Controlling Risk Exposure and Dividends Pay-out

Schemes:
Insurance Company Example
Bjarne Hjgaard Michael Taksary

May 11, 1998

Abstract
The paper represents a model for the nancial valuation of a rm which
has control on the dividend payment stream and its risk as well as poten-
tial prot by choosing dierent business activities among those available
to it. This is an extension of the classical Miller Modigliani theory of
rm valuation theory to the situation of controllable business activities
in stochastic environment. We associate the value of the company with
the expected present value of the net dividend distributions (under the
optimal policy).
The example we consider is a large corporation such as an insurance
company, whose liquid assets in the absence of control uctuate as a Brow-
nian motion with a constant positive drift and a constant diusion coe-
cient. We interpret the diusion coecient as risk exposure, while drift is
understood as potential prot. At each moment of time there is an option
to reduce risk exposure, simultaneously reducing the potential prot, like
using proportional reinsurance with another carrier for an insurance com-
pany. Another thing that the management of the company controls is the
dividends paid-out to the shareholders. The objective is to nd a policy
which maximizes the expected total discounted dividends paid out until
the time of bankruptcy. Two cases are considered:
a) The rate of dividend pay-out is bounded by some positive constant
M.
b) There is no restriction on the rate of dividend pay-out.
We use recently developed techniques of Mathematical Finance to ob-
tain an easy understandable closed form solution. We show that there are
two levels u0 < u1 . As a function of currently available reserve, the risk
exposure monotonically increases on (0; u0 ) from 0 to maximum possible.
When the reserve exceeds u1 the dividends are paid at the maximal rate in
the rst case and in the second case every excess above u1 is distributed as
dividend. We also show that for M small enough u0 = u1 and the optimal
risk exposure is always less than the maximal.
 Department of mathematics, Aalborg University, Denmark.
y Department of AMS, SUNY, Stony Brook, USA.This work is supported by NATO Col-
laborative Research Grant CRG 951275 and as NSF Grant DMS 9301200.

1
 Keywords: Dividends pay-out, proportional reinsurance, diusion mod-
els, Stochastic Control Theory, HJB equation.

1 Introduction

The classical paper by Miller & Modigliani [32] provides the valuation formula
for an innite horizon rm under the assumption of perfect certainty. It shows
that the value of the company can be equated with to the present value of
the net distributions to shareholders over innite horizon. There were several
extensions of this work, in which it was shown that in most cases the Miller
Modigliani approach can be used in the case of stochastic environment as well
(e.g., Sethi et al. [38], [39], [37]).
In this paper we consider a rm valuation problem for a company in which the
dividend stream as well as the risk exposure are controlled by management.
We equate the value of such company to the expected present value of the net
dividend distributions (under the optimal policy).
While our methods are rather general, the framework of a large insurance com-
pany seems to the best illustration to the model we consider (for a discussion
of the relation to consumption/investment models, see Remark 1.1 below).
Optimizing dividends pay-out is a classical problem in actuarial mathematics,
on which earlier work is given in e.g. de Finetti [13], Borch [2], [3], Buhlmann
[6], Gerber [16], [17] and Buzzi [7]. Recently, there has been a renewed interest
in the diusion models for the corporations with controllable risk exposure and
dividends distribution, e.g. Radner & Shepp [35] and Browne [4], [5]. In these
papers the problem is formulated and solved in the framework of controlled
diusions, see e.g. Fleming & Rishel [14]. Our approach is also based on con-
trolled diusion techniques, in particular the so-called mixed classical-singular
control. In this framework the problem is also partially treated by Whittle [43]
and the case of no reinsurance options is solved in this framework by Asmussen
& Taksar [1] and to some extend by Paulsen & Gjessing [33]. For other appli-
cations of control theory in insurance mathematics see Hjgaard & Taksar [22],
Martin-Lof [29], [30], [31], Davis [9] and Dayananda [11].
Consider a corporation whose liquid assets at time t are described by a stochas-
tic process fRt g. For an insurance company fRt g is the reserve of the company
at time t . We will refer to this process, as the risk process.
To give a mathematical formulation of the optimization problem, we start with
a probability space (
; F ; IP), a ltration fFt gt0 and a process fWt g, which is
a standard Brownian motion with respect to fFt g. The ltration Ft represents
the information available at time t and any decision is made based upon this
information. We assume, that in the case of no control the risk process evolves

2
according to
dRt = dt + dWt
with ;  > 0. For a motivation of this model see e.g. Asmussen & Taksar [1],
Grandell [20] and Dayananda [11]. The initial reserve R0 is supposed to be
F0 -measurable. Without loss of generality we can assume that it is equal to a
deterministic value x.
A control policy  is described by a two-dimensional stochastic process fa (t); Lt g,
where 0  a (t)  1 corresponds to the risk exposure at time t and Lt  0 is
a non-decreasing process whose value corresponds to the cumulative amount of
the liquid assets distributed up to time t. For the case of the insurance company
1 a (t) denotes the fraction of the incoming claims that is reinsured at time
t while Lt denotes the total amount of dividends paid out up to time t. When
applying policy  we let fRt g denote the controlled risk process. The increment
Rt+dt Rt will then be distributed as a (t)(Rt+dt Rt ) (Lt+dt Lt ). The
dynamics for Rt are then given by
dRt = a (t)dt + a (t)dWt dLt (1.1)
R0 = x L 0 :
 
(1.2)
The above equation is derived under the assumption sometimes called cheap
reinsurance. The latter means that the reinsuring companies have the same
safety loading as the insuring company.
The policy  is said to be admissible if the process fa (t); Lt g is adapted to
the ltration fFt g and 0  a (t)  1, and Lt is nonnegative non-decreasing
right-continuous functional. In this case we call the process fa (t); Lt g the
control process or simply the control. We denote by  the set of all admissible
policies. For a given admissible policy  we dene the return function V by
Z 
V (x) = IE e ct
dLt ; (1.3)
0
where  = inf ft : Rt = 0g with fRt g the solution to (1.1) and c > 0 is a
discount rate. For any admissible Lt we put L0 = 0, thus the integral in the
right hand side is considered from 0 to 1 and always includes the quantity
L0 . Note also that  is not an endogenously determined random variable, it
rather depends on our policy. We will call  the bankruptcy time.
The objective is to nd the optimal return function, which is dened as
V (x) = sup V (x); (1.4)
2

