1 + (1 − t) µ̂2

c(t) = − .

t2 σ̃12 + (1 − t)2 σ̃22

We now want to find the t∗ ∈ [0, 1] which maximizes the limiting expected

risk-adjusted return [0, 1] ∋ t → r∞ (t). We start with the following lemma.

Lemma 3.4. The function

c

(−∞, 0] ∋ c → −

′

c + log Φ (c)

is monotonely decreasing.

Proof. Using the substitution z = x2 /2, we get for every c ∈ (−∞, 0)

c c ∞

x e−z ϕ(c)

Φ(c) = ϕ(x) dx < ϕ(x) dx = √ =− ,

−∞ c c

c 2π c2 /2

−∞

hence

1

′

log Φ (c) < −1 .

c

Therefore, it suffices to show that g : (−∞, 0) → R with

1

′

g(c) = log Φ (c), c ∈ (−∞, 0) ,

c

is monotonely decreasing.

Since

ϕ(c) ′ −c2 ϕ(c) Φ(c) − ϕ(c) Φ(c) − c ϕ(c)2

g ′ (c) = = ,

c Φ(c) c2 Φ(c)2

we obtain that for every c ∈ (−∞, 0)

g ′ (c) ≤ 0 ⇐⇒ (c2 + 1)Φ(c) + c ϕ(c) ≥ 0

1 ϕ(c)

⇐⇒ 1 + 2 Φ(c) ≥ − .

c c

Since for c < 0

c

1 1

1 + 2 Φ(c) = 1 + 2 ϕ(x) dx

c c

−∞

c

1 ϕ(x)

c ϕ(c)

≥ 1 + 2 ϕ(x) dx = − =− ,

−∞ x x −∞ c

the lemma is proved.

28 CHAPTER 3. EXPECTED SHORTFALL

01 2 3 4 5 6

01 2 3 4 5 6

r(c=-1)

r(c=0)

10 10

8 8

10 6 10

6 8 8

N2 4 6 N2 4 6

4 2 4

2 2 N1

0 2 N1 0 0

0

01 2 3 4 5 6

01 2 3 4 5 6

r(c=-5)

r(c=-2)

10 10

8 8

10 6 10

6 8 8

N2 4 6 N2 4 6

2 4 2 4

2 N1 2 N1

0 0 0 0

Figure 3.4: Plot of the risk-adjusted return r(N1 , N2 ): at the top left for the

parameter c = 0, at the top right for c = −1, at the bottom left for c = −2, at the

bottom right for c = −5.

Due to the lemma, it remains for us to find the t∗ ∈ [0, 1] which minimizes

[0, 1] ∋ t → c(t). Solving the equation c′ (t∗ ) = 0 leads to

µ̂1 σ̃22

t∗ = ,

µ̂1 σ̃22 + µ̂2 σ̃12

and

µ̂21 µ̂22

c(t∗ ) = − + .

σ̃12 σ̃22

µ̂1 µ̂2

c(1) = − > c(t∗ ) and c(0) = − > c(t∗ ) .

σ̃1 σ̃2

3.2. THE N -DIMENSIONAL MODEL 29

0

0

5

10

N1 8

6

4

10

2 N2

Figure 3.5: Plot of the risk-adjusted return r(N1 , N2 ) for the parameters c = −5,

c = −2, c = −1, c = 0, respectively.

ν1 = 5, µ1 = 1, µ̃1 = 2, σ1 = 2, σ̃1 = 1,

ν2 = 3, µ2 = 1, µ̃2 = 1, σ2 = 1, σ̃2 = 1,

and choosing

30 CHAPTER 3. EXPECTED SHORTFALL

0

0 10 0.5

20 30 t

N 40 501

(1 − t) N and for the parameters c = −5, c = −2, c = −1, c = 0, respectively.

t

3.3. CONCLUSION 31

−c(t)

r∞ (t) =

′

,

c(t) + log Φ c(t)

where

t+1

c(t) = √ .

t2 − 2 t + 1

Moreover, the t∗ ∈ [0, 1] which maximises r∞ (t) is

2

t∗ =

3

and therefore

r∞ (t∗ ) ∼

= 6.429 .

We can observe that, for the same values of N1 and N2 , increasing c,

r(N1 , N2 ) becomes greater. This is a direct consequence of Lemma 3.1 which

shows that the map c → E[−R | R ≤ c] decreases monotonously for any

c ∈ (c0 , ∞), where c0 = inf {c ∈ R | P (R ≤ c) > 0}. Moreover, assuming that

N1 , N2 → ∞ such that N1 /(N1 + N2 ) → t, we can observe in the following

figures that in any case – for every c ≤ 0 – the return r(N1 , N2 ) converges to

r∞ (t). In particular, in Figure 6, we can observe that r∞ (t) ≤ r∞ (t∗ ) ∼

= 6.429

for all t ∈ [0, 1].

3.3 Conclusion

If we examine the portfolio of an insurance company represented by the model

(3.1) and we try to optimize it by determining the number of contracts, we

can conclude that, for the expected risk-adjusted return rN defined by (3.2),

a limit exists.

Considering the n-dimensional model we obtain a limit of the upper

bounds which depends directly on the partition of the contracts between

the different n units of the company. An optimal partition can be calculated

in the case of normal distributions. In general, it has to be done numerically.

Nevertheless, we cannot find the optimal number of contracts which should

assure a maximal risk-adjusted return to the company.

Usually, the company has a fixed capital C at its disposal to invest. So,

considering that the insurance company wants to invest this capital C, it is

possible to calculate an optimal solution to the following problem:

E R(N1 , . . . Nn )

maximize

C

32 CHAPTER 3. EXPECTED SHORTFALL

In this case, using the expected shortfall as risk measure, we do not obtain

a general solution, but it exists and can be found numerically if the distri-

butions of Yi for i = 1, . . . , n are known. If the random variables Yi for

i = 1, . . . , n are independent and normally distributed, this numerical cal-

culation is not very complicated, because of the particular properties of the

normal distribution.

However, we can observe that the obtained solution is not always a good

one, because frequently the optimal values for Ni for i = 1, . . . , n are not

integers. For this reason we have to consider once more which optimal integer

values we shall choose.

In the following chapters we will show that we obtain better solutions to

such a problem if we take the standard deviation risk measure into consid-

eration.

Chapter 4

deviation risk measure

company defined in Section 2.5 once again. We will now examine the risk-

adjusted performance of the company by studying the return

E[R]

r=

ρ(R)

and using the standard deviation risk measure of R defined by

where κ > 0 is some positive constant and σ(R) denotes the standard devi-

ation of the risk R.

In consequence, we assume the existence of second moments for the fol-

lowing, because the definition of σ(R) clearly requires

this.

Considering the portfolio of the form R = ni=1 Ri , let Ri be real-valued

random variables on (Ω, F, P ) having finite expectation and finite second

moment for all i ∈ {1, . . . , n}

Ni

Ri = νi Ni − Xi,j − Yi Ni , (4.1)

j=1

where Ni are some positive integers for all i ∈ {1, . . . , n}. For the sequences

{Xi,j }j∈N and for the random variables Yi with i ∈ {1, . . . , n} the assump-

tions mentioned in Section 2.5.2 are still valid. Moreover, we assume that

(R1 , . . . , Rn ) are non-trivial and this means that ρ(R) takes values other than

zero, where R is the portfolio of (R1 , . . . , Rn ).

