de Finetti Scoops Markowitz

Harry M. Markowitz

Volume 4, Number 3, Third Quarter 2006

In 1940, in the context of choosing optimum reinsurance levels, Bruno de Finetti essentially proposed mean-variance analysis with correlated risks. It was not until 1952 that Markowitz and Roy introduced mean-variance analysis with correlated risks into the financial literature. De Finetti solved the problem of computing mean-variance efficient frontiers for a particular constraint set (one that describes the reinsurance problem) assuming uncorrelated risks. While he understood and explained the importance of the case with correlated risks, he did not provide an algorithm for this case. In fact, one of his conjectures concerning its solution was incorrect. The present article summarizes de Finetti’s contribution, presents an algorithm for solving “the de Finetti problem” when risks are correlated, and illustrates these matters with an easily visualized two-policy reinsurance problem.