Curtin University

Department of Mathematics and Statistics

Risk models

A portfolio of insurance policies, covering

Insurable risks:
The risk that is of interest to policyholder and is quantifiable
Insurable risk events should:
Be independent
Have low probability of occurrence
Be pooled with similar risks
Have an ultimate liability
Avoid moral hazards

Types of general insurance:

Liability to third parties
Property damage
Financial loss
Fixed benefits

Number of claims, N, and individual claim amounts, , = 1, , .

How many claims? How severe? Depends on length of time

Short-term insurance contracts

Basic ideas:
Definition:
Policy lasts for a fixed, relatively short, period (e.g. often 1 year)
Insurance company receives premium from policyholder(s)
Insurer pays claims arising from policy during term of policy

Important feature:

Premium is set at a level to cover claims during short term of policy only.
Different from life assurance policy (related to mortality rate)

Aggregate claims paid by insurer:

N: number of claims in some fixed term (eg 1 year);
: amount of claim , = 1, , .
Aggregate claims: = =1
(if = 0, let = 0)
Collective risk model: claims arising from a group of policies taken as a whole
Compound distribution: sum of random number of random quantities

Collective risk model:

Total claim amount in fixed period in portfolio of insurance contracts.

Number of claims, N, from the risk as a collective

Assumptions:
{ } =1 are i.i.d.: individual claim amounts independent of each other,
and have the same distribution.
is independent of { } =1 : claim number independent of individual
claim amounts

Example

A compound distribution is such that

( = 0) = 0.6, ( = 1) = 0.3,
( = 2) = 0.1. Claim amounts are either for 1 unit or 2 units, each with
probability 0.5. Derive the distribution of .
Solution
 Distribution of =
=1

( ) = ( = , )
=0

= ( = , )
=0 =1

= ( = ) ( )
=0 =1

How to model N?
How to calculate (=1 )?

. . . ~(): ( ) = ()
=1
fold convolution of

Convolution: X and Y independent = +

p.d.f =
() = () ( ) (discrete r.v.)
() = () ( ) (continuous r.v.)

c.d.f =
() = () ( ) (discrete r.v.)
() = () ( ) (continuous r.v.)

Example
1 1 1
If (0) = 2 , (1) = 4 , (2) = 4 and 1 , 2 , 3 are independent and identically
distributed like , find the density of = 1 + 2 + 3 .
Solution
 Moments: required in risk premium

[] = [[|]]

() = [(|)] + ([|])

In the collective claims model, aggregate claims, , is expressed as:

= 1 + 2 + +
= random number of claims
1 , 2 , , independent and distributed like
1 , 2 , , and are independent

If we condition on the related variable :

|= = 1 + + (sum of a given number of terms)

[| = ] =

[| = ] =

Written generally as:

(|) =
(|) =

Mean:

() =
=
= pure risk premium

Variance:

() = [(|)] + [(|)]

() = ()() + ()[()]2

Example

Suppose (1) = .6 and (2) = .4 gives the distribution of claim amount variable ,
and ( = 0) = .7, ( = 1) = .2 and ( = 2) = .1 gives the distribution of the
claim number variable .

i. Calculate [], (), [] and ().

ii. What are [|] and [|]?
iii. What are [] and ()?
Solution
 Moment generating function:

i.i.d. and independent of N, =

=1 .

mgf:

Example

Assume the number of claims has a (100,0.01) distribution, and individual claim
sizes are (10,0.2).

(i) Find the mean and variance of the aggregate claim amount.
(ii) Find an expression for the mgf of the aggregate claim amount.
Solution
Cumulant Generating Function

Defined as:
() = log ()
() = (0)
() = (0)
() = (0)

Typical compound distributions

How to model N? Reinsurance?

3 models: Poisson, Binomial, negative Binomial

Compound Poisson distribution: with parameter and ().

Number of claims, ~():

( = ) = , = 0,1,
!
Moments: [] = [] =
Mgf: () = [ ] = exp{( 1)}

Individual claim amount, . . . ~():

= ( ), () = [exp{ }]

Aggregate claim amount: =

=1

Mean:() =

() =

[( 1 )3 ] =

mgf: () =

Advantage: mathematical ease in application.

Example

There are n portfolios of insurance policies, believed independent of each other, with
the portfolios aggregate claim amounts equal to modelled by a compound
Poisson distribution with parameter and (), = 1,2, , where () denotes
the distribution function of the individual claim amounts.

Then the aggregate claim amount of these n portfolios, = =1 , has a compound

1
Poisson distribution with parameter = =1 and () = =1 ()

Show this.
Solution
 Compound Binomial Distribution:

Example

A group life insurance policy covering n lives, with each insured life subject to the
same mortality rate q and lives independent with respect to mortality. Thus, the
distribution of the number of deaths in a year is binomial: ~(, )

~(, )
pdf : ( = ) = (1 ) , = 0,1, . . ,
Moments: () = , () = (1 )
mgf: () = ( ) = (1 + )

. . . ~():
= ( ), () = [exp{ }]

Aggregate claim amount: =

=1 .

Mean: () = ()( ) = 1 .

Variance:
() =

[( [])3 ] = 3 3 2 2 1 + 2 3 13

mgf:

() =
 Compound negative binomial distribution:

Example

The number of claims from a motor portfolio, , is believed to have

(, ) distribution with parameter = 4000 and = 0.9 , and
the claim size has (, ) with = 5 and = 1200.

To compute the risk premium, we need to calculate the mean and variance of the
aggregate claim distribution.

~(, )

pdf : ( = ) = +1 (1 ) , = 0,1, ..
(1)
Moments: () = , () = (1 )/2
mgf: () = ( ) = [1 (1 ) ]
= 1: reduces to ()

. . . ~():
= ( ), () = [exp{ }]

Aggregate claim amount: =

=1 .

(1)
Mean: () = ()( ) = 1 .

Variance:
() =

3 2 1 2 2 3 13 3
[( [])3 ] = + +
2 3

mgf: () =
Solution