33

34 CHAPTER 4. STANDARD DEVIATION

Let C > 0 be the capital that the company wants to invest. Now we look

at the following problem:

E[R]

maximize (4.2)

C

subject to ρ(R) ≤ C

Ni ≥ 0 integers for i ∈ {1, . . . , n}

but not all of them equal to zero.

maximal return r, which means a better performance for the company.

First, we will examine the simplest cases with n = 1 and n = 2, and

then we will take the same approach for a general n-dimensional model. In

Section 4.3 we will repeat the same procedure, again analyzing the same

model, but this time with the assumption that Ni are Poisson-distributed

random variables with parameters λi > 0 for all i = 1, . . . , n. This last

assumption is convenient for us, because in this case the optimal solution of

the optimization problem consists of real positive values which are no longer

required to be integers.

We start considering n = 1. Let the portfolio be represented by

N

R(N ) = νN − Xj − Y N (4.3)

j=1

and take the assumptions mentioned in Section 2.5. We then have that N

is a positive integer, {Xj }j∈N are uncorrelated random variables with finite

mean µ, Y has finite mean µ̃ and the sequence {Xj }j∈N and Y are uncor-

related. Moreover, we assume that both Xj for all j ∈ N and Y have finite

variances denoted by σ 2 = Var(Xj ), independent of j ∈ N, and σ̃ 2 = Var(Y )

respectively.

Then we can compute

E R(N ) = N (ν − µ − µ̃)

√

ρ R(N ) = −N (ν − µ − µ̃) + κ N σ 2 + N 2 σ̃ 2 .

4.1. THE SIMPLEST CASES: N = 1 AND N = 2 35

N (ν − µ − µ̃)

maximize

C √

subject to − N (ν − µ − µ̃) + κ N σ 2 + N 2 σ̃ 2 ≤ C , (4.4)

N > 0 integer.

For the sake of practicality we define

ν − µ − µ̃

a= .

C

Note that a is a positive constant because ν − µ − µ̃ is assumed to be

positive and the capital C to invest is positive too. Moreover, from now on,

we assume

κ

σ̃ > a. (4.5)

C

This means that even for the case σ 2 = 0, we get ρ R(N ) > 0 for every

N ∈ N, hence, accepting contracts involves real risk. Furthermore, for any

σ2 ≥ 0 ,

ρ R(N )

lim > 0,

N →∞ N

i.e., the risk per contract stays positive even in the limit N → ∞.

Returning to the optimization problem; if we square the constraint (4.4)

we reduce the previous formulation to

maximize aN

κ2 κ2

subject to N 2 σ̃ 2

− a2

+ N σ 2

− 2a − 1 ≤ 0, (4.6)

C2 C2

N > 0 integer.

Given that κσ̃/C is assumed to be greater than a, we obtain that the con-

straint (4.6) is fulfilled if N ∈ [z1 , z2 ] ∩ N, where with z1 and z2 we denote

the zeros of the constraint itself. So, since a is positive and the function to

maximize becomes greater with increasing N , the value of N which assures

all requirements is the greatest positive integer which satisfies the condition

(4.6). We have that the greatest zero of (4.6) has the following form:

2 2

κ2 2 κ2 2

− Cκ 2 σ 2 − 2a + C 2 σ − 2a + 4 C 2 σ̃ − a2

z2 =

2

2 Cκ 2 σ̃ 2 − a2

√

2aC 2 − κ2 σ 2 + κ κ2 σ 4 − 4aσ 2 C 2 + 4σ̃ 2 C 2

=

.

2 κ2 σ̃ 2 − a2 C 2

36 CHAPTER 4. STANDARD DEVIATION

in consequence of these arguments we can conclude that the solution of the

optimization problem (4.4) is

2 2 2

√

2aC − κ σ + κ κ 2 σ 4 − 4aσ 2 C 2 + 4σ̃ 2 C 2

N∗ =

,

2 κ2 σ̃ 2 − a2 C 2

where with ⌊x⌋ we denote the greatest integer smaller than x, i.e.,

⌊x⌋ = max{k ∈ Z | k ≤ x} .

N1

N2

R(N1 , N2 ) = ν1 N1 − X1,j − Y1 N1 + ν2 N2 − X2,j − Y2 N2 , (4.7)

j=1 j=1

where N1 , N2 are positive integers, {X1,j }j∈N and {X2,j }j∈N are sequences

of uncorrelated random variables which are uncorrelated to Y1 and Y2 . We

suppose that the sequences {X1,j }j∈N and {X2,j }j∈N are uncorrelated and Y1

and Y2 are uncorrelated, too. Furthermore, we assume that the first two

moments of {X1,j }j∈N and {X2,j }j∈N do not depend on j ∈ N. Moreover, we

define

µ̃i = E[Yi ] and σ̃i2 = Var(Yi ), for i = 1, 2,

Then, we calculate

E R(N1 , N2 ) = N1 (ν1 − µ1 − µ̃1 ) + N2 (ν2 − µ2 − µ̃2 ) ,

+ κ N1 σ12 + N12 σ̃12 + N2 σ22 + N22 σ̃22 .

above

ν1 − µ1 − µ̃1 ν2 − µ2 − µ̃2

a1 = and a2 = .

C C

Once again, we assume that these constants are positive, because we consider

contracts with positive expectation.

4.1. THE SIMPLEST CASES: N = 1 AND N = 2 37

The initial optimization problem (4.2) therefore turns out to have the

following form

maximize a1 N1 + a2 N2

κ

subject to − a1 N1 − a2 N2 + N1 σ12 + N12 σ̃12 + N2 σ22 + N22 σ̃22 ≤ 1 ,

C

(4.8)

N1 , N2 ≥ 0 integers, not both of them equal to zero.

maximize a1 N 1 + a2 N 2

κ2 κ2 2

2 2 2 κ 2 2

subject to N1 σ − 2a1 + N 2 σ − 2a2 + N σ̃ − a

C2 1 C2 2 1

C2 1 1

κ2

+ N22 2

σ̃22 − a22 − 2a1 a2 N1 N2 − 1 ≤ 0 , (4.9)

C

N1 , N2 ≥ 0 integers, not both of them equal to zero.

Note that, both here and in the n-dimensional case, we make the same as-

sumption as in (4.5) and, in general, this implies

κ

σ̃i > ai for all i ∈ {1, . . . , n}.

C

In particular in this case, where n = 2, it is assumed that

κ κ

σ̃1 > a1 and σ̃2 > a2 . (4.10)

C C

Now we consider only the constraint (4.9). It can be written as

κ2 κ2

N1 σ2

2 1

− 2a1 + N2 σ2

2 2

− 2a2 + q ≤ 1 , (4.11)

C C

where with q we denote a real quadratic form

q = XT AX, (4.12)

with !

N1

X=

N2

κ2 2 2

!

C 2 σ̃1 − a1 −a 1 a2

A= κ2 2 2

.

−a1 a2 C 2 σ̃2 − a 2

38 CHAPTER 4. STANDARD DEVIATION

(4.12) can be reduced to a diagonalized representation, and by an orthogonal

change of variables the expression (4.11) can be rewritten in a form related to

an ellipse. It therefore follows that the optimization problem can be solved

directly.

