Individual Risk Models for a Short Term (Part 1) by Dr. G.

Leduc

October 13, 2011

Individual Risk Models for a Short Term (Part 1)

by Dr. G. Leduc
1. Introduction
Risk Management is critical for modern corporation. Now a day, such risk management
massively involve what is called ”security derivatives” which are also known as ”portfolio
insurance”. Typical risk for an international normal corporation is the currency risk which
is often managed through Future contracts on currency. Another example is the credit
risk coming from lending money to house owners. Banks will lend money to individual
but at the same time will make contracts with other banks so that they take a portion
of the risk involved in the loans. This is why the 2008-2009 credit crunch in the USA
has affected banks all around the world. This is all to say that insurance (or risk sharing
in one form or an other) are massively used to manage risk and this will be the primary
model for this course.

2. The claim indicator random variable 

There are two parties: an insured and an insurance company. the insured is facing a loss.
In order to manage that loss he takes an insurance. The insured may or may not make a
claim to the insurance company. This yields a random variable  with  = 1 if the insured
makes a claim and  = 0 if the insured doesn’t make a claim. Hence  has the following
density function (pdf)
  ()
0 
1 
where
=1−
The variable  is known as the Claim Indicator random variable. A random variable
taking the value 0 with probability  and the value 1 with probability 1 −  is called a
Bernoulli random variable.

Remark A Claim Indicator random variable takes the value 1 with probability . You
should know by heart that  () =  and   () =  (1 − ). You should also know
by heart that a sum of  independent iid () is a ( ) and
that it has average  and variance (1 − ). You must be able to prove that as
well. Furthermore, you should now that the number of success in  independent
trial with probability  of a success is a ( ).

1
 Individual Risk Models for a Short Term (Part 1) by Dr. G. Leduc 2

3. The claim severity  and claim  = 

The best way to introduce  is to start with an example.

Example 1. An insurance company offers one year term life insurance paying  = $100 000
in case of accidental death over the next year. Assuming that for some individual, the
probability of dying within the next year is  = 005. Calculate the density function of
.

Solution 1.  will definitely take only two values  or 0. And we will have

  ()
0 1−
 
or
  ()
0 095
100 000 005

Now if a claim occurs, the claim will be  = $100 000 and

 = 

where  is the claim indicator random variable. But this is a special case. For a automobile
or fire insurance, the amount that will be claim is a random variable . Knowing that
a claim occurs,  measure how bad the claim is going to be for the insurance company.
That’s why it is sometimes called the claim severity [ also has other names. It is also
called the Benefit random Variable]. The claim random variable  [for the insurance
company  is a loss random variable] is given by

 = 

You can think of  saying if the customer had claims or not and  as the total value of
that claim. We will always assume that  and  are independent.1

Example 2. Suppose that a claim occurs with probability  = 005 and that, knowing
that the claim occurs the severity of the claim has the following average and variance

 =  ()
 2 =   ()

Calculate  (  | ),   (  | ),  () and   () assuming that  and  are inde-
pendent.

Solution 2. we have

 (  | ) =  (  | ) =  () = 

also
  (  | ) =   (  | ) =  2   () =  2  2
1 Some books don’t assume that  and  are independent but there really is nothing to gain by doing

that.
 Individual Risk Models for a Short Term (Part 1) by Dr. G. Leduc 3

and
 () =  ( (  | )) =  ( ) =   () =  
as well as
  () =  (  (  | )) +   ( (  | ))
¡ ¢
=   2  2 +   ( )
¡ ¢
=  2   2 + 2   ()
¡ ¢
=  2   () +  2 () + 2   ()
¡ ¢
=  2  (1 − ) +  2 + 2  (1 − )
=  2  + 2  (1 − )
Remark If  is a constant is it also a r.v.? Suppose that the amount to be paid by the
company is a constant  as in the example of a one year term. Can we see this as
a random variable? Well, sometimes it is practical to do so! If  is a constant this
corresponds to the case where
  ()
 1
and we get
 () =  · 1 = 
¡ ¢
  2 = 2 · 1 = 2
¡ ¢
  () =   2 − ( ())2 = 0
hence
 = 
 2 = 0

4. The aggregate claims 

If an insurance company has  insured for one of its line of insurance products then the
aggregate claim  that it faces is given by
 = 1 + 2 +  + 
where 1  2    are iid and represent the claim random variable for each customer.
The ’s have the form
 = 
where  is the claim indicator r.v. and  is the claim severity random variable.
Note that these claims are for one accounting period, let’s say one year. This is why
the model is called the Individual Risk Models for a Short Term.
What really matters for an insurance company is the aggregate claim random variable
. It is critical for the insurance company to understand  and to manage it properly.
Otherwise it will go bankrupt. One of the basic things to know about  is its average and
its standard deviation. An other interesting question is "how much money one should
have so that with probability 95% this money will be enough to pay all claims?" An other
question is: "If each customer is charged 110% of  (), what is the probability that this
will be enough to pay all the charges?" We will solve such problems in Part 2 using the
central limit theorem before. For the moment, we will only calculate  and   ...
 Individual Risk Models for a Short Term (Part 1) by Dr. G. Leduc 4

Example 3. A portfolio consists of 100 policies, 95% incur no claim in the next year and
5% of them incur a single claim. The claim amount variable  is uniform on [0 1000].
Find the expected value and standard deviation of the aggregate claims .

Solution 3. •
• First recall that the expectation and variance of  are given by
1000
 =
2
2
(1000)
2 =
12

• Second, let us calculate the expectation and variance of . Note that

 ( = 1) =  = 005
 ( = 0) =  = 095

We have
 =  ·  =  · 500 = 25
and
 2 = 2  + 2  = 16 04167

• Let us now calculate  () and   ().

 =  ()
=  (1 ) +  (2 ) +  +  (100 )
=   +   +  +  
= 100 · ( )
= 100 · (500 · 005)
= 2500

and, by independence,

 2 =   ()
=   (1 ) +   (2 ) +  +   (100 )
=  2 +  2 +  + 2
¡ ¢
= 100 ·  2
= 100 · (16 04167) 

Note that
  = 126656
To answer the other questions mentioned above we need the central limit theorem.
And this is done in "Individual Risk Models for a Short Term (Part 2)".

5.  and  2 always exist for us...

We will always assume  and  2 exist. Indeed there are cases where  () = ∞ or
 () does not exist or   () = ∞ or   () but we will stay away from these cases...