and to nd an optimal policy  that satises V (x) = V (x) for all x.
The problem we consider is a so-called mixed singuar/regular stochastic control
problem. Within a dierent framework this types of problems were considered
in Lechoczky & Shreve [27], Davis & Norman [10] and Cadenillas & Hausmann
[8].
3
Our rst step would be to nd the qualitative behaviour of the function V . Let
 be any admissible control. Dene another admissible control ^ by
(
a^ (t) = a (t) t <  ;
0 t  
and (
^
L =
 Lt t <  :
t L t  
Then ^ =  and
V^ (x) = V (x) for all x:
In other words setting a (t) and dLt to any quantity (in particular to 0) for
t   does not change the value of V (x). Thus without loss of generality we
can reduce the set of admissible policies to A, where A   is dened as
 2 A if and only if a (t) = 0 and dLt = 0 for t >  :
Then for any  2 A we have Rt = 0 for t >  and
Z1
V (x) = IE e ct dLt dt: (1.5)
0

Proposition 1.1 The function V dened by (1.4) is concave.

Proof Let x be an admissible policy for the initial reserve x1 and x for the
1 2
initial reserve x2 . Let 0 <  < 1 and dene  by
a (t) = ax1 (t) + (1 )ax2 (t):
and
Lt  = Lt x1 + (1 )Lt x2 : (1.6)
Then by linearity of (1.1)  is an admissible policy for the initial reserve  =
x1 +(1 )x2 and Rt = Rtx1 +(1 )Rtx2 with  = x1 _ x2 . Linearity


of the equations (1.5) and (1.6) implies

V ( ) = Vx1 (x1 ) + (1 )Vx2 (x2 ):
For any " > 0 we can choose xi such that Vxi (xi )  V (xi ) "=2. Since  is
suboptimal we then have
V ( )  V (x1 ) + (1 )V (x2 ) ":
Concavity of V follows from the arbitrariness of ". 2

4
Remark 1.1 The problem of this paper can also be formulated as a consump-
tion/investment problem in the following way. Suppose that there is an indi-
vidual investor who has two assets available for him: one is risky and one is
risk-free. The price of the risky asset is governed by an arithmetic Brownian
motion with drift  and diusion , while the price of the risk free asset is
constant. He continuously trade the assets, incurring no transaction cost, using
proceeds to nance his consumption. If we denote by a (t) the proportion of
his wealth that he keeps in the risky asset at time t and by Lt his cumulative
consumption up to time t, then the dynamics of his wealth is given by (1.1),
(1.2). If the objective is to optimize the expected total discounted consumption
until the time of his bankruptcy, then this consumption/investment problem is
equivalent to the one we are considering in this paper. It should be mentioned,
however, signicant dierence between this model and the classical consump-
tion/investment models. First, in the classical consumption/investment models
(see Karatzas et al. [23], Presman & Sethi [34] and Sethi et al. [40]) the prices
of risky assets are governed by geometric Brownian motions. Second, the objec-
tive is to maximize the expected total discounted utility of consumption. The
utility function U (
) is actually a function of consumption rate and it is assumed
to be concave with derivative at innity equal to zero. The latter ensures that
in the optimization problem one can consider only those functionals L, which
are dierentiable thus dealing only within the domain of the classical stochastic
control. In our case we have \utility" function U (x) equal to x, thus eliminat-
ing the possibility to deal only with the dierentiable functional L unless this
requirement is set a priori. It is also important to observe that in case of the
risky asset governed by a geometric Brownian motion, the problem becomes by
and large trivial: either it is optimal to consume everything instantaneously,
or the optimal value function is equal to innity (see Radner & Shepp [35]).
Thus while formally, one can formulate the problem of the present paper in the
framework of consumption/investment model, with \non-natural" risky assets
and utility function, it is impossible to apply directly the results of those models
to our case. Nevertheless some tools and techniques can be \borrowed" from
those models and successfully employed in the dividend optimization problem.
2

The rest of the paper is organized as follows: In Section 2 we consider the

problem with bounded rate of dividend payment and in Section 3 the case of no
restriction is treated. In both sections we follow the standard line of stochastic
control: First we assume that the optimal return function is suciently smooth
and nd that under these assumptions it satises a second order dierential
equation known as the Hamilton-Jacobi-Bellman equation (HJB). Thereafter
we nd a solution of the HJB and nally we prove the verication theorem,
which shows that the solution to the HJB actually coincides with the optimal
return function. This proof also indicates what is the optimal control and
thereby the optimal policy. In Asmussen & Taksar [1] a problem very similar
to the present is treated, but with no option of reinsurance, that is a (t)  1
for all . In section 4 we compare numerically their results with ours. This
5
numerical comparison indicates the gain of proportional reinsurance. Finally
in Section 5 we investigate partly how the solutions depend on the exogenous
parameters.

2 Bounded dividend pay-out rate

In this section we consider the case, in which the rate of dividend pay-out is
bounded by some 0 < M < 1. In this case Lt can be represented in the
following way Zt
Lt = l (s)ds;

0  l (s)  M: (2.1)
0
Notice that here (1.1), (1.2) can be written as
dRt = (a (t) l (t))dt + a (t)dWt (2.2)
R0 = x (2.3)
and Z 
V (x) = IE e ct
l (t)dt: (2.4)
0
We dene for all 0  a  1 and 0  l  M the dierential operator La;l by
2 2
La;lg(x) =  2a g00 (x) + (a l)g0 (x) cg(x): (2.5)

2.1 The Hamilton-Jacobi-Bellman equation

Proposition 2.1 Assume V dened by (1.4) is twice continuously dieren-
tiable on (0; 1). Then V satises the Hamilton-Jacobi-Bellman equation

max 1 2 a2 V 00 (x) + (a l)V 0 (x) cV (x) + l = 0 (2.6)
a2[0;1];l2[0;M ] 2
with V (0) = 0.

