Financial modeling, actuarial valuation and solvency in insurance (Q444331)

This book is a mathematically rigorous text on solvency modeling. It combines ideas from financial mathematics, actuarial sciences and economic theory. It studies solvency questions in incomplete markets, analyses hedging risks, and studies asset-and-liability management questions, as well as issues like the limited liability options, dividends to shareholder questions, the role of re-insurance, etc. The book is for readers and practioners in the financial and actuarial industries. Readers should have a good background in probability theory, statistics, stochastic processes, martingales, etc. The book has three parts. Part I considers financial valuation principles. Part II studies actuarial valuation and solvency. Part III is an appendix and presents mathematical techniques of wider interest. Part I (Financial valuation principles) introduces the financial valuation framework. The crucial property is that all assets and liabilities are valued consistently at any time. This eliminates arbitrage. The tools are equivalent martingale measures (from financial mathematics) and state price deflators (from actuarial mathematics). These are introduced and their interrelationship is described. They are applied to the valuation of cash flows. There follow explicit models. The first models are based on spot rate processes which describe the short-term behavior of interest rates. The latter models describe the arbitrage-free development of the entire interest rate curve. At the end of Part I explicit examples of cash-flow valuation are provided. It introduces the financial market and the price process of its financial instruments and derivatives. Part II (Actuarial valuation and solvency) refines the valuation framework introduced in Part I. The aim is to distinguish between hedgeable and non-hedgeable parts in an actuarial context. Using the state-price deflator setup all risk drivers that cannot be explained by financial market movements are isolated. This requires that the state-price deflator is decoupled into the financial deflator and the probability distortion. The financial deflator describes the price formation in the financial market. The probability distortion is used for calculating the risk-margin (which supports the risk bearing of non-hedgeable assets). There follows the valuation portfolio. This is a systematic approach that decouples insurance liabilities that can be replicated by instruments of the financial market and the insurance technical component. The best-estimate reserves are then obtained by replacing the insurance technical component by its expected value. This construction is demonstrated for explicit insurance portfolios. Now, every risk- averse risk bearer will charge an additional risk margin for compensating possible shortfalls in the outcomes. Therefore, the protected valuation is introduced. This construction relies on probability distortions which under appropriate assumptions provide positive risk margins and the corresponding risk-adjusted reserves. Explicit numerical examples follow. After this, the core of risk measurement and solvency assessment is introduced. Based on the value principles it determines whether the financial assets are sufficient to cover the liabilities also in the case of well-specified stress situations. Well-specified stress situations are described by introducing a risk measure examining whether the asset and liability positions in the full balance sheet approach are sufficiently safe according to the chosen risk measure. This adds the dynamic aspect to the balance sheets of insurance companies. The notions of asset deficit and free capital that play a crucial role in solvency considerations are introduced. Further, this book discusses limited liability options, the Margrabe option, dividend payments, cost-of-capital loadings, risk spreading, and the law of large numbers (the basics for insurance). There follow insights in selected topics and further developments, where the authors build their own insurance company. They study solvenceny for different business plans showing how all the risk factors enter the risk management and solvency analysis. They study the important topics of parameter uncertainty, applied cost-of-capital concepts, modeling of accounting and calender years dependence in non-life insurance as well as premium liability and re-insurance modeling. The latter provides mitigation techniques for insurance technical risks.