MODELING

SOURCES: 1. Klugman, S. A., Panjer, H. H., and Willmot, G E. (2004), Loss Models: From Data to Decisions, 2nd edition, John Wiley and Sons, New York, Chapter 1. 2. Chatfield, C. (2000), Time-Series Forecasting, Chapman & Hall.

Problem in actuarial science: To build a mathematical model which can be used to forecast insurance costs in the future. Definition: A model is a simplified mathematical description which is constructed based on the knowledge and experience of an analyst combined with data from the past. a model is an approximation to the real phenomenon Sources of Uncertainties Three main sources of uncertainties in any mathematical or statistical models: 1. Model uncertainty: Uncertainty about the structure of the model Error in the specification of the structure of the model Error in specifying that the parameters were fixed when they were actually dependent on time. Parameter Uncertainty Assuming that the model is appropriate, since the parameters are estimated using the data available, there are uncertainties about the estimates of the parameters. standard error of the estimators Process Uncertainty This is an uncertainty about the data, which includes: the unexplained random variation and measurement and recording errors

2.

3.

There is no such thing as the true model because no model can describe fully the generating process underlying the data. There is no such thing as one best model Modeling process There are six (6) steps in the process of building mathematical (or probabilistic) models for a certain real problem: 1

1. Model choice A model is formulated or selected based on an analysts: prior knowledge and experience; and the nature and form of the available data. 2. Model calibration Data are used to calibrate the chosen model; parameter(s) is (are) estimated using the available data. 3. Model validation It is important to check whether the fitted model conforms adequately to the data. There are various diagnostic tests to validate the fitted model, such as: the chi-square goodnessof-fit test; the Kolmogorov-Smirnov test; qualitative methods. 4. Investigation of other possible models Even after a suitable model has been found, it is important to investigate if there are other plausible models. In insurance practice, it is important to consider more than one model for a particular problem. 5. Model selection All valid models are compared using some criteria; this also includes sensitivity analysis of such models. A model (or maybe more than one model) is selected using previous results or some other criteria. 6. Model modification for application to the future The selected models need to be adapted for application to the future. For example, loss or claims data are very much affected by inflation. Unless this particular variable has been taken into account in the model, the (parameters of the) selected models need to be adjusted to forecast the loss in the future. From time to time, improvements on the model(s) chosen need to be carried out, that is the six steps above need to be repeated, as more data collected and/or environment (such as inflation, interest rate, government policy, etc) changes.