Proof By similar arguments as in Hjgaard & Taksar [22] we can prove that V
satises the Dynamic programming principle
Z  ^ 
c(^ )
V (x) = sup IE e cs
l (s)ds + e V (R 
^ ) : (2.7)
 0
For any admissible  and h > 0 let h = h ^ inf ft : Rt 62 (x h; x + h)g. Then
h < 1 a.s. and h ! 0 a.s. Fix a; l arbitrary and choose  such that a (t) = a

6
and l (t) = l. Choose h < x, then h <  and by suboptimality of  we get
from (2.7) with  = h
"Z #
h
V (x)  IE e cs
lds + e ch
V (R ) :

h
0
Z h Z h
= IE
0
e cs
lds + V (x) + IE
0
e L
cs a;l
V (Rs )ds;

where we have used Ito's formula (see e.g. ksendal [44]) applied to g(t; x) =
e ct V (x). Subtract V (x) from both sides and divide by IE[h ] to get
Z h
0  IE[1h ] IE e cs(l + La;l V (Rs ))ds ! l + La;l V (x);
 0
when h ! 0. Arbitrariness of a and l yields
0  a2[0;max
1];l2[0;M ]
l + La;l V (x): (2.8)

For any h < x and  > 0 there exist policies ~x satisfying
"Z #
h
sup IE e cs
l (s)ds + e ch
V (R ) 
h
 0
"Z #
h~x
 IE 0
e cs
l~x (s)ds + e ch~x
V (R ~x

h~x
) + :

Let  = (IE[h~x ])2 and, using arguments similar to the above, we get
" Z #
0  1 IE
h~x
e (l~x (s) + L cs a~x (s);l~x ~
V (R ))ds + (IE[ ])2
 h
IE[h~x ] s ~x

0
" Z h #
1
 IE[h ] IE
x
e cs max (l + La;l V (Rs~ ))ds + (IE[h~x ])2
~

~x 0 a2[0;1];l2[0;M ]

! a2[0;max
1];l2[0;M ]
l + L V (x);
a;l
(2.9)
when h ! 0. The validity of (2.6) now follows from (2.8) and (2.9). That
V (0) = 0 is obvious from V (0) = 0 for all . 2

2.2 Constructing a solution

In this section we construct a solution f of (2.6). Let l(x) be the function, that
maximizes (2.6) with V replaced by f for all x; a and let u1 = inf fu : f 0 (u) = 1g.
Then by concavity of f (
l(x) = M 0 x < u1 : (2.10)
x>u 1

7
Therefore for all x < u1
 
1 2 2 00 0
max  a f (x) + af (x) cf (x) = 0: (2.11)
a2[0;1] 2

Let a(x) be the maximizer of the left hand side of (2.11). Let O  [0; u1 ) be
such that 0 < a(x) < 1 for all x 2 O. Then
f 0 (x)
a(x) = ; x 2 O: (2.12)
2 f 00 (x)
Inserting (2.12) in (2.11) we must have for all x 2 O
2 [f 0 (x)]2
cf (x) = 0: (2.13)
22 f 00 (x)
The solution f1 to (2.13) with f1 (0) = 0 can be easily found \from scratch". It
is f1 (x) = c1 x , where
c
=  : (2.14)
2 + c
2
2

The maximizer is given by

x
a(x) = : (2.15)
2 ( 1)
If we put
2
u0 = (1 ) (2.16)

then it is easily seen that O = (0; u0 ). On the other hand a(x) = 1 for x > u0 .
Inserting the latter into (2.11) we obtain the following solution for u0 < x < u1
f2 (x) = c2 ed x
+ c3 e d x ;
+
(2.17)
where q

 2
+ 2c
d =  2
: (2.18)

For x > u1 the function f must satisfy the following equation
1 2 f 00(x) + ( M )f 0 (x) cf (x) + M = 0; (2.19)
2
and by concavity f (x)  ax + b when x ! 1 with a; b > 0. A solution f3 of
(2.19) is
M ^
f3 (x) = + c4 edx ;
c
where s
d^ =
(  M ) 1 ( M )2 + 2c: (2.20)
 2  2

8
We then conjecture the following solution
8
< f1 (x) = c1 x x < u0
>

f (x) = > 2f ( x) = c 2 ed x + c ed x u < x < u

3 0 +
1 ; (2.21)
: f (x) = M + c edx ^
3 c 4 x > u 1
where u0 is given by (2.16) and c1 ; c2 ; c3 ; c4 ; u1 are unknown constants. To
obtain twice continuous dierentiability at u0 we need the function and its rst
and second derivatives to be continuous at u0 . Since in the neighbourhood
of u0 the function f satises (2.11) with a = 1, it is sucient by (2.6) to
check that only two of the quantities are continuous. Let  = c2 =c1 ed u and 0

 = c3 =c1 ed u , then the following equations must be satised.

+ 0

 +  = u 0 (2.22)
d  + d+  = u 0 1 : (2.23)
These equations have a solution
1 1 ( !
(;  ) = u0 d(d+ ud0 ) ; u0 d u0 )

d+ d
: (2.24)
+
p
To simplify these expressions let v1 = 2 + 2c2 . Then d+ d = 2v1 =2 ,
= 2c2 =v12 and u0 = 2 =v12 . This yields
d 2 2c2 2 2
d u = +
+ 0 v12
=  + v1 2c v12
2
v1 + v1
= v12
= v 1
1
and
2 u0 1 ( v1 1) u 0 ( v1 ) 2 u 0
= = 22 = 2 ( d+ ):
2v1
By similar arguments
2 u 0
=
2 ( d ):
As a result
f2 (x) = ( d+ ed (x u0 )
d ed+ (x u0 )
); u0 < x; (2.25)
where  = c1 2 u 0 =(2) with c1 > 0 unknown. Now we need to determine the
unknown c1 ; c4 ; u1 . By similar arguments as above we only need to equalize
^
from left and right the rst and the second derivatives at u1 . Let  = c4 edu 1

then by the denition of u1 we get the following equations

 = ^
1 (2.26)
  d
 d+ d ed (u u ) d d+ ed (u u ) = 1
1 0 + 1
(2.27)
0

 
 d+ d2 ed (u u ) d d2+ ed (u u ) = d;^
1 0 + 1
(2.28)
0

9
where we have used (2.26) in (2.28). Dividing (2.28) by (2.27) we eliminate 
and solve for u1 , getting
!
1 d^ d
u1 = u0 + ln (2.29)
d+ d d+ d^
and from (2.27)
=
1 > 0: (2.30)
d+ d (e (u1 d + ed (u u ) )
u0 ) + 1 0

After all free constants having been determined, we can suggest the following
solution
8  
>
> 2 x
x < u0
< 2 u0
f (x) = > (d+ e d (x u0 ) +d e d+ (x u0 ) ) u0 < x < u1 ; (2.31)
>
: 1 ed^(x u1 )
M
c + d^
x > u1
where u0 ; u1 is given by (2.16) and (2.29), ;  by (2.14),(2.30) and d ; d^ is
given by (2.18) and (2.20).
To show that f dened by (2.31) solves the problem, we rst need to ensure,
that u1  u0 .

