Risks 2014, 2, 260-276; doi:10.

3390/risks2030260
OPEN ACCESS

risks
ISSN 2227-9091
www.mdpi.com/journal/risks
Article

The Impact of Systemic Risk on the Diversification Benefits of a

Risk Portfolio
Marc Busse 1 , Michel Dacorogna 1 and Marie Kratz 2, *
1

SCOR SE, 26 General Guisan Quai, 8022 Zrich, Switzerland; E-Mails: mbusse@scor.com (M.B.);
mdacorogna@scor.com (M.D.)
2
ESSEC Business School Paris, CREAR, av. Bernard Hirsch BP 50105,
95021 Cergy-Pontoise Cedex, France
* Author to whom correspondence should be addressed; E-Mail: kratz@essec.edu.
Received: 2 December 2013; in revised form: 15 May 2014 / Accepted: 17 June 2014 /
Published: 9 July 2014

Abstract: Risk diversification is the basis of insurance and investment. It is thus crucial
to study the effects that could limit it. One of them is the existence of systemic risk that
affects all of the policies at the same time. We introduce here a probabilistic approach to
examine the consequences of its presence on the risk loading of the premium of a portfolio
of insurance policies. This approach could be easily generalized for investment risk. We see
that, even with a small probability of occurrence, systemic risk can reduce dramatically the
diversification benefits. It is clearly revealed via a non-diversifiable term that appears in the
analytical expression of the variance of our models. We propose two ways of introducing
it and discuss their advantages and limitations. By using both VaR and TVaR to compute
the loading, we see that only the latter captures the full effect of systemic risk when its
probability to occur is low.
Keywords: diversification; expected shortfall; investment risk; insurance premium; risk
loading; risk measure; risk management; risk portfolio; stochastic model; systemic risk;
value-at-risk
MSC classifications: 91B30; 91B70; 62P05

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261

1. Introduction
Every financial crisis reveals the importance of systemic risk and, as a consequence, the lack of
diversification. Diversification is a way to reduce the risk by detaining many different risks, with various
probabilities of occurrence and a low probability of happening simultaneously. Unfortunately, in times
of crisis, most of the financial assets move together and become very correlated. The 2008/2009 crisis is
not an exception. It has highlighted the interconnectedness of financial markets when they all came to a
stand still for more than a month waiting for the authorities to restore confidence in the system (see, e.g.,
the Systemic Risk Survey of the bank of England, available on-line). For any financial institution, it is
important to be aware of the limits to diversification, while, for researchers in this field, studying the
mechanisms that hamper diversification is crucial for the understanding of the dynamics of the system
(see, e.g., [1,2] and the references therein). Both risk management and research on risk would enhance
our capacity to survive the inevitable failures of diversification. A small fact, like turmoils in the U.S.
sub-prime real-estate market, a relatively small market compared to the whole U.S. real-estate market,
can trigger a major financial crisis that extends to all markets and all regions in the globe. Systemic
risk manifests itself by a breakdown of the diversification benefits and the appearance of dependence
structures that were not deemed important during normal times.
Since the crisis, the literature on this subject has been abundant. It mainly centers on two approaches.
On one hand, there exist attempts to explain the appearance of systemic risk through structural
macro-economic or financial models that include feedback loops and non-linear effects [27]. On
the other hand, empirical indicators have been proposed to measure the danger of systemic risk in
order to provide early-warning systems [812]. While these studies are essential to progress in our
understanding of the economic factors leading to the emergence of economic crisis due to systemic
risk, our approach is to concentrate on the more fundamental underlying mathematical mechanisms
that break diversification. In the economic literature, systemic risk is identified with contagion effects
and the literature concentrates on finding ways of modeling or measuring it. One consequence of this
contagion is the breaking of the law of large numbers and the sudden disappearance of the stabilizing
effect of diversification, joining here one of the main questions asked in quantitative risk management
(see e.g. [13]). Another important subject of debate in the risk management literature is the controversy
about risk measures (see e.g. [14,15] and references therein). The aim of our study is precisely to look
at these aspects of the problem through a simple and didactic model. The question we want to answer is:
are there simple mathematical mechanisms that break the law of large numbers and destroy the benefits
of diversification?
In this study, we introduce a simple stochastic modeling to understand and point out the limitations
to diversification and the mechanism leading to the occurrence of systemic risk. The idea is to combine
two generating stochastic processes that, through their mixture, produces in the resulting process a
non-diversifiable component, which we identify to be a systemic risk. Depending on the way of mixing
these processes, the diversification benefit appears with various strengths, due to the emergence of the
systemic component. The use of such a model, which is completely specified, allows us to obtain
analytical expressions for the variance and then to identify the non-diversifiable term. With the help of

