Insurance Pricing:

Basic Statistical Principl es

Michael R. Powers
Basic Definitions -- Forecasting vs. Estimating
Unknown Quantity:
Any qua ntity about which there is imperfect informa tion.
Why is informat ion imperfect?
Qua ntity has not yet been reali zed.
Qua ntity has not yet been obser ved.
Qua ntity cannot be observed.
Random Variable:
A formal stat istical mode l used to represent an unknown quan tity
(usua ll y denoted by a letter, e.g., X or Y).
The model is de scribed by :
(i) The set of poss ible valu es that the unknown quan tit y can
assume (sample space).
(ii) The relative likelihoods tha t the quan tit y will take on each
of the valu es it can assume (probability distribution function).
Parameter:
A propert y of a rando m variable that pr ovide s a convenient way of
expressing some informa tion about (i) and (ii ).
Examples:
Mean, Median, Mode (Measures of Location).
Variance, Stan dard Deviat ion, Coefficient of Variation
(Measures of Spr ead) .
Per cent ile s (10
th
, 25
th
, 50
th
, etc.).
If a param eter is un known, shou ld it be t reated as a random
variable?
Obse rvation:
The value of a random variable when it has become known.
If there ar e man y obser vations of the same random variable,
they ar e usua lly represented by

X
1
, X
2
, X
3
, , or

Y
1
,Y
2
, Y
3
, .
Sample:
A collection of obser vations.
Usually, the letter n is us ed to de not e the num ber of
obser vat ions in a samp le.
Estimate:
A reasonab ly good gue ss at the value of an un known pa ramet er,
based upon a sampl e of one or more obser vations.
Often, one begins by estimat ing the mean and standa rd
deviation of a rand om var iable.
Statistician s use a var iety of different methods for estimat ing
pa rameter s (e.g., maximum likelihood, method of moment s, least
squares, minimum mean squared-error, minimum expected loss).
Statistician s use a var iety of different criteria for evalua ting the
qua lity of an estimat e (e.g., unbiasedness, eff iciency, consistency,
robustness).
Forecast (Prediction):
A reasonab ly good guess at the value of an uno bser ved rand om
variable, based upon a sample of one or more obser vat ions.
A random variable is usual ly forecast by estimat ing its mean,
med ian , or mo de .
Caution: After spend ing much effort developing a good
estimat ion method, it is easy to forget that the ultima te goal is to
forecast.
Meas ures of Location/ Central Tendency
Mean:
The expected valu e of a rando m variable, on the aver age; also
called t he expected value or the average.
If a random variable X can take on the val ue s A, B, C, ..., then

Mean = A Pr X = A { }+ B Pr X = B { }+ C Pr X = C { }+ .
The mean is the mo st commo nly used measure of what valu e a
rand om var iable is like ly to ta ke.
Me dian:
The smallest val ue tha t has at l east a 50% chance of being great er
tha n the rand om variable; also called the 50
th
percentile.
(This val ue may not be un ique.)
For a rand om variable X, the Med ian is the smallest valu e of x
such that

Pr X s x { }> 1 2.
The med ian is often used in plac e of the mean when the rand om
variable has a skewed distribution.
This occurs when it is possible for the random variable to ta ke
on extremely large (or smal lbut not both) values with small
probabil it y.
Mode :
Of all possible values, the on e tha t a ran dom variable is most like ly
to take. (This valu e may not be uniqu e.)
For a rand om variable X,

Pr X = Mode { }> Pr X = x { } for any
ind ividua l alt er nat ive value x.
The mode may be useful in short-ter m, on e-shot plann ing,
when de cisions are based upon cons ider at ion of the most likely
outcome.
In comp lex problems, it ma y be easier to calculat e the mode
tha n either the mean or the med ian .
Population vs. Sample Parameters
The thr ee parameter s de fined above are all popu lat ion
pa rameter s.
They are sometimes called the population mean, population
median, and population mode, respectively .
The word pop ulat ion refer s to the fact that these pa rameter s
are theoretical val ue s under lying the distribution of the random
variable, regard less of what values ar e ultima tely observed in a
samp le.
Each of the three parameter s defined above has a sampl e
count er pa rt that can be calculat ed from obser vat ions of the
rand om var iable, and used to estimat e the correspon ding
pop ulat ion pa rameter .
Given n observati ons

X
1
, X
2
, X
3
, ,X
n
,

Sample Mean = X
1

1
n
|
\

|
.
| + X
2

1
n
|
\

|
.
| + X
3

1
n
|
\

|
.
| + X
n

1
n
|
\

|
.
|


=
X
1
+ X
2
+ X
3
+ X
n
n
.
The sampl e mean is often de noted by

X (read X-bar).

