Sie sind auf Seite 1von 162

ACTL3162

General Insurance Techniques

Exercises
Contents

1 Introduction 2
1.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

2 Collective Risk Modelling 5


2.1 Compound distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Explicit claims count distributions . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3 Parameter estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

3 Individual Claim Size Modelling 32


3.1 Data analysis and descriptive statistics . . . . . . . . . . . . . . . . . . . . . . . 32
3.2 Selected parametric claims size distributions . . . . . . . . . . . . . . . . . . . . 33
3.3 Model selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.4 Calculating within layers for claim sizes . . . . . . . . . . . . . . . . . . . . . . . 36
3.5 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

4 Approximations for Compound Distributions 56


4.1 Approximations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
4.2 Algorithms for compound distributions . . . . . . . . . . . . . . . . . . . . . . . 59
4.3 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

5 Solvency and Ruin Theory 79


5.1 Solvency considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
5.2 Ruin theory in discrete time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
5.3 Ruin theory in continuous time . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
5.4 Dependence modelling and copulas . . . . . . . . . . . . . . . . . . . . . . . . . 81
5.5 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

6 Premium Calculation Techniques and Tariffication 103


6.1 Premium Risk-based Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

i
ACTL3162 General Insurance Techniques Exercises

6.2 Simple tariffication methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103


6.3 Gaussian approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
6.4 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

7 Generalised Linear Models (GLMs) 108


7.1 Components of a GLM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
7.2 Deviance and Scaled Deviance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
7.3 Fit a GLM and Evaluate the quality of a model . . . . . . . . . . . . . . . . . . 110
7.4 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

8 Bayesian Models and Credibility Theory 122


8.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
8.2 Exact Bayesian models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
8.3 Linear credibility estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
8.4 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

9 Claims Reserving 142


9.1 Outstanding loss liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
9.2 Claims reserving algorithms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
9.3 Stochastic claims reserving methods . . . . . . . . . . . . . . . . . . . . . . . . . 144
9.4 Claims development result . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
9.5 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

10 Game and Decision Theory 156


10.1 Decision theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
10.2 Game theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
10.3 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

1
Module 1

Introduction

1.1 Preliminaries
Exercise 1.1: [NLI1, Solution][?, Exercise 1]

(a) Assume X N (0, 1). Prove that a + bX N (a, b2 ) for a, b R

(b) Assume that Xi are independent and Xi N (i , i2 ), prove i Xi N ( i i , i i2 ).


P P P

(c) Assume X N (0, 1). Prove that E[X 2k+1 ] = 0 for all k N0 (natural numbers with
zero).

Exercise 1.2: [NLI2, Solution][?, Exercise 2] Assume that Xk has a 2 -distribution with k N
degrees of freedom, i.e. Xk is absolutely continuous with density
1
f (x) = k/2
xk/21 exp(x/2), for x 0. (1.1)
2 (k/2)

(a) Prove that f is a density (hint: see Section 3.3.3 and proof of Proposition 2.20 in ?).

(b) Prove
MXk (r) = (1 2r)k/2 for r < 1/2. (1.2)
d
(c) Choose Z N (0, 1) and prove Z 2 = X1 .
i.i.d Pk d
(d) Choose Z1 , ..., Zk N (0, 1). Prove i=1 Zi2 = Xk and calculate the first two moments of
the latter.

1.2 Solutions
Solution 1.1: [NLI1, Exercise]

(a) The moment generate function of a + bX is


2 b2 /2
Ma+bX (r) = E[er(a+bX) ] = era E[erbX ] = era MX (rb) = era+r , (1.3)

which is the moment generating function of N (a, b2 ).

2
ACTL3162 General Insurance Techniques Exercises

P
(b) We can write down the moment generating function for i Xi (using the assumption of
independence),
!
Y Y X X
MPi Xi (r) = MXi (r) = exp(ri + r2 i2 /2) = exp r i + r 2 i2 /2 , (1.4)
i i i i

which is the moment generating function of N ( i i , i i2 ).


P P

(c) It is tempted to use the moment generating function to solve this exercise, but obtaining
explicit formula for the n-th derivative of the m.g.f. is not so easy. We will resort back
to the old fashion way. First denote E[X 2k+1 ] = I2k+1 for k N0 , then
Z  
2k+1 1 1 2
I2k+1 = x exp x dx
2 2
Z  1 2

1 d exp x
= x2k 2
dx
2 dx
  x= Z  
1 2k 1 2 1 2k1 1 2
= x exp x + 2k x exp x dx
2 2 x= 2 2
1
= 2k I2k1 . (1.5)
2
(2k2)
This recursive formula keeps on going and yields I2k+1 = 2k . . . 22 I1 . Since I1 =
2 2
E[X] = 0, therefore we have E[X 2k+1 ] = 0 for all k N0 .

Solution 1.2: [NLI2, Exercise]

(a) To show that f is a density function, first note that f (x) 0 for all x 0. Secondly
using a gamma density with shape parameter k/2 for k N and scale parameter 1/2, we
have
Z
1
k/2
xk/21 exp(x/2)dx = 1. (1.6)
0 2 (k/2)

(b) The moment generating function for Xk is


Z
1
MXk (r) = exp(rx) k/2 xk/21 exp(x/2)dx
0 2 (k/2)
Z
1
= k/2 xk/21 exp((1/2 r)x)dx
2 (k/2) 0
(1/2 r)k/2 (k/2)
= , if 1/2 r > 0
2k/2 (k/2)
= (1 2r)k/2 . (1.7)

(c) We start with the cumulative function of Z 2 , for x 0,



F (x) = P(Z 2 x) = P( x Z x)
Z x  
1 1 2
= exp z dz
x 2 2
Z x  
1 1 2
=2 exp z dz. (1.8)
0 2 2

3
ACTL3162 General Insurance Techniques Exercises

Let z= y 1/2 and dz = 1/2y 1/2 dy, using this change of variable, we have z changes from
0 to x and y changes from 0 to x. The cumulative probability function F (x) becomes
Z x  
1 1
F (x) = exp y y 1/2 dy
2 2
Z0 x  
1 1
= 1/2 (1/2)
exp y y 1/2 dy, (1.9)
0 2 2

which is the cumulative function of Chi-square with 1 degree of freedom, X1 .


i.i.d.
(d) Suppose Z1 , ..., Zk N (0, 1), then Z12 , ..., Zk2 are i.i.d. Chi-square random variables with
2 d
Pk
1 degree of freedom. Then to prove i=1 Zi = Xk , it suffices to show that the sum
Pk i 1 2 k
i=1 X1 has Chi-square distribution with k degrees of freedom, where X1 , X1 , ..., X1 are
i.i.d. Chi-square random variables with 1 degree of freedom. This can be done using the
moment generating function,
k
Y k
Y
MPk Zi2 (r) = MX1i (r) = (1 2r)1/2 = (1 2r)k/2 . (1.10)
i=1
i=1 i=1

4
Module 2

Collective Risk Modelling

2.1 Compound distributions


Exercise 2.1: [los3K, Solution] [?, Problem 2.2.2] Throw a true die and let X denote the
outcome. Then, toss a coin X times. Let Y denote the number of heads obtained. What are
the expected value and the variance of Y ?

Exercise 2.2: [los7, Solution] Let the sum S = X1 + X2 + X3 with X1 , X2 and X3 distributed
as follows:
x f1 (x) f2 (x) f3 (x)

0 0.2 - 0.5
1 0.3 - 0.5
2 0.5 p -
3 - 1p -
4 - - -

where 0 < p < 1. You are also given that FS (4) = 0.43. Calculate the value of p.

Exercise 2.3: [los8, Solution] Consider the following three distributions:

x fX1 (x) fX2 (x) fX3 (x)


0 0.1 0.0 0.30
1 0.2 0.2 0.10
2 0.2 0.0 0.05
3 0.2 0.3 0.30
4 0.2 0.4 0.15
5 0.1 0.1 0.10

Calculate

1. The distribution of X1 + X2

2. The distribution of X1 + X2 + X3

5
ACTL3162 General Insurance Techniques Exercises

Exercise 2.4: [los11, Solution] An insurance portfolio has the following characteristics:

Distribution of N Distribution of X
n P (N = n) x p (x)
0 0.4 1 0.6
1 0.3 2 0.4
2 0.3

Number of claims, N , and claim amounts, X, are mutually independent. Compute the condi-
tional probability that the average claim size exceeds the expected claim size, given that there
is at least one claim.

Exercise 2.5: [los12, Solution] Aggregate claims are

S = X 1 + X2 + + XN

where:

Xi has a uniform distribution on (1, 5), i = 1, 2, ...;

N has the distribution

n P (N = n)
0 0.3
1 0.2
2 0.5

N , X1 , X2 , . . . are mutually independent.

Determine P (S < 4).

Exercise 2.6: [los13K, Solution] [?, Problem 2.3.1] Calculate Pr[S = s] for s = 0, 1, . . . , 6
when S = X1 + 2X2 + 3X3 and Xj Poisson(j).

Exercise 2.7: [los9R, Solution] [R ]

1. Use R to perform the convolutions required in Exercice 2.3: 1 and 2.

2. Generalize your code in order to be able to calculate the distribution of 1 X1 +2 X2 +3 X3


in function of i and fXi (x), i = 1, 2, 3, if the i s are positive integers and for any non-
negative range of Xi , i = 1, 2, 3. You should not have to change your program if the
distributions or the i s change.
To check your program, try to run it with 1 = 3, 2 = 0 and 3 = 2, as well as the
same probabilities as in Exercise 2.3, except for fX1 (5) = fX1 (6) = 0.05. Here is the
distribution you should get:

x Solution
1 0 0.0300
2 1 0.0000
3 2 0.0100
4 3 0.0600
5 4 0.0050
6 5 0.0200

6
ACTL3162 General Insurance Techniques Exercises

7 6 0.0900
8 7 0.0100
9 8 0.0350
10 9 0.1200
11 10 0.0200
12 11 0.0500
13 12 0.1200
14 13 0.0300
15 14 0.0500
16 15 0.0750
17 16 0.0300
18 17 0.0350
19 18 0.0750
20 19 0.0225
21 20 0.0350
22 21 0.0150
23 22 0.0225
24 23 0.0075
25 24 0.0150
26 25 0.0050
27 26 0.0075
28 27 0.0000
29 28 0.0050

Exercise 2.8: [los21R, Solution][R ] Consider Exercise 2.6 above. Can you use the R code
developed in Exercise 2.7 to get the distribution of S? Why?

Exercise 2.9: [los22R, Solution][R ] Implement the formula



X
fS (x) = pn (x) Pr[N = n]
n=0

in R as a function of the distributions of N and X. What are the conditions for this to be
feasible? Print the pmf and df of S, as well as the descriptive statistics of S. Try to make your
code as efficient as possible.
Check your code with ?, Example 12.2.2.

[Properties of compound Poisson random variables]

Exercise 2.10: [los23R, Solution][R ] Let S compound Poisson(, p(xi ) = i ), i = 1, . . . , m.


Use Theorem 12.4.2 to develop a program in R that calculates and displays fS (x) and FS (x)
for x s, in function of the inputs s, and i , i = 1, . . . , m.
Check your results with Exercise 1.12 and plot fS (x) for x 36. You should get:

x f_S F_S
1 0 0.0024787522 0.002478752
2 1 0.0024787522 0.004957504
3 2 0.0061968804 0.011154385
4 3 0.0128068862 0.023961271
5 4 0.0149757944 0.038937065
6 5 0.0243950527 0.063332118
7 6 0.0332600344 0.096592153
[...]
37 36 0.0004111363 0.999152382

7
ACTL3162 General Insurance Techniques Exercises

0.06
0.05
0.04
results$f_S

0.03
0.02
0.01
0.00

0 5 10 15 20 25 30 35

results$x

2.2 Explicit claims count distributions


Exercise 2.11: [los10, Solution] Calculate E[S], V ar(S) and mS (t) in case N has the following
distribution:

1. Poisson()

2. binomial(n, p)

3. negative binomial(r, p)

Exercise 2.12: [NLI2.7, Solution][?, Corollary 2.7] Assume S1 , ..., Sn are independent with
Sj CompBinom(vj , p, G) for all j = 1, ..., n. Show that the aggregated claim has a compound
binomial distribution with
n
X Xn
S= Si CompBinom( vj , p, G). (2.1)
i=1 j=1

Exercise 2.13: [los14, Solution] Let S compound Poisson( = 2, p(x) = x/10), x =


1, 2, 3, 4. Calculate Pr[S = s] for s 4:

1. using the basic convolution method for compound distributions;

2. using the sparse vector algorithm.

Exercise 2.14: [los15K, Solution] [?, Problem 3.5.8] Assume that S1 is compound Poisson
distributed with parameter = 2 and claim sizes p(1) = p(3) = 21 . Let S2 = S1 + N , where
N is Poisson(1) distributed and independent of S1 . Determine the mgf of S2 . What is the
corresponding distribution? Determine Pr[S2 2.4]. Leave the powers of e unevaluated.

8
ACTL3162 General Insurance Techniques Exercises

Exercise 2.15: [los16, Solution] You are given S = S1 + S2 , where S1 and S2 are independent
and have compound Poisson distributions with 1 = 3 and 2 = 2 and individual claim amount
distributions:
x p1 (x) p2 (x)
1 0.25 0.10
2 0.75 0.40
3 0.00 0.40
4 0.00 0.10
Determine the mean and variance of the individual claim amount for S.

Exercise 2.16: [los17K, Solution] [?, Problem 3.4.3] Assume that S1 is compound Poisson
with 1 = 4 and claims p1 (j) = 14 , j = 0, 1, 2, 3, and S2 is also compound Poisson with 2 = 2
and p2 (j) = 21 , j = 2, 4. If S1 and S2 are independent, then what is the distribution of S1 + S2 ?

Exercise 2.17: [los18, Solution] Suppose that S has a compound Poisson distribution with
parameter and with discrete claims distribution

p (xi ) = P (X = xi ) = i , for i = 1, 2, ..., m.

Now suppose S can be written as Xm


S= xi Ni
i=1
where Ni denotes the frequency of the claim amount xi for i = 1, 2, ..., m.

1. Prove that N1 , N2 , ..., Nm are mutually independent.

2. Prove that each Ni has a Poisson distribution and find its parameter.

[In other words, prove A Theorem 12.4.2.]

Exercise 2.18: [los19, Solution] Suppose that the number of accidents incurred by an insured
driver in a single year has a Poisson distribution with parameter . If an accident happens, the
probability is p that the damage amount will exceed a deductible (or excess) amount. On the
assumption that the number of accidents is independent of the severity of the accidents, derive
the distribution of the number of accidents that result in a claim payment.

Exercise 2.19: [sur1K, Solution] [?, Problem 4.2.2] Let {N (t), t 0} be a Poisson process
with parameter , and let pn (t) = Pr[N (t) = n] and p1 (t) 0. Show that

p0n (t) = pn (t) + pn1 (t), n = 0, 1, 2, . . . ,

and interpret these formulas by comparing pn (t) with pn (t + dt).


[Express pn (t + dt) as a function of pn (t) and interpret this relation.]

Exercise 2.20: [NLI6, Solution][?, Exercise 6] An insurance company decides to offer a no-
claims bonus to good car drivers, namely,

a 10% discount after 3 years of no claim, and

a 20% discount after 6 years of no claim.

9
ACTL3162 General Insurance Techniques Exercises

How does the base premium need to be adjusted so that this no-claims bonus can be financed?
For simplicity we assume that all risks have been insured for at least 6 years. Answer the
question in the following two situations:

(a) Homogeneous portfolio with i.i.d. risks having i.i.d. Poisson claim counts with frequency
parameter = 0.2.

(b) Heterogeneous portfolio with independent risks being characterised by a frequency param-
eter having a gamma distribution with mean = 0.2 and Vco() = 1 (Vco stands for
coefficient of variation). Conditionally, given , the individual years have i.i.d. Poisson
claim counts with frequency parameter .

2.3 Parameter estimation


Exercise 2.21: [Fit1, Solution] Consider a set of n right-censored insurance claims observations
where the observed data is represented as

(xj , j ) for j = 1, 2, ..., n

where xj refers to the claim amount observed and j is the (right-censor) indicator whether
the applicable policy limit has been reached. You are to fit a (simple) exponential distribution
model to the observed claims with

fX (x) = ex , for x > 0.

1. Write down the log-likelihood function for estimating the exponential parameter.

2. Maximize this function and solve for the parameter estimate.

3. Describe how you can derive a standard error of your parameter estimate.

Exercise 2.22: [Fit2, Solution] [Institute of Actuaries, Subject 106, September 2000] An insur-
ance company has a portfolio of policies with a per-risk excess of loss reinsurance arrangement
with a deductible of M > 0. Claims made to the direct insurer, denoted by X, have a Pareto
distribution with cumulative distribution function
 
200
FX (x; ) = 1 .
200 + x
There were a total of n claims from the portfolio. Of these claims, I were for amounts less than
the deductible. The claims less than the deductible are

xi , for i = 1, 2, ..., I.
PI
The value of the statistic i=1 log (200 + xi ) = y is given.

1. Derive an expression for the maximum likelihood estimate of in terms of n, I, M and


y.

2. From last years experience, we have the following information:

M = 600, n = 500, I = 400, y = 2209.269.

10
ACTL3162 General Insurance Techniques Exercises

(a) Verify that the maximum likelihood estimate of is


b = 1.75.
(b) Assuming that = 1.75, estimate the average amounts paid by the insurer and the
reinsurer on a claim made during the year.

Exercise 2.23: [Fit3, Solution] Observations (which are number of claims) Y1 , Y2 , ..., Yn are
independent Poisson random variables with E(Yi ) = i where

, for i = 1, 2, ..., m
log i =
+ , for i = m + 1, m + 2, ..., n

Here we assume m < n. Derive the maximum likelihood estimates of and .

Exercise 2.24: [Fit4, Solution][?, Exercise 12.52] Consider the Inverse Gaussian distribution
with density function expressed as
 1/2 "  2 #
x
fX (x) = exp , for x > 0.
2x3 2x

1. Show that n n 
(xj )2

X X 1 1 n
= 2
+ (x )2 ,
j=1
xj j=1
xj x x
Pn
where x = (1/n) j=1 xj .

2. For a given sample x1 , x2 , ..., xn , show that the maximum likelihood estimates of and
are

b=x
and
n
b =  .
Pn 1 1
j=1
xj x

Exercise 2.25: [Fit5, Solution] The following 20 claim amounts were observed over a period
of time:
132 149 476 147 135 110 176 107 147 165
135 117 110 111 226 108 102 108 227 102
You are interested in estimating the probability that a claim will exceed 200. You are to fit the
Pareto distribution with cumulative distribution function of the form

FX (x) = 1 (100/x) for x > 100 and > 0.

1. Determine the MLE of the Pareto parameter .

2. Use this to estimate the probability that a claim will exceed 200.

Exercise 2.26: [NLI8, Solution][?, Exercise 8] Natural hazards in Switzerland are covered by
the so-called Schweizersische Elementarschade-Pool (ES-Pool). This is a pool of private Swiss
insurance companies which organises the diversification of natural hazards in Switzerland.
For pricing of these natural hazards one distinguishes between small events and large events,
the latter having a total claim amount exceeding CHF 50 millions per events. The following

11
ACTL3162 General Insurance Techniques Exercises

15 storm and flood events have been observed in years 1986-2005 (these are the events with a
total claim amount exceeding CHF 50 millions).

date amount in CHF mio. date amount in CHF mio.


20.06.1986 52.8 18.05.1994 78.5
18.08.1986 135.2 18.02.1999 75.3
18.07.1987 55.9 12.05.1999 178.3
23.08.1987 138.6 26.12.1999 182.8
26.02.1990 122.9 04.07.2000 54.4
21.08.1992 55.8 13.10.2000 365.3
24.09.1993 368.2 20.08.2005 1051.1
08.10.1993 83.8

Fit a Pareto distribution with parameters = 50 and > 0 to the observed claim sizes.
Estimate parameter using the unbiased version of the MLE.
We introduce a maximal claims cover of M = 2 billions CHF per event, i.e. the individual
claims are given by Yi M = min{Yi , M } (see also Section 3.4.2 in ?). For the yearly
claim amount of storm and flood events, we assume a compound Poisson distribution
with Pareto claim sizes Yi . What is the expected total yearly claim amount?
What is the probability that we observe a storm and flood event next year which exceeds
the level of M = 2 billions CHF?

2.4 Solutions
Solution 2.1: [los3K, Exercise] Firstly, one should notice that X is a discrete uniform random
variable over {1, 2, 3, 4, 5, 6}. Therefore we have

1+2+3+4+5+6 7
E(X) = = ,
6 2
 2
2 2 12 + 22 + 32 + 42 + 52 + 62 7 35
V ar(X) = E(X ) (E(X)) = = .
6 2 12
We have Y |X = x binomial(x, 1/2). Hence,
E (Y ) = E [E (Y |X )] = E [1/2X] = 7/4
and
V ar (Y ) = V ar [E (Y |X )] + E [V ar (Y |X )]
= V ar [1/2X] + E [1/4X] = 77/48.

Solution 2.2: [los7, Exercise] First set up the following table:


x f1 (x) f2 (x) f1+2 (x) f3 (x) f1+2+3 (x) FS (x)
0 0.2 0 0 0.5 0 0
1 0.3 0 0 0.5 0 0
2 0.5 p 0.2p 0 0.1p 0.1p
3 0 1 p 0.2 + 0.1p 0 0.1 + 0.15p 0.1 + 0.25p
4 0 0 0.3 + 0.2p 0 0.25 + 0.15p 0.35 + 0.4p

12
ACTL3162 General Insurance Techniques Exercises

Thus, 0.35 + 0.4p = 0.43 implies p = 0.2.