Lemma 2.1 u1  u0 if and only if

2
M  2 + c : (2.32)

p p
Proof Recall v1 = 2 + 2c2 and let v2 = ( M )2 + 2c2 . Then it follows
from (2.29) that u1  u0 is equivalent to
d^ d + M v2 +  + v1 = M v2 + v1  1:
^ =  + v1 +  M + v2 v1 M + v2
(2.33)
d+ d
It is satised if and only if M  v2 , which is equivalent to (2.32). 2

Concavity of f for all x  u0 follows from < 1. Because d^ < 0, f is also

concave on [u1 ; 1). Since d is negative f 000 (x) > 0 for all u0 < x < u1 and
concavity of f on [u0 ; u1 ] then follows from continuity of the second derivative.
The maximizing function a(x) can be written as
x
a(x) =
u0
^ 1: (2.34)

Theorem 2.1 Assume M  2 + c and let f be given by (2.31). Then f is a

2

concave solution of (2.6).

10
Proof The maximization with respect to l is obvious from concavity and the
construction. For x < u0 from the construction follows that f maximizes (2.6)
to zero with respect to a. For u0 < x < u1 we only need to show, that
2 a2 00
f (x) + af 0(x) cf (x)  0
2
for all a < 1. Since there is an equality for a = 1, the above inequality holds if
and only if
2 (1 a2 ) 00
Ga (x) = f (x) + (1 a)f 0 (x)  0:
2
for any a < 1 and all u0  x  u1 . Substituting x = u0 , we can use (2.12) to
get
2 (1 a2 ) 00 0
H0 (a) = Ga (u0 ) =
2 f (u0 ) + (1 a)f (u0 )
2
= (12 a ) f 0 (u0 ) + (1 a)f 0 (u0 )
2
= f 0(u0 )( 12 a + a2 ) > 0
and substituting x = u1 we can use twice continuous dierentiability to obtain
2 d^
H1 (a) = Ga (u1 ) = (1 a2 )
2 + (1 a);
which is a convex function of a. Let v2 be as in Lemma 2.1. Simple dierenti-
ation shows that H1 (a) attains its minimum at
 
a = 2 ^ =  1:
 d  M + v2
The last inequality follows from the assumption. Therefore Ga (u1 )  0. It
is easy to see, that both f 0(x) and f 00(x) satisfy (2.11) with a = 1 for all
u0 < x < u1 and since Ga (x) is a (dependent on a) linear combination of these
functions, it satises the same dierential equation for any a. It then follows
from the maximum principle, that Ga (x)  0 for all u0 < x < u1 and all a < 1.
For x > u1 we again need to prove
2 (1 a2 ) 00
Ga (x) = f (x) + (1 a)f 0 (x)  0:
2
for any a < 1. Here, however, we need only to consider
2 d^
e d^(x u ) Ga (x) = (1 a2 )
2 + (1 a) = H1 (a);
1

which is already treated. The proof is complete. 2

Now we consider the case, in which M < =2 + c2 =. Let the `switching
points' u0 and u1 be dened by the same formulae as above. Then based on
11
the calculations we have done in Lemma 2.1 one can assume that u1 < u0 in
this case. For x > u0 we again get the equation (2.19) with solution
M
ed^(x u1 )
f3 (x) =
+
c
for some unknown  and for u1 < x < u0 we get the equation
 
1 2 2 00 0
max  a f (x) + (a M )f (x) cf (x) + M = 0 (2.35)
a2[0;1] 2

having a solution (say f2 (x)). The switching point u0 is then determined by

f20 (u0 )
2 f200 (u0 )
=1
but by the \smooth t" condition it fails because
f20 (u0 ) f30 (u0 )
2 f200 (u0 )
= = = 
2 f300 (u0 ) 2 d^  M + v2
< 1:

The latter suggests that no such u0 exists and we conjecture u0 = 1, meaning

there exists only one switching point u1 .
Then for x < u1 we get the equation (2.11) and we nd as before a solution
f1 (x) = c1 x with dened by (2.14). For x > u1 the HJB equation becomes
(2.35). Let f  be a solution of

max 1 2 a2 f 00 (x) + (a M )f 0 (x) cf (x) = 0 (2.36)
a2[0;1] 2

then obviously a solution to (2.35) is f (x) = f  (x)+ M=c. Thus we dierentiate

(2.36) w.r.t. a to obtain the maximizer, and then substitute this maximizer back
into (2.36) to obtain
2 [f 0 (x)]2
Mf 0 (x) cf (x) = 0: (2.37)
22 f 00 (x)
As in Hjgaard & Taksar [22] the concavity of f implies existence of a function
X : IR ! [0; 1), such that
f 0 (X (z )) = e z : (2.38)
It is easy to see, that
and f 00(X (z )) = Xe0 (z ) :
z
f 0 (X (z )) = e z
(2.39)
It should be noted, that the above transformation is used in various works in
Mathematical Finance, e.g. Karatzas et al [23], [24] and Presman & Sethi [34].
Substituting x = X (z ) in (2.37) and using (2.39), we obtain
2 0
22 X (z )e Me cf (X (z )) = 0: (2.40)
z z

12
Dierentiating with respect to z and applying (2.39) once more leads to
!
2 00 2 z 0
22 X (z )e 22 + c e X (z ) + Me = 0:
z z