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Monte Carlo simulations, we explore the various components of the model and check that we reproduce
the analytical results.
The paper is organized as follows: in the first section, we introduce, to measure the effects on
diversification, the standard insurance framework for pricing risk and define the risk measures that are
used in this study. The second section is dedicated to the mathematical presentation of the model and its
various approaches to systemic risk, as well as numerical applications. The obtained results are compared
numerically and analytically in the third section, where we also discuss the influence of the choice of
the risk measure on the diversification benefits. We conclude the study and suggest new perspectives to
extend it.
2. Insurance Framework
Before moving to stochastic modeling, let us introduce the insurance framework in which we are
going to compute the risk diversification. It is an example of application, but this study on systemic risk
could easily be generalized to any financial institution.
2.1. The Technical Risk Premium
In insurance, risk is priced based on the knowledge of the loss probability distribution. Let L be the
random variable (rv) representing a loss defined on a probability space (, A, IP).
2.1.1. One policy case
For any policy incurring a loss L(1) , we can define, as in [16], the technical premium, P , that needs to
be paid, as:
P = IE[L(1) ] + K + e
(1)
with : the return expected by shareholders before tax, K: the risk capital assigned to this policy, e: the
expenses incurred by the insurer to handle this case.
An insurance company is a company in which we can invest. Therefore, the shareholders that have
invested a certain amount of capital in the company expect a return on investment. Therefore, the
insurance firm has to make sure that the investors receive their dividends, which corresponds to the
cost of capital the insurance company must charge on its premium. This is what we have called .
We will assume that the expenses are a small portion of the expected loss:
e = aIE[L(1) ]

with 0 < a << 1

which transforms the premium as:

P = (1 + a)IE[L(1) ] + K.
We can now generalize this premium principle Equation (2) for N similar policies (or contracts).

(2)

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2.1.2. The case of a portfolio of N policies

The premium for one policy in the portfolio, incurring now a total loss L(N ) =
(1)
Li s are N independent copies of L(1) ), can then be written as
P =

PN

i=1

(1)

Li (where the

(1 + a)IE[L(N ) ] + KN
KN
= (1 + a) IE[L(1) ] +
N
N

where KN is the capital assigned to the entire portfolio.

2.2. Cost of Capital and Risk Loading
First, we have to point out that the role of capital for an insurance company is to ensure that the
company can pay its liability, even in the worst cases, up to some threshold. For this, we need to define
the capital that we have to put behind the risk. We are going to use a risk measure, say , defined on the
loss distribution. This allows us to estimate the capital needed to ensure the payment of the claim up to
a certain confidence level. We then define the risk-adjusted-capital K as a function of the risk measure
associated with the risk1 L as:
K = (L) IE[L]
(3)
since the risk is defined as the deviation from the expectation.
Note that we could have also defined K as K = (L) IE[L] P , since the premiums can serve to
pay the losses. This would change the premium P defined in Equation (1) into P defined by:

1+a
IE[L] +
(L).
P =
1+
1+
Such an alternative definition would reduce the capital, but does not change fundamentally the results of
the study.
Consider a portfolio of N similar policies, using the notation for the loss as in Section 2.1. Let R
denote the risk loading per policy, defined as the cost of the risk-adjusted capital per policy. Using
Equation (3), R can be expressed as a function of the risk measure , namely:


KN
(L(N ) )
(1)
R=
=
IE[L ] .
(4)
N
N
2.3. Risk Measures
We will consider for two standard risk measures, the value-at-risk (VaR) and the tail value-at-risk
(TVaR). Let us recall the definitions of these quantities (see, e.g., [17]).
The value-at-risk with a confidence level is defined for a risk L by:
VaR (L) = inf {q R : IP(L > q) 1 } = inf {q R : FL (q) }

(5)

where q is the level of loss that corresponds to a VaR (simply, the quantile of L of order ) and FL
the cdf of L.
1

We use here the word risk instead of loss. In fact, these two words are used for one another in an insurance context.