Solution 2.3: [los8, Exercise]

1. The range of X1 + X2 will be [0, 10]. We have


x fX1 (x) fX2 (x) fX1 +X2 (x)
0 0.1 0.0 0.00 = 0.1 0
1 0.2 0.2 0.02 = 0.1 0.2 + 0.2 0
2 0.2 0.0 0.04 = 0.1 0 + 0.22 + 0.2 0
3 0.2 0.3 0.07 = 0.1 0.3 + 0.2 0 + 0.22 + 0.2 0
4 0.2 0.4 0.14 = 0.1 0.4 + 0.2 0.3 + 0.2 0 + 0.22 + 0.2 0
5 0.1 0.1 0.19 = 0.12 + 0.2 0.4 + 0.2 0.3 + 0.2 0 + 0.22 + 0.1 0
6 0.18 = 0.2 0.1 + 0.2 0.4 + 0.2 0.3 + 0.2 0 + 0.1 0.2
7 0.16 = 0.2 0.1 + 0.2 0.4 + 0.2 0.3 + 0.1 0
8 0.13 = 0.2 0.1 + 0.2 0.4 + 0.1 0.3
9 0.06 = 0.2 0.1 + 0.1 0.4
10 0.01 = 0.12
P
Check your results by verifying that x fX1 +X2 (x) = 1.
2. In order to get the distribution of X1 + X2 + X3 , it suffices to calculate the convolution
of X1 + X2 with X3 . We have then
x fX3 (x) fX1 +X2 (x) fX1 +X2 +X3 (x)
0 0.30 0.00 0
1 0.10 0.02 0.006
2 0.05 0.04 0.014
3 0.30 0.07 0.026
4 0.15 0.14 0.057
5 0.10 0.19 0.0895
6 0.18 0.109
7 0.16 0.132
8 0.13 0.149
9 0.06 0.1355
10 0.01 0.1095
11 0.085
12 0.054
13 0.025
14 0.0075
15 0.001

Solution 2.4: [los11, Exercise] Let S = X1 + + XN denote the aggregate claims. Then we
wish to compute the probability P NS > E (X) |N > 0 where E (X) = 1.4. Thus, we have
 
S Pr [S > 1.4N N > 0]
Pr > E (X) |N > 0 =
N Pr [N > 0]
Pr [S > 1.4 |N = 1 ] Pr [N = 1] + Pr [S > 2.8 |N = 2 ] Pr [N = 2]
=
h i 1 0.4
(0.4) (0.3) + 1 (0.6)2 (0.3)
= = 0.52.
0.6

13
ACTL3162 General Insurance Techniques Exercises

To understand 1 (0.6)2 , note that if N = 2 then S {2, 3, 4} and thus


 

Pr[S > 2.8|N = 2] = 1 Pr[S = 2|N = 2] = 1 0.62 .

Solution 2.5: [los12, Exercise] Use equation



X
FS (x) = P n (x) Pr[N = n]
n=0

to get the exact value of P (S < 4) :



X
P (S < 4) = P (X1 + + XN < 4 |N = n) P (N = n)
n=0
= 0.3 + P (X1 < 4) 0.2 + P (X1 + X2 < 4) 0.5

where you can verify


3
P (X1 < 4) =
4
and Z 3 Z 4x1
1 1 1
P (X1 + X2 < 4) = dx2 dx1 = .
1 1 4 4 8
Thus,
3 1
P (S < 4) = 0.3 + 0.2 + 0.5 = 0.5125.
4 8

Solution 2.6: [los13K, Exercise] We have S = X1 + 2X2 + 3X3 with Xj Poisson(j) :

x f1 (x) f2 (x) = f1+2 (x) f3 (x) = f1+2+3 (x)


e1 e2 e3 e3 e6
0 1 1 1 1 1
1 1 0 1 0 1
2 1/2 2 2 1/2 0 2 1/2
3 1/6 0 2 1/6 3 5 1/6
4 1/24 2 3 1/24 0 6 1/24
5 1/120 0 2 41/120 0 9 101/120
6 1/720 1 1/3 2 301/720 4 1/2 13 301/720

e1 /x! e2 2x/2 / (x/2)! e3 3x/3 / (x/3)!

Solution 2.7: [los9R, Exercise]

1. Try to copy this code and paste this code in a R document. If you source it, you should
find the same results as in Exercise 1.8.1 and 1.8.2.

14
ACTL3162 General Insurance Techniques Exercises

# put probabilities of the three distributions in vectors


fX1 <- c(.1,.2,.2,.2,.2,.1)
fX2 <- c(0,.2,0,.3,.4,.1)
fX3 <- c(.3,.1,.05,.3,.15,.1)

#####################
# convolution 1.8.1 #
#####################

#initialise an empty vector of type double for the probabilities


fX12_8a <- c()

# we need to put 0s in the probability vectors


# this is to avoid NAs in the recursions afterwards
# the appropriate number depends on the range of the sum, here [0,10]
fX1 <- c(fX1,rep(0,5))
fX2 <- c(fX2,rep(0,5))

#perform the convolutions


for(i in 1:11) # we know that the range of X_1+X_2 is [0,10]
{#now we calculate the probability
fX12_8a[i] <- sum( fX1[1:i]*fX2[i:1] )
}# end of the for loop

#print results
results<-data.frame(x=c(0:10),DistrX1=fX1,DistrX2=fX2,Solution=fX12_8a)
print("Exercise 1.8.1")
print(results)

#####################
# convolution 1.8.2 #
#####################

#use the same algorithm as above, but with fX12_8a and fX3...

#initialise an empty vector of type double for the probabilities


fX123_8b <- c()

# add 0s
fX12_8a <- c(fX12_8a,rep(0,5))
fX3 <- c(fX3,rep(0,10))

#perform the convolutions


for(i in 1:16) # we know that the range of X_1+X_2+X_3 is [0,15]
{#now we calculate the probability
fX123_8b[i] <- sum(fX3[1:i]*fX12_8a[i:1])
}# end of the for loop

#print results
resultsb<-data.frame(x=c(0:15),DistrX3=fX3,DistrX1X2=fX12_8a,Solution=fX123_8b)
print("Exercise 1.8.2")
print(resultsb)

Here is how your output should look like:

[1] "Exercise 1.8.1"


x DistrX1 DistrX2 Solution
1 0 0.1 0.0 0.00
2 1 0.2 0.2 0.02
3 2 0.2 0.0 0.04

15
ACTL3162 General Insurance Techniques Exercises

4 3 0.2 0.3 0.07


5 4 0.2 0.4 0.14
6 5 0.1 0.1 0.19
7 6 0.0 0.0 0.18
8 7 0.0 0.0 0.16
9 8 0.0 0.0 0.13
10 9 0.0 0.0 0.06
11 10 0.0 0.0 0.01
[1] "Exercise 1.8.2"
x DistrX3 DistrX1X2 Solution
1 0 0.30 0.00 0.0000
2 1 0.10 0.02 0.0060
3 2 0.05 0.04 0.0140
4 3 0.30 0.07 0.0260
5 4 0.15 0.14 0.0570
6 5 0.10 0.19 0.0895
7 6 0.00 0.18 0.1090
8 7 0.00 0.16 0.1320
9 8 0.00 0.13 0.1490
10 9 0.00 0.06 0.1355
11 10 0.00 0.01 0.1095
12 11 0.00 0.00 0.0850
13 12 0.00 0.00 0.0540
14 13 0.00 0.00 0.0250
15 14 0.00 0.00 0.0075
16 15 0.00 0.00 0.0010

2. Here is one possibility:

#############
# variables #
#############

# vectors of probabilities
fX1 <- c(.1,.2,.2,.2,.2,.05,.05)
fX2 <- c(0,.2,0,.3,.4,.1)
fX3 <- c(.3,.1,.05,.3,.15,.1)

# weights
alpha <- c(3,0,2)

################
# convolutions #
################

#just to be sure..
if(sum(alpha)==1) print("there is no convolution to do!")

#calculate the range of S


Xmax <- c(length(fX1)-1,length(fX2)-1,length(fX3)-1)
rangeS <- sum(Xmax*alpha)

#for convenience, put probabilities in an array, with 0s where relevant


fX <- array(c(fX1,rep(0,rangeS-Xmax[1]),
fX2,rep(0,rangeS-Xmax[2]), #we complete each colun with 0s
fX3,rep(0,rangeS-Xmax[3])), #end of values
c(rangeS+1,3)) #now the dimension of the array (second argument)

#####
#note that we have at most only two convolutions to do

16
ACTL3162 General Insurance Techniques Exercises

# if we scale the Xs correctly

#initialising results array - 3 columns for scaled Xs, one for convolution
#of first two, last for the solution
fS <- array(rep(0,(rangeS+1)*5),c(rangeS+1,5))

#appropriately scaling the fXs


for(i in 1:3) { # for each X
if(alpha[i]==0) next
for(j in 1:(Xmax[i]+1)) {
fS[(j-1)*alpha[i]+1,i] <- fX[j,i]
} # end of j loop
}# end of i loop

for(i in 1:(rangeS+1)) {
if(alpha[2]==0){ # then only 1 and 3 need to be convoluted (see test above)
fS[i,5] <- sum(fS[1:i,1]*fS[i:1,3]) #end of the story
} else { if(alpha[1]==0){ #then only 2 and 3 need to be convoluted
fS[i,5] <- sum(fS[1:i,2]*fS[i:1,3]) #end of the story
} else { fS[i,4] <- sum(fS[1:i,1]*fS[i:1,2]) # we do 1 and 2 and see...
if(alpha[3]==0) { # if alpha 3 is 0, then it is finished
fS[i,5] <- fS[i,4] # ... and we translate results in column 5
# otherwise we do the last convolution 1*2 with 3:
} else {fS[i,5] <- sum(fS[1:i,3]*fS[i:1,4])}
} # end alpha 3 if
} #end second else
} # end for

#print results
results<-data.frame(x=c(0:rangeS),Solution=fS[,5])
print("Solution")
print(results)
plot(results)
#check we have a true distribution..:
if(min(fS[,5])<0) print("Oups some probabilities are negative") else
print("All probabilities are positive")
if(max(fS[,5])>1) print("Oups some probabilities are > 1") else
print("All probabilities are < 1")
print(c("The sum of them is: ",sum(fS[,5])))

And the plot is

17
ACTL3162 General Insurance Techniques Exercises

0.12
0.10
0.08
Solution

0.06
0.04
0.02
0.00

0 5 10 15 20 25

You can see the effect of the scaling as the pmf is not smooth.

Solution 2.8: [los21R, Exercise] The support of the Xi is not finite, which means that it is
not possible to calculate the exact distribution of S without truncating the distribution of Xi
at some points; otherwise the program will consider the support of S as infinite and there will
be infinite loops. However, it is possible to achieve a decent level of accuracy (if one is patient),
but that would require careful additional programming to determine where the distribution of
the Xi s should be truncated. This would also require analysis to check if the moments and
quantiles of S are reasonably conserved...
Note that it is not possible to develop a code for the general case

S = 1 X1 + 2 X2 + 3 X3 , i 0 (integers), i = 1, . . . , 3

if some of the Xi s have infinite support without truncating them. However, if all the Xi s are
Poisson, we can then use A Theorem 12.4.1 and allow for any number of i s.

Solution 2.9: [los22R, Exercise] First note that this formula can only be used if X and N are
both discrete and with a finite range. One possible code is as follows:

# inputs #
##########

fX <-c(0,.5,.4,.1)
fN <-c(.1,.3,.4,.2)

# program #
###########

# range of X, N and S
rX <- length(fX)-1
rN <- length(fN)-1

18
ACTL3162 General Insurance Techniques Exercises

rS <- rX*rN

###initialise our results array


#first create a vector with the contents of the array
cont <- c()
#first column
cont <- c(cont,1,rep(0,rS)) #p*0(x)
cont <- c(cont,fN[1]) #last line is distribution of N
#second column
cont <- c(cont,fX,rep(0,rS-rX),fN[2])
#following columns are 0s, except in the last line
for(i in 1:(rN-1)) { #there will be rN-1 convolutions
cont <- c(cont,rep(0,rS+1),fN[i+2])
} #end of the i loop
#last two columns for pmf and df
#(not in the loop to avoid n/as in the last row - a detail)
cont <- c(cont,rep(0,2*(rS+2)))
#and finally the array
distS <- array(cont,c(rS+2,rN+3))

# perform the convolutions


if(fX[1]>0){
for(i in 1:(rN-1)) {
for(j in 1:((1+i)*rX+1)) { #lower side of triangle - see below
distS[j,i+2] <- sum(distS[1:j,2]*distS[j:1,i+1])
} # end j loop
} # end i loop
} else { #for efficiency: if f_X(0)=0, there will only be probabilities
# in a triangle with upper side with slope -1 from col 2
# and lower side with slope -rX (whether mass is >0 or not!)
for(i in 1:(rN-1)) {
for(j in 1:((1+i)*rX+1)) { #first change (lower side)
distS[j,i+2] <- sum(distS[1:max(j-i,1),2]*distS[(j+1)-(1:max(j-i,1)),i+1])
#second change (upper side) is max(j-1,1)
} # end j loop
} # end i loop
}

# calculate pmf and pf


# first line (cant be put in the following loop)
distS[1,rN+2] <- sum(distS[1,1:(rN+1)]*distS[rS+2,1:(rN+1)]) #pmf at i
distS[1,rN+3] <- distS[1,rN+2]
# next lines
for(i in 2:(rS+1)) {
distS[i,rN+2] <- sum(distS[i,1:(rN+1)]*distS[rS+2,1:(rN+1)]) #pmf at i
distS[i,rN+3] <- distS[i-1,rN+3]+distS[i,rN+2]
} # end i loop

# print results #
#################
results <- data.frame(x=0:rS,pmf=distS[1:(rS+1),rN+2],df=distS[1:(rS+1),rN+3])
print(results)
source("path to program of Exercise 11.a")
pmf_to_desc_stats(distS[1:(rS+1),rN+2],1)

#check we have a true distribution..:


if(min(distS[1:(rS+1),rN+2])<0) print("Oups some probabilities are negative") else
print("All probabilities are positive")
if(max(distS[1:(rS+1),rN+2])>1) print("Oups some probabilities are > 1") else
print("All probabilities are < 1")

Efficiency comments:

1. Consider the convolutions part. In the bounds for j and for the convolutions, we recognise
that the probability masses of the convolutions will spread in the shape of a triangle
in the table of successive convolutions. The upper side of the triangle has slope 0 if
Pr[X = 0] > 0 and slope -1 otherwise. The lower side of the triangle will always have a
slope of minus the range of X. So you will have probabilities everywhere only if the range
of X is infinite (which will never happen in this program - see the note at the beginning of
the solution) and if Pr[X = 0] > 0. We can thus save resources by doing the convolutions
(products) only when these probabilities are different form zeros, which is achieved by

19
ACTL3162 General Insurance Techniques Exercises

choosing the bounds appropriately.


2. Note the line

distS[j,i+2] <- sum(distS[1:j,2]*distS[j:1,i+1])

We use here the fact that R is a vector based program and we can perform j products in
a single line using 1:j and j:1 in the index of distS. This effectively does the same as
the following loop

temp <- 0
for(k in 1:j) {
temp <- temp + distS[k,2]*distS[j-k+1,i+1]
} # end k loop
distS[j,i+2] <- temp

which is a more traditional way to program it (in VBA or Maple or Mathematica, you
would program the convolution with the loop).

What impact do these considerations have? Here are the approximate processing time if
fX (x) = 0.01, x = 1, 2, . . . , 100 and fN (x) = 0.05, x = 0, 1, . . . , 19 (performed on an iMac
with 3.06 GHz Intel Core 2 Duo chip):

no triangle triangle
loop 2 min. 56 sec. 1 min. 5 sec.
vector 3 sec. 1.5 sec.

In this case, using the vector-based programming is much more important than being smart
about the triangle, but this is because we use R and we can take advantage of its very powerful
algorithms to handle vectors. In VBA, the triangle trick would be crucial.
Finally, note the shape of the pmf of S in this case (we omit here the mass at 0):
0.0012
0.0010
distS[2:(rS + 1), rN + 2]

0.0008
0.0006
0.0004
0.0002
0.0000

0 500 1000 1500

1:rS

20
ACTL3162 General Insurance Techniques Exercises

You can see the effect of compounding: when probabilities are due to only a few claims there
are irregularities (jumps) in the pmf (lhs of plot). When we are looking at outcomes of S that
involve a lot a different possible number of claims, the pmf is much smoother (rhs of plot).

Solution 2.10: [los23R, Exercise] Here is the code with the parameters corresponding to Ex-
ercise 1.12:
# Inputs #
##########

fX <- c(0,1/6,2/6,3/6)
l <- 6
s <- 36

# Program #
###########

#initialise the vectors for the lambda_is and alpha_is


lambda <- c()
alpha <- c()

# calculate the lambda_is and the alpha_is


for(i in 2:length(fX)) # we can discard alpha=0
{if(fX[i]>0) {
lambda <- c(lambda,fX[i]*l)
alpha <- c(alpha,i-1)}
} #end i loop

#number of variables
num <-length(alpha)
#number of columns that are necessary
#(the num distributions + num-1 convolutions)
colu <- 2*num -1

#initialise our results array


fS <- array(0,c(s+1,colu))

#initialise the first num columns (Poisson rvs)


for(i in 1:num){
for(j in seq(1,(s+1),by=alpha[i])){ #we spread the probabilities
fS[j,i] <- exp(-lambda[i])*lambda[i]^((j-1)/alpha[i])/factorial(((j-1)/alpha[i]))
} # end of j loop
} # end of i loop

#perform the convolutions


for(i in 1:(num-1)){
for(j in 1:(s+1)){
fS[j,num+i] <- sum(fS[1:j,num+i-1]*fS[j:1,num-i])
} # end j loop
} # end i loop

#calculate the df
FS <- c()
for(i in 1:(s+1)){FS[i]<-sum(fS[1:i,colu])}

#print results
results <- data.frame(x=c(0:s),f_S=fS[,colu],F_S=FS)
plot(results$x,results$f_S)
print(results)

Solution 2.11: [los10, Exercise] Poisson:


E (N ) = ; V ar (N ) = ;
exp et 1 ;
 
mN (t) =
; V ar (S) = 2 + 2 ;

E (S) =
mS (t) = exp [ (mX (t) 1)] .

21
ACTL3162 General Insurance Techniques Exercises

Binomial:

E (N ) = np; V ar (N ) = npq;
n
mN (t) = q + pet ;
E (S) = np ; V ar (S) = np 2 + npq2 ;
mS (t) = [q + pmX (t)]n .

Negative Binomial:

E (N ) = r (1 p) /p; V ar (N ) = r (1 p) /p2 ;
r
p/ 1 (1 p) et ;

mN (t) =
E (S) = r (1 p) /p ; V ar (S) = r (1 p) /p 2 + r (1 p) /p2 2 ;
mS (t) = {p/ [1 (1 p) mX (t)]}r .

Solution 2.12: [NLI2.7, Exercise] Assume S1 , ..., Sn are independent Sj CompBinom(vj , p, G)


for all j = 1, ..., n. The moment generating function of Sj (see Proposition 2.6 from ?) for
j = 1, ..., n is
MSj (r) = (pMY1 (r) + (1 p))vj for r R. (2.2)
Since Sj for j = 1, ..., n are independent, then the moment generating function of the sum is
n
Y Pn
M j Sj (r) =
P
(pMY1 (r) + (1 p))vj = (pMY1 (r) + (1 p)) j=1 vj . (2.3)
j=1
Pn
Sj CompBinom( nj=1 vj , p, G).
P
This proves that j=1

Solution 2.13: [los14, Exercise]

1. First, note that:

x p0 (x) p1 (x) p2 (x) p3 (x) p4 (x)


0 1 0 0 0 0
1 0 0.1 0 0 0
2 0 0.2 0.01 0 0
3 0 0.3 0.04 0.001 0
4 0 0.4 0.10 0.006 0.0001
pn e2 2e2 2e2 4 2
3
e 2 2
3
e

Thus,

P (S e2 ;
= 0) =
P (S 0.2e2 ;
= 1) =
P (S 0.42e2 ;
= 2) =
P (S e2 (0.6 + 0.08 + 0.0013) = 0.6813e2 ;
= 3) =
 
2 4
P (S = 4) = e 0.8 + 0.2 + 0.006 + 0.000067 = 1.008067e2 .
3

22
ACTL3162 General Insurance Techniques Exercises

2. S compound Poisson( = 2) with p (x) = 0.1x, x = 1, 2, 3, 4. Write fj for the pdf with
Sj = 1 N1 + + j Nj , j = 1, 2, 3, 4, and pj for the pdf of j Nj so that
pj (x) = P (j Nj = x) = exp (0.2 j) (0.2 j)x/j / (x/j)!.
x p1 p2 = f2 p3 = f3 p4 = f4
0 .819 .670 .549 .549 .301 .449 .1353
1 .164 .110 .060 .0270
2 .016 .268 .231 .127 .0568
3 .001 .045 .329 .205 .0922
4 .000 .054 .048 .062 .359 .1364

Solution 2.14: [los15K, Exercise] Write S1 = N + 3N3 with


N Poisson ( p(1) = 1) and
N3 Poisson ( p(3) = 1) ,
Now S2 = N1 + 3N3 with N1 being the sum of two independent N Poisson(1). Thus we have
N1 Poisson (1 = 1 + 1 = 2) and
N3 Poisson (3 = 1) again.
From this and Theorem 12.4.2, we observe that S2 is compound Poisson with = 3 and
1 3
P (X = 1) = = 2/3; P (X = 3) = = 1/3.
1 + 3 1 + 3
Next, invoke Panjer to compute
P (S 2) = P (S 2.4) .
Or using an ad hoc method:
P (S2 2.4) = P (N1 2 & N3 = 0)
= P (N1 2) P (N3 = 0)
= 20 /0! + 21 /1! + 22 /2! e2 e1 = 5e3 .


Solution 2.15: [los16, Exercise] From Theorem 12.4.1, we know S is compound Poisson with
= 5 and individual claims distribution
x P (x)
3
1 5
(0.25) + 25 (0.10) = 0.19
3
2 5
(0.75) + 25 (0.40) = 0.61
2
3 5
(0.40) = 0.16
2
4 5
(0.10) = 0.04
Thus, mean of individual claim amount is
1 0.19 + 2 0.61 + 3 0.16 + 4 0.04 = 2.05
and the variance of individual claim amount is
(1 2.05)2 0.19 + (2 2.05)2 0.61
+ (3 2.05)2 0.16 + (4 2.05)2 0.04
= 0.5075.

23
ACTL3162 General Insurance Techniques Exercises

Solution 2.16: [los17K, Exercise] According to Theorem 12.4.1, S is compound Poisson(6)


and
4 1 1
p (0) = =
6 4 6
4 1 1
p (1) = =
6 4 6
4 1 2 1 2
p (2) = + =
6 4 6 2 6
4 1 1
p (3) = =
6 4 6
2 1 1
p (4) = = .
6 2 6

Solution 2.17: [los18, Exercise] Define the sum of the number of claims arising from each
possible claim amount by
Xm
N= Ni .
i=1

So conditional on N = n, the number of claims N1 , N2 , ..., Nm of each claim amount have a


multinomial distribution with parameters n, 1 , 2 , ..., m . Its joint moment generating function
(m.g.f.) can be obtained as
" m
!#
" m
! #
X X X
E exp ti Ni = E exp ti Ni N = n P (N = n)


i=1 n=0 i=1

X n e n
= 1 et1 + 2 et2 + + m etm
n=0
n!