Put
 = 22 =2 ; (2.41)
then
X 00 (z ) (1 + c) X 0 (z ) + M = 0: (2.42)
The solution to (2.42) is given by
M
X (z ) = k1 e(1+c)z +
1 + c z + k2 (2.43)
where k1 and k2 are free parameters. From (2.38) we determine a solution of
(2.36) for x > u1 Zx
f (x) = e X (y) dy + c2 (2.44)
1

u1
with c2 free. Since M=c can be incorporated into the free parameter c2 the
solution to (2.35) is of the same form. From (2.38) and the denition of u1
follows that X (0) = u1 . Concavity of f implies that X 1 (x) is an increasing
function on [u1 ; 1). Thus k1  0. The maximizing function a(x) of the left
hand side of (2.35) for x > u1 is given by
f 0(x) 
a(x) = 2 00 = 2 X 0 (X 1 (x)):
 f (x) 
If k1 > 0 then a(x) is strictly increasing and a(x) = 1 must have a solution.
However, we have already argued that this is not possible. This contradiction
leads to a conjecture that k1 = 0 and we obtain
a(x) = 2
M
= 2M = M
< 1: (2.45)
 (1 + c) (1 + 2c ) 2 + c

2
2 2

Since X (0) = k2 = u1 , the following solution is suggested

(
c1 x x < u1
f (x) = 1+c
(x u1 ) :
M
1+c e M + c2 x > u 1
To determine the unknown c1 ; c2 ; u1 we have the following equations
M
c1 u 1 = c2 (2.46)
c
c1 u 1 1 = 1 (2.47)
c1 ( 1)u 1 2 = 1 + c : (2.48)
M
Combine (2.47) and (2.48) and apply (2.14) and (2.41) to obtain
M(1 ) M (1 )
u1 =
1 + c = c
: (2.49)

13
From (2.46) and (2.47) we have c2 = M=c and nally c1 = u11 = . Using (2.14)
and (2.41) we obtain the following solution
8  
< u1 x x < u1
f (x) = : u1 (2.50)
M (x u1 )
c
M
c (1 e ) x > u1
with dened by (2.14) and u1 by (2.49). The maximizing function a(x) is
then given by ( x
a(x) =  u(1 ) x < u1 ;
2
(2.51)
x>u 1
2 (1 ) 1
where it is easily veried, that this expression coincides with the expression
given by (2.45) for x > u1 . Since a(x) < 1 for all x the following theorem
follows easily from construction.

Theorem 2.2 Assume M < 2 + c and let f be given by (2.50). Then f is a
2

concave solution of (2.6). 2

2.3 The verication theorem

Let f be given by (2.50) for M < 2 + c and by (2.31) for M  2 + c . Since
2 2

f satises (2.6), it follows

La;l f (x)  l for all x and a; l 2 [0; 1]  [0; M ]: (2.52)
Dene the policy  as
 
a (t) = a(Rt ) and l (t) = l(Rt ) for all t <  ; (2.53)
where a(x) is given by (2.51) for M < 2 + c and by (2.34) for M  2 + c
2 2

and (
l(x) = M 0 x < u1 ;
xu 1
where u1 is given by (2.49) for M < 2 + c and by (2.29) for M  2 + c .
2 2

Theorem 2.3 Let V be given by (1.4), f be given by (2.50) for M < 2 + c 2

and by (2.31) for M  2 + c and  given by (2.53). Then

2

V (x) = f (x) = V (x):

Proof Let R0 = x and x an arbitrary policy . Choose 0 < " < x and let
" = inf ft : Rt = "g, then Ito's formula yields
Z t^"
e c(t^ ) f (Rt^" ) = f (x) + L
cs a (s);l (s)
f (Rs )ds
"
e
0

14
 Z t^"
+ e cs
a (s)f 0 (Rs )dWs
0
Z t^"
 f (x) e cs
l (s)ds
0
Z t^"
+ e cs
a (s)f 0 (Rs )dWs : (2.54)
0
In (2.54) the last inequality is due to (2.52). Since f 0(Rs )  f 0 (") < 1 on [0; t ^
" ], the last term on the r.h.s. is a zero-mean martingale. Taking expectations
in (2.54) we obtain
Z t^"
c(t^" )
IE[e f (Rt^" )] + IE e cs
l (s)ds  f (x): (2.55)
0
By concavity of f , f (y)  a + by for some a; b > 0. Therefore
e c(t^ ) f (Rt^" )  a + bRt^"  K (1 + Rt^ + ")  K (2 + Rt^ ); (2.56)
"

where the constant K does not depend on ". Furthermore

 Z t^ Z t^ 
IE[Rt^ ] = IE x + (a (s) l (s))ds + a (s)dWs
 0  0
Z t^
= IE x + (a (s) l (s))ds  x + t:
0
Thus the term on the l.h.s. of (2.56) is majorized by a positive random variable
with a nite expectation. Since " "  when " ! 0
Z t^" Z t^
e cs
l (s)ds " e cs
l (s)ds:
0 0
Thus letting " ! 0 in formula (2.55) in the next section, we use dominated and
monotone convergence theorems for the rst and the second terms in (2.55)
respectively, to get
Z t^
c(t^ )
IE[e f (Rt^ )] + IE e cs
l (s)ds  f (x): (2.57)
0
Since f (0) = 0 we have by same arguments
IE[e c(t^ ) f (Rt^ )] = e ct IE[f (Rt ); t <  ] ! 0
as t ! 1. Letting t ! 1 in (2.57) we have
Z 
IE e cs
l (s)ds  f (x)
0
or equivalently f (x)  V (x). Since  is arbitrary we obtain f (x)  V (x).
Now notice that La(x);l(x) f (x) = l(x) for all x. Thus considering  we can fol-
low the same proof as above in which all inequalities are replaced by equalities,
and obtain Z 
IE e csl (s)ds = f (x):
0

15
This implies that f (x) = V (x)  V (x). Therefore f (x) = V (x). 2

Since  is the optimal policy we will refer to a(x); l(x) as the optimal feedback
control functions.