So we denote the eigenvalues of A by α1 and α2 and the associated or-

thonormal eigenvectors by P1 and P2 , then we can represent q in the form

!T !

x x

q= B = α1 x2 + α2 y 2 , (4.13)

y y

where !

T α1 0

B = P AP =

0 α2

and !

p11 p12

P = P1 , P2 = ,

p21 p22

its columns. For more details see Gilbert and Gilbert (1995) Chapter 8.5.

From now on, we denote Y = (x, y)T . Then, by a change of variables from

N1 , N2 to x, y according to the rule that X = PY, the constraint considered

until now can be re-written as follows:

β1 x + β2 y + α1 x2 + α2 y 2 ≤ 1. (4.14)

Recall that if A is a real and symmetric matrix, its eigenvalues are real, so

α1 , α2 , β1 and β2 are real constants dependent on a1 , a2 , σ̃1 , σ̃2 , κ and C.

In particular, α1 and α2 have the following forms:

" #

1 κ2 2

κ2 2

αi = σ̃ + σ̃22 − a21 − a22 ± (σ̃ 2 − σ̃22 ) − a21 + a22 + 4a21 a22 ,

2 C2 1 C2 1

where we choose α1 to correspond to the plus sign and α2 to the minus sign.

Both constants are positive due to (4.10).

Then the values of the constants β1 and β2 can be calculated too, but for

reasons of space, we will not list these formulae at full length. However it

holds that

κ2 κ2

2 2

βi = p1i σ − 2a1 + p 2i σ − 2a2

C2 1 C2 2

for i = 1, 2.

4.1. THE SIMPLEST CASES: N = 1 AND N = 2 39

follows

κ2 2 2

!

vi C 2 σ̃1 − a1 − αi + a1 a2

Pi = , with vi = 2 .

vi −a1 a2 − Cκ 2 σ̃22 − a22 − αi

formed once again, so as to get the following form related to an ellipse

β1 x + β2 y + α1 x2 + α2 y 2 ≤ 1

βi

⇐⇒ α1 (x − γ1 )2 − γ12 + α2 (x − γ2 )2 − γ22 ≤ 1, with γi = ,

2αi

2

2

⇐⇒ α1 x − γ1 + α2 x − γ2 − α1 γ12 − α2 γ22 ≤ 1

2

2

α1 x − γ1 α2 y − γ2

⇐⇒ + ≤ 1. (4.15)

1 + α1 γ12 + α2 γ22 1 + α1 γ12 + α2 γ22

1 + α1 γ12 + α2 γ22

εi = for i = 1, 2 .

αi

Clearly, ε1 and ε2 represent the two half axes of the ellipse given in (4.15).

By the same change of variable, the function to maximize

a1 N 1 + a2 N 2

becomes

ã1 x + ã2 y (4.16)

with

ãi = a1 p1i + a2 p2i for i = 1, 2 .

maximize f (x, y)

subject to the condition g(x, y) ≤ 0 , (4.17)

where

f (x, y) = ã1 x + ã2 y ,

2

2

x − γ1 y − γ2

g(x, y) = + − 1.

ε21 ε22

40 CHAPTER 4. STANDARD DEVIATION

f (x, y) = const

ε2

ε1

(γ1 , γ2 )

g(x, y) = 0

for the moment. An optimization problem of this form can be illustrated by

Figure 4.1, where the line f (x, y) = const is orthogonal to (ã1 , ã2 ).

We see that the required maximal value for f (x, y) is reached on the

boundary of the ellipse described by g(x, y) = 0, at the point on the ellipse

whose tangent is parallel to the straight line. The optimal solution is (x∗ , y ∗ )

and it can be calculated with the aid of Lagrange multipliers. In fact, by

introducing suitable multipliers, the constrained extremum problem can be

treated as one of an ordinary extremum. More precisely, as follows from the

Lagrange multipliers rule, it holds that:

if f has a relative extremum in (x∗ , y ∗ ) subject to the constraint g(x∗ , y ∗ ) = 0

and if gy (x∗ , y ∗ ) = 0, then a real number δ called the Lagrange multiplier

exists such that (x∗ , y ∗ , δ) is the critical point of the function H defined by

H(x, y, δ) = f (x, y) + δg(x, y). For more details see Appendix B.

Therefore, the pertinent problem to resolve is

Hx (x, y, δ) = fx (x, y) + δgx (x, y) = 0

Hy (x, y, δ) = fy (x, y) + δgy (x, y) = 0 (4.18)

Hδ (x, y) = g(x, y) = 0.

4.1. THE SIMPLEST CASES: N = 1 AND N = 2 41

We get a system of three equations and in our case we find a solution with the

aid of the computer. Then, through the inverse change of variables, we can

finally determine the values for N1 and N2 , respectively, that solve the initial

problem (4.8). We obtain that the number of contracts which guarantee a

maximal risk-adjusted return are

√

N1 =

2 2 2 2 2 2 2 2

2 C a1 σ̃2 + a2 σ̃1 − κ σ̃1 σ̃2

and

√

N2∗ =

,

2 2 2 2 2 2 2 2

2 C a1 σ̃2 + a2 σ̃1 − κ σ̃1 σ̃2

where

2

C 2 4 σ̃12 σ̃22 − a1 σ12 σ̃22 − a2 σ22 σ̃12 − a1 σ22 − a2 σ12 + κ2 σ14 σ̃22 + σ24 σ̃12

s= .

a21 σ̃22 + a22 σ̃12

Note that N1∗ and N2∗ defined above are not necessarily integers, so they have

to be rounded in practice.

Remark. We can proceed analogously even if we consider a model of the same

form as (4.7) and we allow correlation between the two random variables

Y1 , Y2 . In fact, it holds that

and

= Var(R1 ) + Var(R2 ) + 2 Cov(R1 , R2 )

= N1 σ̃12 + N12 σ̃12 + N2 σ̃22 + N22 σ̃22 + 2 N1 N2 ρY σ̃1 σ̃2 ,

because

Cov(R1 , R2 ) = N1 N2 Cov(Y1 , Y2 )

= N1 N2 ρY σ̃1 σ̃2 ,

problem of the form of (4.2) for such a model R, we must find an optimal

solution in the same way as before. As a matter of fact, in this case the

42 CHAPTER 4. STANDARD DEVIATION

constraint has the following form

κ2 κ2 2

2 2 2 κ 2 2

N1 σ − 2a 1 + N 2 σ − 2a 2 + N σ̃ − a

C2 1 C2 2 1

C2 1 1

κ2

+ N22 σ̃ 2

− a2

− 2 N 1 N 2 a 1 a 2 − ρ Y σ̃1 σ̃2 −1≤0

C2 2 2

κ2 κ2

2 2

N1 σ − 2a1 + N2 σ − 2a2 + q ≤ 0,

C2 1 C2 2

where with q we denote a real quadratic form

!T !

N1 N1

q= A

N2 N2

with !

κ2 2

− a21

σ̃

C2 1

−a1 a2 + ρY σ̃1 σ̃2

A= κ2 2 .

−a1 a2 + ρY σ̃1 σ̃2 C2 2

σ̃ − a22

variables, form related to an ellipse, Lagrange multipliers) we can compute

the optimal solution.

