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Chapter 2
Chapter 2
Contents
2.1 Discrete Distributions . . . . . . . . . . . . . . . . . . . . . . . . 2
1
CHAPTER 2. MODELS FOR CLAIM FREQUENCIES
pk = P (N = k), k = 0, 1, 2, . . .
3. As is true with the moment generating function, the pgf can be used to generate
moments. In particular, P 0 (1) = E(N ) and P 00 (1) = E[N (N − 1)].
= e−λ eλz
= eλ(z−1) , λ > 0.
3. Since P 0 (z) = λeλ(z−1) and P 00 (z) = λ2 eλ(z−1) , then the mean and variance can be
computed from the pgf as follows:
E(N ) = P 0 (1) = λ
E[N (N − 1)] = P 00 (1) = λ2
V (N ) = E[N (N − 1)] + E(N ) − [E(N )]2 = λ2 + λ − λ2 = λ.
Proof:
Ni ∼ P oi(λi ), i = 1, 2, . . . , n
λi (z−1)
PNi (z) = e
N = N1 + · · · + Nn
PN (z) = PN1 +···+Nn (z)
= PN1 (z)PN2 (z) · · · PNn (z)
= eλ1 (z−1)
e 2
λ (z−1)
· · · eλn (z−1)
Pn
= exp i=0 λi (z − 1)
Pn
=⇒ N ∼ P oi i=0 λi
Example 2.2.2. Dental Insurance Company sells a policy that covers two types of dental
procedures: root canals and fillings. There is a limit of 1 root canal per year and a separate
limit of 2 fillings per year. The number of root canals a person needs in a year follows
a Poisson distribution with λ = 1, and the number of fillings a person needs in a year
is Poisson with λ = 2. The company is considering replacing the single limits with a
combined limit of 3 claims per year, regardless of the type of claim. Determine the
change in the expected number of claims per year if the combined limit is adopted.
2. Like the Poisson distribution, it has positive probabilities on the nonnegative inte-
gers.
3. Because it has two parameters, it has more flexibility in shape than the Poisson.
k = 0, 1, 2, . . . , r > 0, β > 0.
5. The pgf for the negative binomial distribution is P (z) = [1 − β(z − 1)]−r .
Proof:
∞
X k+r−1 β
P (z) = (1 − q)r (qz)k , let q = 1+β
k=0
k
∞
(1 − q)r X k + r − 1
= r
(1 − qz)r (qz)k
(1 − qz) k=0 k
1
r r
(1 − q)r
1+β 1 1+β
= = βz r
=
(1 − qz)r 1 − 1+β 1+β 1 + β − βz
= [1 − β(z − 1)]−r .
Notes:
(a) Negative binomial distribution is a generalization of the Poisson in the following two
ways:
(c) Geometric distribution is the special case of negative binomial distribution when
r = 1.
3. Its variance is smaller than its mean, making it useful for data sets in which the
observed sample variance is less than the sample mean.
Frequency 0 1 2 3 4
Number of insured 6070 3022 764 126 18
Based on the portfolio’s sample moments, which of the following distributions provide the
best fit to the portfolio’s number of claims?
A. Binomial B. Poisson C. Negative Binomial D. Lognormal E. Pareto
This recursion describes the relative size of successive probabilities in the counting distri-
bution. Panjer and Willmot found that negative binomial, Poisson and binomial are the
only possible distribution satisfying this recursive formula.
(1) − (2) : b
2
= (r−1) β
2 1+β
β
=⇒ b = (r − 1) , 1+β
rβ β β
a= 1+β
− (r − 1) 1+β = 1+β .
β q
• Since a = 1+β
> 0, a = 0 and a = − 1−q < 0 for the negative binomial, Poisson
and binomial, respectively. Therefore, we can use the sign of a to determine the
distribution belongs to the (a, b, 0) class. The values of a and b are as summarized
in Table 2.1.
Distribution a b p0
Poisson 0 λ e−λ
q q
Binomial − 1−q (m + 1) 1−q (1 − q)m
β β
Negative Binomial 1+β
(r − 1) 1+β (1 + β)−r
β
Geometric 1+β
0 (1 + β)−1
• Note from Table 2.1 that the slope a of the straight line is 0 for the Poisson dis-
tribution, is negative for the binomial distribution, and is positive for the negative
binomial distribution, including the geometric.
• This relationship suggests a graphical way of indicating which of the three distribu-
tions might be selected for fitting to data. Begin by plotting
p̂k nk
k =k
p̂k−1 nk−1
against k.
