BAS 310-Risk Theory for Actuarial Science

LECTURE-NOTES

Lecturer: Mr. Saviour Chibeti

August 3, 2022

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1 REINSURANCE
Objectives:
ˆ Describe the terms "excess" (deductibles) and "retention restrictions."
ˆ . Explain how simple forms of proportional and excess of loss reinsurance operate.
ˆ In the case of excesses (deductibles) and reinsurance, calculate the distribution and asso-
ciated moments of the claim amounts paid by the insurer and reinsurer.
ˆ Using maximum likelihood and the method of moments, estimate the parameters of a
failure time or loss distribution when the data is complete or partial.

1.1 Introduction

We looked at loss distributions in the previous chapter and how they might be used to;
(i) calculate appropriate premiums.
(ii) Determine capital requirements for solvency standards
(iii) Calculate risk measures
The essence and purpose of insurance are to lower the nancial costs incurred by individuals,
corporations, and other entities as a result of the occurrence of certain contingent occurrences.
An insurance rm sells policies that guarantee that the insurer will reimburse policyholders
for a portion of the nancial losses incurred as a result of these unforeseen catastrophes. The
insurer's pooling of liabilities makes total losses more predictable than they would be for each
individual insured, lowering risk relative to the whole. Individuals, corporations, and other en-
tities can engage in hazardous activities with the help of insurance. In a capitalist marketplace,
this boosts innovation, competition, and eciency.

An insurance company's claims must be paid in full, but it may take out an insurance policy
to protect itself from high claims; this type of coverage is known as a reinsurance policy. The
reinsurance contract will be assumed to be one of two relatively simple types for the purposes
of this chapter: individual excess of loss reinsurance or proportional reinsurance.

The nature and goal of reinsurance is to lower the nancial costs incurred by insurance
rms as a result of the likely occurrence of specic insurance claims, hence boosting market
innovation, competition, and eciency. The cession of liability shares spreads risk throughout
the insurance sector even more. An insurance business may obtain fairly complete reinsurance
from one or more reinsurers, just as an individual or company gets an insurance policy from
an insurer.

1.1.1 Proportional Reinsurance

The direct writer (the original insurance rm) and the reinsurer share the cost of all claims
for each risk in a proportional reinsurance arrangement. To implement this reinsurance, the
direct writer must pay a premium. This premium may or may not be computed using the same
formula as the insurer's rates. For example, if a structure is insured against re, the direct
writer may keep 75% of the premium and will be responsible for 75% of all claims, major and
small. There are two types of proportional reinsurance:

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 (i) In quota share reinsurance, all risks have the same proportions.
(ii) In surplus reinsurance, proportions can dier from one risk to the next.

1.1.2 Non-proportional Reinsurance

The direct writer pays the reinsurer a xed premium in a non-proportional reinsurance contract.
Only when a portion of the claim amount falls inside a specic reinsurance tier for example,
if the claim amount falls between k100, 000 and k800, 000 would the reinsurer be obligated to
make payments. A lower limit, a retention limit (e.g. k100, 000), and an upper limit (e.g.
k800, 000 or "innity" if the insurance is innite) will dene the layer. The majority of claims
are usually reimbursed in full by the direct writer.
We'll discuss two types of non-proportional reinsurance in this section:

(i) Individual excess of loss (XOL) reinsurance, this reinsurance requires the reinsurer to
make a payment when the claim amount for any individual claim exceeds a predetermined
excess point or retention. For example, if a claim from a car policy exceeds k100, 000, the
reinsurer might agree to pay the excess, but only up to k10, 000.
(ii) Stop loss reinsurance, this reinsurance requires the reinsurer to make payments if the
total claim amount for a group of policies exceeds a certain threshold (usually expressed
as a percentage of the gross premium). For instance, When the total claim amount for
all car policies exceeds, say 120% of the total gross premium, the reinsurer may agree to
pay 80% of the excess, with no maximum limit.

2 Reinsurance Arrangements
Any claims that have been made by the customers, the policyholder have to be met. When the
claim amount is very large, the insurance company will try to take an insurance policy against
that claim with the insurance company
Denition 2.0.1. The gross claim amount is the original amount before any reinsurance ad-
justments.
Whatever the claim amount that is incurred by policyholders it is referred to as the gross
claim amount.
Denition 2.0.2. The net claim amount is the actual claim amount that the direct insurer
pays after allowing for payments under the reinsurance agreements.
Any kind of claim that is typically subtracted because of the payments that is done by the
reinsurer. Reinsurer settles some portion of the claim because of the reinsurance arrangement.

Now the same applies to the premium also.

Denition 2.0.3. The premium which is direct collected from the customer is called the gross
premium.
Denition 2.0.4. The portion of the premium that is paid to the reinsurer is referred to as the
net premium amount.