If we consider a general model related to a firm consisting of n units, i.e.,

n

R= Ri , with Ri of the form of (4.1),

i=1

adapted to solve an n-dimensional optimization problem, too.

Starting from the initial problem of the form of (4.2), we square the

constraint ρ(R) ≤ C and then we represent it with help of a quadratic form

defined from an n × n−matrix A. Diagonalizing A and by an orthogonal

change of variables, we can rewrite the constraint in a form related to a conic

section. Therefore, we get a problem with new variables, i.e., x1 , . . . , xn

instead of N1 , . . . , Nn and it has the following form

maximize f (x1 , . . . , xn )

subject to the condition g(x1 , . . . , xn ) ≤ 0,

4.3. THE SECOND VARIANT OF THE MODEL 43

where, as before, the maximal value for f (x1 , . . . , xn ) is reached on the bound-

ary described by g(x1 , . . . , xn ) = 0.

This means that the optimal solution (x∗1 , . . . , x∗n ) can be found employ-

ing the Lagrange multipliers rule (see Appendix B for more details). As a

consequence, we have to solve a system of n + 1 equations with respect to

the unknowns x1 , . . . , xn , δ

$

Hxi (x1 , . . . , xn , δ) = fxi (x1 , . . . , xn ) + δgxi (x1 , . . . , xn ) = 0 , i = 1, . . . , n

Hδ (x1 , . . . , xn ) = g(x1 , . . . , xn ) = 0 .

(4.19)

Then, by the inverse orthogonal change of variables, we can determine the so-

lution of the initial problem with respect to the original variables N1 , . . . , Nn .

Due to the length of the expression related to the two-dimensional case, we

avoid listing the values of N1∗ , . . . , Nn∗ , i.e., the optimal solution of the initial

problem.

are random variables

In this section, we still consider the same model representing the whole port-

folio of a company – but with one difference. In fact, we assume that the

number of contracts for every unit i, denoted by Ni with i ∈ {1, . . . , n}, are

Poisson-distributed random variables with parameter λi > 0.

To resume, we have

n

Ni

R= νi Ni − Xi,j − Yi Ni , (4.20)

i=1 j=1

with

finite means and finite variances for all i ∈ {1, . . . , n}

1

Note that these independence assumptions are introduced for simplicity. In fact, even

if we consider a model which does not fulfil these supplementary requirements, we can

proceed in a similar way.

44 CHAPTER 4. STANDARD DEVIATION

variances finite

• the sequences {Xi,j }j∈N , i ∈ {1, . . . , n}, are independent of the random

variables Y1 , . . . , Yn .

of the sequences {Xi,j }j∈N for all i ∈ {1, . . . , n} and of the random variables

Y1 , . . . , Yn .

Recall that the aforementioned assumption

κ νi − µi − µ̃i

σ̃i >

C C

We are now interested in the solution of the optimization problem

E[R]

maximize (4.21)

C

subject to ρ(R) ≤ C

λi > 0 for all i ∈ {1, . . . , n}.

We observe that this problem is analogous to (4.2), but that this time we have

weaker conditions, in fact the values of the solution are no longer required

to be integers.

Before considering this problem, we must do some calculations needed in

the following. First, in the next Proposition we recall two particular equalities

concerning expectation and variance.

X be an R-valued random variable defined on a prob-

ability space Ω, F, P with a finite second moment and let G be a sub-σ-field

of F. Then

E[X] = E E[X | G]

4.3. THE SECOND VARIANT OF THE MODEL 45

because of the Wald Identity we obtain

n

Ni

E[R] = E Ni νi − Xi,j − Ni Yi

i=1 j=1

n

Ni

!

= E[Ni νi ] − E Xi,j − E[Ni Yi ]

i=1 j=1

n

= νi E[Ni ] − E[Ni ]E[Xi,j ] − E[Ni ]E[Yi ]

i=1

n

= λi νi − µi − µ̃i

i=1

and since all the sequences {Xi,j }j∈N with i ∈ {1, . . . , n} are independent of

Y1 , . . . , Yn it holds that

n

Ni

Var(R) = Var Ni νi − Xi,j − Ni Yi

i=1 j=1

n

Ni

= Var(Ni νi ) + Var Xi,j + Var(Ni Yi ) − 2 Cov Ni νi , Ni Yi

i=1 j=1

Ni

! Ni

!!

− 2 Cov Ni νi , Xi,j + 2 Cov Xi,j , Ni Yi .

j=1 j=1

Var(Ni νi ) = νi2 Var(Ni ) = λi νi2 ,

Ni

j=1

Ni

! Ni !

Cov Ni νi , Xi,j = νi Cov Ni , Xi,j

j=1 j=1

Ni

Ni

!

= νi E Ni Xi,j − E[Ni ]E Xi,j

j=1 j=1

2

= νi E Ni µi − E[Ni ]E[Ni ]µi

= λi νi µi ,

46 CHAPTER 4. STANDARD DEVIATION

Ni

! Ni

Ni

Cov Xi,j , Ni Yi = E N i Yi Xi,j − E Xi,j E Ni Yi

j=1 j=1 j=1

2

= E Ni2 µi µ̃i − E Ni µi µ̃i

= λi µi µ̃i ,

Cov Ni νi , Ni Yi = νi Cov Ni , Ni Yi

2 2

= νi E[Ni Yi ] − E[Ni ] E[Yi ]

= λi νi µ̃i .

n

i=1

− 2λi νi µi − 2λi νi µ̃i

n

= λ2i σ̃i2 + λi νi2 + µ2i + µ̃2i + 2µi µ̃i − 2νi µi − 2νi µ̃i

i=1

+ σi2 + σ̃i2

n

= λ2i σ̃i2 + λi (νi − µi − µ̃i )2 + σi2 + σ̃i2 .

i=1

Remark. Note that, if we allow dependence between the sequences {Xi,j }j∈N ,

for i ∈ {1, . . . , n}, and also between the random variables Y1 , . . . , Yn , it holds

that

n

Ni

Var(R) = Var Ni νi − Xi,j − Ni Yi

i=1 j=1

n

n−1 Ni

Nk

+2 Cov Ni νi − Xi,j − Ni Yi , Nk νk − Xk,j − Nk Yk ,

i=1 k>i j=1 j=1

In order to determine the solution of (4.21) we take the same approach

as in the previous section. This means that we consider the simplest cases

with n = 1 and n = 2. Because of the length of the expressions we will

not reiterate the general case, but all the following argumentations can be

4.3. THE SECOND VARIANT OF THE MODEL 47

to the model (4.20).

Let n = 1 and

N

R(N ) = νN − Xj − Y N

j=1

Poisson-distributed random variable with parameter λ > 0.

From the previous calculations we obtain

E R(N ) = λν − µ − µ̃

We now have the standard deviation risk measure for R(N ) which is

Consequently, in this case the initial problem (4.21) has the following form

λ(ν − µ − µ̃)

maximize

C

λ > 0.

order to get shorter expressions. We define

ν − µ − µ̃

a= ,

C

2

b = ν − µ − µ̃ + σ 2 + σ̃ 2 .

argumentations already mentioned.

Moreover, if we square the constraint we obtain a new formulation of the

problem to solve, which is very similar to (4.6).

maximize aλ

κ2 κ2

subject to λ2 σ̃ 2

− a2

+ λ b − 2a − 1 ≤ 0, (4.22)

C2 C2

λ > 0.

