Incorporating model uncertainty into optimal insurance contract design

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Insurance: Mathematics and Economics, ISSN: 0167-6687, Vol: 73, Page: 68-74

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Georg Ch. Pflug; Anna Timonina-Farkas; Stefan Hochrainer-Stigler
Elsevier BV
Mathematics; Economics, Econometrics and Finance; Decision Sciences
article description
In stochastic optimization models, the optimal solution heavily depends on the selected probability model for the scenarios. However, the scenario models are typically chosen on the basis of statistical estimates and are therefore subject to model error. We demonstrate here how the model uncertainty can be incorporated into the decision making process. We use a nonparametric approach for quantifying the model uncertainty and a minimax setup to find model-robust solutions. The method is illustrated by a risk management problem involving the optimal design of an insurance contract.