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

21 Pages Posted: 16 Dec 2010  

Jerome L. Stein

Brown University - Division of Applied Mathematics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: December 14, 2010

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.

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

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

Suggested Citation

Stein, Jerome L., Optimal Capital Requirements for a Large Insurer/AIG: A Stochastic Optimal Control Approach (December 14, 2010). Available at SSRN: https://ssrn.com/abstract=1725594 or http://dx.doi.org/10.2139/ssrn.1725594

Jerome L. Stein (Contact Author)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

Brown University - Division of Applied Mathematics ( email )

Providence, RI 02912
United States
401-863-2143 (Phone)
401-863-1355 (Fax)

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