OptimalConsumptionandInsuranceAContinuous-TimeMarkov.pdfVIP

Optimal Consumption and Insurance: A Continuous-Time Markov Chain Approach Holger Kraft∗ and Mogens Steffensen† Abstract Personal financial decision making plays an important role in modern finance. Decision problems about consumption and insurance are modelled in a continuous-time multi-state Markovian framework. The optimal solution is derived and studied. The model, the problem, and its solution are exemplified by two special cases: In one model the individual takes optimal positions against the risk of dying; in another model the individual takes optimal positions against the risk of losing income as a consequence of disability or unemployment. Key words : Personal finance, multi-state model, stochastic control, financial decision making, mortality-disability-unemployment risk JEL-Classification: G11, G22, J65 ∗kraft@mathematik.uni-kl.de, Fachbereich Mathematik, Universit¨at Kaiserslautern, Erwin-Schr¨odinger-Strasse, D-67653 Kaiserslautern, Germany †Corresponding and presenting author, mogens@math.ku.dk, Department of Mathematical Sciences, Univer- sitetsparken 5, DK-2100 Copenhagen O, Denmark 1 1 Introduction Optimal personal financial decision making plays an important role in modern financial mathemat- ics and economics. It covers broad disciplines like micro-economic equilibrium theory and portfolio optimization. Merton (1969,1971) initiated the area of continuous-time consumption-investment problems which has become a paradigm for a large set of developments and generalizations. These are often driven by modifications of financial market models or individual preferences. In this article we disregard the investment decision of the individual