X n 1
= e 1 et1 + 2 et2 + + m etm
n=0
n!
m
!
X
= e exp i eti
i=1
Ym
exp i eti 1 .
 
=
i=1

This implies mutual independence of N1 , N2 , ..., Nm [explain why?]. Furthermore, by setting


ti = t and tj = 0 for all j 6= i, we obtain the m.g.f. of Ni which is given below:

E [exp (ti Ni )] = exp i eti 1


 

which is the m.g.f. of a Poisson with parameter i .

Solution 2.18: [los19, Exercise] Denote N to be the number of accidents which is given to be
Poisson() distribution. Now, suppose N1 is the number of these accidents that lead to claims
(i.e. damage amount exceeds the deductible or excess). Then clearly, conditionally on N , N1
has a Binomial (N, p) distribution, since an accident leads to either a claim or no claim. Thus,
we have
m!
P (N1 = n |N = m) = pn (1 p)mn , n m.
n! (m n)!

24
ACTL3162 General Insurance Techniques Exercises

By the law of total probability, we find that



X
P (N1 = n) = P (N1 = n |N = m) P (N = m)
m=n

X m! e m
= pn (1 p)mn
m=n
n! (m n)! m!

e pn X 1
= m (1 p)mn
n! m=n (m n)!

e pn n X 1
= [ (1 p)]mn
n! m=n
(m n)!

e (p)n X 1
= [ (1 p)]k
n! k=0
k!
e (p)n (1p) ep (p)n
= e =
n! n!
which gives a Poisson distribution with parameter p.
This could have been anticipated (and also shown) as a consequence of Theorem 12.4.2.

Solution 2.19: [sur1K, Exercise] We have

pn (t) = P (N (t) = n) = et (t)n /n!

with p1 (t) = 0. This implies the derivative

p0n (t) = et () (t)n /n! + et n (t)n1 /n!


= pn (t) + pn1 (t)

which gives the result for n = 0, 1, ... Note that for all n, we can write

p0n (t) = [pn (t + dt) pn (t)] /dt.

Using the previous result,

pn (t) + pn1 (t) = [pn (t + dt) pn (t)] /dt.

Re-arranging, we get

pn (t + dt) = pn1 (t) dt + pn (t) (1 dt) .

Thus, the probability of having n jumps till t + dt is equal to the probability of getting n 1
jumps till t and another one within the next tiny interval dt, plus the probability of getting n
jumps till t and not other one within the next tiny interval dt.
Note that this expression could have been written directly using the law of total probability
and the property of the Poisson process seen in the lecture.

Solution 2.20: [NLI6, Exercise]

25
ACTL3162 General Insurance Techniques Exercises

(a) Assume that we are currently evaluating all the policies and we can break them down into
three categories: no claim for 6+ years (e60.2 = 0.3012), no claim for 3-6 years (e30.2
e60.2 = 0.2476174) and the rest. So about 30.12% of policies receive a 30% discount and
24.76% of policies receive a 10% discount. Now assume that the new premium is P and
we wish to solve
P 0.7 e60.2 + 0.9 (e30.2 e60.2 ) + 1 e30.2 = E[Y ] = P = 1.13 E[Y ] (2.4)
 

So in order to finance the bonus, we have the raise the base premium by 13 percent.
(b) For claims in the heterogeneous portfolio, we have assumed that the frequency parameter
follows a Gamma(, ) distribution. Using the fact that the mean = 0.2 and Vco() =
1, we can work out that = 1 and = 5. Thus, the probability of having zero claim in
one year (conditioning on values of ) is
Z
Prob[Number of Claims = 0|] = e 5 e5 d = 5/6. (2.5)
0

So the three categories have the following break-down, no claim for 6+ years ((5/6)6 =
0.334898), no claim for 3-6 years ((5/6)3 (5/6)6 = 0.2438057) and the rest. Using the
same method, the new premium we wish to solve is
P 0.7 (5/6)6 + 0.9 ((5/6)3 (5/6)6 ) + 1 (5/6)3 = E[Y ] = P = 1.142661 E[Y ],
 

(2.6)
which yields a 14% increase on the base premium.

Solution 2.21: [Fit1, Exercise] Note that there are no truncation in the observations and that
P (X > x) = ex .

1. The likelihood function for the observed data (xj , j ), j = 1, 2, ..., n can be written as
n
Y 1j j
L (; xj , j ) = exj exj
j=1

so that the log-likelihood function for estimating is expressed as


n
X
` (; xj , j ) = log L (; xj , j ) = [(1 j ) (log xj ) xj j ]
j=1
n
X
= [(1 j ) log xj + xj j xj j ]
j=1
n
X n
X
= log (1 j ) xj .
j=1 j=1

2. Maximizing the log-likelihood function in (a), we find


n n
` (; xj , j ) 1X X
= (1 j ) xj = 0
j=1 j=1

so that Pn
j=1 (1 j )
b = Pn .
j=1 xj

26
ACTL3162 General Insurance Techniques Exercises

3. Standard errors can be derived based on the second derivative of the log-likelihood. In
this case, it will be
n
2 ` (; xj , j ) 1 X
= 2 (1 j )
2 j=1
which should be negative at the optimum. So the standard error of our parameter estimate
will equal to
qP
#1/2 n
j=1 (1 j )
" n
1 X b
(1 j ) = P
q = P n .
j=1 xj
b2 j=1 n
(1 )
j=1 j

It is the square root of the negative of the inverse of the Hessian (which is the second
derivative) evaluated at the MLE.

Solution 2.22: [Fit2, Exercise] Note that the density of the Pareto can be expressed as
200
fX (x; ) = .
(200 + x)+1
Note also that the deductible of the Excess of Loss is equivalent to a policy limit from the point
of view of the insurer.

1. The likelihood of , given the observed claims is then


I (nI)
200

Y 200
L (; xi ) =
i=1
(200 + xi )+1 200 + M
I
I 200n Y
= (nI)
(200 + xi )1
(200 + M ) i=1

so that the log-likelihood is

` (; xi ) = log L (; xi )
I
X
= I log + n log 200 (n I) log M ( + 1) log (200 + xi ) .
i=1

First order condition gives us


I
` (; xi ) I X
= + n log 200 (n I) log (200 + M ) log (200 + xi ) = 0
i=1

which gives
I

b= PI .
(n I) log (200 + M ) n log 200 + i=1 log (200 + xi )

You may wish to check that this gives the maximum by evaluating the second derivative:

2 ` (; xi ) I
2
= 2 < 0.

27
ACTL3162 General Insurance Techniques Exercises

2. Based on the values from last years experience, we have


400 400

b= = = 1.75.
100 log (800) 500 log 200 + 2209.269 228.57

The average amount for one claim is


Z
1.75 2001.75 200
E (X) = x 2.75 dx = = 266.67
0 (200 + x) 0.75

and the portion of this average claims paid by the reinsurer is


Z Z
(x M ) fX (x) dx = zfX (z + M ) dz
M 0
200 z800
Z
= dz
800 0 (800 + z)+1
   1.75
1 800 1 800
= = = 94.28.
4 1 4 1.75 1

Therefore, the rest is paid by the direct insurer which is

266.67 94.28 = 172.39.

Solution 2.23: [Fit3, Exercise] The likelihood can be written as


n
Y
L (, ; yi ) = ei (i )yi /yi !
i=1

so that log-likelihood is
n
X
` (, ; yi ) = log L (, ; yi ) = [i + yi log i log yi !]
i=1
m
X n
X

 + 
= [e + yi log yi !] + e + yi ( + ) log yi !
i=1 i=m+1
m
X n
X n
X
+
= me + yi (n m) e + ( + ) yi log yi !.
i=1 i=m+1 i=1

Differentiating this log-likelihood we get


m n
` (, ; yi )
X
+
X
= me + yi (n m) e + yi = 0
i=1 i=m+1

and n
` (, ; yi ) X
= (n m) e+ + yi = 0.
i=m+1

These yield to
m
X n
X n
X

me + yi yi + yi = 0
i=1 i=m+1 i=m+1

28
ACTL3162 General Insurance Techniques Exercises

so that the solutions are  Pm 


i=1 yi

b = log
m
and  Pn   Pm 
i=m+1 yi i=1 yi
b = log log .
nm m

Solution 2.24: [Fit4, Exercise]

1. We have
n n 
(xj )2 2
X X 
= xj 2 +
j=1
xj j=1
xj
n n  2
2 2
  
X X
= + 2 + xj
j=1
xj x j=1
x
n 
n2

2
X 1 1
= + 2n + nx
j=1
xj x x
n  
2
X 1 1 n 2
2x + x2

= +
j=1
xj x x
n  
X 1 1 n
= 2
+ (x )2
j=1
xj x x

which proves the required result.

2. The likelihood of the sample is given by


"n
#
X (xj )2
L (, ; xj ) = c n/2 exp 2
2 j=1 xj

and the corresponding log-likelihood gives


n
n X (xj )2
` (, ; xj ) = log c + log 2
2 2 j=1 xj
" n   #
n X 1 1 n 2
= log c + log 2 2 + (x )
2 2 j=1
xj x x
" n    2 #
n X 1 1 n x
= log c + log + 1 .
2 2 j=1 xj x x

Therefore, differentiating we have


   
` 2n x x
= 1 2 =0
2 x

which implies

b=x

29
ACTL3162 General Insurance Techniques Exercises

and, similarly, we have


" n    2 #
` n1 1 X 1 1 n x
= + 1 =0
2 2 j=1 xj x x

which implies
n
b = P  .
n 1 1
j=1 xj
x

They both yield the desired results.

Solution 2.25: [Fit5, Exercise] Notice that the density of the given Pareto can be written as

fX (x) = 100 x1 .

1. We maximize the likelihood given by


Y 
L () = 20 10020 x1
i

and taking the log likelihood, we have


X
` () = 20 log + 20 log 100 ( + 1) log xi .

Differentiating, we get

` () 20 X
= + 20 log 100 log xi = 0

so that
20 20

b= P = = 2.848.
log xi 40 log 10 99.1252 92.1034
2. The required probability estimate is therefore

P (X > 200) = (100/200)2.848 = 0.139.

Solution 2.26: [NLI8, Exercise]

From ?, Lemma 3.7, we have the biased MLE estimator of (given )


n
!1
1X
M LE = log Yi log . (2.7)
n i=1

Then the unbiased MLE estimator for is


n1
M LE = 0.9824864. (2.8)
n

30
ACTL3162 General Insurance Techniques Exercises

In previous part of the question, the fitted distribution for claim sizes Yi is a Pareto
distribution (50,0.9824864). Next we count the number of claims for each year and fit
them to a Poisson distribution. There are 2 claims in 1986, 2 in 1987, 1 in 1990, 1 in
1992, 2 in 1993, 1 in 1994, 3 in 1999, 2 in 2000 and 1 in 2005. These claim counts yield an
MLE estimator for the Poisson parameter of M LE = 5/3. The expected claim amount
(per claim) is
Z 2000 Z
E[min(Yi , 2000)] = yg(y)dy + 2000g(y)dy
0 2000
= I(G(2000)) + 2000(1 G(2000))
 0.9824864+1  0.9824864
2000 2000
=1 + 2000
50 50
= 41.34829. (2.9)

So the expected total yearly claim amount is (using properties of compound Poisson),
5/3 41.34829 = 68.91382.

The probability that we observe a storm and flood event next year which exceeds the
level of 2 billions CHF is the product between probability of having one claim and claim
amount exceeds 2 billions,
Z
M LE
M LE e g(y)dy = 0.00648. (2.10)
2000

31
Module 3

Individual Claim Size Modelling

3.1 Data analysis and descriptive statistics


Exercise 3.1: [los36R, Solution][R ] Develop a function that will yield a vector with the first
three central moments, 1 and 2 in function of the cgf of a random variable. One possible
beginning is
CMom123Gam12 <- function(cgf,param){

where cgf is an expression and where param is a list with the numerical values of the
parameters of cgf. The following commandfor an inverse Gaussian( = 2, = 4)
CMom123Gam12(expression(alpha*(1-sqrt(1-2*t/beta))),list(alpha=2,beta=4))

should yield
0.500000 0.125000 0.093750 2.121320 7.500000

[Hint: use the functions D and eval.]

Exercise 3.2: [los20R, Solution][R ]

1. Create a function that will calculate and return (to the assigned itemitem<-function())
a vector with E[], V ar(), 1 () and 2 () of a non-negative discrete random variable (with
finite range) in function of its pmf. In addition, a binary variable indicates if these de-
scriptive statistics should be printed in a data frame or not. Thus, the code (in a separate
R document) should look like
pmf_to_desc_stats <- function(pmf,print) {

[code omitted ^]

where pmf is a vector with the probabilities and where print is a binary (0-1) variable
indicating if the results should print or not.
2. Add this function to the code developed in Exercise 2.7 part 2 to print the descriptive
statistics. You should get something like
[1] "Descriptive statistics"
mean variance skewness kurtosis
1 12.05 35.1675 0.1213840 -0.4493699

32
ACTL3162 General Insurance Techniques Exercises

3.2 Selected parametric claims size distributions


Exercise 3.3: [los1K, Solution] [?, Problem 3.8.1] Determine the mean and the variance of the
lognormal and the Pareto distribution. Proceed as follows: if Y lognormal(, 2 ), then ln Y
N (, 2 ); if Y Pareto(, x0 ), then Y /x0 Pareto(, 1) and ln(1 + Y /x0 ) exponential().

Exercise 3.4: [NLI7, Solution][?, Exercise 7] Assume Y (, c), where its density is for
y 0,
c 1
g(y) = y exp(cy). (3.1)
()

Prove the statements of the moment generating function MY and the loss size index
function I(G(y)). Hint: use the trick of the proof of Proposition 2.20 in ?.

Prove the statement


1 I(G(u))
e(u) = Y u, E[Y 1{u1 <Y u2 } ] = Y (I(G(u2 )) I(G(u1 ))). (3.2)
1 G(u)

Exercise 3.5: [los2K, Solution] [?, Problem 2.2.1] Determine the expected value and the vari-
ance of X = IB if the claim probability equals 0.1. First, assume that B equals 5 with
probability 1. Then, let B Uniform(0,10).

Exercise 3.6: [los4K, Solution] [?, Problem 2.2.5] If X = IB, what is mX (t)?

Exercise 3.7: [los5K, Solution] [?, Problem 2.2.6] Consider the following cdf F:

0 for x < 2
x
F (x) = for 2 x < 4
4
1 for 4 x

Determine independent random variables I, X, and Y such that Z = IX + (1 I)Y has cdf
F , I Bernoulli, X is a discrete and Y a continuous random variable.

Exercise 3.8: [los6K, Solution] [?, Problem 2.2.8] Suppose that T = qX + (1 q)Y and
Z = IX + (1 I)Y with I Bernoulli(q). Compare E[T k ] with E[Z k ], k = 1, 2.

3.3 Model selection


Exercise 3.9: [NLI5, Solution][?, Exercise 5] Consider the data given in Table 3.1. Estimate
the parameters for the Poisson and the negative-binomial models. Which model is preferred?
Does a 2 -goodness-of-fit test reject the null hypothesis on the 5% significance lvel of having
Poisson distributions?

t 1 2 3 4 5 6 7 8 9 10
Nt 1000 997 985 989 1056 1070 994 986 1093 1054
vt 10000 10000 10000 10000 10000 10000 10000 10000 10000 10000

Table 3.1: Observed claims counts Nt and corresponding volumes vt

33
ACTL3162 General Insurance Techniques Exercises

Exercise 3.10: [Fit6R, Solution] The following data are the results of a sample of 250 losses:

Range of loss Number of observations

0 - 25 5
25 - 50 37
50 - 75 28
75 - 100 31
100 - 125 23
125 - 150 9
150 - 200 22
200 - 250 17
250 - 350 15
350 - 500 17
500 - 750 13
750 - 1,000 12
1,000 - 1,500 3
1,500 - 2,500 5
2,500 - 5,000 5
5,000 - 10,000 3
10,000 - 25,000 3
25,000 2

Consider the inverse exponential distribution with CDF

FX (x) = exp (/x) , for x > 0, > 0.

1. Determine the maximum likelihood estimate of . (Be careful with the log-likelihood
function, since the data are grouped.)
2. Conduct a 2 goodness-of-fit test of this inverse exponential distribution model on the
data.
3. Explain the two other types of hypothesis tests, together with their similarities and differ-
ences, that can be conducted in determining the quality of the fit of your chosen model.

Exercise 3.11: [NLI9, Solution][?, Exercise 9] Assume we have i.i.d. claim sizes Y = (Y1 , ..., Yn )0
with n = 1000 which were generated by a gamma distribution, see Figure 3.1. The sample mean
and sample standard deviation are given by


bn = 0.1039 and
bn = 0.1039. (3.3)

If we fit the parameters of the gamma distribution we obtain the method of moments estimator
and the MLEs

bM M = 0.9794 and b
cM M = 9.4249, (3.4)
bM LE = 1.0013 and b
cM LE = 9.6360. (3.5)

This provides the fitted distributions displayed in Figure 3.2. The fits look perfect and the
corresponding log-likelihoods are given by

MM , b
`Y (b cM M ) = 1264.013 and `Y (b
M LE , b
cM LE ) = 1264.171. (3.6)

34
ACTL3162 General Insurance Techniques Exercises

Figure 3.1: i.i.d. claim sizes Y = (Y1 , ..., Yn )0 with n = 1000; lhs: observed data; rhs: empirical
distribution function.

Figure 3.2: Fitted gamma distribution; lhs: log-log plot; rhs: QQ plot.

M LE , b
(a) Why is `Y (b cM LE ) > `Y (b
M M , b
cM M ) and which fit should be preferred according to
AIC?

(b) The estimates of are very close to 1 and we could also use an exponential distribu-
cM LE = 9.6231
tion function. For the exponential distribution function we obtain MLE b
M LE
and `Y (b
c ) = 1264.169. Which model (gamma or exponential) should be preferred
according to the AIC and the BIC?

Exercise 3.12: [Fit7R, Solution][R ] The data in the attachment liability.txt contains data
on liability insurance claim sizes (in German former currency - Marks) for the year 1982.

1. Give a summary of the data.

2. Fit a Pareto distribution to these data using maximum likelihood estimation. Provide the
usual graphical comparisons (histogram vs. fitted parametric density function, empirical

35
ACTL3162 General Insurance Techniques Exercises
90 Chapter 3. Individual Claim Size Modeling
CDF vs. fitted parametric CDF, Q-Q plot, P-P plot).
Example 3.15 (leverage effect of claims inflation). Assume that Y0 Pareto(, )
3. Fit a Weibull distribution to these data using maximum likelihood estimation. Provide
with > 1 and choose a deductible d > . In that case we have, see (3.10),
the usual graphical comparisons.
A B
4. Fit a lognormal distribution to these data using 1
d maximum likelihood estimation. Provide
E [(Y0 d)+ ] = d.
the usual comparisons. 1
5. Which distribution would you choose? Justify your answer.
Choose inflation index i > 0 such that (1 + i) < d. From (3.7) we obtain

(d)
3.4 = (1 + i)Y
CalculatingY1 within 0 Pareto((1
layers + i), ).sizes
for claim

w)
This provides for > 1 and i > 0
Exercise 3.13: [sur12K, Solution] [?, Problem 3.8.5] Determine the cdf of Pr[Z d] and the
stop loss premium E[(Z d)+A B or combination Z of exponential distribution as
] for a mixture
d 1
in E [(Y1 d)+ ] = d
p(x) (1
= qe+ x
i) + (1 1 x , x > 0.
q)e
A B
d of Z 1z, given Z > z.

(m
Also determine the conditional = (1 + i)
distribution

d > (1 + i) E [(Y0 d)+ ] .
1
Exercise 3.14: [sur13, Solution] Show that
Observe that we obtain a strict inequality, i.e. the pure riskZ premium grows faster
than the claim sizes itself. The reason forx)dF
this(x)
faster growth is[1that
F claims
Z d d
E [(S d) + ] = E[S] d + (d = E[S] (x)] dx.Y0 d
may entitle for claims payments after 0 claims inflation adjustments,
0 i.e. not only the
claim sizes are growing under inflation but also the number of claims is growing if
tes
Exercise 3.15: [NLI10, Solution][?, Exercise 10] In Figure 3.3 we display the distribution
one does not adapt the deductible to inflation.
function of loss without reinsurance Y G and the resulting distribution function of the
loss to the insurer after applying different re-insurance covers to loss Y . Can you explicitly
Exercise
determine the 10. In Figurecovers
re-insurance 3.30 we display
from the the distribution
graphs in Figurefunction
3.3? Note of loss Y
that and
theGfunctions
belowthearedistribution
cumulative function of the
distribution loss after applying different re-insurance covers to
functions.
no
NL

Figure
Figure 3.3: 3.30: Distribution
Cumulative functions
Distribution implied
functions by re-insurance
implied contracts.
by re-insurance contracts

Y . Can you explicitly determine the re-insurance covers from the graphs in Figure
Exercise
3.30. 3.16: [NLI11, Solution][?, Exercise 11] Assume claims sizes Yi in a give line
of
business can be described by a log-normal distribution with mean E[Yi ] = 3000 and Vco(Yi ) = 4
(coefficient of variation).
Version June 29, 2015, M.V. Wthrich, ETH Zurich
36
ACTL3162 General Insurance Techniques Exercises

Up to now the insurance company was not offering contracts with deductibles. Now it wants to
offer the following three deductible versions d = 200, 500, 1000. Answer the following questions:

1. How does the claims frequency change by the introduction of deductibles?

2. How does the expected claim size change by the introduction of deductibles?

3. By which amount changes the expected total claim amount?

Exercise 3.17: [sur14K, Solution] [?, Problem 3.10.4] Assume that X1 , X2 , . . . are independent
and identically distributed risks that represent the loss on a portfolio in consecutive years. We
could insure these risks with separate stop loss contracts for one year with a retention d, but
we could also consider only one contract for the whole period of n years with the retention
nd. Show that E [(X1 d)+ ] + . . . + E [(Xn d)+ ] E [(X1 + . . . + Xn nd)+ ]. If d E[Xi ],
examine how the total net stop loss premium for the one-year contracts E [(X1 d)+ ] relates
to the stop loss premium for the n-year period E [(X1 + . . . + Xn nd)+ ].
Hint [?, Rule of thumb 3.10.1]: For retentions t larger than the expectation = E[U ] = E[W ],
we have for the stop loss premiums of risks U and W :
E [(U t)+ ] V ar(U )
.
E [(W t)+ ] V ar(W )

Exercise 3.18: [sur15, Solution] [2005 Quiz 1 Question 4] An insurer has a portfolio consisting
of 1000 one year term life insurance policies that pays $100 in the event of death within one
year. The probability of death is 0.002.
The insurer has a EoL reinsurance for each policy in excess of $90.

