Individual Risk Models for a Short Term (Part 2

Exercises)
Normal Approximation of S and Reinsurance
by Dr. G. Leduc

1. Exercises
Exercise 1. Consider a portfolio of 32 policies. For each policy, the probability q
of a claim is 61 and B, the bene…t amount given that there is a claim, has pdf.

2(1 y) if 0 y 1
fB (y) =
0 elsewhere

Let S be the total claims for the portfolio. Using a normal approximation, estimate
P (S > 0:81).

Solution 1. Step 1 (Identify the situation) we are in the individual risk model
X = IB, and I is the claim indicator. That’s because we know the number of
insured n = 32, we know B, and each insure can have 0 or 1 claim, with the
probability of a claim is q = 16 .
Step 2 (Calculate the basics: X ; 2X ; S ; and 2S ). You should know and be able
to prove that

X = q B;
2 2 2
X = Bq + B q (1 q) ;
S = n X = 32 X;
2 2 2
S = n X = 32 X:

2
So, as always in that type of questions, we also need to calculate B and B.

Z 1
B = E (B) = yfB (y)dy
1
Z 1
= y2(1 y)dy
0
Z 1
= 2y 2y 2 dy
0
1
= ;
3
1
2 INDIVIDUAL RISK M ODELS FO R A SHO RT TERM (PART 2 EXERCISES)

Z 1
E B2 = y 2 fB (y)dy
1
Z 1
= y 2 2(1 y)dy
0
Z 1
= 2y 2 2y 3 dy
0
1
= ;
6
2
B = E B2 2
B
2
1 1
=
6 3
1
= :
18
2 2
Replacing this in the expressions for X; X; S; and S we get
1 1 1
X = =
6 3 18
2
2 1 1 1 1 1 2
X = + 1 =
18 6 3 6 6 81
1 16
S = 32 =
18 9
2 2 64
S = 32 =
81 81
8
S =
9
Step 3 (Calculate P (S > 0:81) using the Central Limit Theorem (CLT))
P (S > 0:81) = 1 P (S 0:81)
S S 0:81 S
P (S 0:81) = P ( )
S S
0:81 S
S
16
0:81 9
= 8
9
= ( 1:088 75)
( 1:1)
= 1 (1:1)
= 1 0:8643
= 0:135 7
Hence
P (S > 0:81) = 1 0:135 7 = 0:8643:
 INDIVIDUAL RISK M ODELS FOR A SHORT TERM (PART 2 EXERCISES) 3

Exercise 2. A life insurance company covers 15; 000 lives for 1-year term life
insurance in amount shown below
Bene…t amount Number covered
$10,000 8000
$20,000 3000
$30,000 2000
$50,000 1500
$100,000 500
The probability of a claim q for each of the 15; 000 lives, assumed to be mutually
independent, is 0:02. The company wants to set a retention limit for each life and
cede the rest of the coverage to a reinsurance company. Reinsurance is available
at a cost of $250 for each unit of $10; 000. Calculate the probability that the total
cost (aggregate retained claims + reinsurance cost) will not exceed 7; 500; 000 if the
retention limit is
(1) 20; 000
(2) 30; 000
(3) 50; 000
[Advice: in order to get smaller numbers, change the monetary units
from $ to thousand of $ it will make smaller numbers. Just make sure to
change every thing from $ to thousand of $]
Solution 2. I will do the case where the retention limit is 20; 000. The other cases
are left as exercises. Do at least one case!
Step 1) (Split the portfolio into the ceded and retained portfolio). Here we only
need the retained portfolio, so we will ignore the ceded part. The retained portfolio
is
Bene…t amount Number covered
$10,000 8000
$20,000 3000
$30,000 2000
$50,000 1500
$100,000 500
in other words:
Bene…t amount Number covered
$10; 000 8000
$20; 000 7000 = 3000 + 2000 + 1500 + 500
Step 2) (Write the full table). We use the notation "R"-symbol to indicate the
retained portion of S, X and B. So the full table is
2
k qk bR
k nk E (XR ) = bR
k qk V ar (XR ) = bR k qk (1 qk )
1 0:02 10; 000 8000 200 1; 960; 000
2 0:02 20; 000 7000 400 7; 840; 000
That gives
E (SR ) = 8000 200 + 7000 400 = 4; 400; 000
V ar (SR ) = 8000 1; 960; 000 + 7000 7; 840; 000
= 70; 560; 000; 000
p
SR = 70; 560; 000; 000 = 265; 631
4 INDIVIDUAL RISK M ODELS FO R A SHO RT TERM (PART 2 EXERCISES)