Sample Median = Observation

X
i
that is m id-way up a ranking
of

X
1
, X
2
, X
3
, ,X
n
.
(This val ue may not be un ique.)

Sample Mode = Observation

X
i
that occ urs more frequent ly
tha n any other ind ividua l observation.
(This val ue may not be un ique.)
Meas ures of Spread/ Dispersion
Variance:
The expected valu e of the squa red difference between a random
variable and its mean, on th e aver age.
If a random variable X can take on the val ue s A, B, C, ..., then

Variance = A Mean ( )
2
Pr X = A { }

+ B Mean ( )
2
Pr X =B { }+ C Mean ( )
2
Pr X = C { }+ .
Even thou gh it may be less fami liar than th e stan dar d de viat ion,
the variance is a more pr imitive parameter (i.e., it mu st be
calculat ed first).
Standard De vi ation:
The squar e root of the variance.
The standa rd de via tion is often used to constr uct intervals
wher e an estimat ed parameter or forecast rando m variable is
likely to be (as in p lus or minu s 2 standar d deviat ions ).
This app lication is for mal ized in the construction of confidence
intervals.
Coefficient of Variation:
The rat io of the standa rd deviat ion to the mean.
The coefficient of variat ion measures the spread in th e
distribut ion of a random variable in relation to the mean of the
rand om var iable.
Consider two random var iables X and Y such that :

Standard Deviation X
| |
= Standard Deviation Y
| |
, and

Mean X
| |
> Mean Y
| |
.
Then,

Coeff. of Variation X
| |
< Coeff. of Variation Y
| |
.
Sample Parameters
As with the measures of location, there ar e samp le
count er pa rts to each of the above three popu lat ion
pa rameter s that can be used to estima te the popu lat ion
pa rameter s.
Benefits of Large Sampl e Sizes
Law of Large Numbers:
As the sampl e size (n) increases, the stan dard deviat ion of the
samp le mean (

X ) becomes smaller and sma ller , and the samp le
mean gets closer and closer to th e popu lation mean.
The law of large num ber s provide s the primary supp ort for the
notion that bigger sampl e sizes are better (as long as they are
not much more expensive to comp ile).
Portfoli o
Ri sk 1 Ri sk 2 Ri sk 3 Ri sk 4 Ri sk 5 Ri sk 6 Ri sk 7 Ri sk 8 Ri sk 9 Ri sk 10 Average
1996 538,633 511,498 554,861 502,400 404,106 480,249 512,676 548,757 512,700 506,100 507,198
1997 397,637 487,200 470,054 521,500 545,700 457,900 517,689 505,112 472,888 548,430 492,411
1998 460,502 440,451 467,068 375,000 478,235 466,317 547,136 504,308 540,812 480,348 476,018
1999 500,253 525,099 464,706 534,700 533,256 524,403 479,853 557,838 485,198 451,369 505,668
2000 523,079 476,300 510,151 487,628 459,689 533,214 427,038 491,862 436,491 459,816 480,527
Sampl e Statisti cs
Mean 484,021 488,110 493,368 484,246 484,197 492,417 496,878 521,575 489,618 489,213 492,364
Standard Dev. 56,539 32,889 39,115 63,658 57,533 34,308 45,760 29,605 39,609 39,264 14,181
Coeff. Of Var. 0.12 0.07 0.08 0.13 0.12 0.07 0.09 0.06 0.08 0.08 0.03
Exhibit 1c: Total Loss Experience for 10 Risks ( No Trend Effects )
Risk Theory Appli cations:
(i) Consider a risk pool with n member s, each of which has
ident ical exposur e to loss. If each member of the pool cedes
its enti re exposure to the pool in return for covering