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 By evaluating the net amount paid for dierent sizes of the gross claim, we may compute
the moments of the net claim amount paid by a direct insurer or the amount paid by a reinsurer.

In this chapter, we are interested in understanding

(i) What the typical mechanism of computing the expected claim amount is.
(ii) Probably the variance in the claim amount in case there is.
Example 2.0.5. A reinsurer has agreed to make the following payments in respect of individual
claims incurred by a direct insurer:
(i) nothing, if the claim is less than k5, 000
(ii) the full amount reduced by k5, 000, if the claim is between k5, 000 and k10, 000
(iii) half the full amount, if the claim is between k10, 000 and k20, 000
(iv) k10, 000, if the claim exceeds k20, 000
Formulate a function for the original claim size.

Solution
Remember, we learn by doing. The amount paid by the reinsurer as a function, f (x) of the
original claim size say x can be expressed algebraically as:



 0 x ≤ k5, 000

x − 5, 000 k5, 000 < x ≤ k20, 000
f (x) =


 x/2 k10, 000 < x ≤ k20, 000

10, 000 x > k20, 000.

2.1 Excess of Loss Reinsurance

Denition 2.1.1. Excess of loss reinsurance is a kind of reinsurance where the reinsurance
company is paying above a certain amount. We call this amount as the retention level and it
will be denoted as M .
Let us assume the claim has come, whatever the claim amount, the insurer is going to settle
that claim if that claim is less than or equal to some constants M , the retention level. If the
claim amount is X then
X ≤ M.

The insurer will take care of the claim amount as long as it is less than or equal to the retention
level. But the moment the claim amount goes beyond the retention level, it is transferred
to the reinsurer and the reinsurer will pay the excess, this is what we call the excess of loss
reinsurance. If the claim amount
X ≤ M,

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the amount that is paid by the insurer is given by
Y = X.

That is, the insurer pays the full claim amount. Now if the claim amount is greater than the
retention level.
X > M,

the insurer will pay only the retention level and the reinsurer will pay
Z =X −M
= X − Y.

If there was no reinsurance, the claim can be any amount which means very high claim are
also possible, which means the mean claim amount is going to be much higher. Now with
reinsurance arrangement, we are able to
(i) reduces the mean claim amount drastically.
(ii) reduce the variance since the mean has been reduced.
The mean and the variance are because there is an upper gap on the claims, the claims can not
cross the retention level M , there is a kind like an upper bound.

2.1.2 Mean, Variance and Moment generating Function of the Insurer and the
Reinsurer
Let X be a claim amount. For the insurer, the mean claim function is given by
Z ∞
E(X) = xf (x)dx,
0

in case there is no reinsurance and f (x) denotes the probability density function of the claim
amount X .

When we consider the excess of loss reinsurance with retention M , we know that the claim
for the insurer is Y = X if the claim amount is less than or equal to the retention level, then
the average claim amount by the insurer is given by

Z M Z ∞
E(Y ) = xf (x)dx + M f (x)dx
0 M

Z M
= xf (x)dx + M P (X > M )
0

We use the above expression to nd out how much on average the insurer will pay for the claim
amount.

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In the same way, we can compute E(Y 2 ),

Z M Z ∞
2 2
E(Y ) = x f (x)dx + M 2 f (x)dx
0 M

From E(Y ) and E(Y 2 ), we can then compute the variance. that is

V ar(Y ) = E(Y 2 ) − [E(Y )]2 .

The moment generating function for the claim amount, Y of the insurer is given by

MY (t) = E(eY )

Z M Z ∞
tx
= e f (x)dx + etM f (x)dx
0 M

Z M
= etx f (x)dx + etM P (X > M ).
0

If we are looking at it from the reinsurance perspective, the average claim amount by the rin-
surer is given by

Z ∞
E(Z) = (X − M )f (x)dx.
M

Also, we can compute E(Z 2 ), we have

Z ∞
2
E(Z ) = (X − M )2 f (x)dx.
M

From E(Z) and E(Z 2 ), we can compute the variance and hence we have
V ar(Z) = E(Z 2 ) − [E[Z]]2

We can also calculate the moment generating function of the claim amount of the reinsurer, Z ,
we have

MZ (t) = E(eZ )

Z M Z ∞
t0
= e f (x)dx + et(x−M ) f (x)dx
0 M

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Example 2.1.3. Suppose that the claims from a portofolio have an exponential distribution
with parameter λ = 0.025 and the retention limit of M = 200. Find the mean claim amount
paid by the reinsurer on all claims.