48 CHAPTER 4. STANDARD DEVIATION

We observe that, with respect to the problem (4.6), the only difference

is the value of the constant related to the variable λ. In this case we will

not rewrite all the passages to calculate the solution, because those in the

previous section are easily adaptable. Therefore, we can determine that the

optimal solution of (4.22) is

√

∗ 2aC 2 − κ2 b + κ κ2 b2 − 4abC 2 + 4σ̃ 2 C 2

λ =

.

2 κ2 σ̃ 2 − a2 C 2

N1

N2

R(N1 , N2 ) = ν1 N1 − X1,j − Y1 N1 + ν2 N2 − X2,j − Y2 N2 ,

j=1 j=1

with the assumptions cited at the beginning of this section. From the previ-

ous calculation we obtain

ν1 − µ1 − µ̃1

a1 = ,

C

ν2 − µ2 − µ̃2

a2 = ,

C

b1 = (ν1 − µ1 − µ̃1 )2 + σ12 + σ̃12 ,

b2 = (ν2 − µ2 − µ̃2 )2 + σ22 + σ̃22 ,

maximize a 1 λ 1 + a2 λ 2

κ

subject to − a1 λ1 − a2 λ2 + λ1 b1 + λ21 σ̃12 + λ2 b2 + λ22 σ̃22 ≤ 1, (4.23)

C

λ 1 , λ2 > 0 .

κ κ

σ̃1 > a1 and σ̃2 > a2 .

C C

4.4. THE THIRD VARIANT OF THE MODEL 49

Once again, squaring the main constraint, we get a new formulation very

similar to (4.9) with the exception of the constants related to λ1 and to λ2

respectively, i.e.,

maximize a1 λ1 + a2 λ2

κ2 κ2 2

2 κ 2 2

subject to λ1 b1 − 2a1 + λ2 b2 − 2a2 + λ1 σ̃ − a1

C2 C2 C2 1

κ2

+ λ22 σ̃ 2

− a2

2 − 2a1 a2 λ1 λ2 − 1 ≤ 0 (4.24)

C2 2

λ 1 , λ2 > 0 .

We can calculate the solution for this problem in the same way as in the

previous section. Without rewriting all the passages concerning the respec-

tively real quadratic form q, its matrix and the orthogonal change of variables

– which bring us to a form of the constraint corresponding to an ellipse – we

obtain that the optimal value of the function to maximize is reached by

√

λ1 =

2 2 2 2

2 C a1 σ̃2 + a2 σ̃1 − κ σ̃1 σ̃2

and

√ 2 2

2

λ∗2 =

,

2 2 2 2

2 C a1 σ̃2 + a2 σ̃1 − κ σ̃1 σ̃2

2

κ2 σ̃2 b21 + σ̃1 b22 + C 2 4 σ̃1 σ̃2 − a2 σ̃1 b2 − a1 σ̃2 b1 − a1 b2 − a2 b1

s= .

a21 σ̃2 + a22 σ̃1

All these argumentations are also valid for an n-dimensional problem. Con-

sequently, the initial optimization problem (4.21) has optimal solutions for

every model of the form of (4.20), but because of the length of the expression

we will not list general solutions.

sum of a positive integer and a random

variable for i ∈ {1, . . . , n}

In this section, we consider a different variation of the model examined in

this work and defined in Section 2.5. This new variation is based on the

50 CHAPTER 4. STANDARD DEVIATION

every unit i of the company, for i ∈ {1, . . . , n}. We define

Ni = Nifix + Nipois for i ∈ {1, . . . , n}.

This means that the number of contracts of any unit i is defined as the sum

of a fixed integer Nifix and a Poisson-distributed random variable Nipois with

parameter λi ≥ 0.

We observe that this variant of the model includes both versions we con-

sidered previously. In fact, if we set Nifix = 0 for all i ∈ {1, . . . , n}, we obtain

the same variant as those examined in Section 4.3 or, if we set λi = 0 for all

i ∈ {1, . . . , n}, we have the initial model considered in Sections 4.1 and 4.2.

We represent the whole portfolio through

fix pois

n Ni +Ni

fix pois

R= νi Ni + Ni − Xi,j − Yi Nifix + Nipois ,

i=1 j=1

with i ∈ {1, . . . , n} are independent sequences of i.i.d. random variables,

independent of the random variables Y1 , . . . , Yn and that Y1 , . . . , Yn are in-

dependent, too. Moreover, N1 , . . . , Nn are assumed to be independent of all

the sequences {Xi,j }j∈N with i ∈ {1, . . . , n} and of Y1 , . . . , Yn . Analogously,

we define the finite means and finite variances of Xi,j and Yi , respectively, by

µi = E[Xi,j ] and σi2 = Var(Xi,j ), for all j ∈ N and all i ∈ {1, . . . , n} ,

µ̃i = E[Yi ] and σ̃i2 = Var(Yi ), for all i ∈ {1, . . . , n}.

Our interest turns to the following optimization problem in order to de-

termine the portfolio which guarantees a maximal return.

E[R]

maximize , (4.25)

C

subject to ρ(R) ≤ C,

λi ≥ 0 for all i ∈ {1, . . . , n} ,

Nifix ≥ 0, integers for all i ∈ {1, . . . , n} .

We will consider only the simplest case with n = 1, because the form of Ni

already entails solving a two-dimensional optimization problem. A solution

for a more general problem can be computed with the same argumentations,

which can be easily adapted. For the sake of practicality, we rewrite the risk

R as follows

Ñ

R = ν Ñ − Xj − Y Ñ ,

j=1

4.4. THE THIRD VARIANT OF THE MODEL 51

where

Ñ = N + N p ,

with N denoting some positive integer and N p a Poisson-distributed random

variable with parameter λ ≥ 0. Using the formulae cited in the previous

section, we compute

E[R] = (N + λ)(ν − µ − µ̃) ,

+N p

N !

j=1

+N p

N ! +N p

N !

p p

− 2 Cov ν(N + N ), Xj + 2 Cov Xj , Y (N + N )

j=1 j=1

− 2 Cov ν(N + N p ), Y (N + N p )

= λ (ν − µ − µ̃)2 + σ 2 + σ̃ 2 + N σ 2 + (N 2 + λ2 )σ̃ 2 .

To simplify the calculations we introduce the constants

a = (ν − µ − µ̃)/C ,

b = (ν − µ − µ̃)2 + σ 2 + σ̃ 2 .

Moreover, as in previous sections we assume κσ̃/C > a. Therefore, the

optimization problem can be written as

maximize a(N + λ) (4.26)

κ

subject to − a(N + λ) + λb + N σ 2 + (N 2 + λ2 ) σ̃ 2 ≤ 1 ,

C

λ ≥ 0, N ≥ 0 .

If we square the main constraint we obtain

maximize a(N + λ) (4.27)

κ2 κ2 κ2

subject to λ2 2 2 σ̃ 2 − a2 + λ 2 b − 2a + N 2 2

σ̃ 2 − a2

C C C

κ2 κ2

+N σ 2 − 2a − 2N λ 2 σ̃ 2 − 2a − 1 ≤ 0,

C2 C

λ ≥ 0, N ≥ 0.