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The tail value-at-risk at a confidence level of L satisfies:

Z 1
1
TVaR (L) =
VaRu (L)du = IE[L | L > V aR (L)].
FL contin.
1
When considering a discrete rv L, it can be approximated by a sum, which may be seen as the average
over all losses larger than VaR :
TVaR (L) =

1
1 X
qu (L)ui
1 u i

(6)

where qui (L) = VaRui (L) and ui ui ui1 corresponds to the probability mass of the particular
quantile qui . This measure is the only coherent risk measure independently of the underlying distribution
(see Artzner et al. 1999 [18]) and would always give rise to a diversification benefit, when it exists, as a
function of N .
3. Stochastic Modeling
Suppose an insurance company has underwritten N policies of a given risk. To price these policies,
the company must know the underlying probability distribution of this risk, as seen in the previous
section. In this study, we assume that each policy is exposed n times to this risk.
In a portfolio of N policies, the risk may occur n N times. Therefore, we introduce a sequence
(Xi , i = 1, . . . , N n) of rvs Xi defined on (, A, IP) to model the occurrence of the risk, with a given
severity l. Note that we choose a deterministic severity, but it could be extended to a random one, with a
specific distribution.
Hence, the total loss amount, denoted by L, associated with this portfolio is given by:
L = l SN n

with SN n :=

Nn
X

Xi .

i=1

3.1. The First Model, under the iid Assumption

We start with a simple model, considering a sequence of independent and identically distributed (iid)
rvs Xi s. Let X denote the parent rv, and assume that it is simply Bernoulli distributed, i.e., the loss lX
occurs with some probability p:
(
1 with probability p
X=
0 with probability 1 p
Recall that IE[X] = p and var(X) = p(1 p).
Hence, the total loss amount L = l SN n of the portfolio is modeled by a binomial distribution
B(N n, p):
 
Nn k
IP[L = k] = l
p (1 p)N nk , for k = 0, , N n
(7)
k
with IE[L] =

Nn
X
i=1

IE[Xi ] = lN np, and by independence, var(L) = lN n var(X) = lnp(1 p).

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We are interested in knowing the risk premium that the insurance company will ask of a customer if
he buys this insurance policy. Therefore, we compute the cost of capital given in Equation (4) for an
increasing number N of policies in the portfolio, which becomes for this model:


(L)
lnp
(8)
R=
N
since the notation L(N ) in Equation (4) has been simplified to L in this section.
Note that the relative risk per policy defined by the ratio R/IE[L(1) ] is given by:


R
(L)
=
1 .
IE[L(1) ]
lnp

(9)

3.1.1. Numerical Application

We compute the quantities of interest by fixing the various parameters. We choose, for instance,
the number of times one policy is exposed to the risk to be n = 6. Then, we take as the cost of
capital = 15%, which is a reasonable value, given the fact that the shareholders will obtain a return
on investment after taxes of approximately 10%, when considering a standard tax rate of 30%. For a
discussion on the choice of the value of , we refer to [16]. The unit loss l will be fixed to l = 10. We
choose in the rest of the study = 99% for the threshold of the risk measure .
We present in Table 1 an example of the distribution of the loss L = lS1n for one policy (N = 1)
when taking, e.g., p = 1/n = 1/6 (the same probability for each of the n exposures). This would be the
typical distribution for the outcome of a particular value when throwing a die (see [19]).
The expected total loss amount is given by IE[L] = lIE[S1n ] = 10. We see that there is a 26.32%
probability (corresponding to IP[S1n > 10] = 1 IP[S1n 10]) that the company will turn out to be
paying more than the expectation. Thus, we cannot simply ask the expected loss as the premium. This
justifies the premium principle adopted in Section 2.1.
Table 1. The loss distribution for one policy with n = 6 and p = 1/6.
Number of Losses
k

Policy Loss
l X()

Probability Mass
IP[S1n = k]

cdf
IP[S1n k]

0
1
2
3
4
5
6

0
10
20
30
40
50
60

33.490%
40.188%
20.094%
5.358%
0.804%
0.064%
0.002%

33.490%
73.678%
93.771%
99.130%
99.934%
99.998%
100.000%

Now, we compute the cost of capital per policy given in Equation (4) as a function of the number N of
policies in the portfolio. The results are displayed in Table 2 for both risk measures VaR and TVaR and
when taking p = 1/6, 1/4 and 1/2, respectively. The expected total loss amount IE[L] = lIE[S1n ] = nlp
will change accordingly.