1. For the insurer, calculate the expected total annual claims and the variance of total annual
claims without the reinsurance.

2. For the insurer, calculate the expected total annual claims and the variance of total annual
claims with the reinsurance.

3. For the reinsurer, calculate the expected total annual claims and the variance of total
annual claims.

Exercise 3.19: [sur16R, Solution][R ] This question is a follow-up from Exercise 4.18
In Exercise 4.18, we have calculated x, fS (x), FS (x), x = 0, 1, 2, . . . , 25. Now using the same
idea, prepare a table for each of the cases i = 1, 2 and 3 including:

1. d, E[(S d)+ ], E[((S d)+ )2 ], V ar[(S d)+ ], d = 0, 1, 2, . . . , 25.

2. Interpret your results (compare the three assumptions i = 1, 2, or 3).

3.5 Solutions
Solution 3.1: [los36R, Exercise] One possible code is as follows:
CMom123Gam12 <- function(cgf,param){
#initialising vectors
dcgf <- c(cgf) # for cgf, cgf, cgf, etc...
kappa <- c() # for the cumulants

37
ACTL3162 General Insurance Techniques Exercises

param <- data.frame(param,t=0)

for(i in 1:4){
dcgf <- c(dcgf, D(dcgf[i],"t")) # i-th derivative
kappa <- c(kappa, eval(dcgf[i+1],param)) #i-th cumulant
}
# remember that 4-th cumulant is not the 4-th central moment!

#calculating skewness and kurtosis


gamma <- c(kappa[3]/kappa[2]^(3/2),kappa[4]/kappa[2]^2)

#returning results
c(kappa[1:3],gamma)
}

Solution 3.2: [los20R, Exercise]

1. One possible code is as follows:

pmf_to_desc_stats <- function(pmf,print) {


# range of rv
range <- length(pmf)-1

# descriptive statistics
m <- sum(pmf*(0:range))
v <- sum(pmf*(0:range - m)^2)
g1 <- sum(pmf*(0:range - m)^3)/v^(3/2)
g2 <- sum(pmf*(0:range - m)^4)/v^2-3

# print results
if(print==1){
results <- data.frame(mean=m,variance=v,skewness=g1,kurtosis=g2)
print(results)
}

# return vector of results


c(m,v,g1,g2)
}

Note that it is important to return a vector with the results you may need to use later in
your code, because they are lost once the function has been processed. In other words, if
you run the function on one line, m (the mean) will not be available in the subsequent
lines. This also means (and this is the reason why it is so) that you can use m in your
main code and use the function without having a conflict between the two ms.
2. Add the following lines to the code:

source("[path to file]")
print("Descriptive statistics")
pmf_to_desc_stats(fS[,conv+1],1)

Note that [path to the file] needs to be replaced by the path to the R document where
the code of your function is. If you create several functions, you could put all of them in
a single file that is sourced at the beginning of your normal R files. This way, you can
use all your functions whenever you want. Note that before spending time creating a new
function, it may be advisable to check if this function does not already exist in R. . .

38
ACTL3162 General Insurance Techniques Exercises

Solution 3.3: [los1K, Exercise] If Y lognormal(, 2 ), then log Y N (, 2 ) . Use that


E (Y j ) = mlog Y (j) . Thus,

E (Y ) = E [exp (log Y )] = mlog Y (1)


 
1 2
= exp +
2
and

E Y2

= E [exp (2 log Y )] = mlog Y (2)
= exp 2 + 2 2


so that
V ar (Y ) = exp 2 + 2 exp 2 1 .
  

 
If Y Pareto(, x0 ) then xY0
Pareto(, 1) and log 1 + xY0 Exponential ().
Proof
 
Y
Pr y = Pr [Y yx0 ]
x0
 
x0
=1
x0 + yx0
1
=1 which is the CDF of a Pareto (, 1) random variable
(1 + y)
and
   
Y
Pr ln 1 + y = Pr [Y (ey 1)x0 ]
x0
 
x0
=1
x0 + x0 (ey 1)
= 1 ey which is the CDF of an Exp() random variable

So

E [Y ] = E [Y + x0 ] x0
 
Y
= x0 E + 1 x0
x0
   
Y
= x0 E exp 1 ln +1 x0
x0
= x0 MZ (1) x0 where Z Exponential()

= x0 x0
1
x0
=
1
Now
   
Y
E exp 2 ln +1 = MZ (2) where Z Exponential()
x0

=
2

39
ACTL3162 General Insurance Techniques Exercises

But
    " 2 #
Y Y + x0
E exp 2 ln +1 =E
x0 x0
1 
= 2 E Y 2 + 2Y x0 + x20

x0
So
 
2 x0
 2 2
E Y = x0 x0 2x0
2 1
 
2 ( 1) ( 1)( 2) 2( 2)
= x0
( 1)( 2)
2
x0
= (2( 1) 2( 2))
( 1)( 2)
2x20
=
( 1)( 2)
Then
2
2x20

x0
V ar [Y ] =
( 1)( 2) 1
2
2x0 ( 1) x20 ( 2)
=
( 1)2 ( 2) ( 1)2 ( 2)
x20 (2 2 + 2)
=
( 1)2 ( 2)
x20
=
( 1)2 ( 2)

Solution 3.4: [NLI7, Exercise]

First we find the moment generating function MY (r),


Z
c 1
MY (r) = exp(ry) y exp(cy)dy
0 ()
 Z
(c r) 1

c
= y exp[(c r)y]dy
cr 0 ()
 
c
= . (3.7)
cr
Next we find the loss size index function for level y, I(G(y))
I(G(y)) = E[Y 1{Y y} ]/Y
c y c 1
Z
= x x exp(cx)dx
0 ()
Z y
c+1
= x+11 exp(cx)dx
0 ( + 1)
Z cy
1
= z +11 exp(z)dz
( + 1) 0
= G( + 1, cy). (3.8)

40
ACTL3162 General Insurance Techniques Exercises

E[Y u|Y > u] = E[Y |Y > u] u


Z
yg(y)
= dy u
u 1 G(u)
Z Z u
yg(y) yg(y)
= dy dy u
0 1 G(u) 0 1 G(u)
E[Y 1{Y u} ]
= Y u
1 G(u)
I(G(u))
= Y 1 u (3.9)
1 G(u)

E[Y 1{u1 <Y u2 } ] = E[Y (1{Y u2 } 1{Y u1 } )]


= E[Y 1{Y u2 } ] E[Y 1{Y u1 } ]
= Y (I(G(u2 )) I(G(u1 ))). (3.10)

Solution 3.5: [los2K, Exercise] First note that with B = 5 w.p. 1, we have = E [B |I = 1] =
5 and 2 = Var[B|I = 1] = 0. We will use the decomposition of variance result that Var[X] =
Var[E[B|I]] + E[Var[B|I]]. Below, we also have that q = 0.1, which is the probability of a claim
occurring. It is then clear that
E (X) = q = 0.5
and
V ar (X) = 2 q (1 q) + 2 q = 9/4.
100
Now, if B U (0, 10), then = 5 and 2 = 12
. Thus,

E (X) = q = 0.5

and
V ar (X) = 2 q (1 q) + 2 q = 37/12.

Solution 3.6: [los4K, Exercise] Condition on I = 1 and I = 0:

mX (t) = E E eXt |I
 

= (1 q) e0 + qmX|I=1 (t)
= 1 q + qmB (t) .

Solution 3.7: [los5K, Exercise] F (x) has a jump of size 1/2 in 2 and is uniform on (2, 4), so
F is the following mixture of cdfs:
1 1
F (x) = G (x) + H (x)
2 2
with dG (2) = 1 and H Uniform(2, 4). The mixed r.v. I X + (1 I) Y has cdf F for I
Bernoulli(1/2), X 2 and Y Uniform(2, 4), independent.

41
ACTL3162 General Insurance Techniques Exercises

Solution 3.8: [los6K, Exercise] We have for the r.v. T = qX + (1 q) Y :

E (T ) = qE (X) + (1 q) E (Y )

and

E T2 = E q 2 X 2 + 2q (1 q) XY + (1 q)2 Y 2
  

= q 2 E X 2 + 2q (1 q) E (X) E (Y ) + (1 q)2 E Y 2 .
 

For the r.v. Z = IX + (1 I) Y :

E (Z) = E [IX + (1 I) Y ]
= E (I) E (X) + (1 E (I)) E (Y )
= qE (X) + (1 q) E (Y ) = E (T )

and

E Z2 = E I 2 X 2 + 2I (1 I) XY + (1 I)2 Y 2
  

= E I 2 E X 2 + 0 + E (1 I)2 E Y 2
    

= qE X 2 + (1 q) E Y 2 .
 

Note also that FZ (x) = q FX (x) + (1 q) FY (x) .

Solution 3.9: [NLI5, Exercise] Obtaining MLE for Poisson is easy and the formula is
T
1 X
M LE
P OI = PT Nt . (3.11)
t=1 vt t=1

The corresponding Chi-square statistics is


T
X (Nt M LE vt )2
P OI
2P OI = M LE
= 14.83803. (3.12)
t=1
P OI vt

We compare this value to the 95%-quantile of the Chi-square distribution with 9 degrees of
freedom 16.91898. Since the value of test statistic is smaller than the critical value, we cannot
reject the null hypothesis on the 5% significance level.
For the negative-binomial model, we do not have explicit formula for the MLE and we use
the function fitdistr(...) from the MASS package in R. Note that we can do this since vt
have uniform values of 10000, so we can find the maximum likelihood estimator for the size
parameter and divide by 100000. Theen test statistic for the negative binomial model is similar
to the Poisson one,
T
X (Nt M LE
N B vt )
2
2N B = M LE
= 1955.112. (3.13)
t=1
N B vt

This is way larger than the 95%-quantile of the Chi-square distribution with 9 degrees of
freedom 16.91898. So it is clear that the Poisson model is preferred.
R-code:

42
ACTL3162 General Insurance Techniques Exercises

# r-code for Exercise 5 in NLI


# read the table first
N.vector<-c(1000,997,985,989,1056,1070,994,986,1093,1054)
v.vector<-rep(10000,10)
# Poisson MLE estimator of Lambda
lambda.Poi<-sum(N.vector)/sum(v.vector)
# chi square test statistics
sum((N.vector-lambda.Poi*v.vector)^2/(lambda.Poi*v.vector))
# we then need the 95%-quantile of the chi-sq with 9 degrees of freedom
qchisq(0.95,9)

# package MASS is needed


library(MASS)
# use fitdistr(...) function to find the MLE
NB.fit<-fitdistr(N.vector,"negative binomial")
lambda.NB<-NB.fit$estimate[1]/10000
# chi square test statistics
sum((N.vector-lambda.NB*v.vector)^2/(lambda.NB*v.vector))

Solution 3.10: [Fit6R, Exercise] Denote the range of losses by [ai , bi ) for i = 1, 2, ...18 since
there are 18 given intervals of losses. Note that for a1 = 0 and b18 = .

1. Therefore the likelihood of the sample is given by


18
Y
L (; ai , bi , ni ) = [F (bi ) F (ai )]ni
i=1

where ni refers to the number of claims observed in the i-th range of loss. The log-
likelihood is given by
18
X
` (; ai , bi , ni ) = ni log [exp (/bi ) exp (/ai )] .
i=1

Differentiating this w.r.t. gives us


 
` (; ai , bi , ni )
18
X ni b1i exp (/bi ) + 1
ai
exp (/ai )
= =0
i=1
exp (/bi ) exp (/ai )

which can only be numerically computed. So we will use Excel to find the MLE of . In
the sheet Parameter Estimate of Fit6R.xls(x), the derivatives are computed and use
goal seek to find the MLE such that the derivative is zero. The parameter estimate for
is 93.18568.

2. In the sheet Chi-sq Test of Fit6R.xls(x), we use Excel to compute the Chi-square test
statistic 16.5232 and the associated p-value 0.34825.
It is clear that the result of the chi-square test above does support the Inverse Exponential
model for the given data. The two other tests that can be conducted are the Kolmogorov-
Smirnoff (K-S) and the Anderson-Darling (A-D) tests. Both test, similar to the chi-square

43
ACTL3162 General Insurance Techniques Exercises

test, whether the data comes from the assumed population. K-S and A-D tests are quite
similar - both look at the difference between the empirical and model dfs: K-S in absolute
value, A-D in squared difference. But A-D is weighted average, with more emphasis on
good fit in the tails than in the middle; K-S puts no such emphasis. For K-S and A-D
tests, no adjustments are made to account for increase in the number of parameters. The
result is that more complex models often will fare better on these tests. On the other
hand, the 2 test adjusts the d.f. for increases in the number of parameters. All 3 tests
are sensitive to sample size:

test statistics tend to increase when sample size increase.


large sample size therefore increases probability of rejecting all models

Solution 3.11: [NLI9, Exercise]

(a) The maximum likelihood estimators (b M LE , b


cM LE ) jointly maximise the likelihood func-
tion, which also maximise the log-likelihood function. This is the reason why we have
M LE , b
`Y (b cM LE ) > `Y (b
MM , b
cM M ). For both methods, two estimated parameters are
involved, so the MLE approach produces the smallest AIC value and is preferred.

(b) We calculate the AIC and the BIC for gamma and exponential fits,

AICexp = 2526.34 and AICgamma = 2524.34, (3.14)


BICexp = 2521.43 and BICgamma = 2514.53. (3.15)

According to both the AIC and the BIC criteria, exponential distribution is preferred
(smallest AIC/BIC).

Solution 3.12: [Fit7R, Exercise]

1. The summary of the data is provided below.

data<-read.table("liability.txt",header=T)
attach(data)
source("DataSummStats.R")
DataSummStats(liability)
Value
Number 6.800000e+02
Mean 7.416837e+04
5th Q 3.000000e+04
25th Q 3.500000e+04
Median 5.000000e+04
75th Q 7.500000e+04
95th Q 2.000000e+05
Variance 8.689669e+09
StdDev 9.321839e+04
Minimum 3.000000e+04
Maximum 1.200000e+06
Skewness 6.440000e+00
Kurtosis 5.720000e+01

44
ACTL3162 General Insurance Techniques Exercises

2. The Pareto distribution has density,



f (x) = , x1 , ..., xn > .
x+1
Using the maximum likelihood estimation, we can obtain

mle = min(x1 , ..., xn )


n
mle = Pn .
i=1 (log(xi ) log())

Substituting the data yields, mle = 30000 and mle = 2.012135. The graphical compar-
isons are shown below.

source("qpareto.R")
source("dpareto.R")
source("ppareto.R")
#MLE
lambda.hat<-min(liability)
alpha.hat<-860/sum(log(liability)-log(lambda.hat))
par.hat.p<-c(alpha.hat,lambda.hat)
par.hat.p
par(mfrow=c(2,2))

#histogram
hist(liability,breaks=100,prob=T,xlab="claims",main="Histogram of Claims")
xgrid<-seq(min(liability),max(liability),length=860)
lines(xgrid,dpareto(xgrid,par.hat.p[1],par.hat.p[2]),col=2)
legend(300000,0.00002,legend=c("Pareto Model"),lty=1,col=2)

#empirical distribution function


empirical<-ecdf(liability)
plot(xgrid,empirical(xgrid),type="l",xlab="claims",ylab="cdf",main="Empirical CDF")
lines(xgrid,ppareto(xgrid,par.hat.p[1],par.hat.p[2]),col=2)
legend(300000,0.6,legend=c("Empirical cdf","Estimated cdf"),lty=1,col=1:2)

#qqplot
plot(qpareto(empirical(liability),par.hat.p[1],par.hat.p[2]),liability,
xlab="theoretical quantiles",ylab="sample quantiles",main="Q-Q plot",cex=0.45)
abline(0,1,col=2)

#ppplot
plot(ppareto(liability,par.hat.p[1],par.hat.p[2]),empirical(liability),
xlab="theoretical probability",ylab="sample probability",main="P-P plot",cex=0.45)
abline(0,1,col=2)

45
ACTL3162 General Insurance Techniques Exercises

3. The cumulative distribution function of Weibull distribution is


k
F (x) = 1 e(x/) , x 0.

Use constrOptim function in R to find the maximum likelihood estimator, we obatin

mle = 79791.605439
kmle = 1.184008.

loglike<-function(x,par){
-sum(log(dweibull(x,par[1],par[2])))
}

init.est <- c(1,5000)


fit.wei<-constrOptim(init.est,loglike,NULL,ui=c(1,1),ci=c(0,0),x=liability)
par.hat.w<-fit.wei$par
par.hat.w
par(mfrow=c(2,2))

#histogram
hist(liability,breaks=100,prob=T,xlab="claims",main="Histogram of Claims")
xgrid<-seq(min(liability),max(liability),length=860)

46
ACTL3162 General Insurance Techniques Exercises

lines(xgrid,dweibull(xgrid,par.hat.w[1],par.hat.w[2]),col=2)
legend(300000,0.00002,legend=c("Weibull Model"),lty=1,col=2)

#empirical distribution function


empirical<-ecdf(liability)
plot(xgrid,empirical(xgrid),type="l",xlab="claims",ylab="cdf",main="Empirical CDF")
lines(xgrid,pweibull(xgrid,par.hat.w[1],par.hat.w[2]),col=2)
legend(300000,0.6,legend=c("Empirical cdf","Estimated cdf"),lty=1,col=1:2)

#qqplot
plot(qweibull(empirical(liability),par.hat.w[1],par.hat.w[2]),liability,
xlab="theoretical quantiles",ylab="sample quantiles",main="Q-Q plot",cex=0.45)
abline(0,1,col=2)

#ppplot
plot(pweibull(liability,par.hat.w[1],par.hat.w[2]),empirical(liability),
xlab="theoretical probability",ylab="sample probability",main="P-P plot",cex=0.45)
abline(0,1,col=2)

4. For the log-normal case, there are two parameters need to be estimated ( and 2 ). Use

47
ACTL3162 General Insurance Techniques Exercises

a similar method mentioned in the previous question, we obtain that

mle = 10.9373482
mle = 0.6262126

The graphical comparisons are below.

loglike<-function(x,par){
-sum(log(dlnorm(x,par[1],par[2])))
}

init.est <- c(10,0.5)


fit.ln<-constrOptim(init.est,loglike,NULL,ui=c(1,1),ci=c(0,0),x=liability)
par.hat.l<-fit.ln$par
par.hat.l
par(mfrow=c(2,2))

#histogram
hist(liability,breaks=100,prob=T,xlab="claims",main="Histogram of Claims")
xgrid<-seq(min(liability),max(liability),length=860)
lines(xgrid,dlnorm(xgrid,par.hat.l[1],par.hat.l[2]),col=2)
legend(300000,0.00002,legend=c("Lognormal Model"),lty=1,col=2)

#empirical distribution function


empirical<-ecdf(liability)
plot(xgrid,empirical(xgrid),type="l",xlab="claims",ylab="cdf",main="Empirical CDF")
lines(xgrid,plnorm(xgrid,par.hat.l[1],par.hat.l[2]),col=2)
legend(300000,0.6,legend=c("Empirical cdf","Estimated cdf"),lty=1,col=1:2)

#qqplot
plot(qlnorm(empirical(liability),par.hat.l[1],par.hat.l[2]),liability,
xlab="theoretical quantiles",ylab="sample quantiles",main="Q-Q plot",cex=0.45)
abline(0,1,col=2)

#ppplot
plot(plnorm(liability,par.hat.l[1],par.hat.l[2]),emprical(liability),
xlab="theoretical probability",ylab="sample probability",main="P-P plot",cex=0.45)
abline(0,1,col=2)

48
ACTL3162 General Insurance Techniques Exercises

5. #loglikelihood
sum(log(dpareto(liability,par.hat.p[1],par.hat.p[2])))
sum(log(dweibull(liability,par.hat.w[1],par.hat.w[2])))
sum(log(dlnorm(liability,par.hat.l[1],par.hat.l[2])))

#kolmogorov-smirnoff
max(abs(ecdf(liability)(liability)-ppareto(liability,par.hat.p[1],par.hat.p[2])))
max(abs(ecdf(liability)(liability)-pweibull(liability,par.hat.w[1],par.hat.w[2])))
max(abs(ecdf(liability)(liability)-plnorm(liability,par.hat.l[1],par.hat.l[2])))

#A-D statistics
f.p<-function(x){
860*dpareto(x,par.hat.p[1],par.hat.p[2])*(ecdf(liability)(x)
-ppareto(x,par.hat.p[1],par.hat.p[2]))^2/
(ppareto(x,par.hat.p[1],par.hat.p[2])*(1-ppareto(x,par.hat.p[1],par.hat.p[2])))
}
f.w<-function(x){
860*dweibull(x,par.hat.w[1],par.hat.w[2])*(ecdf(liability)(x)
-pweibull(x,par.hat.w[1],par.hat.w[2]))^2/
(pweibull(x,par.hat.w[1],par.hat.w[2])*(1-pweibull(x,par.hat.w[1],par.hat.w[2])))
}
f.l<-function(x){
860*dlnorm(x,par.hat.l[1],par.hat.l[2])*(ecdf(liability)(x)
-plnorm(x,par.hat.l[1],par.hat.l[2]))^2/

49
ACTL3162 General Insurance Techniques Exercises

(plnorm(x,par.hat.l[1],par.hat.l[2])*(1-plnorm(x,par.hat.l[1],par.hat.l[2])))
}
sum(f.p(seq(30001,1200000)))
sum(f.w(seq(30001,1200000)))
sum(f.l(seq(30001,1200000)))

#Chi-square statistics
n=100
interval<-seq(30000,1200000,length=n)
e.p<-c()
for(i in 1:n-1){
e.p[i]<-860*(ppareto(interval[i+1],par.hat.p[1],par.hat.p[2])
-ppareto(interval[i],par.hat.p[1],par.hat.p[2]))
}
e.w<-c()
interval<-seq(30000,1200000,length=n)
for(i in 1:n-1){
e.w[i]<-860*(pweibull(interval[i+1],par.hat.w[1],par.hat.w[2])
-pweibull(interval[i],par.hat.w[1],par.hat.w[2]))
}
e.l<-c()
for(i in 1:n-1){
e.l[i]<-860*(plnorm(interval[i+1],par.hat.l[1],par.hat.l[2])
-plnorm(interval[i],par.hat.l[1],par.hat.l[2]))
}
o<-c()
for(i in 1:n-1){
o[i]<-860*(ecdf(liability)(interval[i+1])-ecdf(liability)(interval[i]))
}
sum((e.p-o)^2/e.p)
sum((e.w-o)^2/e.w)
sum((e.l-o)^2/e.l)
We will evaluate the models based on the following table.
Model Loglikelihood K-S A-D 2
Pareto -7822.041 0.1820444 205.7854 95384.95
Weibull -8284.174 0.1876902 30.54793 37484626594
Lognormal -8083.975 0.1968117 21.46748 6058129
Using the table above, we will choose the Pareto distribution as it has the highest log-
likelihood, lowers K-S and 2 test statistics. But its high value of A-D statistic is quite
baffling and therefore not considered.