Then, if we consider only the constraint, we can rewrite it in a new form

related to an ellipse. In fact, introducing a quadratic form

κ2 2 κ2

2 2 2 2 κ 2 2 2

q = λ 2 2 σ̃ − a + N σ̃ − a − 2N λ 2 σ̃ − 2a

C C2 C

52 CHAPTER 4. STANDARD DEVIATION

matrix P with the orthonormal eigenvectors of A in its columns. Then, by

a change of variables from N, λ to x, y according to

! !

N x

=P ,

λ y

β1 x + β2 y + α1 x2 + α2 y 2 ≤ 1.

We observe that we get the same result as in the previous sections. The

only differences are the values of the constants, but, in any case, the way to

proceed is similar. Without writing all the calculations needed to compute

these values, we can now solve the optimization problem as we did in Section

4.2, and we obtain that the optimal solution is

4 2

2

2 2

2 2

N∗ =

2κ2 σ̃ 2 a2 C 2 − κ2 σ̃ 2

2 2

√

3κ σ̃ − 2a2 C 2 s

+ 2 2 2 2

2κ σ̃ a C − κ2 σ̃ 2

and

√

∗ 4aC 2 − κ2 σ 2 + b − 2 s

λ = ,

2κ2 σ̃ 2

where we use s as short notation for

s=

2 2 4a2 C 2 − 5κ2 σ̃ 2

+ .

4a2 C 2 − 5κ2 σ̃ 2

Chapter 5

Capital allocation

An insurance company has a total target return and spreads down the total

return to different portfolios when establishing a business plan. The company

is also interested in comparing the individual returns ri = E[Ri ]/Ci of the

various business units i ∈ {1, . . . , n}.

The vital question concerning this is: how can one choose Ci ? The idea

is to introduce a capital allocation principle and to split up the risk capital

amongst the various business units, but there is no general answer to the

question of how the risk capital should be allocated. There are different

classes of capital allocation methodologies, and a formal description can be

found in Albrecht (1997).

In the following sections, we consider two different capital allocation prin-

ciples, namely the covariance principle and the expected shortfall principle.

We now want to calculate the well-known covariance principle for the special

case of RAC(R) = −E[R] + κσ(R) with κ > 0 and with R having the

following form

n n Ni

R= Ri = νi Ni − Xi,j − Yi Ni

i=1 i=1 j=1

where

• N1 , . . . , Nn are positive integers,

• {Xi,1 , Xi,2 , . . . , Xi,Ni } are finite sequences of i.i.d. random variables with

finite means and finite variances for all i ∈ {1, . . . , n} with

µi = E[Xi,j ] and σi2 = Var(Xi,j ),

53

54 CHAPTER 5. CAPITAL ALLOCATION

ρik = corr(Xi,j , Xk,l )

for all i, k ∈ {1, . . . , n}, i = k and j ∈ {1, . . . , Ni }, l ∈ {1, . . . , Nk },

• Y1 , . . . , Yn are random variables with finite means and finite variances

µ̃i = E[Yi ] and σ̃i2 = Var(Yi ),

• the sequences {Xi,1 , . . . , Xi,Ni }, for every i ∈ {1, . . . , n}, are indepen-

dent of the random variables Y1 , . . . , Yn .

Remark. There are restrictions on the correlation coefficients ρik with i, k in

{1, . . . , n}, i = k. The covariance matrix of the (N1 + · · · + Nn )-dimensional

random vector

(X1,1 , . . . , X1,N1 , X2,1 , . . . , X2,N2 , . . . , Xn,1 , . . . , Xn,Nn )

has to be positive semidefinite. If this is the case, then there exist at least

multivariate normally distributed random variables with the prescribed de-

pendence structure.

In general it holds that

Cov(Ri , R)

Ci = C ,

Var(R)

where C denotes the capital the company wants to invest and Ci is the capital

the company will allocate to business unit i.

Let us compute the enumerator and the denominator separately. On one

side, we have that, for the enumerator, it holds that

n

Cov(Ri , R) = Cov Ri , Rk

k=1

n

= Var(Ri ) + Cov Ri , Rk

k=1

k
=i

Ni

n

j=1 k=1

k =i

n

k=1

k =i

5.1. COVARIANCE PRINCIPLE 55

Ni

Nk

j=1 l=1

Ni

Nk

= Cov Xi,j + Yi Ni , Xk,l + Yk Nk

j=1 l=1

Nk

Ni

j=1 l=1

=ρik σi σk =ρ̃ik σ̃i σ̃k

{1, . . . , n} with i = k,

ρ̃ik = corr Yi , Yk .

n

Var(R) = Var Rj

j=1

n

n−1

n

= Var Rj + 2 Cov Rj , Rk

j=1 j=1 k=j+1

n

n−1

n

j=1 j=1 k=j+1

Ci = C n 2 2 2

n−1 n

.

j=1 Nj σj + Nj σ̃j + 2 j=1 k=j+1 Nj Nk ρjk σj σk + ρ̃jk σ̃j σ̃k

Remark. In the case where {Xi,j }j∈N are independent sequences consisting

of i.i.d. random variables and Y1 , . . . , Yn are independent too, it holds that

all correlation coefficients are zero. Therefore, it follows that

Ni σi2 + Ni2 σ̃i2

Ci = C n 2 2 2

.

j=1 Nj σj + Nj σ̃j

assume that all Ni , with i ∈ {1, . . . , n}, which denote the number of contracts

for every unit i, are Poisson-distributed random variables with parameters

56 CHAPTER 5. CAPITAL ALLOCATION

having the following form

n

n

Ni

R= Ri = νi Ni − Xi,j − Yi Ni ,

i=1 i=1 j=1

where

• N1 , . . . , Nn are Poisson-distributed random variables, i.e.,

Ni ∼ POIS(λi ) with λi > 0,

finite means and finite variances for all i ∈ {1, . . . , n}

µi = E[Xi,j ] and σi2 = Var(Xi,j ),

µ̃i = E[Yi ] and σ̃i2 = Var(Yi ),

• all the sequences {Xi,j }j∈N with i ∈ {1, . . . , n} are independent of the

random variables Y1 , . . . , Yn ,

• N1 , . . . , Nn are assumed to be independent of all the sequences {Xi,j }j∈N

with i ∈ {1, . . . , n} and of Y1 , . . . , Yn .

Remark. Consider sequences {Ui }i∈N and {Vi }i∈N of i.i.d. random variables.

For simplicity, assume that E[Ui ] = E[Vi ] = 0 and Var(Ui ) = Var(Vi ) = 1

for all i ∈ N. If the correlation ρ = Cov(Ui , Vj ) does not depend on i, j ∈ N,

then ρ has to be zero. To see this, fix n ∈ N. Then

n !

0 ≤ Var (Ui + Vi )

i=1

n

n

i=1 i,j=1

2

= 2n + 2n ρ

implies ρ ≥ −1/n. Similarly,

n

!

0 ≤ Var (Ui − Vi ) = 2n − 2n2 ρ,

i=1

hence ρ ≤ 1/n. Since n ∈ N was arbitrary, ρ = 0. For this reason, the above

sequences {Xi,j }j∈N for i ∈ {1, . . . , n} are assumed to be uncorrelated.