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Table 2. The risk loading per policy as a function of the number N of policies in the portfolio
(with n = 6).
Risk Measure

Number N of Policies

Risk Loading R per Policy with Probability

p = 1/6 p = 1/4
p = 1/2

VaR
1
5
10
50
100
1,000
10,000

3.000
1.500
1.050
0.450
0.330
0.102
0.032

3.750
1.650
1.200
0.540
0.375
0.117
0.037

4.500
1.800
1.350
0.600
0.420
0.135
0.043

1
5
10
50
100
1,000
10,000

3.226
1.644
1.164
0.510
0.372
0.116
0.037

3.945
1.817
1.330
0.707
0.425
0.134
0.042

4.500
1.963
1.482
0.675
0.476
0.154
0.049

10.00

15.00

30.00

TVaR

IE[L]/N

Note that, when considering a large number N of policies, the binomial distribution of L could be
replaced by the normal distribution N (N np, N np(1 p)) (for N n 30 and p not close to zero, nor
one; e.g., np > 5 and n(1 p) > 5) using the central limit theorem (CLT). The VaR of order of L
could then be deduced from the th-quantile, q , of the standard normal distribution N (0, 1), as:
p
(10)
V aR (L) = N np(1 p) q + N np.
Thus, the risk loading R would become, in the case of being VaR:
r
nlp(1 p)
R=
q
N

ever smaller as a function of N .

We can see in Table 2 that the risk loading drops practically by a factor of 100 for a portfolio of
10,000 policies, compared with the one computed for one policy (N = 1) that represents 30% of the loss
expectation (IE[L] = 10 in this case). We notice also numerically that, if R increases with p, the relative
risk per policy R/IE[L(1) ] decreases when p increases. When considering the Gaussian approximation
and the explicit VaR given in Equation (10), the relative risk per policy when choosing = VaR, is, as a

function of p, of the order 1/ p, giving back the numerical result. Finally, it is worth noting that the risk
loading with TVaR is always slightly higher than with VaR for the same threshold, as TVaR goes beyond
VaR in the tail of the distribution.
In this setting, a fair game is defined by having an equal probability of losing at each exposure:
p = 1/n. The biased game will be when the probability differs from 1/n, generally bigger. We can

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thus define two states, one with a normal or equilibrium state (p = 1/n) and a crisis state with a
probability q >> p. In the next section, we will introduce this distinction.
3.2. Introducing a Structure of Dependence to Reveal a Systemic Risk
We propose two examples of models introducing a structure of dependence between the risks, in order
to explore the occurrence of a systemic risk and, as a consequence, the limits to diversification. We still
consider the sequence (Xi , i = 1, . . . , N n) to model the occurrence of the risk, with a given severity l,
for N policies, but do not assume anymore that the Xi s are iid
3.2.1. A Dependent Model, but Conditionally Independent
We assume that the occurrence of the risks Xi s depends on another phenomenon, represented by an
rv, say U . Depending on the intensity of the phenomenon, i.e., the values taken by U , a risk Xi has
more or less chances to occur. Suppose that the dependence between the risks is totally captured by U .
Consider, w.l.o.g., that U can take two possible values denoted by one and zero; U can then be modeled
by a Bernoulli B(
p), 0 < p << 1. The rv U will be identified with the occurrence of a state of systemic
risk. Therefore, p could mathematically take any value between zero and one, but we choose it here to
be very small, since we want to explore rare events. We still model the occurrence of the risks with a
Bernoulli, but with a parameter depending on U . Since U takes two possible values, the same holds for
the parameters of the Bernoulli distribution of the conditionally independent rvs Xi | U , namely:
(Xi | U = 1) B(q)

and

(Xi | U = 0) B(p).

We choose q >> p, so that whenever U occurs (i.e., U = 1), it has a big impact in the sense that there
is a higher chance of loss. We include this effect in order to have a systemic risk (non-diversifiable) in
our portfolio.
Looking at the total amount of losses SN n , its distribution can then be written, for k IN, as:
IP(SN n = k) = IP [SN n = k | U = 1] IP(U = 1) + IP [SN n = k | U = 0] IP(U = 0)
= p IP [SN n = k | U = 1] + (1 p) IP [SN n = k | U = 0].

The conditional and independent variables, Sq := SN n | (U = 1) and Sp := SN n | (U = 0), are distributed

as Binomials B(N n, q) and B(N n, p), with mass probability distributions denoted by fSq and fSp ,
respectively. The mass probability distribution fS of SN n appears as a mixture of fSq and fSp (see,
e.g., [20]):
(11)
fS = p fSq + (1 p) fSp with Sq B(N n, q) and Sp B(N n, p).
Note that p = 0 gives back the normal state, developed in Section 3.1.
The expected loss amount for the portfolio, denoting L = L(N ) , is given by:




IE[L] = l IE[SN n ] = l p IE[Sq ] + (1 p) IE[Sp ] = N nl p q + (1 p) p

whereas for each policy, it is:



l
IE[L] = l n p q + (1 p) p
N

(12)

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from which we deduce the risk loading defined in Equations (3) and (4).
Let us evaluate the variance var(SN n ) of SN n . Straightforward computations (see [19]) give:





2
IE[SN
]
=
N
n
p

q
1

q
+
N
nq
+
(1

)
p
1

p
+
N
np
n
which, combined with Equation (12), provides:


var(SN n ) = N n q(1 q)
p + p(1 p)(1 p) + N n(q p)2 p(1 p)
2

from which we deduce the variance for the loss of one contract as N12 var(L) = Nl 2 var(SN n ), i.e.,

l2 n 
1
q(1 q)
p + p(1 p)(1 p) + l2 n2 (q p)2 p(1 p).
(13)
var(L) =
2
N
N
Notice that in the variance for one contract, the first term will decrease as the number of contracts
increases, but not the second one. It does not depend on N and, thus, represents the non-diversifiable
part of the risk.
3.2.2. Numerical Application
For this application, we keep the same parameters n = 6 and p = 1/n as in Section 3.1, and we
choose the loss probability during the crisis to be q = 1/2. We explore different probabilities p of the
occurrence of a crisis. The calculation consists in mixing the two Binomial distributions, according to
Equation (11), for an increasing number of policies N . Results for the two choices of risk measures are
shown in Table 3.
Table 3. For Model Equation (11), the risk loading per policy as a function of the probability
of occurrence of a systemic risk in the portfolio using VaR and TVaR measures with
= 99%. The probability of giving a loss in a state of systemic risk is chosen to be q = 50%.
Risk Measure

Risk Loading R with Occurrence of a Crisis State

p = 0.1% p = 1.0% p = 5.0% p = 10.0%

Number N of Policies

In a Normal State
p = 0

1
5
10
50
100
1,000
10,000

3.000
1.500
1.050
0.450
0.330
0.102
0.032

2.997
1.497
1.047
0.477
0.327
0.101
0.029

4.469
2.070
1.770
1.410
1.605
2.549
2.837

4.346
3.450
3.300
3.060
3.000
2.900
2.866

5.693
3.900
3.450
3.030
2.940
2.775
2.724

1
5
10
50
100
1,000
10,000

3.226
1.644
1.164
0.510
0.372
0.116
0.037

3.232
1.707
1.266
0.760
0.596
0.396
0.323

4.711
2.956
2.973
2.970
2.970
2.970
2.970

4.755
3.823
3.578
3.196
3.098
2.931
2.876

5.899
4.146
3.665
3.141
3.020
2.802
2.732

10.00

10.02

10.20

11.00

12.00

VaR

TVaR

IE[L]/N

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In Table 3, we see well the effect of the non-diversifiable risk. As expected, when the probability of
occurrence of a crisis is high, the diversification does not play a significant role anymore, already with
100 contracts in the portfolio. The interesting point is that for p 1%, the risk loading barely changes
when there is a large number of policies (starting at N = 1,000) in the portfolio. This is true for both
VaR and TVaR. The non-diversifiable term dominates the risk. When looking at a lower probability p
of the occurrence of a crisis, we notice that the choice of the risk measure matters. For instance, when
choosing p = 0.1%, the risk loading, compared to the normal state, is multiplied by 10 in the case of
TVaR, for N = 10,000 policies, and hardly moves in the case of VaR! This effect remains, but to a lower
extent, when diminishing the number of policies. It is clear that the VaR measure does not capture the
crisis state well, while TVaR is sensitive to the change of state, even with such a small probability and a
high number of policies.
Another interesting effect worth noticing is the fact that the risk loading for any given N should
increase with increasing p since the influence of the biased die should increase (as it appears clearly
in (12) and (13), the expectation and variance being increasing functions of p (with p < 1/2)). Yet,
we see that, with VaR and TVaR, it is not the case starting with N = 50, although the effect is much
smaller for TVaR. It seems to decrease when p increases from 5 to 10%. Pushing p to 15%, we see
that the effect of the bias levels off, which could explain the fluctuations around this level and thus this
numerical instability.
To explore the increase of the risk loading of the VaR for p = 1%, we redid 1,000 times the 106
simulations. It turns out that the obtained values are very unstable, for instance for N = 10, 000, it
jumps from 0.2 to 2.9, without taking any value in between. For the TVaR, it is more stable and we do
not see such a behavior; in this case, the variation is less than 1%. When considering values for p close
to 1% (0.9 or 1.1%), the variation for the VaR becomes again more or less stable, we do not observe any
more such jumps.
3.2.3. A More Realistic Setting to Introduce a Systemic Risk
We adapt further the previous setting to a more realistic description of a crisis. At each of the n
exposures to the risk, in a state of systemic risk, the entire portfolio will be touched by the same increased
probability of loss, whereas, in a normal state, the entire portfolio will be subject to the same equilibrium
probability of loss.
For this modeling, it is more convenient to rewrite the sequence (Xi , i = 1, . . . , N n) with a vectorial
notation, namely (Xj , j = 1, . . . , n), where the vector Xj is defined by Xj = (X1j , . . . , XN j )T .
Hence, the total loss amount SN n can be rewritten as:
SN n =

n
X
j=1

S(j)

where S(j) is the sum of the components of Xj : S(j) =

N
X

Xij .