Solution 3.13: [sur12K, Exercise]


We get the same mixtures or combinations of the cdfs and slps with exponential distributions:
P (Z > d) = qed + (1 q) ed
E (Z d)+ = qed / + (1 q) ed /.
 

For the conditional distribution of Z z, given Z > z :


P (Z z > y |Z > z ) = q (z) ey + (1 q (z)) ey
with q (z) the following function:
q (z) = qez / qez + (1 q) ez .
 

q () is monotonic with q (0) = q and q () = 1 if 0 < < .

50
ACTL3162 General Insurance Techniques Exercises

Solution 3.14: [sur13, Exercise]


Z
E[(S d)+ ] = (x d)f (x)dx
d
Z Z
= xf (x)dx d f (x)dx
d d
Z Z d Z Z d
= xf (x)dx xf (x)dx d f (x)dx + d f (x)dx
0 0 0 0
Z d
= E[S] d + (d x)dF (x)
0
Z d
d
= E[S] d + [(d x)F (x)]x=0 F (x)d(d x)
0
Z d
= E[S] d + F (x)d(x)
0
Z d
= E[S] [1 F (x)]dx
0

Solution 3.15: [NLI10, Exercise]


Note that G(y) gives the cumulative distribution of the losses without reinsurance.
First for re-insurance type 1, there is a mass at zero (blue line) and this probability mass
corresponds to GY (1). This means that re-insurance type 1 is a deductible at level 1, (Y 1)+ .
For re-insurance type 2, the probability mass beyond y = 2 is zero and the distribution function
remains the same as G(y) below y = 2. Both imply that the re-insurance type 2 is a non-
proportional reinsurance contract with policy limit 2, Y 2.
For re-insurance type 3, the distribution function is the same as the original below y = 1, so
there is no re-insurance contract for this section. There is a mass at y = 2 (discontinuity in red
line) and the resulting distribution function corresponds to GY (2). This means that for claims
of size larger than 1, the re-insurance type 3 provides a deductible of level 1.

Solution 3.16: [NLI11, Exercise]

1. The claims frequency is not affected by the introduction of deductibles.

2. With the introduction of deductibles, the expected claim size will decrease.

3. Recall that E[(Y d)+ ] = P[Y > d]e(d), where d > 0 is the deductible level and e(d) is
the mean excess above d. For a log-normal distributed claim,

log d ( + 2 )
     
log d
E[(Y d)+ ] = Y 1 d 1 . (3.16)

Substituting d = 200, 500, 1000 yields E[(Y 200)+ ] = 2822.893, E[(Y 500)+ ] = 2620.95
and E[(Y 1000)+ ] = 2372.275.
R-codes:

51
ACTL3162 General Insurance Techniques Exercises

mean<-3000
vco<-4

sigma2<-log(vco^2+1)
sigma<-sigma2^(1/2)
mu<-log(mean)-sigma2/2

d<-200
mean*(1-pnorm((log(d)-mu-sigma2)/sigma))-d*(1-pnorm((log(d)-mu)/sigma))

d<-500
mean*(1-pnorm((log(d)-mu-sigma2)/sigma))-d*(1-pnorm((log(d)-mu)/sigma))

d<-1000
mean*(1-pnorm((log(d)-mu-sigma2)/sigma))-d*(1-pnorm((log(d)-mu)/sigma))

Solution 3.17: [sur14K, Exercise] Notice that


X  X  X  X
xi nd = (xi d) (xi d)+ = (xi d)+ .
+ + +

Now, replace xi by Xi and take expectations:


 X   h  i
E xi nd = nE X d + .
+

Also,
 1
V ar X = V ar (X1 ) .
n
Using the hint, for d ,

h  i   V ar X
E X d + /E (X1 d)+ .
V ar (X1 )
This leads to P 
E ( xi nd)+
  1.
E (X1 d)+
Hence, the slp for a one-year contract with retention d is about as large as the one for an n-year
period with retention nd.

Solution 3.18: [sur15, Exercise] Let S be the total annual claims paid by the insurer in the
absence of the stop-loss reinsurance, S be the total annual claims paid by the insurer in the
presence of the stop-loss reinsurance, and SR be the total annual claims paid by the reinsurance.
We have:

1. Expected total annual claims without the reinsurance:

E(S) = n q = 1000 100 0.002 = 200

and variance of total annual claims without the reinsurance:

V ar(S) = n b2 q (1 q) = 1000 1002 0.002 0.998 = 19960.

52
ACTL3162 General Insurance Techniques Exercises

2. Expected total annual claims with the reinsurance:

E(S ) = n b q = 1000 [100 (100 90)+ ] 0.002 = 180

and variance of total annual claims with the reinsurance:

V ar(S ) = n b2 q (1 q) = 1000 [100 (100 90)+ ]2 0.002 0.998 = 16168.

3. Expected total annual claims for the reinsurer:

E(SR ) = n bR q = 1000 (100 90)+ 0.002 = 20

and variance of total annual claims without the reinsurance:

V ar(SR ) = n b2R q (1 q) = 1000 (100 90)2+ 0.002 0.998 = 199.6.

Solution 3.19: [sur16R, Exercise] For the solution code, refer to solution of [los40R, Exercise]

1. Below are tables for d, E[(S d)+ ], E[((S d)+ )2 ], V ar[(S d)+ ], d = 0, 1, 2, . . . , 25.

print(c("Distribution of stop-loss premiums if N is Poisson"))


[1] "Distribution of stop-loss premiums if N is Poisson"
print(Poisson[,4:7],print.gap=3)
d E[(S-d)+] E[(S-d)+^2] Var[(S-d)+]
0 18.0000000000 454.000000000 130.000000000
1 17.0407622040 418.959237796 128.571661303
2 16.0978292895 385.820646302 126.680538467
3 15.1663097922 354.556507221 124.539554507
4 14.2547909497 325.135406479 121.936341460
5 13.3594574196 297.521158110 119.046055564
6 12.4886716496 271.673029040 115.706109469
7 11.6397107390 247.544646652 112.061780564
8 10.8208210870 225.084114826 107.993945829
9 10.0303982617 204.232895477 103.624006188
10 9.2766869917 184.925810224 98.868888682
11 8.5673901552 167.081733077 93.681559005
12 7.8896753530 150.624667569 88.377690393
13 7.2449475938 135.490044622 83.000778985
14 6.6340789981 121.611018030 77.600013876
15 6.0574949924 108.919444039 72.226198457
16 5.5162157850 97.345733262 66.917096675
17 5.0096373915 86.819880085 61.723413291
18 4.5387041817 77.271538512 56.671702863
19 4.1017018776 68.631132453 51.807174160
20 3.6992547622 60.830175813 47.145690017
21 3.3292385667 53.801682484 42.717853050
22 2.9879389459 47.484504971 38.556725827
23 2.6745280175 41.822038008 34.668937892
24 2.3877410250 36.759768966 31.058461763
25 2.1264373905 32.245590550 27.723854574

print(c("Distribution of stop-loss premiums if N is Negative Binomial"))


[1] "Distribution of stop-loss premiums if N is Negative Binomial"
print(NegBin[,4:7],print.gap=3)
d E[(S-d)+] E[(S-d)+^2] Var[(S-d)+]
0 18.00000000 535.0000000 211.0000000
1 17.09525987 499.9047401 207.6568301

53
ACTL3162 General Insurance Techniques Exercises

2 16.21168860 466.5977917 203.7789445


3 15.34164188 435.0444612 199.6784858
4 14.49603081 405.2067885 195.0718792
5 13.66814123 377.0426165 190.2245318
6 12.86859214 350.5058831 184.9052195
7 12.09161076 325.5456802 179.3386293
8 11.34760558 302.1064638 173.3383114
9 10.63176435 280.1270939 167.0926806
10 9.95437163 259.5409579 160.4514433
11 9.32218787 240.2643984 153.3612117
12 8.71665314 222.2255574 146.2455154
13 8.13869304 205.3702112 139.1318868
14 7.58859823 189.6429200 132.0560968
15 7.06644148 174.9878802 125.0532850
16 6.57275805 161.3486807 118.1475323
17 6.10673999 148.6691827 111.3769094
18 5.66900677 136.8934359 104.7557981
19 5.25781821 125.9666109 98.3219586
20 4.87370111 115.8350916 92.0821292
21 4.51463981 106.4467507 86.0647781
22 4.17744116 97.7546697 80.3036551
23 3.86159068 89.7156379 74.8037554
24 3.56626265 82.2877846 69.5695553
25 3.29074389 75.4307780 64.6017827

print(c("Distribution of stop-loss premiums if N is Binomial"))


[1] "Distribution of stop-loss premiums if N is Binomial"
print(Bin[,4:7],print.gap=3)
d E[(S-d)+] E[(S-d)+^2] Var[(S-d)+]
0 1.800000e+01 4.135000e+02 8.950000e+01
1 1.701680e+01 3.784832e+02 8.891185e+01
2 1.604479e+01 3.454216e+02 8.798634e+01
3 1.508165e+01 3.142952e+02 8.683907e+01
4 1.413351e+01 2.850800e+02 8.532380e+01
5 1.319920e+01 2.577473e+02 8.352842e+01
6 1.228477e+01 2.322633e+02 8.134766e+01
7 1.139022e+01 2.085883e+02 7.885132e+01
8 1.052165e+01 1.866765e+02 7.597125e+01
9 9.680273e+00 1.664745e+02 7.276686e+01
10 8.872400e+00 1.479219e+02 6.920238e+01
11 8.106065e+00 1.309434e+02 6.523512e+01
12 7.374416e+00 1.154629e+02 6.108090e+01
13 6.679437e+00 1.014091e+02 5.679419e+01
14 6.022823e+00 8.870681e+01 5.243241e+01
15 5.405522e+00 7.727846e+01 4.805880e+01
16 4.829187e+00 6.704376e+01 4.372271e+01
17 4.293645e+00 5.792092e+01 3.948554e+01
18 3.800209e+00 4.982707e+01 3.538548e+01
19 3.347468e+00 4.267939e+01 3.147385e+01
20 2.936074e+00 3.639585e+01 2.777532e+01
21 2.564032e+00 3.089575e+01 2.432149e+01
22 2.227323e+00 2.610439e+01 2.114343e+01
23 1.924682e+00 2.195239e+01 1.824799e+01
24 1.654269e+00 1.837344e+01 1.563683e+01
25 1.414363e+00 1.530480e+01 1.330438e+01

2. As we have discussed in Exercise 1.31, the variability of S is different under different


assumption. If the portfolio has a bigger variance(more risk), then the stop-loss premium
will be higher. Hence we will expect the most stop-loss premium for the most variable

54
ACTL3162 General Insurance Techniques Exercises

portfolio, i.e. the negative binomial case. We will expect the least stop-loss premium for
the least variable portfolio, i.e. the binomial case. Illustration by the diagram below.

Stoploss Premium

15
E[(Sd)+]

10

Poi
NegBin
Bin
5
0

0 20 40 60 80

55
Module 4

Approximations for Compound


Distributions

4.1 Approximations
Exercise 4.1: [los29, Solution] [2004 Final Exam Question] For a specific type of insurance
risk, the claim amount X is being modeled as the product of two random variables I and B as

X = I B,

where I is the claim indicator random variable and B is the random variable representing the
amount of the claim, conditional on the event that a claim occurs.
Now, assume that the probability that a claim occurs is P (I = 1) = q, or otherwise, the
probability that no claim occurs is P (I = 0) = 1 q. Furthermore, denote by and 2 to be
the mean and the variance of B, respectively.

1. Show that the mean and variance of X are given by

E (X) = q and V ar (X) = q 2 + q (1 q) 2 .

2. Suppose that B can be expressed as

B =bZ

where b is a fixed constant and Z is a Poisson random variable with parameter , so that
B takes possible values of 0, b, 2b, 3b, and so on. Determine expressions for the mean,
variance, and probability distribution of X in terms of the parameters , q, and b.

3. Consider further two types of the above risk:

Risk Claim Parameters


Type Random Variable

A XA b = 1, = 1.5, q = 0.1
B XB b = 2, = 1.0, q = 0.2

Given that the two types of risk are independent, use the convolution formula to calculate
the probability that XA + XB is greater than 3. Do not use any approximations.

56
ACTL3162 General Insurance Techniques Exercises

4. Consider a portfolio of 100 independent Type A risks (above). Use the Normal (Central
Limit Theorem) approximation to calculate the probability that the average claim amount
per risk is greater than 0.5.

Exercise 4.2: [NLI12, Solution][?, Exercise 12] Assume that S has a compound Poisson dis-
tribution with expected number of claims v > 0 and claim size distribution G having finite
third moment.

1. Prove that the fit of moment approximation for a translated gamma distribution for X
provides the following system of equations

E[Y13 ]
vE[Y1 ] = k + /c, vE[Y12 ] = /c2 and = 2 1/2 . (4.1)
(v)1/2 E[Y12 ]3/2

2. Solve this system of equations for k R, > 0 and c > 0 (assume that G(0) = 0).

Exercise 4.3: [los31K, Solution] [?, Problem 3.6.1] Assume S is compound Poisson distributed
with parameter = 12 and uniform(0, 1) distributed claims. Approximate Pr[S < 10] with the
CLT approximation, the translated gamma approximation and the NP approximation.

Exercise 4.4: [los32K, Solution] [?, Problem 2.5.9] An insurers portfolio contains 2000 one-
year life insurance policies. Half of them are characterised by a payment b1 = 1 and a probability
of dying within 1 year of q1 = 1%. For the other half, we have b2 = 2 and q2 = 5%. Use the CLT
to determine the minimum safety loading, as a percentage, to be added to the net premium
to ensure that the probability that the total payment exceeds the total premium income is at
most 5%.

Exercise 4.5: [los33K, Solution] [?, Problem 2.5.13] A portfolio consists of two types of con-
tracts. For type k, k = 1, 2, the claim probability is qk and the number of policies is nk . If
there is a claim, then its size is x with probability pk (x):

nk qk pk (1) pk (2) pk (3)


Type 1 1000 0.01 0.5 0 0.5
Type 2 2000 0.02 0.5 0.5 0

Assume that the contracts are independent. Let Sk denote the total claim amount of the
contracts of type k and let S = S1 + S2 . Calculate the expected value and the variance of a
contract of type k, k = 1, 2. Then, calculate the expected value and the variance of S. Use the
CLT to determine the minimum capital that covers all claims with probability 95%.

Exercise 4.6: [los34, Solution] We want to approximate the individual model Se by a collective
model S. Show that j = ln(1 qj ) yields both a larger expectation and a larger variance
than the ones of S.
e For both cases, compare Pr[Ii = j] and Pr[Ni = j], j = 0, 1, 2, . . . in both
models as well as the cdfs of Ii and Ni .

Exercise 4.7: [los35K, Solution] [?, Problem 3.7.2] Consider a portfolio of 100 one-year life
insurance policies. 25 policies have insured amounts 1 and probability dying within this year
0.01, 25 policies have insured amounts 1 and probability dying within this year 0.02, 25 policies
have insured amounts 2 and probability dying within this year 0.01 and 25 policies have insured
amounts 2 and probability dying within this year 0.02.

57
ACTL3162 General Insurance Techniques Exercises

Determine the expectation and the variance of the total claims S. e Choose an appropriate
compound Poisson distribution S to approximate S and compare the expectations and the
e
variances. Determine for both S and Se the parameters of a suitable approximating translated
gamma distribution.

Exercise 4.8: [los37R, Solution][R ] Develop a function that will return and print (if the user
wishes so) the following approximations of Pr[S s] in function of the first three central
moments, as well as 1 and 2 :

Normal Power 1 (CLT)

Normal Power 2

Edgeworth 1 (first 2 terms)

Edgeworth 2 (first 3 terms)

Edgeworth 3 (first 4 terms)

translated gamma

Note: Edgeworths approximation(each term improves the accuracy):


" #
S E[S] 1 2 2
Pr p z (z) (3) (z) + (4) (z) + 1 (6) (z),
V ar(S) 6 24 72

where () denotes the standard normal distribution, and

dk
(k) (x) = (x).
dxk
Note
1 1 2
(1) (x) = (x) = e 2 x
2
(2) (x) = x(x)
(3) (x) = (x2 1)(x)
etc. . .

Application of this function to an inverse Gaussian( = 2, = 4) (moments as in the previous


exercise) with s = 0.6 should yield:

Approximations for Pr[X<=0.6]


NP1 NP2 EW1 EW2 EW3 TG
Pr[X<=0.6] 0.6113513 0.7037253 0.7360268 0.8349541 0.7386938 0.728984

Exercise 4.9: [los41R, Solution][R ] [From Assignment question3, 2008]


This question is a follow-up Exercise 4.18

1. For each of the three cases i = 1, 2, 3, give the true value of Pr(Si > 50) as well as its
CLT, translated gamma and normal power approximations.

2. Interpret your results (compare the three assumptions i = 1, 2, or 3).

58
ACTL3162 General Insurance Techniques Exercises

4.2 Algorithms for compound distributions


Exercise 4.10: [los24, Solution] Determine a and b for the (a, b) family (Poisson, negative
binomial and binomial), also called Panjer distributions (see MW Definition 4.6).

Exercise 4.11: [los25, Solution] Let S compound Poisson( = 2, p(x) = x/10), x =


1, 2, 3, 4. Determine fS (s) for s = 0, 1, 2, 3, 4. using Panjers recursion algorithm.

Exercise 4.12: [los26, Solution] Check the results of Exercise 2.5 using Panjers recursion
algorithm.

Exercise 4.13: [los27, Solution] The individual claim amount distribution has the following
distribution:
x P (X = x)
1 0.2
2 0.2
3 0.2
4 0.4
Determine fS (s) for s = 0, 1, 2, 3, 4:

1. if S is compound Poisson with parameter = 1, and

2. if S is compound Negative Binomial with parameters (r = 2, p = 0.2).

Exercise 4.14: [los28, Solution] Let p(x) be Poisson(1). Verify that pn (x) using de Prils
algorithm will yield the exact probabilities of a Poisson(n) random variable for x = 0, 1, 2, 3.

Exercise 4.15: [los30R, Solution][R ] Develop a function for Panjers recursion that returns
fS (x) and FS (x), and this in function of a, b, fX (x) and fS (0). In addition, the function should
allow for the choice (type below) between computing

the first s (vartype below) recursion to get up to fS (s), or

whatever number of values that is necessary in order to have all FS (x) < 1  and the
first > 1 . ( vartype below)

Finally, the function should also allow its user to print fS (x) and FS (x) for all the recursions
that were performed (binary print below). The function could then begin in the following
way:

Panjer <- function(a,b,fX,fS0,type,vartype,print) {

[code omitted ^]

Exercise 4.16: [los38R, Solution][R ] Develop a function that will discretise a continuous dis-
tribution in m steps of length h, in function of its pdf or cdf. One possible beginning is

discretisation <-function(densityorcdf,type,h,m){

59
ACTL3162 General Insurance Techniques Exercises

where densityorcdf is a function and where type is binary and defines if densityorcdf if
a cdf (1) or a density (0).
The following codediscretisation of a gamma( = 2, = 4)
pmf<-discretisation(function(x){16*x*exp(-4*x)},0,0.002,1500)
plot(pmf)

should yield the following plot:


0.0030
0.0025
0.0020
0.0015
pmf

0.0010
0.0005
0.0000

0 500 1000 1500

Index

Exercise 4.17: [los39R, Solution][R ] Let S compound Poisson( = 20, p(x) = 0.2e0.2x ).
We are interested in determining Pr[S 150]. Use the functions developed in the previous
exercises to compute all 6 approximations mentioned in Exercise 4.8, as well as the equivalent
probability using Panjers recursion after having discretised p(x) with h = 0.01 and m =
5000. Calculate the deviation between the approximations and the probability calculated with
Panjers recursion.
Here are the outputs you should get:
Approximations for Pr[X<=150]:
NP1 NP2 EW1 EW2 EW3 TG Panjer
Pr[X<=150] 0.9430769 0.93132 0.9295227 0.9306522 0.93277 0.9325275 0.9323526

Deviation with Panjer probability:


NP1 NP2 EW1 EW2 EW3 TG Panjer
Pr[X<=150] 0.01072422 -0.001032627 -0.002829964 -0.001700449 0.0004173918 0.0001748720 0

Exercise 4.18: [los40R, Solution][R ] [From Assignment question3, 2008]


Let
0.2 if x = 0,

0.1 if x {1, 3, 5, 7, 9, 10},

Pr(Xj = x) =

0.05 if x {2, 4, 6, 8}, and
0 otherwise,

and
Si = X1 + X2 + . . . + XNi , i = 1, 2, 3

60
ACTL3162 General Insurance Techniques Exercises

with

N1 Poisson(1 = 4),
N2 Neg Bin(r2 = 4, p2 = 0.5), and
N3 Bin(n3 = 8, p3 = 0.5),

and X1 , X2 , . . . , Xj , . . . , Ni are mutually independent for i = 1, 2, 3.

1. Using Panjers recursion formula, prepare a table for each of the cases i = 1, 2 and 3
including:

x, fS (x), FS (x), x = 0, 1, 2, . . . , 25

2. Compute the following moments for X and Si , i = 1, 2, 3:

E[()k ], k = 1, 2, 3
E[( E[])k ], k = 2, 3
1 ()

For the moments of Si , use the distribution of Si you computed with Panjers recursion
formula (after an appropriate number of recursions).

3. Interpret your results in part 1 and 2 (compare the three assumptions, i = 1, 2 or 3).

4.3 Solutions
Solution 4.1: [los29, Exercise] This was a Year 2004 final exam question.

1. Applying law of iterated expectations, we find

E (X) = E [E (X |I )] = E (X |I = 1) P (I = 1) = qE (B) = q

and applying variance formula using conditionals, we have

V ar (X) = V ar [E (X |I )] + E [V ar (X |I )]
= [E (B)]2 V ar (I) + qV ar (B)
= q (1 q) [E (B)]2 + qV ar (B)

after noting that E (X |I ) = E (B) I, V ar (X |I = 1) = V ar (B |I = 1) = V ar (B), and


V ar (X |I = 0) = 0. Thus, we have

V ar (X) = q (1 q) 2 + q 2 .

