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An insurance risk model with stochastic volatility

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  • Chi, Yichun
  • Jaimungal, Sebastian
  • Lin, X. Sheldon

Abstract

In this paper, we extend the Cramér-Lundberg insurance risk model perturbed by diffusion to incorporate stochastic volatility and study the resulting Gerber-Shiu expected discounted penalty (EDP) function. Under the assumption that volatility is driven by an underlying Ornstein-Uhlenbeck (OU) process, we derive the integro-differential equation which the EDP function satisfies. Not surprisingly, no closed-form solution exists; however, assuming the driving OU process is fast mean-reverting, we apply the singular perturbation theory to obtain an asymptotic expansion of the solution. Two integro-differential equations for the first two terms in this expansion are obtained and explicitly solved. When the claim size distribution is of phase-type, the asymptotic results simplify even further and we succeed in estimating the error of the approximation. Hyper-exponential and mixed-Erlang distributed claims are considered in some detail.

Suggested Citation

  • Chi, Yichun & Jaimungal, Sebastian & Lin, X. Sheldon, 2010. "An insurance risk model with stochastic volatility," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 52-66, February.
    • Handle: RePEc:eee:insuma:v:46:y:2010:i:1:p:52-66
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    Cited by:

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    2. Teng, Ye & Zhang, Zhimin, 2023. "On a time-changed Lévy risk model with capital injections and periodic observation," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 214(C), pages 290-314.
    3. He, Yue & Kawai, Reiichiro & Shimizu, Yasutaka & Yamazaki, Kazutoshi, 2023. "The Gerber-Shiu discounted penalty function: A review from practical perspectives," Insurance: Mathematics and Economics, Elsevier, vol. 109(C), pages 1-28.

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