Solution
Remember, we learn by doing. Since the claim amount for the reinsurer is given by
Z = X − M,

we have that the mean claim amount is given by

Z ∞
E(Z) = (x − M )f (x)dx
M

and therefore we have,

Z ∞
E(Z) = (x − M )f (x)dx
M

Z ∞
= (x − 200)λe−λx dx
200

Z ∞ Z ∞ 
−λx −λx
=λ xe dx + 200e dx
200 200

The rst part we integrate by part, we have

∞
xe−λx
Z
1
xe−λx dx = − 2 eλx .
200 λ λ
Now we have,
Z ∞ Z ∞ 
−λx −λx
E(Z) = λ xe dx + 200e dx
200 200

∞ ∞ 
xe−λx
 
1 −200 −λx
=λ − 2 e−λx + e
λ λ 200 λ 200

= 0.025 [0 − (43.12286)] + [0 − (−53.90358)]

= 0.025(−43.12286 + 53.90358)

= 0.2695

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2.2 The reinsurer's conditional claims distribution

Interesting point, the insurance company is transferring the claims to the reinsurance com-
pany. The reinsurance company do not get all the claims but only a record of claims with a
claim amount greater than the retention M . so the reinsurance company may not get a typical
information of the claim distribution, so they only get a truncated distribution or an estimation.

Suppose that W is a random variable with this truncated distribution. Then we have that
W = X − M |X > M.

We now assume that the underlying claim amounts have a probability density function f (x) and
the cumulative density function F (x) and that the reinsurer is only informed of the claims that
are greater than the retention level M and the only records that the reinsurer has is w = x+M .
We are now interested in the distribution of w. For the claim amount w paid by the reinsurer,
the probability density function can be constructed from the following arguments, that is
P (W < w) = P (X < w + M |X > M )

P (X < w + M and X > M )

= by using Baye's Formula
P (X > M )

P (M < X < w + M )
=
P (X > M )

R w+M
M
f (x)dx
=
1 − F (x)

F (w + M ) − F (M )
=
1 − F (M )

For the above derivation, we make use of the result

Z b
P (a < X < b) = f (x)dx
a

= F (b) − F (a)

When we dierentiate P (W < w) with respect to w, we have the probability density function
of w

f (w + M )
g(w) = ,
1 − F (M )

provided, w is greater than zero.

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Example 2.2.1. The claim amount X follows an exponential distribution with parameter λ.
Find the distribution of the reinsurer.

Solution
Since the claim amount X follows an exponential distribution, we have that

f (x) = λe−λx ,

and we have that

F (x) = 1 − e−λx

Hence the distribution of the reinsurer is given by

f (w + M )
g(w) =
1 − F (M )

λe−λ(w+M )
=
1 − (1 − e−λM )

λe−λ(w+M )
=
e−λM

= λe−λw .

Therefore we see that the distribution of the reinsurer is the as the original claim distribution.

If we assume that W denote the amount payable by the reinsurer on claims in which it is
involved, we have that
W = Z|Z > 0
= X − M |X > M

when we consider the distribution of W , we have that

E(Z)
E(W ) =
P (Z > 0)

E(Z)
=
P (X > M )

2.3 Proportional Reinsurance

Irrespective of the size of the claim, the insurer pays a xed proportion and the remaining is
payed by the reinsurer.

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Suppose that the claim amount is given by X and the retained proportion(retention level)
is α%, then the insurer is going to pay
Y = αX.

The reinsurer is going to pay

Z = (1 − α)X.

We can then nd the distribution of Y and Z using the change of variables.
Example 2.3.1. Claims occur as a generalized Pareto distribution with parameters α = 6,
β = 200 and k = 4 with a retention of 80%. Find the mean and variance of the claim amount
paid by the insurer and the reinsurer on individual claim.

Solution
Suppose that X represent the size of the individual claim, we rst compute the mean claim
amount then we have,

kβ
E(X) =
α−1

4 · 200
=
6−1

800
=
5

= 160

Similarly, we compute the variance of the claim amount, X , we have

β 2 k(k + α − 1)
V ar(X) =
(α − 1)2 (α − 2)

(200)2 × 4(4 + 6 − 1)
=
(6 − 1)2 (6 − 2)

1440000
=
100

= 14400

Since the retention is 80%, we have that the insurer's claim amount is given by
Y = 0.8X.

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Therefore the mean claim amount of the insurers is given by

E(Y ) = E(0.8X)

= 0.8E(X)

= 0.8 × 160

= 128

The variance for the insurers claim amount is given by,

V ar(Y ) = V ar(0.8X)

= 0.82 V ar(X)

= 0.64 × 14400

= 9216

Similarly, we do the same for the reinsurer. The claim amount paid by the reinsurer is given
by
Z = (1 − 0.8)X = 0.2X.

We have that
E(Z) = E(0.2X)

= 0.2E(X)

= 0.2 × 160

= 32.

For the variance, we have that

V ar(Z) = V ar(0.2X)

= 0.22 V ar(X)

= 0.04 × 14400

= 576.

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