2. First, notice that E (Z) = V ar (Z) = so that

E (X) = qb

and
V ar (X) = q (1 q) b2 2 + qb2 .

61
ACTL3162 General Insurance Techniques Exercises

Next, since Z is Poisson, the m.g.f. of B is

mB (t) = exp ebt 1


 

and the m.g.f of X is then

mX (t) = E[etx ]
= E[etIB ]
= E[etIB |I = 1]P (I = 1) + E[etIB |I = 0]P (I = 0)
= E[etIB ]q + 1 (1 q)
bt 1)
= qe(e + (1 q)

X k ekbt
= qe + (1 q)
k=0
k!


X k kbt
= (1 q) + qe + qe e .
k=1
k!

The distribution of X can be identified by using the 1-1 correspondence between distri-
bution and mgf, i.e. by matching

X
mX (t) = E[etX ] = ety P (t = y)
y=0

with the expression above. Thus, by carefully selecting coefficients of eXt , we find

P (X = 0) = (1 q) + qe

and
x
P (X = bx) = qe , for x = 1, 2, 3, ...
x!
3. Notice that XA takes possible values 0, 1, 2, ... while XB takes possible values 0, 2, 4, ...
Now, doing the convolution for XA + XB , we have
(1) (2) (3) (4) (6)
x P (XA = x) P (XB = x) P (XA + XB = x) P (XA + XB x)
= (2)*(3)
0 0.922313 0.873576 0.805710 0.805710
1 0.033470 0 0.029238 0.834949
2 0.025102 0.073576 0.089789 0.924737
3 0.012551 0 0.013427 0.938164
i 1.5 1.0
x x/2
qe1.5 (1.5)
x!
qe1 (1)
(x/2)!

Therefore, the required probability is P (XA + XB > 3) = 1 P (XA + XB 3) = 1


0.938164 = 0.061836.
4. For Type A, the mean is (per policy)

E (X) = q = 0.1 (1.5) = 0.15

and
V ar (X) = q (1 q) 2 + q = 0.3525.

62
ACTL3162 General Insurance Techniques Exercises

Thus, using Normal (CLT) approximation, we have


100
! P100 !
1 i=1 XAi 50 100 (0.15)
X
P XAi > 0.5 = P > p
100 i=1 0.3525 (100)
P100 !
i=1 XAi 50 100 (0.15)
= P > p
0.3525 (100)
= P (Z > 5.8951) = 1 P (Z 5.8951)
1 1 = 0.0

Solution 4.2: [NLI12, Exercise]

1. Let X = k + Z, where Z (, c) such that the three parameters of X fulfil

E[X] = E[S], Var(X) = Var(S) and X = S . (4.2)

Equating the first moment yields

E[S] = E[X] = vE[Y1 ] = k + /c. (4.3)

Equating the second moment (i.e. variance) yields

Var(S) = Var(X) = vE[Y12 ] = /c2 . (4.4)

Lastly equation the skewness

E[(S E[S]])3
S = X = = 2 1/2
S3
E[Y13 ]
= = 2 1/2 . (4.5)
(v)1/2 E[Y12 ]3/2

2. From equating skewness, we can first solve for

(v)E[Y12 ]3
=4 . (4.6)
E[Y13 ]2

Next from equating variance, we can solve for c

(v)E[Y12 ]3 1 E[Y12 ]
c2 = 4 = c = 2 > 0. (4.7)
E[Y13 ]2 vE[Y12 ] E[Y13 ]

Finally substituting the solved and c into equation for the expectation gives k

(v)E[Y12 ]2
k = vE[Y1 ] 2 . (4.8)
E[Y13 ]

63
ACTL3162 General Insurance Techniques Exercises

Solution 4.3: [los31K, Exercise] Note that for compound Poisson moments, it can be derived
that

E[Z] = E[X]
V ar[Z] = E[X 2 ]
E [(X E[X])3 ]
Skew[Z] =
3
3
E[X ]
=
3
where X is the severity distribution and is the frequency severity. Plugging in these expres-
sions, we have that
E (S) = 1 = 6
and
1
V ar (S) = 2 = 12 =4
3
and
3 1  3
S = 3 / = 12 / 4 = 3/8.
4
(Note that the third moment of a U (a, b) distribution is 14 (a + b)(a2 + b2 ).
CLT:
P (S < 10) P [Z < (10 6) /2] = (2) = 0.977.
Translated Gamma: Using known expressions for the skewness of a Gamma distribution (skew-
ness = 2 ), we have that = 4/ 2 = 28 49 ;. Further, it is also known that =
2
= 83 ;. Finally,
using the expression in the lecture slides, we have that the shift x0 = 2
= 4 32 .Thus,
 
2 4 8
P (S < 10) G 10 4 ; 28 ; = 0.968.
3 9 3

NP approximation: Calculating s using the expressions in the lecture notes, we have that
 
P (S < 10) P (Z < 2) 97 8 = 0.968.

Solution 4.4: [los32K, Exercise] Denote S to be the total payment. We have

S = 1000 1 0.01 + 1000 2 0.05 = 110

and
V ar (S) = 1000 12 0.01 0.99 + 1000 22 0.05 0.95 = 199.9
We know (y) = 0.95 for y = 1.645. So by letting P be equal to smallest premium income, it
should satisfy  
P 110
P Z 0.95,
199.9

therefore the premium income must be P 110 + 1.645 199.9 = 133.258, and the loading
therefore has to be at least 23.258/110 = 21.14%.

64
ACTL3162 General Insurance Techniques Exercises

Solution 4.5: [los33K, Exercise] Let X1 be a claim of type 1, then P (X1 = 0) = 1 q1 , and
P (X1 = j) = q1 p1 (j) , for j = 1, 3. So

E (X1 ) = 1 0.01 0.5 + 3 0.01 0.5 = 0.02

and
E X12 = 12 0.01 0.5 + 32 0.01 0.5 = 0.05


so that V ar (X1 ) = 0.0496. Also,

E (X2 ) = 1 0.02 0.5 + 2 0.02 0.5 = 0.03

and
E X22 = 12 0.02 0.5 + 22 0.02 0.5 = 0.05


so that V ar (X2 ) = 0.0491. Then, calculating the expected value and variance of S:

E (S1 ) = 1000 0.02 = 20, V ar (S1 ) = 1000 0.0496 = 49.6

and
E (S2 ) = 2000 0.03 = 60, V ar (S1 ) = 2000 0.0496 = 98.2
and thus
E (S1 + S2 ) = 20 + 60 = 80, V ar (S1 + S2 ) = 147.8.
This capital is p
E (S) + 1.645 V ar (S) = 99.999.

Solution 4.6: [los34, Exercise] Let S be based on j = log (1 qP j ) , bj > 0, for all j. Note
that qj < j since log (1 qj ) = qj + qj /2 + qj /3 + Since S = n1 Nj bj , so that
2 3

n
X n
X  

E (S ) = j bj > qj bj = E (S) = E Se
1 1

and n n
X X  
V ar (S ) = j b2j > qj b2j = V ar (S) > V ar Se .
1 1

Therefore, since P (Ii = 0) = 1 qi = 1 P (Ii = 1) ,

P (Ni = n) = (1 qi ) [ log (1 qi )]n /n!

which implies

P (Ni = 0) = 1 qi = P (Ii = 0)
P (Ni = 1) < P (Ii = 1)
P (Ni = 2, 3...) > P (Ii = 2, 3, ...) = 0.

Furthermore,

P (Ni = 0) = exp (i ) = exp (qi ) > P (Ii = 0)


P (Ni = 1) = qi exp (qi ) < P (Ii = 1)
P (Ni = 2, 3...) > P (Ii = 2, 3, ...) = 0.

For CDFs of Ii and Ni : should be straightforward.

65
ACTL3162 General Insurance Techniques Exercises

Solution 4.7: [los35K, Exercise] For S, e we have


  X
E Se = ni qi bi = 25 (0.01 + 0.02 + 0.02 + 0.04) = 2 14

and   X
V ar Se = ni qi (1 qi ) b2i = 3.6875
and X

e=ni qi (1 qi ) (1 2qi ) b3i / 3 = 0.906.1

Take the collective risk model: S CP = 1 12 , p (1) = p (2) = 1/2





= 2 14 ; 2 = 3.75; = 3 / (2 )3/2 = 6.75 3 = 0.93.

For Se :
= 4.871; = 1.149; x0 = 1.988.
For S :
= 4.630; = 1.111; x0 = 1.917.

Solution 4.8: [los37R, Exercise] One possible code is as follows:

Approx <- function(Mom,s,print){

#standardised s
z<-(s-Mom[1])/Mom[2]^.5

#Vector of results
aprob <- c()

# Normal Power #
################

#Normal Power 1 (CLT)


aprob <- c(aprob,pnorm(s,Mom[1],Mom[2]^.5))
#Normal Power 2
temp <- sqrt(9/Mom[4]^2+6*z/Mom[4]+1)-3/Mom[4]
aprob <- c(aprob,pnorm(temp))

# Edgeworth #
#############

#Calculating the derivatives of phi


phi<-expression(1/sqrt(2*pi)*exp(-x^2/2))
dphi<-c(phi);
for (i in 2:6){dphi <- c(dphi,D(dphi[i-1],"x"))}

#Edgeworth 1
aprob <- c(aprob,pnorm(z)-Mom[4]/6*eval(dphi[3],list(x=z)))
#Edgeworth 2
aprob <- c(aprob,as.double(aprob[3])+Mom[5]/24*eval(dphi[4],list(x=z)))
#Edgeworth 3
aprob <- c(aprob,as.double(aprob[4])+Mom[4]^2/72*eval(dphi[6],list(x=z)))

# Translated Gamma #
####################

#parameters
tgbeta <- 2*Mom[2]/Mom[3]
tgalpha <- tgbeta^2*Mom[2]
x0 <- Mom[1]-tgalpha/tgbeta

#approximation

1
Correction to the skewness formula: made on 21-9-2004.

66
ACTL3162 General Insurance Techniques Exercises

aprob <- c(aprob,pgamma(s-x0,shape=tgalpha,rate=tgbeta))

approximations <- data.frame(NP1=aprob[1],NP2=aprob[2],EW1=aprob[3],EW2=aprob[4],EW3=aprob[5],TG=aprob[6])


row.names(approximat ions) <- paste("Pr[X",as.character(s),"]",sep="")

#print results
if(print==1){
cat("Approximations for Pr[X",as.character(s),"]\n",sep="")
print(approximations)
} # end if

Solution 4.9: [los41R, Exercise] For the solution code, refer to [los40R, Exercise]

1. The following are the comparisons of the three approximation method.

print(c("Comparison of true probability and approximations for S(50)"))


[1] "Comparison of true probability and approximations for S(50)"
print(Proba,digits=5,print.gap=2)
True CLT Gamma NP
If N is Poisson 0.0091035 0.00250348 0.0103916 0.0107226
If N is Negative Binomial 0.0326376 0.01379840 0.0340177 0.0372348
If N is Binomial 0.0011910 0.00035914 0.0020282 0.0020194

2. Recall that we have computed the skewness of the distribution of S under the different
assumptions.

X S if N Poisson S if N Neg Bin S if N Binomial


Var(.) 12.25 130.000 211.00 89.500
E[(.-E[.])^3] 6.00 1050.000 3534.00 354.750
gamma(.) 0.14 0.708 1.15 0.419

We can see that under the negative binomial and Poisson assumptions of N , the coeffi-
cients of skewness of S take value of 1.15 and 0.419. When approximating S, the trans-
lated gamma method produces the most accurate results as the method uses a gamma
distribution to approximate which itself is positively skewed. The normal power method
performs quite well, while the CLT method performs very poorly.
Under the binomial assumption of N , S has a coefficient of skewness of 0.419. In this
case, the normal power method performs the best as it uses the CLT idea which preserves
certain degree of symmetry and at the same time allows for a certain degree of skewness.

Solution 4.10: [los24, Exercise] For Poisson, we have


e n  
Pr[N = n] n!
= e n1
= = 0+
Pr[N = n 1] (n1)!
n n

and thus a = 0 and b = .


For negative binomial, we have
(n+r1)! r
Pr[N = n] n!(r1)!
p (1 p)n n+r1
= (n+r2)!
= (1 p)
Pr[N = n 1] pr (1 p)n1 n
(n1)!(r1)!
 
r1
= (1 p) 1 +
n

67
ACTL3162 General Insurance Techniques Exercises

and thus a = 1 p and b = (1 p)(r 1).


For binomial, we have
m!
Pr[N = n] n!(mn)!
pn (1 p)mn mn+1 p
= m!
=
Pr[N = n 1] (n1)!(mn+1)!
pn1 (1 p)mn+1 n 1p
 
p m+1
= 1
1p n

and thus a = p/1 p and b = (m + 1)p/(1 p).

Solution 4.11: [los25, Exercise] For the compound Poisson:


s
1X
f (s) = hp (h) f (s h)
s h=1

with = 2 and p (j) = j/10 for j = 1, 2, 3, 4. Thus


1
f (s) = {.2f (s 1) + .8f (s 2) + 1.8f (s 3) + 3.2f (s 4)}
s
so that

f (0) = e2
f (1) = .2f (0) = .2e2
f (2) = .42f (0) = .42e2
and so on.

Note that f (0) will be a factor in all the f (x), x > 0. Thus, multiplying all the elements by
f (0) at the end only will be more efficient and will also prevent any rounding error (of the
evaluation of e2 ) to spread and amplify for large x.

Solution 4.12: [los26, Exercise] Note that iXi is compound Poisson with parameters (i =
i, pi (i) = 1). It follows from Theorem 12.4.1 that S is compound Poisson with parameters
= 1 + 2 + 3 = 6 and

1/6 x = 1,
2/6 x = 2,

p(x) =

3/6 x = 3,
0 elsewhere.

We can then apply Panjers recursion as usual with P r[S = 0] = e6 .

Solution 4.13: [los27, Exercise] Use Panjers recursion equation.

1. Note that p (0) = 0 so that with N Poisson(1) :

fS (0) = P (N = 0) = e1

68
ACTL3162 General Insurance Techniques Exercises

and
x
1X
fS (x) = (ax + bh) p (h) fS (x h)
x h=1
x
1X
= hp (h) fS (x h)
x h=1
1
= [0.2fS (x 1) + 0.4fS (x 2) + 0.6fS (x 3) + 1.6fS (x 4)]
x
where in the Poisson case, a = 0, b = . Therefore:

fS (1) = 0.2fS (0) = 0.2e1


1
fS (2) = [0.2fS (1) + 0.4fS (0)] = 0.22e1
2
1
fS (3) = [0.2fS (2) + 0.4fS (1) + 0.6fS (0)] = 0.241e1
3
1
fS (4) = [0.2fS (3) + 0.4fS (2) + 0.6fS (1) + 1.6fS (0)] = 0.4641e1 .
4
...

2. In this case we have

a = 1 p = 0.8 and b = (1 p)(r 1) = 0.8.

Since Pr[X = 0] = 0
fS (0) = Pr[N = 0] = pr = 0.04.
We have then
min(4,s)
X s+j
fS (s) = 0.8 p(j)fS (s j), s = 1, 2, . . . .
j=1
s

and thus

fS (1) = 0.8 2 0.2 0.04 = 0.0128


fS (2) = 0.8 {3/2 0.2 0.0128 + 2 0.2 0.04} = 0.015872
fS (3) = = 0.01959936
fS (4) = = 0.03691315
...

Solution 4.14: [los28, Exercise] Use of de Prils algorithm yields


x   1 j
n 1 X j e 1 n
p (x) = 1 (n + 1) 1 p (x j)
e j=1 x j!
x  
X j 1 n
= (n + 1) 1 p (x j).
j=1
x j!

69
ACTL3162 General Insurance Techniques Exercises

We have then

pn (0) = (p(0))n = en
pn (1) = (n + 1 1)en = nen
n2
 
n n n+12 n
p (2) = e n+ = en
2 2 2
2
n3
 
n n n+13n 2n + 2 3 n n
p (3) = e + + = en .
3 2 3 2 3! 3!

Solution 4.15: [los30R, Exercise] One possible code is as follows:

Panjer <- function(a,b,fX,fS0,type,vartype,print) {


# range of X
rX <- length(fX)-1

# initialisation of our results vectors


pmf <- c(fS0)
df <- c(fS0)

if(type==1) { # if we want the first s recursions


for(i in 1:vartype){ # i=s
temp <- sum((a+b*(1:min(i,rX))/i)*fX[(1:min(i,rX))+1]*pmf[i-(1:min(i,rX))+1])
pmf <- c(pmf, temp/(1-a*fX[1])) # we divide only at the end
df <- c(df,df[i]+pmf[i+1]) # the df...
} # end i loop
i <- vartype+1 # useful to know how many recursions we did for below
} else { # if we focus on the df
i <- 1 # since we use while, we need to create our own counter
while(df[i]<(1-vartype)){ # we can use while here
temp <- sum((a+b*(1:min(i,rX))/i)*fX[(1:min(i,rX))+1]*pmf[i-(1:min(i,rX))+1])
pmf <- c(pmf, temp/(1-a*fX[1]))
df <- c(df,df[i]+pmf[i+1])
i <- i+1 # increment the counter
# the number of recursions is simply i in this case (for below)
} # end while
}

# printing results
if(print==1) {
results <- data.frame(x=0:(i-1),fS=pmf,FS=df)
print(results)
} # end if

#returning results
array(c(pmf,df),c(i,2))
}

Note that we need to return an array now in order to be able to refer to the results as object[i,j]
with i for x and j for fS (j = 1) or FS (j = 2).

Solution 4.16: [los38R, Exercise] One possible code is as follows:

discretisation <-function(densityorcdf,type,h,m){
if(type==1) { #cdf
pmf <- c()
pmf <- c(densityorcdf(h/2))
for(i in 1:(m-1)) {
pmf <- c(pmf,densityorcdf(h*i+h/2)-densityorcdf(h*i-h/2))
}
pmf <- c(pmf,1-densityorcdf((m-.5)*h))
pmf } else { pmf <- c() #density
pmf <- c(as.double(integrate(densityorcdf,0,h/2)[1]))
for(i in 1:(m-1)) {

70
ACTL3162 General Insurance Techniques Exercises

pmf <- c(pmf,as.double(integrate(densityorcdf,h*i-h/2,h*i+h/2)[1]))


}
pmf <- c(pmf,as.double(integrate(densityorcdf,(m-.5)*h,Inf)[1]))
pmf }# end else
} # end function

Solution 4.17: [los39R, Exercise] One possible code is as follows:

# loading the functions


source("...09_IRM_tut_wk03_E12.R")
source("...09_IRM_tut_wk03_E13.R")
source("...09_IRM_tut_wk03_E14.R")
source("...09_IRM_tut_wk03_E15.R")

beta <-.2
lambda <- 20
s<-150

###########################################
# Calculate the approximate probabilities #

# Calculate the moments


cgf <- expression(lambda*((beta/(beta-t))^alpha-1))
param <- list(lambda=20,alpha=1,beta=.2)
Moments <- CMom123Gam12(cgf,param)

# Calculate the approximations


Approx<-Approx(Moments,s,0)

##########################################
# Calculate the "Panjer" probability via #
# discretisation and Panjer #

# Discretise our distribution of X


cdf <- function(x){1-exp(-beta*x)}
pmfX <- discretisation(cdf,1,0.01,5000)

# Calculate the cdf of S until s


# we need thus s/h=150*100 recursions
pmfS <- Panjer(0,lambda,pmfX,exp(lambda*(pmfX[1]-1)),1,15000,0)

# Determine the "Panjer" probability


tprob <- pmfS[15001,2]

#################
# print results #

results <- data.frame(Approx,Panjer=tprob)


cat("Approximations for Pr[X",as.character(s),"]:\n",sep="")
print(results)
cat("\n","Deviation with Panjer probability:\n",sep="")
print(results-tprob)

The plot of fS (x) shows that the distribution of S tends to be normal when is big, but the
distribution is still slightly skewed (1 = 0.474), which is why the CLT approximation performs
badly.