i=1

We keep the same notation for the Bernoulli rv U determining the state and for its parameter p.
However, now, instead of defining a normal (U = 0) or a crisis (U = 1) state on each element of
(Xi , i = 1, . . . , N n), we do it on each vector Xj , 1 j n. It comes back to define a sequence of

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iid rvs (Uj , j = 1, . . . , n) with parent rv U . Hence, we deduce that S(j) follows a Binomial distribution
whose probability depends on Uj :
S(j) | (Uj = 1) B(N, q)

S(j) | (Uj = 0) B(N, p).

and

Note that these conditional rvs are independent.

Let us introduce the event Al defined, for l = 0, . . . , n, as:
Al := {l vectors Xj are exposed to a crisis state and nl to a normal state} =
n
X

n
X

Uj = l

j=1

 
n
Uj = l =
whose probability is given by IP(Al ) = IP
pl (1 p)nl .
l
j=1
We can then write that:
n
n  
X
X


n l
IP(SN n = k) =
IP(SN n = k | Al )IP(Al ) =
p (1 p)nl IP Sq(l) + Sp(nl) = k
l
l=0
l=0


(14)

with, by conditional independence,

Sq(l) =

l 
X
j=1

nl 


X
S(j) | Uj = 1 B(N l, q) and Sp(nl) =
S(j) | Uj = 0 B(N (n l), p).

(15)

j=1

Expectation and variance are obtained by straightforward computations (see [19]). We have:
IE[SN n ] = N n
and, for one contract,

q p p + p

(16)

l
1
IE[L] = IE[SN n ] = nl (
p q + (1 p) p)
N
N
which is equal to the expectation Equation (12) obtained with the previous method. The variance can be
deduced from Equation (16) and:

2


2
2 2
p(1

)
+
q
p

IE[SN
]
=
N
n
q(1

q)
p
+
p(1

p)(1

)
+
N
n
+ N 2 n(q p)2 p(1 p)
n

hence:



var(SN n ) = N n q(1 q)
p + p(1 p)(1 p) + N (q p)2 p(1 p)

which is different from the variance var(SN n ) obtained with the previous model in Section 3.2.1.
Now, for one contract, we obtain:

1
l2
l2 n 
q(1

q)
p
+
p(1

p)(1

)
+ l2 n (q p)2 p(1 p).
var(L)
=
var(S
)
=
N
n
N2
N2
N

(17)

Notice that the last term appearing in Equation (17) is only multiplied by n and not n2 , as in
Equation (13), and not diversifiable by the number N of policies. It looks like the one of Equation (13);
however, its effect is smaller than in the previous model. With this method, we have also achieved
producing a process with a non-diversifiable risk.

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271

3.2.4. Numerical Application

Let us revisit our numerical example. In this case, we cannot, contrary to the previous cases, directly
use an explicit expression for the distributions. We have to go through Monte Carlo simulations. At each
of the n exposures to the risk, we first have to choose between a normal or a crisis state. Since we take
here n = 6, the chances of choosing a crisis state when p = 0.1% is very small. To get enough of the
crisis states, we need to do enough simulations and then average over all of the simulations. The results
shown in Table 4 are obtained with 10 million simulations. We ran it also with one and 20 million
simulations to check the convergence. It converges well, as can be seen in Table 5.
Table 4. For Model Equation (14), the risk loading per policy as a function of the probability
of occurrence of a systemic risk in the portfolio using VaR and TVaR measures with
= 99%. The probability of giving a loss in a state of systemic risk is chosen to be q = 50%.
Risk Measure