• The observed values should form approximately a straight line if one of these models
is to be selected, and the value of the slope should be an indication of which of the
models should be selected.
• Note that this cannot be done if any of the nk are 0. Hence this procedure is less
useful for a small number of observations.
Example 2.3.2. Consider the accident data in Table 6.2, For the 9,461 automobile insur-
ance policies studied, the number of accidents under the policy is recorded in the table.
Also recorded in the table is the observed value of the quantity that should be linear.
n
Number of accidents, k Number of policies, nk kn k
k−1
0 7840
1 1317 0.17
2 239 0.36
3 42 0.53
4 14 1.33
5 4 1.43
6 4 6.00
7 1 1.75
8+ 0
knk
Figure 2.1: Plot of ratio nk−1
against k
Solution: Figure 2.1 plots the value of the quantity of interest against k, the num-
ber of accidents. It can be seen from the graph that the quantity of interest looks
approximately linear except for the point at k = 6. From the graph, it can be seen
that the slope is positive and the data appear approximately linear, suggesting that
the negative binomial distribution is an appropriate model.
Whether or not the slope is significantly different from 0 is also not easily judged
from the graph. Graphically, it is difficult to distinguish between the Poisson and the
negative binomial distribution because the Poisson requires a slope of 0. However, we
can say that the binomial distribution is probably not a good choice since there is no
evidence of a negative slope. In this case it is advisable to fit both the Poisson and
negative binomial distributions and conduct a more formal test to choose between
them.
Example 2.3.3. Claim frequency follows a distribution in the (a, b, 0) class. You are
given that
• the probability of 4 claims is 0.2734375
•the probability of 5 claims is 0.21875
• the probability of 6 claims is 0.109375
Calculate the probability of no claims.
Example 2.3.4. For an auto collision coverage, frequency of claims follows a distribution
from the (a, b, 0) class. You are given that
• the probability of 1 claims is 0.03368973
• the probability of 2 claims is 0.08422434
• the probability of 3 claims is 0.1403739.
Calculate the average number of claims.
Example 2.3.5. For a distribution in the (a, b, 0) class, you are given that p2 = 0.25p1
and p4 = 0.225p3 . Determine p2 .
Example 2.3.6. You are given the following claim frequency data:
Frequency 0 1 2 3 4
Number of insureds 20 24 10 6 3
Which probability distribution is suggested by this data based on (i) successive ratios of
probabilities and (ii) moments?
A. (i) Binomial, (ii) Binomial B. (i) Poisson, (ii) Binomial
C. (i) Negative Binomial, (ii) Poisson D. (i) Negative Binomial, (ii) Negative Binomial.
E. None of the above.
• Thus, it is important to pay special attention to the fit at this point. However, the
three discrete distributions of (a, b, 0) class are inadequate because they do not give
appropriate probability to 0 claims.
Note that the only difference from the (a, b, 0) class is that the recursion begins at p1
rather than p0 .
• To obtain a distribution in this class is to take one from the (a, b, 0) class and
truncate it at 0, i.e., make the probability of 0 equal to zero, and then scale all the
other probabilities so that they add up to 1.
• We distinguish between the situations in which p0 = 0 and those where p0 > 0. The
first subclass is called the zero-truncated distributions. The second subclass is
referred to as the zero-modified distributions.
and pM
0 is an arbitrary number.
3. Then
∞
X ∞
X
M
P (z) = pM
k z
k
= pM
0 + pM
k z
k
k=0 k=1
∞
X
= pM
0 +c pk z k = pM
0 + c[P (z) − p0 ].
k=1
1 = pM
0 + c(1 − p0 ),
resulting in
1 − pM
0
c= or pM
0 = 1 − c(1 − p0 ).
1 − p0
5. Then, we have
1 − pM
0
P M (z) = pM
0 + [P (z) − p0 ]
1 − p0
1 − pM 1 − pM
0 0
= 1− 1+ P (z).
1 − p0 1 − p0
This is a weighted average of the pgfs of the degenerate distribution and the
corresponding (a, b, 0) member.
6. Furthermore,
1 − pM
0
pM
k = pk , k = 1, 2, . . .
1 − p0
pk
pTk = , k = 1, 2, . . .
1 − p0
which implies that
pM M T
k = (1 − p0 )pk
and
∞ ∞
T
X X pk k
P (z) = pTk z k = z
k=1 k=1
1 − p0
1
= [P (z) − p0 ].
