On the Distribution of the Excedents of Funds with Assets and Liabilities in Presence of Solvency and Recovery Requirements

Abstract

In this paper, we consider a profitable, risky setting with two separate, correlated asset and liability processes (first introduced by Gerber and Shiu, 2003). The company that is considered is allowed to distribute excess profits (traditionally referred to as dividends in the literature), but is regulated and is subject to particular regulatory (solvency) constraints. Because of the bivariate nature of the surplus formulation, such distributions of excess profits can take two alternative forms. These can originate from a reduction of assets (and hence a payment to owners), but also from an increase of liabilities (when these represent the wealth of owners, such as in pension funds). The latter is particularly relevant if distributions of assets do not make sense because of the context, such as in regulated pension funds where assets are locked until retirement.

In this paper, we extend the model of Gerber and Shiu (2003) and consider recovery requirements for the distribution of excess funds. Such recovery requirements are an extension of the plain vanilla solvency constraints considered in Paulsen (2003), and require funds to reach a higher level of funding than the solvency level (if and after it is triggered) before excess funds can be distributed again. We obtain closed form expressions for the expected present value of distributions (asset decrements or liability increments) when a distribution barrier is used. The optimal barrier level, as well as its existence and uniqueness are discussed.

Keywords: Optimal dividends, Funding ratio, Stochastic Control, Regulation, Solvency, Recovery requirements

JEL Classification: C44, G24, G32, G35