3 Unrestricted dividend pay-out rate

In this section we let

2 2 d2
La = La;0 = a 2 dx2
d
+ a dx c:

3.1 The Hamilton-Jacobi-Bellman equation

Proposition 3.1 Assume V dened by (1.4) is twice continuous dierentiable
on (0; 1). Then V satises the Hamilton-Jacobi-Bellman equation
  !
max amax 1  a V (x) + aV (x) cV (x) ; 1 V 0 (x) = 0
2 2 00 0 (3.1)
2[0;1] 2

In this case we will only sketch the proof, the remaining steps can be found in
e.g. Fleming & Soner [15], Karatzas & Shreve [25], Harrison & Taksar [21], or
Taksar [42]. As in the proof of Proposition 2.1 it can be shown, that V satises
the dynamic programming principle,
Z  ^ 
c(^ )
V (x) = sup IE e cs
dL + e

s V (R

^ ) : (3.2)
 0
for any fFt g stopping time . Fix a arbitrary and dene  by a (t) = a for all
t and Lt = 0 for t < h and arbitrary for t  h with h as in the proof of
Proposition 2.1. Then we have from (3.2)
V (x)  IE[e c V (Rh )]
h

and as before using Ito's formula we get by arbitrariness of a that

0  max
a
LaV (x):
For any h > 0 we can nd policies y that satisfy Vy (y)  V (y) h2 . Let
0 < h < x and dene  by Lt = h + Lt x h and a (t) = ax h (t) for all t  0.
This corresponds to an initial pay-out of size h and then following an h2 -optimal
policy. Then
V (x)  V (x) = h + Vx h (x h)  h + V (x h) h2 :
Subtracting V (x h) from both sides, dividing by h and letting h ! 0 yields
V 0 (x)  1:
It can then be shown that one of these inequalities is tight.
16
3.2 Constructing a solution
To construct a solution f of (3.1) we follow the same steps as in the case of
restricted dividends. Let u1 = inf fu : f 0(u) = 1g. Then for all x < u1 f must
satisfy  
1 2 2 00 0
max  a f (x) + af (x) cf (x) = 0 (3.3)
a2[0;1] 2
As in the previous section we assume that there exists u0 < u1 such that the
function a(x) maximizing (3.3) satises 0 < a(x) < 1 for all x 2 [0; u0 ). This
problem is similar to that of Section 2.2 and we nd a solution f1 (x) = c1 x
for x < u0 with given by (2.14) and u0 by (2.16). For x > u0 we must
have a(x) = 1. Substituting this into (3.3) we obtain the following solution for
u0 < x < u1
f2 (x) = c2 ed + c3 e d x ;x +
(3.4)
with d given by (2.18). Concavity, (3.1) and the denition of u1 imply f 0(x) =
1 for all x > u1 , This provides us with the third part
f3 (x) = x + c4 :

Making 'smooth t' at u0 and u1 as in the previous section we get the solution
8 2  x 
>
< 2 u0 x < u0
f (x) = > (d+ ed (x u0 ) +d e d+ (x u0 ) ) u0 < x < u1 ; (3.5)
:
x u1 +  x > u1
where 
1 d 
u1 = u0 + ln (3.6)
d+ d d+
and u0 is given by (2.16), d by (2.18),  by (2.30) with u1 from (3.6) and
 = (d+ ed (u1 u0 )
+ d ed + (u1 u0 )
)
 d d  d d+
d+ d
d+
+ d
+d d
d+
+ d

= " d d  d d+ #
d+ d d
d+
+ d
+ d
d+
+ d

 
d+ + d dd+ d2+ d2
= = d+ d [d+ d ]
d+ d [1 dd+ ]
= d+d +d d = c :
+
Note that  = f (u1 ) = =c can be found directly by inserting x = u1 and a = 1
in (3.3). The maximizing function a(x) is here given by (2.34). Concavity
follows by arguments similar to those of Section 2.
It should be noted that this solution is also suggested by Whittle [43], but
it appears that the work there is based on the assumptions of the optimal
17
strategy being a `barrier strategy' without proving this assumption, and there
are no arguments for either the HJB equation or the verication theorem. We
include a proof of this theorem, since we nd it non-trivial.

Theorem 3.1 Let f be given by (3.5). Then f is a twice continuous dieren-

tiable solution of (3.1).

Proof For x < u1 it follows from arguments similar to those of Theorem 2.1.
Since for x > u1
V 0 (x) = 1;
we need only to show that La V (x) is non-positive for each 0  a  1. For
x = u1 this holds due to twice continuous dierentiability and the validity of
the required inequality on [0; u1 ). In particular, a c  0 for all a 2 [0; 1].
For x > u1 we obtain La V (x) = a c(x u1 + ) < a c  0. Thus the
theorem is proved. 2

Remark 3.1 It is readily veried that the solution fM given by (2.31) tends
to the solution f given by (3.5) when M ! 1. First notice that d^ ! 0 when
M ! 1, wherefrom it follows that uM 1 given by (2.29) tends to u1 given by
(3.6) and M in fM tends to  in f . Therefore in the limit the solutions coincide
for all x  u1 . If x > u1 then from d^ ! 0 follows
M 1 M 1
fM (x)  + ^(1 + d^(x u1 )) = + ^ + x u1
c d c d
and by continuity of fM at uM 1
M 1
+ = M (d+ ed (uM u ) + d ed (uM u ) ) ! :
c d^
1 0 + 1 0

Thus the limiting functions coincide. 2

3.3 The verication theorem

For this case the proof of the verication theorem will be based on two propo-
sitions. Below let f be given by (3.5). Since f satises (3.1) we have
Laf (x)  0 for all x (3.7)
and all a 2 [0; 1].

Proposition 3.2 For any admissible policy 

f (x)  V (x)
for all x  0.

18
 P
Proof Fix an arbitrary . Put  = fs : Ls 6= Ls g. Let L^ t = s2;st (Ls
Ls ) be the discontinuous part of L and let L~ t = Lt L^ t be the continuous
part. Choose " > 0 and let " = inf ft : Rt  "g.Then by the generalized Ito
formula (see Dellacherie & Meyer [12, Theorem VIII.27]), we can write
Z t^"
c(t^" )
e f (R 
t^" ) = f (x) + e L
cs a (s)
f (Rs )ds
0
Z t^" Z t^"
+ e cs
f 0(R )dWs
s e cs
f 0(Rs )dLs
0 X 0
+ e cs
[f (Rs ) f (Rs ) f 0 (Rs )(Rs Rs )]
2 ^
s ;s t "
Z t^"
= f (x) + e L
cs a (s)
f (Rs )ds
0
Z t^" Z t^"
+ e cs
f 0(R )dWs
s e cs
f 0(Rs )dL~ s
0 X 0
+ e cs
[f (Rs ) f (Rs )]
s2;st^"

where we have used equality Rs Rs = (Ls Ls ). In view of (3.7) the
second term on the r.h.s. is non-positive. By concavity 0  f 0 (Rs ) < f 0(") on
(0; " ), therefore the third term is a zero-mean square integrable martingale.
Taking expectations, we obtain
Z t^"
IE[e c(t^" )
f (R
t^" )]  f (x) IE e cs
f 0 (Rs )dL~ s
X0
+IE e cs
[f (Rs ) f (Rs )] (3.8)
s2;st^"

