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Optimal Portfolio Insurance

Published online by Cambridge University Press:  06 April 2009

M.J. Brennan  and
R. Solanki
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Extract

The form of the Pareto optimal general insurance contract has been investigated by Borch [5], Arrow [3], and Raviv [16]. This paper extends their work to the consideration of the optimal investment portfolio insurance contract. This is a contract whose payoff depends upon the investment performance of some specified portfolio of common stocks. Portfolio insurance differs from general insurance in two important ways. First, investment portfolio insurance lacks the property of stochastic independence between losses on different contracts which is characteristic of general insurance, and this has led some actuaries to question whether portfolio insurance contracts should be sold in view of the risks they pose for the solvency of insurance companies. Recent developments in the theory of option pricing suggest, however, that under certain assumptions an insurance company will be able to eliminate the risks associated with portfolio insurance contracts by following an appropriately defined investment strategy. Secondly, there exists a market for the pricing of investment risks, the securities market; and, under appropriate assumptions, the equilibrium price of portfolio insurance contracts may be determined without specification of the preferences of insurance companies. This permits consideration of insurance company preference functions to be dispensed with, in marked contrast to the earlier literature concerned with general insurance, which treats insurance company preferences symmetrically with those of the insurance purchaser. In addition, since the characteristics of the insured portfolio are known to the insurer, and the performance of the portfolio is beyond the control of the insured, portfolio insurance is not prone to the problems of adverse selection and moral hazard which are liable to arise in general insurance.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 16 , Issue 3 , September 1981 , pp. 279 - 300
Copyright
Copyright © School of Business Administration, University of Washington 1981

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