Risk Loading R with Occurrence of a Crisis State

p = 0.1% p = 1.0% p = 5.0% p = 10.0%

Number N of Policies

In a Normal State
p = 0

1
5
10
50
100
1,000
10,000
100,000

3.000
1.500
1.050
0.450
0.330
0.102
0.032
0.010

2.997
1.497
1.047
0.477
0.357
0.112
0.033
0.008

2.969
1.470
1.170
0.690
0.615
0.517
0.485
0.475

4.350
1.650
1.350
0.990
0.945
0.882
0.860
0.853

4.200
1.800
1.500
1.200
1.170
1.186
1.196
1.199

1
5
10
50
100
1,000
10,000
100,000

3.226
1.644
1.164
0.510
0.375
0.116
0.037
0.012

3.232
1.792
1.252
0.588
0.473
0.348
0.313
0.301

4.485
1.870
1.342
0.824
0.740
0.605
0.563
0.550

4.515
2.056
1.604
1.183
1.118
1.013
0.981
0.970

4.448
2.226
1.804
1.408
1.358
1.295
1.276
1.269

10.00

10.02

10.20

11.00

12.00

VaR

TVaR

IE[L]/N

The results shown in Table 4 follow the behavior we expect. The diversification due to the total
number of policies is more effective for this model than for the previous one, but we still experience a
part which is not diversifiable. We have also computed the case with 100,000 policies, since we used
Monte Carlo simulations. It is interesting to note that, as expected, the risk loading in the normal state

continues to decrease. In this state, it decreases by 10. However, except for p = 0.1% in the VaR case,
the decrease becomes very slow when we allow for a crisis state to occur. The behavior of this model
is more complex than the previous one, but more realistic, and we reach also the non-diversifiable part
of the risk. For a high probability of occurrence of a crisis (one every 10 years), the limit with VaR is
reached already at 100 policies, while, with TVaR, it continues to slowly decrease. The instability with

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272

increasing p that we noticed in Table 3 has disappeared here for both VaR and TVaR. The cost of capital
always increases with increasing p, except for N = 1. This could be due to the fact that we consider
only one discrete rv and/or to the numerical stability of the results.
Concerning the choice of risk measure, we see a similar behavior as in Table 3 for the case
N = 10,000 and p = 0.1%: VaR is unable to catch the possible occurrence of a crisis state, which shows
its limitation as a risk measure. Although we know that there is a part of the risk that is non-diversifiable,
VaR does not catch it really when N = 10,000 or 100,000, while TVaR does not decrease significantly
between 10,000 and 100,000 reflecting the fact that the risk cannot be completely diversified away.
Finally, to explore the convergence of the simulations, we present in Table 5 the results obtained for
N = 100 and for various numbers of simulations.
It appears that, already for this number of policies (N = 100), the number of simulations has
no influence. Obviously, with a lower number of policies, the number of simulations plays a more
important role, as one would expect, while for a higher number of policies, it is insensitive to a number
of simulations above one million.
Table 5. Testing the numerical convergence: the risk loading as a function of the number of
Monte Carlo simulations, for N = 100, Model Equation (14) and the same parameters as in
Table 4.
Risk Measure

Risk Loading R with Occurrence of a Crisis State

p = 0.1% p = 1.0% p = 5.0% p = 10.0%

Number N of Policies

In a Normal State
p = 0

1 million
10 million
20 million

0.330
0.330
0.330

0.357
0.357
0.357

0.615
0.615
0.615

0.945
0.945
0.945

1.170
1.155
1.170

1 million
10 million
20 million

0.375
0.374
0.375

0.476
0.472
0.473

0.738
0.739
0.740

1.115
1.117
1.118

1.358
1.357
1.358

10.00

10.02

10.20

11.00

12.00

VaR

TVaR

IE[L]/N

4. Comparison and Discussion

Let us start with Table 6, presenting a summary of the expectation and the variance of the total loss
amount per policy, obtained for each model.
For the first Model Equation (7), we see that the variance decreases with increasing N , while for
both of the other models Equations (11) and (14), the variance contains a term that does not depend
on N , which corresponds to the presence of a systemic risk and is not diversifiable. Note that the
variance for Model Equation (11) contains a non-diversifiable part that corresponds to n-times the
non-diversifiable part of the variance for Model Equation (14). This is consistent with the numerical
results in Tables 3 and 4; indeed, the smaller the non-diversifiable part, the longer the decrease of the
risk loading R (i.e., the effect of diversification) with the increase of the number of policies. The latter

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273

model is the most interesting, because it shows both the effect of diversification and the effect of the
non-diversifiable term in a more realistic way. It assumes the occurrence of states that are dangerous to
the whole portfolio, which is characteristic of a state of crisis in the financial markets. Thus, it is more
suitable to explore other properties and the limits of diversification in times of crisis.
Table 6. Summary of the analytical results (expectation and variance per policy) for the
three models with the cdf defined by Equations (7), (11) and (14), respectively.
Model