Since f 0 (x)  1 the mean-value theorem implies f (Rs ) f (Rs )  (Ls Ls ).
The latter combined with (3.8) results in
Z t^"
c(t^" )
IE[e f (Rt^" )] + e cs
f 0 (Rs )dLs  f (x): (3.9)
0
Letting " ! 0, we can apply same arguments as in the proof of Theorem 2.3 to
get Z t^
c(t^ )
IE[e f (Rt^ )] +

e csf 0 (Rs )dLs  f (x): (3.10)
0
We conclude by letting t ! 1. 2

Let a(x) be given by (2.34), and u1 given by (3.6). Consider a pair (fRt g; fLt  g)
which is a solution to the following systems of equations
Z t Z t
   
R t = x+ a(R )ds +
s a(Rs )dWs Lt ;
0 0

Rt
Z1
 u1 ; t  0; (3.11)
 
I (Rt < u1 )dLt = 0:
0

19
The pair (fRt g; fLt  g) is called a solution to the Skorohod problem in [ 1; u1 ).
Existence of such a solution is proved in Lions & Sznitman [28]. The process
fRt g is a diusion process in [ 1; u1 ), re ected

at u1 , whose drift coecient
is a(x), and diusion is a(x). Then fRt g solves (1.1), (1.2) with policy 


corresponding to fa (t); Lt g, where a (t) = a(Rt ).

Proposition 3.3 Let f be dened by (3.5). Then f (x) = V (x) for all x.
Proof For simplicity assume that x  u1 . In this case the results of Lions
& Sznitman [28] show that fLt  g as well as fRt g are continuous processes.
Trivially La(x) f (x) = 0 for all x  u1 . Applying Ito's formula in the same
manner as in the proof of Proposition 3.2, we get
Z t^
  
e ct IEx [f (Rt ); t <  ] = f (x) IE e cs
f 0 (Rs )dLs : (3.12)
0
Since f 0 (u1 ) = 1 one can use (3.11) to get
Z t^ Z t^
    
IE e cs
f 0(Rs )dLs = IE e cs
f 0 (Rs )I (Rs = u1 )dLs
0 Z0t^

= IE e cs
dLs : (3.13)
0
Substitution of (3.13) into (3.12) and making t ! 1 results in
Z  (x) 
f (x) IE e cs
dLs = 0;
0
which completes the proof. 2

Corollary 3.1 Let f be dened by (3.5) then V (x) = f (x) for all x and  is
the optimal policy.

Proof Taking supremum over  in Proposition 3.2, we obtain f (x)  V (x). By

Proposition 3.3 and the denition of V we have f (x) = V (x)  V (x). This
yields V (x) = f (x) = V (x). 2

4 The gain of proportional reinsurance

In Asmussen & Taksar [1] the same problem is solved without a reinsurance
option. Mathematically, this corresponds to a (t)  1 for all . The result of
that paper is given by the following theorems. First the case of bounded rate
of dividend pay-out. Let
M 1
= + ^ (4.1)
c d
20
 
u0 =
1 ln 1 d  (4.2)
d+ d 1 d+
and
=
1 (4.3)
d+ ed+ u0 d ed u0

Theorem 4.1 If   0 then

M
V (x) =
c
(1 edx^ )
and if  > 0 then
(
(ed+ x ed x ) x  u0
V (x) = ^
M + 1 edx
c d^
x  u0
2

Let 2  
 d
u0 = p 2 ln d : (4.4)
 + 2c2 +
Dene  by (4.3) with u0 given by (4.4). The following theorem gives a descrip-
tion of the optimal return function in the case of unrestricted rate of dividends.

Theorem 4.2 If there is no restriction on the dividend pay-out rate, then

(
V (x) = ((eed u eed u) ) + x u xx 
d x + d x  u0
+ 0 0
0 u0
2

Several sets of numerical examples are considered, each set is \crossindexed"

by two parameters. Let
 c2
K= + (4.5)
2 
By case I we refer to the case of M < K and by case II to M  K . Parameter A
corresponds to the case of   0, while B corresponds to  > 0. In Figure 1 we
have compared the two solutions for  = 1, M = 0:5,  = 1; 2 and c = 0:1; 0:5.
In Figure 1 (1),(2),(3) we are in case I,B. In Figure 1 (4) we are in case I,A.
In Figure 2 the same comparison is made for M = 2. In (1),(2),(3) we consider
the case II,B and in (4) the case I,B. In Figure 3 the comparison is made for
the unrestricted case.

21
 (1) (2)

4
4

3 3

2 2

1 1

00 1 2 3 4 5 00 1 2 3 4 5 6 7

(3) (4)

1 1

0.8 0.8

0.6 0.6

0.4 0.4

0.2 0.2

00 00 1 2 3 4 5 6 7
1 2 3 4 5 6 7

Figure 1: The gain of reinsurance calculated for  = 1, M = 0:5 and  = 1 in (1),(3),

 = 2 in (2),(4) and c = 0:1 in (1),(2) and c = 0:5 in (3),(4). The dotted line
represents the solution with no reinsurance.

22
 (1) (2)

14 12

12
10

10
8

4
4

2
2

00 2 4 6 8 10 00 2 4 6 8 10

(3) (4)

3.5

3
3

2.5

2 2

1.5

1 1

0.5

00 2 4 6 8 10 00 2 4 6 8 10

Figure 2: The gain of reinsurance calculated for  = 1, M = 2 and  = 1 in (1),(3),

 = 2 in (2),(4) and c = 0:1 in (1),(2) and c = 0:5 in (3),(4). The dotted line
represents the solution with no reinsurance.
It is interesting to mention that the numerical examples show the gain from
reinsurance to become negligible, when the discount factor increases, or the ini-
tial capital is large. Both phenomena have a simple economic explanation. The
advantage of reinsurance is in reduction of the risk exposure, thus in aecting
the time of bankruptcy. The larger is the discount factor, the less important be-
come the future earnings, making the bankruptcy control irrelevant. Likewise,
when the initial capital is very large, the bankruptcy time is large as well, with
or without reinsurance. Due to the discounting, the eect of having reinsurance
disappears since the optimal policy requires to use it only when the the capital
is small and the probability of the bankruptcy in the near future is large.

