Optimal Capital Requirements for a Large Insurer/AIG: A Stochastic Optimal Control Approach

Abstract:     
A key firm in the recent crisis has been AIG. Its CDS financial intermediation tried to function on too thin layer of capital – high leverage – owing to a misreading of the degree of risk embodied in ever more complex financial products and markets. I explain why the application of stochastic optimal control (SOC)/dynamic risk management is an effective approach to determine the optimal capital requirement and the optimum risk for a large insurer and the probability of a debt crisis. The theoretically derived early warning signal of a crisis is the excess liability ratio, equal to the difference between the actual and optimal ratio.

Number of Pages in PDF File: 21

Keywords: AIG, Insurance, Stochastic Optimal Control, Optimal Capital Requirements, Risk, Financial Crises

JEL Classification: C61, D81, D91, G1, G11, G12, G14

working papers series