5.1. COVARIANCE PRINCIPLE 57

Cov(Ri , R)

Ci = C ,

Var(R)

with

n

Cov(Ri , R) = Var(Ri ) + Cov Ri , Rk

k=1

k
=i

n

σi2 + σ̃i2 + µ2i + Cov(Ri , Rk )

k=1

k =i

and

n

n−1

n

Var(R) = Var(Ri ) + 2 Cov(Ri , Rk ) .

i=1 i=1 k=i+1

separately:

Ni

Nk

Cov(Ri , Rk ) = Cov νi Ni − Xi,j − Yi Ni , νk Nk − Xk,l − Yk Nk

j=1 l=1

Nk

= Cov(νi Ni , νk Nk ) − Cov νi Ni , Xk,l − Cov(νi Ni , Yk Nk )

l=1

Ni

Ni

Nk

− Cov Xi,j , νk Nk + Cov Xi,j , Xk,l

j=1 j=1 l=1

Ni

+ Cov Xi,j , Yk Nk − Cov(Yi Ni , νk Nk )

j=1

Nk

+ Cov Yi Ni , Xk,l + Cov(Yi Ni , Yk Nk ) ,

l=1

with

Cov(νi Ni , νk Nk ) = νi νk ρ̂ik λi λk ,

58 CHAPTER 5. CAPITAL ALLOCATION

Nk

Nk

Cov νi Ni , Xk,l = νi Cov Ni , Xk,l

l=1 l=1

N k Nk !

= νi E Ni Xk,l − E Ni E Xk,l

l=1 l=1

= νi E Ni Nk µk − λi λk µk

= νi µk Cov(Ni , Nk ) = νi µk ρ̂ik λi λk ,

Cov(νi Ni , Yk Nk ) = νi E Ni Yk Nk − E Ni E Yk Nk

= νi µ̃k Cov(Ni , Nk ) = νi µ̃k ρ̂ik λi λk ,

Ni

Ni Ni !

Cov Xi,j , νk Nk = νk E Nk Xi,j − E Nk E Xi,j

j=1 j=1 j=1

= νk µi ρ̂ik λi λk ,

Ni

Nk

Ni

Nk

Ni

Nk

Cov Xi,j , Xk,l = E Xi,j Xk,l − E Xi,j E Xk,l

j=1 l=1 j=1 l=1 j=1 l=1

= E N i Nk µ i µk − µ i µk λ i λ k

= µi µk Cov Ni , Nk

= ρ̂ik λi λk µi µk ,

Ni

Cov Xi,j , Yk Nk = E Ni Nk µi µ̃k − λi µi λk µ̃k

j=1

= µi µ̃k Cov(Ni , Nk ) = µi µ̃k ρ̂ik λi λk ,

Cov(Yi Ni , νk Nk ) = νk E Yi Ni Nk − E Yi Ni E Nk

= νk µ̃i Cov(Ni , Nk ) = νk µ̃i ρ̂ik λi λk ,

Nk

Cov Yi Ni , Xk,l = E Ni Nk µ̃i µk − λi µ̃i λk µk

l=1

= µ̃i µk Cov(Ni , Nk ) = µ̃i µk ρ̂ik λi λk ,

5.1. COVARIANCE PRINCIPLE 59

Cov(Yi Ni , Yk Nk ) = E Yi Ni Yk Nk − µ̃i µ̃k λi λk

= E Yi Yk E Ni Nk − µ̃i µ̃k λi λk

+ λi λk Cov Yi , Yk

= ρ̃ik σ̃i σ̃k ρ̂ik λi λk + ρ̂ik λi λk µ̃i µ̃k

+ ρ̃ik σ̃i σ̃k λi λk ,

where with ρ̂ik and ρ̃ik we denote the linear correlation coefficients between

the dependent random variables, i.e.,

Cov(Ri , Rk ) = ρ̂ik λi λk νi − µi − µ̃i νk − µk − µ̃k + ρ̃ik σ̃i σ̃k

+ λi λk ρ̃ik σ̃i σ̃k .

A similar calculation

√ with i = k for the nine terms given above gives similar

results with ρ̃ik λi λk replaced by λi and ρ̃ik σ̃i σ̃k replaced by σ̃i2 . However,

for the fifth term we get

Ni

! Ni

Ni

N1

!2

2

Var Xi,j =E Xi,j Xi,l + E Xi,j − E Xi,j

j=1 j,l=1 j=1 j=1

j
=l

2

] − (E[Ni ] µi )2

= λ2i µ2i + λi E[Xi,1

2

] − λ2i µ2i

= λi σi2 + λi µ2i ,

hence

n

k=1 !

k =i

+ λi λk ρ̃ik σ̃i σ̃k ,

60 CHAPTER 5. CAPITAL ALLOCATION

and

n

n−1

n

Var(R) = Var(Ri ) + 2 Cov(Ri , Rk )

i=1 i=1 k=i+1

n !

σi2 + σ̃i2 + µ2i +

i=1

n−1

n

+2 λi λk ρ̃ik σ̃i σ̃k

i=1 k=i+1

!

+ ρ̂ik λi λk νi − µi − µ̃i νk − µk − µ̃k + ρ̃ik σ̃i σ̃k .

the {Xi,j }j∈N with i ∈ {1, . . . , n} are uncorrelated sequences and the ran-

dom variables Y1 , . . . Yn are also independent, it holds that all correlation

coefficients are zero. Thus, it follows that

Ci = C

.

n 2 2 2 + σ 2 + σ̃ 2 + µ2

j=1 λ σ̃

j j + λ j (νj − µ j − µ̃ j ) j j j

An alternative to the covariance principle for the purpose of allocation of risk

capital are the conditional expectations.

nLet R1 , . . . , Rn be the stochastic gains of the business units and R =

i=1 Ri the whole profit and loss of an insurance company. Let c ≤ 0 be

the capital loss threshold, for example, the α-quantile rα of R. If a total loss

R ≤ c occurs, we consider the expected shares E[−Ri | R ≤ c] of the single

losses with respect to the total loss. Obviously, it holds that

n

E[−R | R ≤ c] = E[−Ri | R ≤ c] ,

i=1

where E[−R | R ≤ c] denotes the risk capital of the entire company, while

E[−Ri | R ≤ c] denotes the risk capital assigned to business unit i.

This risk capital allocation principle is additive, as is the covariance prin-

ciple, but in addition it can be applied for integrable random variable, so the

existence of second moments is no longer required. In order to compute these

conditional expectations we can use the procedures proposed in Appendix A.

5.2. EXPECTED-SHORTFALL PRINCIPLE 61

consisting of two units, i.e.

N1

N2

R = R1 + R2 = ν1 N1 − X1,j − Y1 N1 + ν2 N2 − X2,j − Y2 N2 ,

j=1 j=1

• the sequences {X1,j }j∈N and {X2,j }j∈N are independent and consist of

independent, identically normally distributed random variables, i.e.,

• the sequences {X1,j }j∈N and {X2,j }j∈N are independent of Y1 and Y2 .

It is known that, given the independent random variables Xi,j that are

normally distributed for i = 1, 2 and all j ∈ N, the random variables R1 , R2

and R are also normally distributed, i.e.,

where we define

and

µR = µ̂1 + µ̂2 , σR2 = σ̂12 + σ̂22 .

We denote the density of the standard normal distribution by

1 1 2

ϕ(u) = √ e− 2 u , u ∈ R,

2π

and the standard normal distribution function by

t

Φ(t) = ϕ(u) du, t ∈ R.

