Optimal Capital Requirements for a Large Insurer/AIG: A Stochastic Optimal Control Approach
Jerome L. Stein
Brown University - Division of Applied Mathematics; CESifo (Center for Economic Studies and Ifo Institute)
December 14, 2010
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
Date posted: December 16, 2010
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