Determination of the optimal premium of non-life insurance via the Stochastic Dynamic Programming method

Abstract

Objective: One of the most important issues facing insurance companies is the determination of fair premium. The purpose of this study is to design a mathematical model for calculating the optimal insurance premium by maximizing the total expected discounted utility of the capital, considering the demand and competition of the non-life insurance market.Methods: In the first stage, the capital equation of the insurance company is defined which is derived from the sum of insurance income and investment income. Insurance income is measured via the difference between insurance premiums and related expenses over the year as a function of stochastic demand. Next, the Stochastic demand function is defined based on the number of insurance policies in the past year, the average premium of the market, company premium which is the control function and a linear stochastic disturbance or variables which are related to the demand function. Since the average premium of the market and disruptive are Stochastic, demand is Stochastic. Consequently, the optimal premium is calculated using the Stochastic Dynamic Programming, discrete-time framework via maximizing the total expected discounted utility of the capital.Results: The numerical results show that the optimal premium is directly related to the average market premium, previous year's demand, break-even premium and the expected expectation of stochastic disturbance. It was also shown that the expected sign of stochastic disturbance determines the optimal premium strategies.Conclusion: From the findings of this study, it can be concluded that insurance companies should determine the optimal non-life insurance premium in a competitive environment via using the expected value sign of stochastic disturbance, which is determined based on the demand function. The results showed that the expected value sign of positive stochastic disturbance indicates a decreasing demand and the insurance company should change the strategy of determining the optimal premium in order to expand demand.

Keywords

• stochastic disturbance
• demand function
• average premium of the market