1 n
( )
th
of the pools losses, then each member reduces the standa rd
deviation of its loss pa yment . As n increases, the standa rd
deviation gets smaller and smal ler , decreasing to 0.
(ii) Consider an insurance compan y that cover s n ide nt ical
exposu res, and charges premiums with a fixed profit
load ing. If the compan ys sur plus remain s proportional to
n, then, as n increases, the compan y's probability of
insolvency get s smaller and smaller, decreasin g to 0.
Normal Approximation (Central Limit Theorem):
As the sampl e size (n) increases, the samp le mean (

X ) takes on a
distribut ion that is no rmal (i.e., havin g the well-known bel l-
shap ed cur ve) with a stan dar d de viat ion that g et s smal ler and
smaller.
The normal approximat ion provides justificat ion for the
assumpt ions that:
(i) an int erval of plus or minus 2 standa rd d evi at ions will
capture an estimated parameter (or forecast rand om
variable) about 95% of the time, and
(ii) an int erval of plus or minus 1 standa rd d evi at ion will
capture an estimated parameter (or forecast rand om
variable) about 68% of the time.
For insurance pool with n risks (and avg. expense load ing t):

Pr insolvency in 1 period
{ }

= Pr 1 + t ( )E Tot. Losses
| |
Tot. Losses s 0
{ }

= Pr Z
n
>
t
nSD Loss per risk
| |
nE Loss per risk
| |
|
\


|
.
|
|










`



)




= Pr Z
n
>
t
Avg. Risk n
| |






`

)

For insurance company with n risks (and avg. profit/ expense
load ing t):

Pr insolvency in 1 period
{ }

= Pr Capital
t =0
+ 1+t ( )ETot . Losses
| |
Tot . Lossess 0
{ }

= Pr Z
n
>
Capital
t=0
nE Loss per risk
| |
|
\


|
.
|
|
+ t
nSD Loss per risk
| |
nE Loss per risk
| |
|
\


|
.
|
|










`



)




= Pr Z
n
>
Avg. Capital n
| |
+ t
Avg. Risk n
| |






`

)


1
Avg. Risk n
| |
~ k
1
n

Avg. Capital n
| |
~
k
2
n
t

n

Pr insolvency of company
{ }

0

n

Pr insolvency of pool
{ }
Least Squares Regression
Regression
Consider a samp le of obser vat ions,

Y
1
,Y
2
, ,Y
n
, and another
samp le

X
1
, X
2
, , X
n
.
Assume tha t there is a relat ionsh ip between each pa ir

Y
i
and

X
i
,
so tha t if

X
n +1
were known, then

Y
n+1
could be for ecast.
The process of quant ifying the relationship between the Ys and
the Xs is called regression.
The Ys ar e called the dependent or target var iables, and th e Xs ar e
called t he independent or explanatory var iables.
Often, the Xs ar e fixed points in time (e.g., the mid- points or
ends of successive years or mon ths).
Linear Least Squares Regression
To study the relat ionship b et ween the Ys and th e Xs, one could
plot the collection of poi nts

X
i
, Y
i
( ) on a graph.
If the points on the graph app ear to follow a str aight line with
only random deviat ions, then it might be reasona ble to assume
tha t

Y
i
= aX
i
+ b+ Random Error ( )
i
,
wher e a and b ar e pa rameter s that must b e estimat ed .
To estimat e a and b usin g the method of l east squa res, on e
would use math emat ical techniq ue s to solve for the values


a
and


b that mi nimize the sum of squa re d errors,

SSE = Y
1
aX
1
b ( )
2
+ Y
2
aX
2
b ( )
2
+ + Y
n
aX
n
b ( )
2
.
The line

y =

a x +

b is often refer red t o as the line of best fit.
To forecast

Y
n+1
given

X
n +1
, simpl y plug

X
n +1
int o the equa tion
for the line of best fit; then:


Y
n+1
=

a X
n+1
+

b .
Simple Log-Linear Mode l
If the points

X
i
, Y
i
( ) app ear to follow an expon ential curve with
only random deviat ions, then it might be reasona ble to assume
tha t

ln Y
i
( )= aX
i
+ b + Random Error ( )
i
,
wher e

ln () denotes the natural logarithm function.
The least-squa res estimat es


a and


b may th en be obtained as in
the linear model. To forecast

Y
n+1
, one mus t first forecast

ln Y
n +1
( ), and then inver t the natural logarithm.
What is the difference betwee n:
Simple Linear Ordinary Least-Squares Regression
and (for example)
Multipl e Logistic Generalized Min.-Abs.-Dev. Regression?