IE[L]/N

Equation (7)

ln p

Equation (11)



ln p q + (1 p) p

Equation (14)



ln p q + (1 p) p

var(L)/N 2
l2 n
p(1 p)
N

l2 n 
q(1 q)
p + p(1 p)(1 p) + l2 n2 (q p)2 p
(1 p
)
N

l2 n 
q(1 q)
p + p(1 p)(1 p) + l2 n (q p)2 p
(1 p
)
N

Here, we should note that there is, in the economic literature, a distinction between systemic risk
implying contagion effects and systematic risk that implies an element that cannot be diversified away.
Yet, there is no clear accepted mathematical definition of either phenomenon. As already mentioned
above, we see that systemic risk manifests itself by a breakdown of the benefit of diversification. It
might be due either to contagion or to the presence of a non-diversifiable risk. In the following, we
propose a mechanism that is equivalent to contagion as it happens simultaneously on many risks, but
could also be assimilated to a non-diversifiable element coming from the mixture of two distributions.
We could interpret our first dependent case as a model for systematic risk in the sense of the economists,
while the second one is more a model for systemic risk because once the biased distribution is chosen,
it is applied to all the N policies (contagion). However, this model does not contain a time component
that the term contagion would imply.
Concerning the choice of risk measure, we have already noticed that there was an issue when
evaluating the VaR with small p. There are other less obvious stability problems, as, for instance, the
VaR in with the cdf Model Equation (11) for p = 1%. It starts to decrease with N increasing, then raises
again for large N , while the TVaR decreases with N increasing, then stabilizes to a value whenever
N 50. For p = 0.1%, in both models with cdf Equations (11) and (14), respectively, VaR is very close
to the Case Equation (7), without systemic risk, while TVaR starts to be significantly impacted already
with 50 policies, indicating that the systemic risk appears mostly beyond the 99% threshold. Even if
there is a part of the risk that is non-diversifiable, VaR, under certain circumstances, might not catch it
(see [15], Proposition 3.3).
We have the following property:
If the risk measure is subadditive, then the risk loading RN defined in (4) satisfies RN R1 0,
N 1.
The proof is straightforward when noticing that for any model we considered,

nN
X
i=1

k 1, and when using the assumption of subadditvity of , (L(N ) ) N (L(1) ). 

Xi =

k+nN
X

i=k+1

Xi ,

Risks 2014, 2

274

This property is satisfied in the three cases. We also see that RN is a decreasing function of N for
TVaR in all tables, but not for VaR. For the latter, we see, in the first dependence model, an increase of
VaR for p = 1% from N = 100 onwards and, in the second case, for p = 10% from N = 1 000 onwards.
The reason for this increase could be due to numerical instabilities or to a break of subadditivity of VaR.
5. Conclusions
In this study, we have shown the effect of diversification on the pricing of insurance risk through the
first simple modeling. Then, for understanding and analyzing possible limitations to diversification
benefits, we propose two alternative stochastic models, introducing dependence between risks by
assuming the existence of an underlying systemic risk. These models, defined with mixing distributions,
allow for a straightforward analytical evaluation of the impact of the non-diversifiable part, which
appears in the close form expression of the variance. We have purposely adopted here a probabilistic
approach for modeling the dependence and the existence of systemic risk. It could be easily generalized
to a time series interpretation by assigning a time step to each exposure n. In the last model, the
occurrence of the rv U = 1 could then be identified with the time of crisis.
In real life, insurers have to pay special attention to the effects that can weaken the diversification
benefits. For instance, in the case of motor insurance, the appearance of a hail storm will introduce a
bias in the usual risk of accidents, due to a cause independent of the car drivers, which will hit a big
number of cars at the same time and, thus, cannot be diversified among the various policies. There are
other examples, in life insurance, for instance, with a pandemic or mortality trend that would affect the
entire portfolio and that cannot be diversified away. Special care must be given to those risks, as they will
affect greatly the risk loading of the premium, as can be seen in our examples. These examples might
also find applications for real cases. This approach can be generalized to investments and banking; both
are subject to systemic risk, although of a different nature than in the above insurance examples.
The last model we suggested, introducing the occurrence of crisis, may find an interesting application
for investment and the change in the risk appetite of investors. It will be the subject of a following paper.
Moreover, the models we introduce here allow one to point out explicitly the impact of dependence;
they are simple enough to compute an analytic expression and to analyze the impact of the emergence of
systemic risks. Yet, they are formulated in such a way that extensions to more sophisticated models are
easy and clear. In particular, it makes it possible to obtain an extension to non-identically-distributed rvs
or when considering random severity. Another interesting perspective would be to consider econometric
models with multiple states.
Acknowledgements
Partial support from RARE-318984 (an FP7 Marie Curie IRSES Fellowship) is kindly acknowledged.
Author Contributions
All authors contributed equally to this work.

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275

Conflicts of Interest
The authors declare no conflicts of interest.
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