1 − p0
1 − pM
M 0
P (z) = pM
0 + [P (z) − p0 ],
1 − p0
thus
1
P T (z) = [P (z) − p0 ]
1 − p0
which implies that
P M (z) = pM M T
0 + (1 − p0 )P (z).
1 X 2 E(N 2 )
E[(N T )2 ] = k pk =
1 − p0 1 − p0
V (N T ) = E[(N T )2 ] − E 2 (N T )
2
E(N 2 )
E(N )
= −
1 − p0 1 − p0
V (N ) − p0 E(N 2 )
=
(1 − p0 )2
9. As pM M T
k = (1 − p0 )pk , the mean and variance for zero-modified distributions
are:
E(N M ) = (1 − pM T
0 )E(N )
and
E[(N M )2 ] = (1 − pM T 2
0 )E[(N ) ]
Thus,
V (N M ) = E[(N M )2 ] − E 2 (N M )
= (1 − pM T 2 M 2 2 T
0 )E[(N ) ] − (1 − p0 ) E (N )
= (1 − pM T 2 M 2 T
0 )[E[(N ) ] − (1 − p0 )E (N )]
= (1 − pM T M 2 T
0 )[V (N ) + p0 E (N )]
= (1 − pM T M M 2 T
0 )V (N ) + p0 (1 − p0 )E (N )
Notes:
pT
• For zero-truncated distribution, pT
k
= a + kb , k = 2, 3, . . . .
k−1
pM
• For zero-modified distribution, pM
k
= a + kb , k = 2, 3, . . . .
k−1
Example 2.4.2. For distribution from (a, b, 1) class, p1 = 0.4, p2 = 0.2, p3 = 0.1. Deter-
mine p0 .
Example 2.4.6. You are given pk denotes the probability that the number of claims
pn m!
equals k for k = 0, 1, 2, . . . . Suppose pm
= n!
, m ≥ 0, n ≥ 0. Using corresponding
zero-modified claim count distribution with pM
0 = 0.1. Calculate pM
1 .
Example 2.4.8. For a zero-modified distribution from (a, b, 1) class, you are given
2. The (a, b) parameter space can be expanded to admit an extension of the negative
binomial distribution to include cases where −1 < r < 0.
3. For the (a, b, 0) class, r > 0 is required. By adding the additional region to the
sample space, the “extended” truncated negative binomial (ETNB) distribution
has parameter restrictions β > 0, r > −1, r 6= 0.
4. When r → 0, the limiting case of the ETNB is the logarithmic distribution with
[β/(1 + β)]k
pTk = , k = 1, 2, 3, . . .
k ln(1 + β)
The pgf of the logarithmic distribution is
ln[1 − β(z − 1)]
P T (z) = 1 −
ln(1 + β)
Proof:
∞
X
P T (z) = pTk z k
k=1
∞ k
1 X β 1 k
= ·z
ln(1 + β) k=1 1 + β k
1 zβ
= − ln 1 −
ln(1 + β) 1+β
− ln( 1+β−zβ
1+β
) ln[1 − β(z − 1)]
= =1− .
ln(1 + β) ln(1 + β)
Example 2.4.9. Determine the first four probabilities for an ETNB distribution with
r = −0.5 and β = 1. Do this for both truncated and modification versions with pM
0 = 0.6.
Example 2.4.10. For a zero-modified ETNB distribution, you are given p1 = 0.72,
p2 = 0.06 and p3 = 0.01.
• The term compounding reflects the idea that the pgf of the new distribution
PS (z) is written as
PS (z) = PN [PM (z)],
where PN (z) and PM (z) are called the primary and secondary distributions,
respectively.
= PN [PM (z)].
then a simple recursive formula can be used. This formula avoids the use of
convolutions and thus reduces the computations considerably.
Theorem 2.5.2. If the primary distribution is a member of the (a, b, 0) class, the
recursive formula is
k
1 X bj
gk = a+ fj gk−j , k = 1, 2, 3, . . .
1 − af0 j=1 k
Theorem 2.5.4. For any compound distribution,g0 = PN (f0 ), where PN (z) is the pgf
of the primary distribution and f0 is the probability that the secondary distribution
takes on the value zero.