71
ACTL3162 General Insurance Techniques Exercises

0.00000 0.00002 0.00004 0.00006 0.00008 0.00010 0.00012


pmfS[, 1]

0 5000 10000 15000

Index

Solution 4.18: [los40R, Exercise] This is the R-code for this question.
#Assignment 2008, Question 3

################################
# Assumptions and parameters #
################################

#Distribution of losses
p <- c(.2,.1,.05,.1,.05,.1,.05,.1,.05,.1,.1)

########
#this will be the array of the moments of X, S with Poisson, S with NB, S with B
Moments <- array (dim=c(6,4))
rownames(Moments) <- c("E[.]","E[.^2]","E[.^3]","Var(.)","E[(.-E[.])^3]","gamma(.)")
colnames(Moments) <- c("X "," S if N Poisson"," S if N Neg Bin"," S if N Binomial")

# Moments of X #
####################

Moments[1,1] <- sum(c(0:(length(p)-1))*p)


Moments[2,1] <- sum(c(0:(length(p)-1))^2*p)
Moments[3,1] <- sum(c(0:(length(p)-1))^3*p)
Moments[4,1] <- Moments[2,1] - Moments[1,1]^2
Moments[5,1] <- Moments[3,1]-3*Moments[2,1]*Moments[1,1]+2*Moments[1,1]^3
Moments[6,1] <- Moments[5,1]/Moments[4,1]^(1.5)

# Initialization of parameters
P_lambda <- 4
NB_r <- 4
NB_p <- 0.5
B_n <- 8
B_p <- 0.5

#End of calculations
end <- 300

##############################################
# Distribution of S and moments of (S-d)+ #
##############################################

#this will be array for outputs about the different distributions:


Output <- array(dim=c(3,end+1,7))

72
ACTL3162 General Insurance Techniques Exercises

# index 1: Poisson / Neg. Bin. / Bin


# index 2: s+1
# index 3: "x","fs(x)","Fs(x)","d","E[(S-d)+]","E[(S-d)+^2]","Var[(S-d)+]"

# Preliminaries #
#####################

## masses at 0 = Fs(0) !!! if p(0)=0


#Output[1,1,2] <- c(exp(P_lambda*(p[1]-1)))
#Output[2,1,2] <- c(p^NB_r)
#Output[3,1,2] <- c((1-B_p)^B_n )

# masses at 0 = Fs(0) !!! if p(0)>0


Output[1,1,2] <- c( exp(P_lambda*(p[1]-1)))
Output[2,1,2] <- c( (NB_p/(1-(1-NB_p)*p[1]))^NB_r )
Output[3,1,2] <- c( ((1-B_p)+B_p*p[1])^B_n )

#Masses at 0 in Fs
Output[1,1,3] <- Output[1,1,2]
Output[2,1,3] <- Output[2,1,2]
Output[3,1,3] <- Output[3,1,2]

#Moments of S for the SL Premiums


Output[1,1,5] = P_lambda*Moments[1,1] # expectation
Output[1,1,7] = P_lambda*Moments[2,1] # variance
Output[1,1,6] = Output[1,1,7] + Output[1,1,5]^2 # second moment around the origin

Output[2,1,5] = NB_r*(1-NB_p)/NB_p*Moments[1,1]
Output[2,1,7] = NB_r*(1-NB_p)/NB_p^2*Moments[1,1]^2 + NB_r*(1-NB_p)/NB_p*Moments[4,1]
Output[2,1,6] = Output[2,1,7] + Output[2,1,5]^2

Output[3,1,5] = B_n*B_p*Moments[1,1]
Output[3,1,7] = B_n*B_p*(1-B_p)*Moments[1,1]^2+B_n*B_p*Moments[4,1]
Output[3,1,6] = Output[3,1,7] + Output[3,1,5]^2

# a-b parameters
ab <- array(dim=c(3,2))
ab[1,1] <- 0
ab[1,2] <- P_lambda
ab[2,1] <- 1-NB_p
ab[2,2] <- (NB_r-1)*(1-NB_p)
ab[3,1] <- -B_p/(1-B_p)
ab[3,2] <- (B_n+1)*B_p/(1-B_p)

sum <- c(0,0,0)

#pdf and cdf and SL premium moments for the three cases
for (i in 1:3)
{
Output[i,1,1] <- 0 # column x
Output[i,1,4] <- 0 # column d
for (s in 1:end)
{
sum[i] <- 0
for (h in 1:min(s,length(p)-1))
{
sum[i] <- sum[i] + (ab[i,1]+ab[i,2]*h/s)*p[h+1]*Output[i,s-h+1,2]
}
Output[i,s+1,1] <- s # label column x
Output[i,s+1,2] <- 1/(1-ab[i,1]*p[1])*sum[i] #fs
Output[i,s+1,3] <- Output[i,s,3] + Output[i,s+1,2] # Fs
Output[i,s+1,4] <- s # label column d
Output[i,s+1,5] <- Output[i,s,5] - 1 + Output[i,s,3] # E[(S-d)+]
Output[i,s+1,6] <- Output[i,s,6] - 2*Output[i,s,5]+1-Output[i,s,3]
Output[i,s+1,7] <- Output[i,s+1,6] - Output[i,s+1,5]^2
}
}

####################
# Moments of S #
####################

73
ACTL3162 General Insurance Techniques Exercises

# Remember: #
###############
##this will be the array of the moments of X, S with Poisson, S with NB, S with B
#Moments <- array (dim=c(6,4))
#rownames(Moments) <- c("E[.]","E[.^2]","E[.^3]","Var(.)","E[(.-E[.])^3]","gamma(.)")
#colnames(Moments) <- c("X "," S if N Poisson"," S if N Neg Bin"," S if N Binomial")

for (i in 2:4) {
Moments[1,i] <- sum(c(0:end)*c(Output[i-1,1:(end+1),2]))
Moments[2,i] <- sum(c(0:end)^2*c(Output[i-1,1:(end+1),2]))
Moments[3,i] <- sum(c(0:end)^3*c(Output[i-1,1:(end+1),2]))
Moments[4,i] <- sum((c(0:end)-Moments[1,i])^2*c(Output[i-1,1:(end+1),2]))
Moments[5,i] <- sum((c(0:end)-Moments[1,i])^3*c(Output[i-1,1:(end+1),2]))
Moments[6,i] <- Moments[5,i]/Moments[4,i]^(1.5)
}

################################
# Probability approximations #
################################

Proba <- array(dim=c(3,4))


rownames(Proba) <- c("If N is Poisson","If N is Negative Binomial","If N is Binomial")
colnames(Proba) <- c("True","CLT","Gamma","NP")

#survival function at the point:


ss <- 50

for (i in 1:3) {
Proba[i,1] <- 1-Output[i,ss+1,3]
Proba[i,2] <- 1-pnorm(ss,Moments[1,i+1],Moments[4,i+1]^.5)
Proba[i,3] <- 1-pgamma(ss-Moments[1,i+1]+2*Moments[4,i+1]^.5/Moments[6,i+1] ,
4/Moments[6,i+1]^2 , 2/Moments[6,i+1]/Moments[4,i+1]^.5)
Proba[i,4] <- 1-pnorm((9/Moments[6,i+1]^2+6*(ss-Moments[1,i+1])/Moments[4,i+1]^.5/Moments[6,i+1]+1)
^.5-3/Moments[6,i+1])
}

###################
# Print results #
###################

# Distributions and stop-loss premium #


#######################################

#End of table
prints <- 80

Poisson <- array(dim=c(prints+1,7))


rownames(Poisson) <- rep("",times=prints+1)
colnames(Poisson) <- c("x","fs(x)","Fs(x)","d","E[(S-d)+]","E[(S-d)+^2]","Var[(S-d)+]")

NegBin <- array(dim=c(prints+1,7))


rownames(NegBin) <- rep("",times= prints +1)
colnames(NegBin) <- c("x","fs(x)","Fs(x)","d","E[(S-d)+]","E[(S-d)+^2]","Var[(S-d)+]")

Bin <- array(dim=c(prints+1,7))


rownames(Bin) <- rep("",times= prints +1)
colnames(Bin) <- c("x","fs(x)","Fs(x)","d","E[(S-d)+]","E[(S-d)+^2]","Var[(S-d)+]")

for (i in 1:7) {
for (j in 1:(prints+1)) {
Poisson[j,i] <- Output[1,j,i]
NegBin[j,i] <- Output[2,j,i]
Bin[j,i] <- Output[3,j,i]
}
}

print(c("Distribution of S and stop-loss premiums if N is Poisson"))


print(Poisson,print.gap=3)
print(c("Distribution of S and stop-loss premiums if N is Negative Binomial"))
print(NegBin,print.gap=3)
print(c("Distribution of S and stop-loss premiums if N is Binomial"))

74
ACTL3162 General Insurance Techniques Exercises

print(Bin,print.gap=3)

# Moments #
###########

options(scipen=2)

print(c("Moments of the 4 distributions"))


print(Moments,digits=3)

# Probabilities #
#################

print(c("Comparison of true probability and approximations for S(50)"))


print(Proba,digits=5,print.gap=2)

# plots #
#########
mfrow=c(2,2)
plot(Poisson[,1],Poisson[,2],main="f(x) of S if N Poisson",xlab="",ylab="",col="1")
plot(NegBin[,1],NegBin[,2],main="f(x) of S if N NegBin",xlab="",ylab="",col="2")
plot(Bin[,1],Bin[,2],main="f(x) of S if N Bin",xlab="",ylab="",col="3")
plot(Poisson[,1],Poisson[,3],main="F(x) of S",xlab="",ylab="",col="1",type="l")
lines(NegBin[,1],NegBin[,3],col="2")
lines(Bin[,1],Bin[,3],col="3")

plot(Poisson[,4],Poisson[,5],type="l",col="1",main="Stop-loss Premium",xlab="d",ylab="E[(S-d)+]",)
lines(NegBin[,4],NegBin[,5],col="2")
lines(Bin[,4],Bin[,5],col="3")
legend(60,10,legend=c("Poi","NegBin","Bin"),lty=1,col=1:3)

1. Below are the tables for x, fS (x), FS (x), x = 0, 1, 2, . . . , 25.

print(c("Distribution of S if N is Poisson"))
[1] "Distribution of S if N is Poisson"
print(Poisson[,1:3],print.gap=3)
x fs(x) Fs(x)
0 0.040762203978 0.04076220
1 0.016304881591 0.05706709
2 0.011413417114 0.06848050
3 0.020000654752 0.08848116
4 0.016185312460 0.10466647
5 0.024547760130 0.12921423
6 0.021824859398 0.15103909
7 0.030071258549 0.18111035
8 0.028466826771 0.20957717
9 0.036711555213 0.24628873
10 0.044414433611 0.29070316
11 0.031582034174 0.32228520
12 0.032987043085 0.35527224
13 0.033859163507 0.38913140
14 0.034284589883 0.42341599
15 0.035304798458 0.45872079
16 0.034700813781 0.49342161
17 0.035645183751 0.52906679
18 0.033930905728 0.56299770
19 0.034555188644 0.59755288
20 0.032430919914 0.62998380
21 0.028716574671 0.65870038
22 0.027888692422 0.68658907
23 0.026623935971 0.71321301
24 0.025483357983 0.73869637
25 0.024071665116 0.76276803

print(c("Distribution of S if N is Negative Binomial"))


[1] "Distribution of S if N is Negative Binomial"
print(NegBin[,1:3],print.gap=3)
x fs(x) Fs(x)
0 0.0952598689 0.09525987
1 0.0211688598 0.11642873
2 0.0135245493 0.12995328
3 0.0244356591 0.15438894
4 0.0177214790 0.17211042
5 0.0283404926 0.20045091
6 0.0225677187 0.22301863

75
ACTL3162 General Insurance Techniques Exercises

7 0.0329761903 0.25599482
8 0.0281639543 0.28415877
9 0.0384485051 0.32260728
10 0.0452089616 0.36781624
11 0.0266490320 0.39446527
12 0.0275746285 0.42203990
13 0.0278652951 0.44990519
14 0.0279380518 0.47784325
15 0.0284733228 0.50631657
16 0.0276653689 0.53398194
17 0.0282848455 0.56226678
18 0.0265446534 0.58881144
19 0.0270714614 0.61588290
20 0.0250558092 0.64093871
21 0.0218626373 0.66280134
22 0.0213481731 0.68414952
23 0.0205224539 0.70467197
24 0.0198092739 0.72448125
25 0.0189021953 0.74338344

print(c("Distribution of S if N is Binomial"))
[1] "Distribution of S if N is Binomial"
print(Bin[,1:3],print.gap=3)
x fs(x) Fs(x)
0 1.679616e-02 0.01679616
1 1.119744e-02 0.02799360
2 8.864640e-03 0.03685824
3 1.500768e-02 0.05186592
4 1.382022e-02 0.06568614
5 1.988766e-02 0.08557380
6 1.986838e-02 0.10544218
7 2.599662e-02 0.13143879
8 2.717911e-02 0.15861790
9 3.350957e-02 0.19212747
10 4.153728e-02 0.23366474
11 3.468674e-02 0.26835149
12 3.666887e-02 0.30502036
13 3.836575e-02 0.34338611
14 3.931281e-02 0.38269892
15 4.096584e-02 0.42366476
16 4.079371e-02 0.46445847
17 4.210595e-02 0.50656442
18 4.069388e-02 0.54725830
19 4.134746e-02 0.58860576
20 3.935274e-02 0.62795850
21 3.533203e-02 0.66329053
22 3.406891e-02 0.69735943
23 3.222769e-02 0.72958712
24 3.050720e-02 0.76009432
25 2.843743e-02 0.78853176

2. The following are moments for X and Si , i = 1, 2, 3:

options(scipen=2)
print(c("Moments of the 4 distributions"))
[1] "Moments of the 4 distributions"
print(Moments,digits=3)
X S if N Poisson S if N Neg Bin S if N Binomial
E[.] 4.50 18.000 18.00 18.000
E[.^2] 32.50 454.000 535.00 413.500
E[.^3] 262.50 13902.000 20760.00 11019.750
Var(.) 12.25 130.000 211.00 89.500
E[(.-E[.])^3] 6.00 1050.000 3534.00 354.750
gamma(.) 0.14 0.708 1.15 0.419

76
ACTL3162 General Insurance Techniques Exercises

3. Firstly recall that

N1 Poisson(1 = 4),
N2 Neg Bin(r2 = 4, p2 = 0.5), and
N3 Bin(n3 = 8, p3 = 0.5).

The random variables N1 , N2 and N3 all have the expected value of 4. But their variances
are different. N1 has variance of 4, N2 has variance of 8 and N3 has variance of 2. Recall
that N in the collective risk model is the random variable that represents the number of
claims in a portfolio. The variability of this random variable will play a vital role in the
distribution of S. We will illustrate this using the following graphs.

Binomial Poisson
0.04

0.04
0.03

0.03
Poisson[1:81, 2]
0.02

0.02
0.01

0.01
0.00

0.00

0 20 40 60 80 0 20 40 60 80

Bin[1:81,
Negative 1]
Binomial Poisson[1:81,
Distribution 1]
functions
1.0
0.08

0.8
Poisson[1:81, 3]
0.06

0.6
0.04

0.4
0.02

0.2
0.00

0 20 40 60 80 0 20 40 60 80

The first three graphs represent the distribution of S under each assumption of Ni , i =
1, 2, 3. Notice that under the negative binomial assumption, S has a big tail. Under the
Poisson assumption, the tail is smaller. Under the binomial assumption, the tail is the
smallest. This is caused by the different values of variance of the random variables Ni
under different assumptions. Under the negative binomial assumption, N has the largest
variance. Therefore this causes a large variability in the entire portfolio which is reflected
by the big tail.

77
ACTL3162 General Insurance Techniques Exercises

This idea is reinforced by the fourth graph, which is the cumulative distribution function
under each assumptions of Ni , i = 1, 2, 3. We notice that, under the negative binomial
assumption (red line), more probabilities are assigned to the larger values of x. In com-
parison, for the binomial assumption, more probabilities are assigned to small values of
x.

78
Module 5

Solvency and Ruin Theory

5.1 Solvency considerations

5.2 Ruin theory in discrete time


Exercise 5.1: [sur2, Solution] An insurance company has a portfolio of policies with the
following characteristics:

initial surplus is 1.0;

individual claim amounts have distribution


x p (x)
2 0.2
4 0.5
6 0.3

one claim occurs at each of time 1, 2, 3, ...; and

premiums are paid at the beginning of each period.

Determine the smallest relative security loading the insurer can choose so that it is certain
that ruin does not occur at time 1.

5.3 Ruin theory in continuous time


Exercise 5.2: [sur3, Solution] Show that all these expressions are equivalent (to determine R)

1 + (1 + )p1 r = mX (r) (1)


+ r = mX (r) (2)
Z
[erx (1 + )] [1 P (x)]dx = 0 (3)
0
er = E[erS(1) ] (4)

where p1 = E(X).

79
ACTL3162 General Insurance Techniques Exercises

Exercise 5.3: [sur4, Solution] Show that


E eRC(t) = eRc0 .
 

Exercise 5.4: [sur5A, Solution] [?, Exercise 13.5] Calculate


lim R
0

and
lim R

Exercise 5.5: [sur6A, Solution] [A Exercise 13.6] Use


1
erx > 1 + rx + (rx)2 , r > 0, x > 0 (1)
2
to show that
2p1
R< ,
p2

Exercise 5.6: [sur7, Solution] Suppose that claims form a compound Poisson process, with
= 1 and p (x) = 1 for 0 < x < 1.
Premiums are received continuously at the rate of c = 1.
Find the adjustment coefficient if proportional reinsurance is purchased with a retention = 0.5
and with reinsurance loading equal to 100%.

Exercise 5.7: [sur8, Solution] An insurance company has aggregate claims that have a com-
pound Poisson distribution with:

= 2;
p (x) = 1/2, 0 x 2; and
premium collection rate is 6.

The insurer buys a proportional reinsurance that reimburses 20% of each individual claim.
The adjustment coefficient with reinsurance is 1.75. Determine the reinsurance loading.

Exercise 5.8: [sur9R, Solution][R ] Let Pr[X = x] = 14 , x = 0, 1, 2, 4, and let = 1.

1. Find R if c = 3.
2. Plot R for = i/100, i = 1, 2, . . . , 100.

Exercise 5.9: [sur10R, Solution][R ] Consider Exercise 5.6 above. Assume now that = 0.60
(where this is the loading of the insurer). Find the optimal that will minimise the probability
of ruin and plot R for = 0.5 + i/100, i = 1, 2, . . . , 49.

Exercise 5.10: [sur11, Solution] Consider a Brownian motion process with drift and volatil-
ity 2 . Using the moment generating function to show that the Brownian motion can be
approximated by a shifted Poisson process { N (t) t, t 0}.
[Hint: you need to determine (, , ) and c(, , )]

80
ACTL3162 General Insurance Techniques Exercises

Exercise 5.11: [sur12R, Solution][R ] Implement in R the approximation of the Brownian


motion by a shifted Poisson process as seen in Exercise 5.10. Plot your process for a number
of jumps equal to three times (approximately three units of time).
If you set the seed for your exponential pseudo-random variables to 12345 (use set.seed(12345))
and if = 0.03, = 3 and = 6, you should get the following graph:

Approximation of a Brownian Motion


20
15
10
W(t)

5
0

0.0 0.5 1.0 1.5 2.0 2.5 3.0

5.4 Dependence modelling and copulas


Exercise 5.12: [cop1, Solution] Suppose (X1 , X2 ) has a bivariate distribution function de-
scribed by
(     1/ )
1 1
P (X1 x1 , X2 x2 ) = exp log + log
1 ex1 1 ex2
for some 1.

1. Derive the marginal distributions of X1 and X2 .


2. Express the bivariate joint distribution as a copula function and show that this copula
belongs to the class of Archimedean copulas. Identify the generator.
3. For what value of do you have the case of independence?

Exercise 5.13: [cop2, Solution] Let Y1 and Y2 be two (underlying) lifetimes with distribution
functions H1 and H2 . Suppose there exists independent rv Z Exp() that represents the
time until a common disaster. Assume both lives are subject to the same disaster, so that the
age-at-death random variables X1 and X2 are given by
X1 = min (Y1 , Z) and X2 = min (Y2 , Z) .
Additionally assume that Y1 Exp(1 ) and Y2 Exp(2 ).

81
ACTL3162 General Insurance Techniques Exercises

1. Derive the marginal distributions for X1 and X2 .


2. Derive the joint distribution function of (X1 , X2 ). Express your answer in the form of a
copula. This form of the copula is sometimes referred to as the Marshall-Olkin copula.

Exercise 5.14: [cop3, Solution] Let (X1 , X2 ) be a bivariate random vector with distribution
function described by a copula as
P (X1 x1 , X2 x2 ) = C (P (X1 x1 ) , P (X2 x2 ))

1. Express the distribution function of min (X1 , X2 ) in terms of the copula.


2. Express the distribution function of max (X1 , X2 ) in terms of the copula.

Exercise 5.15: [cop4, Solution] Consider the case of the bivariate Normal copula written as
C (u1 , u2 ) = 1 (u1 ) , 1 (u2 )


where denotes the joint distribution function of a bivariate standard Normal as given by
Z x2 Z x1
1 s2 + t2 2st
 
1
(x1 , x2 ) = p exp dsdt.
2 1 2 2 (1 2 )

1. Prove that we can re-write the equivalent form of the bivariate Normal copula as
Z u1 !
1 (u2 ) 1 (z)
C (u1 , u2 ) = p dz.
0 1 2

2. Prove that the bivariate Normal copula generates the bivariate Normal distribution if and
only if the marginals are standard Normal.
3. Find an expression for the copula density
2 C (u1 , u2 )
c (u1 , u2 ) =
u1 u2
and explain the significance of the copula density.

Exercise 5.16: [cop5R, Solution][R ] The loss and ALAE recorded for each of 24 claims are
provided in the table below:
Loss ALAE Loss ALAE

1,500 301 11,750 2,530


2,000 3,043 12,500 165
2,500 415 14,000 175
2,500 4,940 14,750 28,217
4,500 395 15,000 2,072
5,000 25 17,500 6,328
5,750 34,474 19,833 212
7,000 50 30,000 2,172
7,000 10,593 33,033 7,845
7,500 50 44,887 2,178
9,000 406 62,500 12,251
10,000 1,174 210,000 7,357

82
ACTL3162 General Insurance Techniques Exercises

Assume that loss has a Pareto distribution with density of the form


fLoss (x) = for x > 0
(x + )+1
and that ALAE has a Gamma distribution with density of the form
1 x
fALAE (x) = x e for x > 0.
()

1. Write an R code to estimate the parameters, together with their standard errors, assuming
loss and ALAE are independent random variables.

2. Re-write your R code to estimate the parameters, together again with their associated
standard errors, assuming this time that loss and ALAE follow a Frank copula with the
form  !
1 eu1 1 eu2 1
C (u1 , u2 ) = log 1 + for 6= 0.
e 1

3. Based on the results of your model estimation, is there evidence to support that loss and
ALAE are not independent?

Exercise 5.17: [cop6R, Solution][R ] [Assignment question 3, 2009]


The following algorithm generates random variates (u, v) from a Farlie-Gumbel-Morgenstern
distribution with parameter :

Generate two independent uniform (0, 1) variates u, t;


p
Set a = (1 2u) 1; b = a2 4(a + 1)t

Set v = 2t/(b a)

The desired pair is (u, v).

In addition, the following algorithm generates random variates (u, v) from a Plackett distribu-
tion with parameter :

Generate two independent uniform (0, 1) variates u, t;


2 2
Set
pa = c(1 t); b = + a( 1) ; c = 2a(u + 1 u) + (1 2a); and d =
2
+ 4au(1 u)(1 ) ;

Set v = [c (1 2t)d]/2b

The desired pair is (u, v).

It can also be shown that Spearmans for a member of the Plackett family of copulas with
parameter > 0 is given by
+1 2
= ln .
1 ( 1)2
Generate 1000 random variates (u, v) from a Plackett distribution with parameter = 1. Use
R to do this, carefully documenting your code. Calculate the corresponding pair of random
variables (x, y) for a bivariate Pareto distribution; that is, with two Pareto marginals FX (x)

83
ACTL3162 General Insurance Techniques Exercises

and FY (y), each with parameters (2, 200). Repeat this exercise for parameters = 0.36 and
= 2.7. Plot your six outcomes on one page (using R), with the first column containing the
(u, v) results, and the second column containing the (x, y) results. The rows should contain
ascending values of .
Repeat the task outlined in the last paragraph, except now for random variates (u, v) from a
Farlie-Gumbel-Morgenstern distribution; the value of used should reflect an equivalent value
of Spearmans to the value of of the previous paragraph.
Comment on your results.

