Band Control of Mutual Proportional Reinsurance

TL;DR

This paper analyzes optimal band control strategies for mutual proportional reinsurance, revealing conditions under which the control reduces to a simple downside-only policy, explaining the decline of mutual insurance companies.

Contribution

It introduces a novel two-sided impulse control model for mutual reinsurance and characterizes the optimal control band, including a threshold where the policy simplifies to downside-only control.

Findings

Optimal band control involves two-sided impulses with specific thresholds.

High upside fixed costs lead to a downside-only control policy.

The model explains the decline of mutual insurance firms historically.

Abstract

In this paper, we investigate the optimization of mutual proportional reinsurance --- a mutual reserve system that is intended for the collective reinsurance needs of homogeneous mutual members, such as P&I Clubs in marine mutual insurance and reserve banks in the U.S. Federal Reserve. Compared to general (non-mutual) insurance models, which involve one-sided impulse control (i.e., either downside or upside impulse) of the underlying insurance reserve process that is required to be positive, a mutual insurance differs in allowing two-sided impulse control (i.e., both downside and upside impulse), coupled with the classical proportional control of reinsurance. We prove that a special band-type impulse control $(a,A,B,b)$ with $a=0$ and $a<A<B<b$, coupled with a proportional reinsurance policy (classical control), is optimal when the objective is to minimize the total maintenance cost. That is, when the reserve position reaches a lower boundary of $a=0$, the reserve should immediately be raised to level $A$; when the reserve reaches an upper boundary of $b$, it should immediately be reduced to a level $B$. An interesting finding produced by the study reported in this paper is that there exists a situation such that if the upside fixed cost is relatively large in comparison to a finite threshold, then the optimal band control is reduced to a downside only (i.e., dividend payment only) control in the form of $(0,0;B,b)$ with $a=A=0$. In this case, it is optimal for the mutual insurance firm to go bankrupt as soon as its reserve level reaches zero, rather than to jump restart by calling for additional contingent funds. This finding partially explains why many mutual insurance companies, that were once quite popular in the financial markets, are either disappeared or converted to non-mutual ones.