Example 2.5.5. An actuary has created a compound claims frequency model with the
following properties:
• The primary distribution is the negative binomial with pgf
PM (z) = eλ(z−1) ,
• There is a close connection between the compound Poisson distributions and the
mixed Poisson frequency distributions
Example 2.5.6. Obtain the pgf for the Poisson-ETNB distribution and show that it
looks like the pgf of a Poisson-negative binomial distribution.
Example 2.5.7. Calculate g3 for the Poisson-ETNB distribution where λ = 3 for the
Poisson distribution and r = −0.5, β = 1 for the ETNB distribution.
is the unconditional pgf of the number of events (where the formula selected depends
on whether Θ is discrete or continuous)
• Let P(z) be the pgf of a mixed Poisson distribution with arbitrary mixing distribu-
tion U (θ).
• Therefore, P 0 (z) = λMΘ0 [λ(z − 1)] and with z = 1 we obtain E(N ) = λE(Θ), where
N has the mixed Poisson distribution.
• Also, P 00 (z) = λ2 MΘ00 [λ(z − 1)], implying that E[N (N − 1)] = λ2 E(Θ2 ) and, there
and thus for mixed Poisson distributions the variance is always greater than the
mean.
Theorem 2.5.10. Suppose P (z) is a mixed Poisson pgf with an infinitely divisible
mixing distribution. Then P (z) is also a compound Poisson pgf and may be expressed
as
P (z) = eλ[P2 (z)−1] ,
If one chooses any infinitely divisible mixing distribution, the corresponding mixed
Poisson distribution can be equivalently described as a compound Poisson distribution.
• Suppose Xj , the severity, represents the ground-up loss on the jth such loss
and there are no coverage modifications. Let N L denote the number of losses.
• Consider a coverage modification such that v is the probability that a loss will
result in a payment. For example, if there is a deductible of d, v = P (X > d).
• Then,
N P = I1 + · · · + IN L
• This result implies that N L and N P are both from the same parametric family
and only the parameter θ need be changed.
Notes:
n P (N = n) x P (X = x)
1 0.8 100 0.2
2 0.2 200 0.7
500 0.1
An insurance for the losses has an ordinary deductible of 100 per loss. Calculate the
probability of 2 or more losses occur.
Example 2.6.2. The number of annual losses has a Poisson distribution with a mean of
5. The size of each loss has a two-parameter Pareto distribution with θ = 10 and α = 2.5.
An insurance for the losses has a ordinary deductible of 5 per loss. Calculate the expected
value of the number of losses.
Example 2.6.3. The number of students of taking an actuarial exam has a negative
binomial distribution with parameters r = 10, β = 1.5. Each student has a 0.4 probability
of passing. Determine the probability that 3 or more students pass.
Example 2.6.4. The frequency distribution of the number of losses when there is no
deductible is Binomial with m = 3 and q = 0.8. Loss amounts have a Weibull distribu-
tion with τ = 0.3 and θ = 1000. Determine the expected number of payments when a
deductible of 200 is applied.
Example 2.6.5. The losses on an auto comprehensive coverage have a Pareto distribution
with parameters α = 2, θ = 1000. The number of losses has a geometric distribution
with an average of 0.2 losses per year. Loss sizes are affected by 10% inflation. A 250
deductible is imposed. Calculate the variance of the frequency of claims after inflation
and the deductible.
PN L (z) = PN L (z; θ, α)
B[θ(z − 1)] − B(−θ)
= α + (1 − α)
1 − B(−θ)
where α∗ = P (N P = 0) = PN P (0).
Example 2.6.6. Let the frequency distribution be zero-modified negative binomial with
r = 2, β = 3 and pM
0 = 0.4. Illustrate the effect when a deductible of 250 is imposed on a
Pareto distribution with α = 3 and θ = 1000.
• Thus, if N is infinitely divisible, the distribution of N ∗ will have the same form as
that of N , but with modified parameters.
Example 2.7.1. It has been determined from past studies that the number of workers
compensation claims for a group of 300 employees in a certain occupation class has nega-
tive binomial distribution with β = 0.3, r = 10. Determine the frequency distribution for
a group of 500 such individuals.
Example 2.7.2. Suppose claims on a portfolio of 500 policies are independent and iden-
tically distributed. Each has a geometric distribution with parameter β = 0.001. If 250
additional policies are put on the books, what is the new probability of no claims during
the years?
Example 2.7.3. For an employee health coverage got 50 individuals, the aggregate claims
frequency distribution is negative binomial with mean 10 and variance 20. The group then
expands to 60. Calculate the probability of 10 claims for the expanded group.