−∞

62 CHAPTER 5. CAPITAL ALLOCATION

Note that t − µ

R

P R≤t =Φ .

σR

We are now interested in the measures of risk

E Ri | R ≤ c

we obtain !

σ̂i2 ′ c − µR

E[Ri | R ≤ c] = µ̂i − (log Φ) .

σR σR

Appendix A

In the following pages we will introduce some rules which will be seen to be

useful to calculate the expected shortfall.

Let X be an integrable random variable with distribution function FX .

Then, for all c ∈ R such that FX (c) < 1, it holds that

∞

1

E X |X > c = x FX (dx). (A.1)

1 − FX (c) c

LetX1 , . . . , Xn be exchangeable1 integrable random variables and let

n

X = i=1 Xi . Then, for all c ∈ R such that P (X > c) > 0 and for all

i, j ∈ {1, . . . , n}, it holds that

E Xi | X > c = E Xj | X > c .

Since the conditional expectation is linear, for all i ∈ {1, . . . , n}, it follows

that

1

E Xi | X > c = E X | X > c

n

and this last conditional expectation can be solved by means of (A.1).

Let X and Y be independent integrable random variables with distribu-

tion functions FX and FY , respectively, and let c ∈ R such that

P (X + Y > c) > 0. It then holds that

1

E X |X + Y > c =

x 1 − FY (c − x) FX (dx) ,

1 − FX ∗ FY (c) R

(A.2)

1

Let I be a

countable set. A sequence Xi , i ∈ I of random variables on a probability

space Ω, F,

P is exchangeable

if, for every permutation ρ of I, the distributions of

Xρ(i) , i ∈ I and Xi , i ∈ I are identical. Note that a finite or infinite i.i.d. sequence is

exchangeable.

63

64 APPENDIX A. CALCULATING EXPECTED SHORTFALL

FY , that is, the distribution function of the sum X + Y , i.e.,

P (X + Y > c) = 1 − FX ∗ FY (c) .

with distribution functions F1 , . . . , Fn , respectively. Let X = X1 and

Y = X2 + · · · + Xn . X and Y are likewise independent with distribution

functions FX = F1 and FY = F2 ∗ · · · ∗ Fn , respectively. The conditional

expectation E X1 | X1 + · · · + Xn > c can be then solved by means of (A.2).

Let

1 2

ϕ(t) = √ e−t /2 , t ∈ R,

2π

and x

Φ(x) = ϕ(t) dt , x ∈ R,

−∞

denote the density and the distribution function of the standard normal dis-

tribution, respectively.

Given X ∼ N (0, 1) and c ∈ R, we obtain with the substitution z = x2 /2

c

1

E[X | X ≤ c] = xϕ(x) dx

Φ(c) −∞

∞

1

= −√ e−z dz

2π Φ(c) c2 /2

2

e−c /2

= −√

2π Φ(c)

ϕ(c)

′

=− = − log Φ (c).

Φ(c)

If Y ∼ N (µ, σ 2 ), then

Y −µ

X := ∼ N (0, 1)

σ

and with the above result we obtain

E[Y | Y ≤ c] = E[µ + σX | µ + σX ≤ c]

= µ + σE[X | X ≤ (c − µ)/σ] (A.3)

′ c − µ

= µ − σ log Φ .

σ

65

In particular, for c = 0,

E[Y ] µ

=

′

E[−Y | Y ≤ 0] −µ + σ log Φ −µ σ

1

=

′

.

−1 + σµ log Φ −µ σ

stants c ∈ R, σ > 0. To compute E[X | σX + Y ≤ c], define

c

γ=√

1 + σ2

and note that

P (σX + Y ≤ c) = Φ(γ)

√

because (σX + Y )/ 1 + σ 2 ∼ N (0, 1). By conditioning on the σ-algebra

generated by X,

1

E[X | σX + Y ≤ c] = E E[X1{σX+Y ≤c} | X]

Φ(γ)

1

= E[XP (Y ≤ c − σX | X)] .

Φ(γ)

Since X and Y are independent,

E[XΦ(c − σX)] = xϕ(x)Φ(c − σx) dx = −σ ϕ(x)ϕ(c − σx) dx .

R R

Since

√

2

x2 + (c − σx)2 = (1 + σ 2 )x2 − 2cσx + c2 = 1 + σ 2 x − σγ + γ 2 ,

√

the substitution u = 1 + σ 2 x − σγ yields

√

R R

ϕ(γ)

=√ ϕ(u) du

1 + σ2 R

ϕ(γ)

=√ .

1 + σ2

66 APPENDIX A. CALCULATING EXPECTED SHORTFALL

Therefore,

σ ϕ(γ)

E[X | σX + Y ≤ c] = − √

1 + σ 2 Φ(γ)

! (A5)

σ ′ c

= −√ (log Φ) √ .

1 + σ2 1 + σ2

2

More generally, for independent X ∼ N (µX , σX ) and Y ∼ N (µY , σY2 )

with σX > 0 and σY > 0, we obtain

E[X | X + Y ≤ c]

X − µX σX X − µX Y − µY c − µX − µ Y

= µX + σX E + ≤ .

σX σY σX σY σY

Since

X − µ X Y − µY

, ∼ N (0, 1) ,

σX σY

equation (A5) gives

E[X | X + Y ≤ c]

!

σX /σY c − µ − µY

= µX − σX (log Φ) ′

X

1 + (σX /σY )2 σY 1 + (σX /σY )2 (A6)

2

!

σX ′ c − µX − µ Y

= µX − 2 (log Φ) 2 .

σX + σY2 σX + σY2

Appendix B

be an open subset of Rn+m . Suppose x ∈ Rn , y ∈ Rm , f : U → R and

g : U → Rm . Let us examine the problem of finding the extrema of f (x, y) =

f (x1 , . . . , xn ; y1 , . . . , ym ) subject to the m constraints:

g1 (x1 , . . . , xn ; y1 , . . . , ym ) = 0 ,

.. ..

. .

gm (x1 , . . . , xn ; y1 , . . . , ym ) = 0 .

Suppose that f ∈ C 1 (U, R) and g ∈ C 1 (U, Rm ). Moreover, assume that

(ξ, η) ∈ M = {(x, y) ∈ U | g(x, y) = 0} is such that the restriction f |M of f to

M has a local extremum at (ξ, η); this means that there is some neighborhood

V of (ξ, η) such that either f (x, y) ≤ f (ξ, η) for all (x, y) ∈ V ∩ M or

f (x, y) ≥ f (ξ, η) for all (x, y) ∈ V ∩ M . Suppose also that the n by n matrix

∂g(ξ, η)/∂y has nonzero determinant. Then, a vector λ = (λ1 , . . . , λm ) ∈ Rm

exists such that the function

m

= f (x, y) + zj gj (x, y) , (x, y, z) ∈ U × Rm ,

j=1

67

68 APPENDIX B. THE LAGRANGE MULTIPLIERS RULE

Hyk = fyk + "λ, gyk # = 0 , k = 1, . . . , m , (B.1)

Hλk = gk = 0 , k = 1, . . . , m .

result is that if one seeks points (ξ, η) at which f |M has local extrema, then

one need only search among those (ξ, η) ∈ M for which the system (B.1) has

a solution λ.

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