23
 (1) (2)
18

14
16

12
14

12 10

10
8

8
6

4
4

2
2

00 00 2 4 6 8 10
2 4 6 8 10

(4)
(3)
10

10

8
8

6
6

4
4

2
2

00 00 2 4 6 8 10
2 4 6 8 10

Figure 3: The gain of reinsurance in the unrestricted case calculated for  = 1 and
 = 1 in (1),(3),  = 2 in (2),(4) and c = 0:1 in (1),(2) and c = 0:5 in (3),(4). The
dotted line represents the solution with no reinsurance.

5 Sensitivity analysis

In this section we consider how the 'switching points' u0 ; u1 depend on the

exogenous parameters ; ; c. The point u0 , which indicates the level at which
maximum retention is reached, is only valid in the case of unbounded rate of
dividend and in the bounded case with M  K , where K is given by (4.5). The
expression for u0 is the same in both cases and given by (2.16), which can be
rewritten as u0 = 2 =(2K ). Now
@K 1 2 c @K 2c
=
@ 2  2 and @
=  ; (5.6)
wherefrom !
@u0 2 1 2 c
=
@ 2K 2 2 2
and @u 0 =  :
@ 2K 2
p
For any xed  the point u0 has a maximum at  =  2c and for any  the
point increases in . In Figure 4 a graph of u0 as a function of ;  with c = 0:1
is given.
24
 3

u02.5
2
1.5
1
0.5
0
0 0
0.5 0.5
1 1
σ 1.5 1.5
2 2 µ
2.5 2.5
3 3

Figure 4: The point u0 as a function of ;  with c = 0:1.

From an economic point of view, this behaviour is obvious: If potential prot is
large (compared to risk), full risk should be taking at a low level, because the
company can manage it and therefore gain more prot, which can be distributed
as dividend. If, on the other hand, the potential prot is small, the company
must 'gamble' and take full risk to gain some prot to distribute as dividend
before bankruptcy.
For the switching point u1 there are three dierent expressions in the cases of
unbounded rate, M  K and M < K . In Figure 5 a graph for each of the three
cases is given.

25
 (1) (2)
7
4
6

u1 5 u13
4
3 2

2
1
1
0 0
0 1.2 0 1.2
0.5 1.4 0.5 1.4
1 1.6 1 1.6
σ 1.8
σ
µ
1.5 1.5 1.8
2
2.2
2 2
2.2
2
µ
2.5 2.5
2.4 2.4
3 3

1.2 (3)
1

0.8
u1
0.6

0.4

0.2

0
0 1.2
0.5 1.4
1 1.6
σ 1.5 1.8
2
2.2
2 µ
2.5
2.4
3

Figure 5: The point u1 as a function of ;  with c = 0:1. In (1) there is unbounded

rate, in (2) M = 2, which ensures M > K and in (3) M = 0:5 which ensures M < K .
In the unbounded case it seems like u1 is increasing in  and decreasing in ,
whereas there seems to be a maximum at (1:2; 2:7) in the bounded cases. If we
for instance look at the expression for u1 in case of M < K , which is given by
(2.49), we can rewrite it as u1 = M2 =(2K 2 ) and then
! !
@u1 (; )
= M  2c2 and @u1 (; ) = M  2c2 ;
@ K 3 2  @ K3 2 
p
which are both equal to 0 if  = = 2pc. In the case of  = 1:2 and c = 0:1
this gives  = 2:683. Inserting  = = 2c we get u1 = M=(4c), which in the
numerical example gives u1 = 1:25. It can also be seen that u1 ! 0 when
 ! 1 for any xed . The boundedness of u1 in this case, of course, leads
to further investigations of the unbounded case. In Figure 6 we plot u1 for this
case with  = 1:2

26
 12
u1

10

0 5 10 15 20 25 σ 30

Figure 6: The point u1 as a function of  in the unbounded case with  = 1:2 and
c = 0:1.

Here we see that u1 ! 12 and by a tedious investigation of the expression given

by (3.6) it can be seen that u1 ! =c when  ! 1, so in this case also u1 has
an upper limit.
These phenomena have a simple economic explanation: If the risk is low com-
pared to potential prot the dividend payments are started at a low level,
because this is not too risky. On the other hand (in the bounded case), if the
risk gets very high the company should pay out as much as possible at an early
time point not taking care of the high probability of immediate ruin (this will be
high anyway). Obviously this argument must hold for the case of unbounded
rate as well, but here u1 does not tend to zero for any . This is, however,
merely of mathematical reasons. Notice that u1 must satisfy that V (u1 ) = =c,
so in the limit as  ! 1 we have V (u1 ) = u1 . Since V (0) = 0 and V 0 (x) = 1
for x > u1 , it follows from concavity that V (x) ! x when  ! 1, which is
exactly the return from the policy with u1 = 0 corresponding to paying out
everything at time zero and go bankrupt. So in the limit these policies give the
same return.
Also the probability of bankruptcy under the optimal policy IP( < 1) depends
on the exogenous parameters. It is well-known from Karlin & Taylor [26] that
IP( < 1) = 0 if Zx R
2 z aa yy dy
S (x)  e dz = 1;
( )
2 2( )

0
for some x > 0. If we choose x < u0 (or x < u1 , if M < K ) then a(y) =
y=(2 ( 1)) and
Zz
2 a (y)
2 a2 (y ) dy = k 2(1 ) log(y );

27
for some k and Z
S (x) = k
x 1 dz:
0 z 2(1 )
So if we choose < 1=2 then S (x) = 1. This corresponds to
2
22 > c: (5.7)
Notice that equality in (5.7) is the relation which maximizes both u0 and u1 .

Remark 5.1 We have only commented on the drift term and diusion term,
but the discount rate obviously plays an important role, as mentioned in the
previous section. In insurance the process fRt g is in general regarded as the
diusion limit of the compound Poisson process frt g given by
X
Nt
rt = x + pt + Uk ;
k=1

where Nt is a Poisson process denoting the number of claims in [0; t] (with

intensity 1), U1 ; U2 ; : : : are i.i.d. claim sizes independent of Nt and p = (1 +
)IE[U ] is the premium rate. In that case  = IE[U ] and 2 = IE[U 2 ] and
therefore 2 =2 < 1, which put constraints on c to fulll (5.7). 2

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