Step 3) Calculate the cost of reinsurance. Here they say that the cost is 250 for
every 10000. Hence the cost is

ceded amount Number covered Reinsurance cost

0 8000 0
0 3000 0
$10,000 2000 500; 000 = 2000 250
$30,000 1500 1; 125; 000 = 1500 3 250
$80,000 500 1; 000; 000 = 500 8 250

Hence the total cost C of reinsurance is

C = 500; 000 + 1; 125; 000 + 1; 000; 000 = 2; 625; 000:

Step 4) (Calculate the requested probability using the CLT) We want to calculate

P (S + C 7 500 000) = P (S 7 500 000 C)

= P (S 4 875 000)
S S 4 875 000 S
= P( )
S S
4 875 000 S
S
4 875 000 4 400 000
=
265 631
= (1:788 194 902)
(1:8)
= 0:9641
 INDIVIDUAL RISK M ODELS FOR A SHORT TERM (PART 2 EXERCISES) 5

Exercise 3. A …re insurance company covers 160 structures against …re damage
up to an amount stated in the contract. The numbers of contracts at the di¤ erent
contract amounts are given below.

Contract Amount Number of Contracts

$10,000 80
$20,000 35
$30,000 25
$50,000 15
$100,000 5

Assume that for each of the structures, the probability of one claim within a year is
0:04, and the probability of more than one claim is 0. Assume that …res in the struc-
tures are mutually independent events. Furthermore, assume that the claim severity
random variable is uniformly distributed over the interval from 0 to the contract amount.
a) Calculate the mean and variance of S.
b) What relative security loading, , should be used so the company can collect
an amount equal to the 99th percentile of the distribution of total claims? (Use a
normal approximation.)

Solution 3. Step 1 (We know we are in the individual risk model. Since we have
many subgroups (we have 5 subgroups in the table) we know that we need to calculate
the Bk and the 2Bk for all the groups k = 1; :::; 4. Recall that for a Uniform [0; C],
2
the expectation is C2 and the variance is C12 . Therefore we have

2
Group (k) Severity (Bk ) Number Insured (nk ) Bk Bk
1 $10,000 80 5000 8 333 333
2 $20,000 35 10 000 33 333 333
3 $30,000 25 15 000 75 000 000
4 $50,000 15 25 000 208 333 333
5 $100,000 5 50 000 833 333 333

This allows to easily write the table

2 2
k qk nk E (XR ) = Bk (qk ) V ar (XR ) = Bk (qk ) (1 qk ) + Bk (qk )
1 0:04 80 200 1 293 333
2 0:04 35 400 5 173 333
3 0:04 25 600 11 640 000
4 0:04 15 1000 32 333 333
5 0:04 5 2000 129 333 333

Thus

E(S) = 200 80 + 400 35 + 600 25 + 1000 15 + 2000 5 = 70 000

V ar(S) = 1 293 333 80 + 5 173 333 35 + 11 640 000 25 + 32 333 333 15 + 129 333 333 5
= 1 707 199 955
p
S = 1 707 199 955 = 41 318
6 INDIVIDUAL RISK M ODELS FO R A SHO RT TERM (PART 2 EXERCISES)

To answer the second question, we use the CTL (Central Limit Theorem). We
want
0:99 = P (S (1 + ) S )
S S (1 + ) S S
= P
S S

S
S

S
=
S
= (2:326)
Hence
S
= 2:326
S
S
= 2:326
S
41 318
= 2:326
70 000
= 1:372 938 114
Note that this value of is very high. This is due to the fact that the variance of
the uniform random variables is very high.