5.5 Solutions
Solution 5.1: [sur2, Exercise] Note that this surplus process is not a Cramer-Lundberg process
since the number of claims is not random.
The surplus process can still be expressed as C (t) = c0 + t S (t) where u = 1 and the
premium rate = E (X) (1 + ) = 4.2 (1 + ). Thus,

P (ruin at t = 1) = P (C (1) < 0)


= P (1 + 4.2 (1 + ) S (1) < 0)
= P (S (1) > 5.2 + 4.2) .

This probability is 0 if 5.2 + 4.2 6 or equivalently 0.8/4.2 = 0.2.

Solution 5.2: [sur3, Exercise] Recall that the adjustment coefficient R is the positive solution
to:
1 + (1 + ) p1 R = mX (R) .
If we multiply both sides by , we have

+ (1 + ) p1 R = mX (R)

and is equivalent to (2), since = (1 + ) p1 ,

+ R = mX (R) .

Again, from equation (1), we have

1 + (1 + ) E (X) R = E eRX


so that Z  Rx 
e 1 (1 + ) Rx dP (x) = 0.
0
This implies
Z Z x Z Z
R eRy (1 + ) R dydP (x) = R eRy (1 + ) R
   
dP (x) dy
0 0 0 y
Z
(1 P (y)) R eRy (1 + ) R dy
 
=
0
= 0.

84
ACTL3162 General Insurance Techniques Exercises

And since R 6= 0, we have (3). From (2) derived above, we have


R = [mX (R) 1]
eR = exp { [mX (R) 1]}
eR = mS(1) (R) = E eRS(1)


E eR(S(1)) = 1


1 
= log mS(1) (R)
R
which confirms (4).

Solution 5.3: [sur4, Exercise] We have


E eRC(t) = E eR[c0 +tS(t)] = eRc0 eRt E eRS(t) = eRc0 eRt E etRS(1)
       

and since eR = E[eRS(1) ] by definition (of R in Exercise 5.2),


E eRC(t) = eRc0 .
 

Solution 5.4: [sur5A, Exercise] Think of the graph of 1 + (1 + )p1 r against mX (r) seen in
lecture.
As 0, the slope of the line tends to p1 , which is exactly m0X (0). There is then only one
root, R = 0, and thus (u) = 1, u 0.
The case is less clear. As , the intersection of 1 + (1 + )p1 r with mX (r) will be
at the limit of mX (r) as r (remember that m0X (r) > 0, r > 0). But, the mgf of X is not
always defined for r [0, ). For instance, if X is exponential(), R as . On the
other hand, if X is inverse Gaussian, there will be no other root than the trivial 0 as
(see A, example 13.4.3.e on page 412).

Solution 5.5: [sur6A, Exercise] Note that the expression on the right hand side of (1) is the
beginning of Taylors
 expansion of the exponential on the left hand side. Now remember that
rX
mX (r) = E e and thus
1
1 + (1 + )p1 R = E eRX > 1 + Rp1 + R2 p2 .
 
2
Subtracting 1 on both sides, dividing by R and reorganising yields to the desired expression.

Solution 5.6: [sur7, Exercise] First, note that


Z 1
h = 2 h (x) p (x) dx = 1
0
and therefore the adjustment coefficient Rh satisfies
Z 1
eRh 1
1 + Rh = eRh ()x dx = .
0 Rh
In the absence of reinsurance ( = 1), the non-trivial solution of this equation can be shown
to be R = 1.793. But if = 0.5, it is clear that
Rh = 1.793/ (1 0.5) = 3.587.

85
ACTL3162 General Insurance Techniques Exercises

Solution 5.7: [sur8, Exercise] Since reinsurance is proportional, h (x) = (1 )x = 0.2x and
reinsurance premium is
Z 2
h = (1 + ) h (x) p (x) dx
0
= 0.4 (1 + )

where denotes the reinsurance loading. Thus, we have


Z 2
+ ( h ) Rh = eRh (xh(x)) p (x) dx
Z 02
2 + [6 0.4 (1 + )] (1.75) = 2 e1.75(0.8x) 0.5dx
0

and from which we can solve for = 110%.

Solution 5.8: [sur9R, Exercise] We solve for the positive R which is the solution to + R =
mX (R). The m.g.f. is given by
1
1 + et + e2t + e4t

mX (t) =
4
so that the equation to solve is
1
1 + eR + e2R + e4R = 0.

1 + R
4

1. If = 3, then = 3/p1 1. Since p1 = 7/4, = 5/7. The resulting R is 0.3159.

2. The resulting plot is as follows


0.4
0.3
0.2
R

0.1
0.0

0.0 0.2 0.4 0.6 0.8 1.0

theta

86
ACTL3162 General Insurance Techniques Exercises

The code used for these answers is

# create our objective function


eqR <- function(r,theta){
return(1+(1+theta)*7/4*r-(1+exp(r)+exp(2*r)+exp(4*r))/4)
}

# create a function for finding the root of eqR for given theta
fR <- function(x){
uniroot(eqR,lower=0.001,upper=2,theta=x)$root
}

# part a
R <- fR(5/7)
print(R)

# part b
plot <- c()
for(i in 1:100){plot <- c(plot,fR(i/100))} # the y values
plot(1:100/100,plot,xlab="theta",ylab="R")

Solution 5.9: [sur10R, Exercise] We have the optimal values

= 0.71 and R = 1.409.

The plot is as follows:


1.40
1.35
1.30
1.25
R

1.20
1.15
1.10

0.5 0.6 0.7 0.8 0.9 1.0

alpha

The code used for these answers is

# create our objective function

87
ACTL3162 General Insurance Techniques Exercises

eqR <- function(r,alpha){


return( 1+(alpha-.2)*r-(exp(alpha*r)-1)/alpha/r )
}

# create a function for finding the root of eqR for given theta
fR <- function(x){
uniroot(eqR,lower=0.001,upper=100,alpha=x)$root
}

# finding the optimal alpha and corresponding R


R <- optimise(fR,interval=c(0.5,0.999),maximum=TRUE)
print(R)

#plotting
plot <- c()
for(i in 1:49) plot <- c(plot,fR(.5+i/100))
plot(51:99/100,plot,xlab="alpha",ylab="R")

Solution 5.10: [sur11, Exercise] Consider the shifted Poisson process { N (t) t, t 0} and
we will match the mean and variance of the shifted Poisson process with the Brownian motion
(1 unit of time), i.e.
= and 2 = 2 . (5.1)
Solving for and yields
2 2
= and = . (5.2)
2
Next we obtain the moment generating function of process { N (t) t}
k
E ek( N (t)t) = etk E ek( N (t)) = etk et(e 1) .
   
(5.3)

Now we use Taylors series expansion on ek 1 and obtain

(k )2 (k )3
ek 1 = k + + + ... (5.4)
2! 3!
If we substitute the expansion back into (5.3) and make change of and c using (5.2), we obtain
 
2 2 (k )2 (k )3
 
tk+ 2 t k + 2! + 3! +...
E ek( N (t)t) = e
 

2 2 2
tk+tk+ tk+ 2 tk2 +o( )
= e . (5.5)

where o( ) 0 when 0. Now if we let 0, then (5.5) becomes


 2 
(t)k+ 2 t k2
E e
 k( N (t)t) 
=e , (5.6)

which is the moment generation function of a Brownian motion process with drift and volatil-
ity 2 .

Solution 5.11: [sur12R, Exercise] Here is a possible code:

88
ACTL3162 General Insurance Techniques Exercises

#model: shifted Poisson process


# = total net loss for constant claims tau
# X(t) = tau*N(t) - ct
# E[X(t)]=(tau*lambda-c) t
# Var(X(t))= tau^2 lambda t
###
# we choose lambda and c such that
# mu = tau lambda - c
# sigma^2 = tau^2 * lambda
###
# we have then
# lambda = sigma^2/tau^2
# c = sigma^2/tau - mu
# and we will let tau -> 0

#initialising parameters
mu <- 3
sigma <- 6
tau <- .03

lambda <- sigma^2/tau^2


c <- sigma^2/tau - mu

# number of jumps
num <- round(3*lambda)

# times between jumps


set.seed(12345)
times <- rexp(num,lambda)

# calculate process
Brownian <- array(c(rep(0,2*(num+1))),c(num+1,2))
for(i in 1:num){
Brownian[i+1,1] <- Brownian[i,1] + times[i]
Brownian[i+1,2] <- tau*i-c*Brownian[i+1,1]
} #end of for loop

# plot Brownian
colnames(Brownian)<-c("t","W(t)")
plot(Brownian,type="l",lwd="0.1",main="Approximation of a Brownian Motion")

Solution 5.12: [cop1, Exercise]

1. By letting x2 , we find the marginal of X1 :

F1 (x1 ) = F (x1 , ) = 1 ex1 .

Similarly, by letting x1 , we find the marginal of X2 :

F2 (x2 ) = F (, x2 ) = 1 ex2 .

Both have Exp(1) distribution.

89
ACTL3162 General Insurance Techniques Exercises

2. Let u1 = F1 (x1 ) and u2 = F2 (x2 ). We find that we can write the bivariate joint distri-
bution function as
n    o
1 1/

P (X1 x1 , X2 x2 ) = C (u1 , u2 ) = exp log u11 + log u2
n o
1/
= exp [( log u1 ) + ( log u2 ) ] .

This is the required copula function and we can indeed re-write this as

( log C) = ( log u1 ) + ( log u2 )

so that we recognize this as an Archimedean copula with generator

(u) = ( log u) .

3. Note that if we set = 1, the copula function becomes

C (u1 , u2 ) = exp { [( log u1 ) + ( log u2 )]}


= exp {log u1 + log u2 } = u1 u2

which is the case of independence.

Solution 5.13: [cop2, Exercise] Denote the marginals of X1 and X2 by F1 and F2 , respectively.

1. Thus, we see that

F1 (x1 ) = P (X1 x1 ) = P (min (Y1 , Z) x1 ) = 1 P (min (Y1 , Z) > x1 )


= 1 P (Y1 > x1 and Z > x1 ) = 1 P (Y1 > x1 ) P (Z > x1 )
= 1 exp (1 x1 ) exp (x1 ) = 1 exp ( ( + 1 ) x1 ) .

Similarly, we have that

F2 (x2 ) = P (X2 x2 ) = P (min (Y2 , Z) x2 ) = 1 P (min (Y2 , Z) > x2 )


= 1 P (Y2 > x2 and Z > x2 ) = 1 P (Y2 > x2 ) P (Z > x2 )
= 1 exp (2 x2 ) exp (x2 ) = 1 exp ( ( + 2 ) x2 ) .

2. For the joint distribution function of (X1 , X2 )0 , we have

F (x1 , x2 ) = P (X1 x1 , X2 x2 )
= P (X1 x1 ) + P (X2 x2 ) + P (X1 > x1 , X2 > x2 ) 1

where

P (X1 > x1 , X2 > x2 ) = P (min (Y1 , Z) > x1 , min (Y2 , Z) > x2 )


= P (Y1 > x1 , Y2 > x2 , Z > max (x1 , x2 ))
= P (Y1 > x1 ) P (Y2 > x2 ) P (Z > max (x1 , x2 ))
= exp (1 x1 ) exp (2 x2 ) exp ( max (x1 , x2 )) .

Therefore, it can be shown that

F (x1 , x2 ) = 1 exp ( ( + 1 ) x1 ) exp ( ( + 2 ) x2 )


+ exp (1 x1 ) exp (2 x2 ) min (exp (x1 ) , exp (x2 )) .

90
ACTL3162 General Insurance Techniques Exercises

In order to find the expression for the copula, we re-write1

P (X1 > x1 , X2 > x2 ) = exp (1 x1 ) exp (2 x2 ) exp ( max (x1 , x2 ))


= exp ( ( + 1 ) x1 ) exp ( ( + 2 ) x2 ) exp ( (x1 + x2 ))
exp ( max (x1 , x2 ))
= exp ( ( + 1 ) x1 ) exp ( ( + 2 ) x2 )
min (exp (x1 ) , exp (x2 ))
= [P (X1 > x1 )] [P (X2 > x2 )]
 
+ +
min [P (X1 > x1 )] 1 , [P (X2 > x2 )] 2

1
!
[P (X2 > x2 )] [P (X1 > x1 )] 1 + ,
= min 1
.
[P (X1 > x1 )] [P (X2 > x2 )] 2 +

We find that the required copula for the Marshall-Olkin bivariate exponential distribution
has the form

C (u1 , u2 ) = u1 + u2 1
 
1 1
+ min (1 u2 ) (1 u1 ) 1 + , (1 u1 ) (1 u2 ) 2 +

after the transformation

u1 = P (X1 x1 ) = 1 P (X1 > x1 )

and
u2 = P (X2 x2 ) = 1 P (X2 > x2 ) .

Solution 5.14: [cop3, Exercise]

1. Note that

P (min (X1 , X2 ) x) = 1 P (min (X1 , X2 ) > x)


= 1 P (X1 > x, X2 > x)
= 1 [1 P (X1 x) P (X2 x) + P (X1 x, X2 x)]
= P (X1 x) + P (X2 x) P (X1 x, X2 x)
= P (X1 x) + P (X2 x) C (P (X1 x) , P (X2 x)) .

since P (X1 x, X2 x) = P (X1 x) + P (X2 x) + P (X1 > x, X2 > x) 1

2. Similarly for the maximum, we have

P (max (X1 , X2 ) x) = P (X1 x, X2 x)


= C (P (X1 x) , P (X2 x)) .

Solution 5.15: [cop4, Exercise]


1
Corrections made as at 1 Nov 2006. Thanks to Eugenia.

91
ACTL3162 General Insurance Techniques Exercises

1. Notice that we can re-write the Normal copula as


Z 1 (u1 ) Z 1 (u2 )
1 s2 + t2 2st
 
1
C (u1 , u2 ) = p exp dsdt
2 1 2 2 (1 2 )
Z 1 (u1 ) Z 1 (u2 ) !
1 1 (s t)2 + t2 2 t2
= p exp dsdt
2 1 2 2 (1 2 )
!2
Z 1 (u1 ) Z 1 (u2 )
1 2 1 1 s t
= e 2 t p exp p dsdt
2 1 2 2 1 2

s t ds
Now apply a change of variable w = p so that dw = p and
1 2 1 2

1 1 t2 ( (u2 )t)/ 1 1
Z x1 Z 1 2  
1 2
C (u1 , u2 ) = e 2 exp w dwdt
2 2 2
Z x1
1 1 2
 p 
e 2 t 1 (u2 ) t / 1 2 dt

=
2
Now applying the transformation t = 1 (z) so that
1 1 2
dz = e 2 t dt,
2
we find that
!
u1 1 1
(u2 )
Z
(z)
C (u1 , u2 ) = p dz
0 1 2
!
u1 1 1
(u2 )
Z
(z)
= p dz.
0 1 2
Indeed this is a nice result!.
2. One direction is pretty obvious: if the marginals are standard Normal, then the bivariate
Normal copula generates a bivariate Normal distribution. Consider that
Z x1 Z x2
1 s2 + t2 2st
 
1
C (F1 (x1 ) , F2 (x2 )) = p exp dsdt
2 1 2 2 (1 2 )
which is the Normal copula with Normal marginals if and only if
1 (F1 (x1 )) = x1 and 1 (F2 (x2 )) = x2
whenever F1 = F2 = , the Normal marginals.
3. Using the canonical representation of the bivariate Normal with standard Normal marginals,
we find that2
1 x21 + x22 2x1 x2
 
1
f (x1 , x2 ) = p exp
2 1 2 2 (1 2 )
 2
1 x
= c ( (x1 ) , (x2 )) exp 1
2 2
 2
1 x
exp 2
2 2
2
Corrections made as at 3 Sep 2010. Thanks to Alex, Kieran.

92
ACTL3162 General Insurance Techniques Exercises

so that
 
x2 +x22 2x1 x2
1
exp 12 1 (1 2)
2 12
c ( (x1 ) , (x2 )) =  2  2
x x
1 exp 1 1 exp 2
2 2 2 2
 2 2 2 2

1 x1 + x2 2x1 x2
= p exp .
1 2 2 (1 2 )

Let u1 = (x1 ) and u2 = (x2 ) so that

x1 = 1 (u1 ) and x2 = 1 (u2 ) .

We therefore find the density of the Normal copula as


!
1 2 1 (u1 )2 + 2 1 (u2 )2 21 (u1 ) 1 (u2 )
c (u1 , u2 ) = p exp .
1 2 2 (1 2 )

To interpret, the copula density distorts the independence to induce the actual dependence
structure.

Solution 5.16: [cop5R, Exercise] R code for optimization of log-likelihood both the case of
independence and the case of Frank copula.

1. The following is the R code for maximizing the log-likelihood for the case of independence.

# Data analysis of the Loss-ALAE data - fitting the Independence copula.


#
# read the data file
source("DataSummStats.R")
source("dPareto.R")
source("pPareto.R")

Loss.ALAE <- read.csv("LossData-FV.csv")


attach(Loss.ALAE)

# understand and summarize the data.


DataSummStats(ALAE)

# plot LOSS vs ALAE

plot(log(Loss),log(ALAE),main="LOSS vs ALAE on a log scale",pch=20)

# to fit the Independent copula


"neg.loglik" <- function(parm,x1,x2)
{
p.lambda <- parm[1]
p.theta <- parm[2]
g.alpha <- parm[3]
g.beta <- parm[4]
f1 <- dPareto(x1,alpha=p.theta,x0=p.lambda)
f2 <- dgamma(x2,shape=g.alpha,rate=1/g.beta)

93
ACTL3162 General Insurance Techniques Exercises

log.ll <- log(f1)+log(f2)


return(sum(-log.ll))
}
init.est <- c(36000,2.6,0.75,804)

fit.Indep <- optim(init.est, neg.loglik,NULL,x1=Loss,x2=ALAE)


parm.hat <- fit.Indep\$par
loglik.Indep <- -fit.Indep\$value
AIC.Indep <- (-2*loglik.Indep+2*length(parm.hat))/length(Loss)
print(loglik.Indep)
print(fit.Indep)
print(AIC.Indep)

# next estimate the standard errors.


library(nlme)
negll.Indep.Hess <- fdHess(parm.hat, neg.loglik, x1=Loss,x2=ALAE)
inv.Indep.Hess <- solve(negll.Indep.Hess\$Hessian)
parm.se <- sqrt(diag(inv.Indep.Hess))
output <- cbind(parm.hat,parm.se) output <- round(output,digits=3)
rownames(output)<- c("lambda","theta","alpha","beta")
colnames(output)<- c("estimate","std error") print(output)

The results of the estimation, together with the standard errors are as follows:

estimate std error


lambda 32536.132 26066.697
theta 2.463 1.490
alpha 0.443 0.105
beta 12002.412 4659.556

2. The following is the R code for maximizing the log-likelihood for the case of the Frank
copula.

# Data analysis of the Loss-ALAE data - fitting the Frank copula.


#
# read the data file
source("DataSummStats.R")
source("dPareto.R")
source("pPareto.R")

Loss.ALAE <- read.csv("LossData-FV.csv")


attach(Loss.ALAE)

# understand and summarize the data.


DataSummStats(ALAE)

# to fit the Frank copula, need C12.Frank function


"C12.Frank" <- function(u1,u2,d.alpha) {
tmp1 <- exp(d.alpha)-1
tmp2 <- exp(d.alpha*(u1+u2))
tmp3 <- (exp(d.alpha*u1)-1)*(exp(d.alpha*u2)-1)
num <- d.alpha*tmp1*tmp2
den <- (tmp1+tmp3)^2

94
ACTL3162 General Insurance Techniques Exercises

return(num/den)
} "neg.loglik" <- function(parm,x1,x2) {
p.lambda <- parm[1]
p.theta <- parm[2]
g.alpha <- parm[3]
g.beta <- parm[4]
f.alpha <- parm[5]
f1 <- dPareto(x1,alpha=p.theta,x0=p.lambda)
f2 <- dgamma(x2,shape=g.alpha,rate=1/g.beta)
u1 <- pPareto(x1,alpha=p.theta,x0=p.lambda)
u2 <- pgamma(x2,shape=g.alpha,rate=1/g.beta)
f12 <- C12.Frank(u1,u2,f.alpha)
log.ll <- log(f1)+log(f2)+log(f12)
return(sum(-log.ll))
} init.est <- c(36000,2.6,0.75,804,-2.1)

fit.Frank <- optim(init.est, neg.loglik,NULL,x1=Loss,x2=ALAE)


parm.hat <- fit.Frank\$par
loglik.Frank <- -fit.Frank\$value
AIC.Frank <- (-2*loglik.Frank+2*length(parm.hat))/length(Loss)
print(loglik.Frank)
print(fit.Frank)
print(AIC.Frank)

# next estimate the standard errors.


library(nlme)
negll.Frank.Hess <- fdHess(parm.hat, neg.loglik, x1=Loss,x2=ALAE)
inv.Frank.Hess <- solve(negll.Frank.Hess\$Hessian)
parm.se <- sqrt(diag(inv.Frank.Hess))
output <- cbind(parm.hat,parm.se)
output <- round(output,digits=3)
rownames(output)<- c("lambda","theta","alpha","beta","delta")
colnames(output)<- c("estimate","std error") print(output)

The results of the estimation, together with the standard errors are as follows:

estimate std error


lambda 31682.240 23288.123
theta 2.293 1.287
alpha 0.432 0.105
beta 11699.070 4474.634
delta -2.217 1.420

3. To examine whether there is evidence of independence or not, we test


H0 : = 0
against the alternative
H0 : 6= 0
based on the Frank copula model. This is because when = 0 in the Frank copula, we
get the independence copula (verify this by taking limit!). The test statistic is


b 0 2.217 0
  =
= 1.56 < 2.

s.e.
b 1.420

95
ACTL3162 General Insurance Techniques Exercises

So therefore, we cannot reject the null hypothesis that Loss and ALAE are independent.
There is no strong evidence to support that they are not independent. Indeed, if we
examine the scatterplot between Loss and ALAE, this also helps to confirm this because
we see no evidence of any particular dependencies between Loss and ALAE.

LOSS vs ALAE on a log scale


10
8
log(ALAE)

6
4

8 9 10 11 12

log(Loss)

Solution 5.17: [cop6R, Exercise]

1. Determining the parameters of the copulas


For FGM copulas with parameter , Spearmans rho is given by = /3. We have then

parameter
Plackett FGM Type of dependence
0.36 -0.987 -0.329 negative
1.00 0.000 0.000 independence
2.70 0.962 0.321 positive

In fact, the Plackett copulas allow for stronger negative and positive dependences than
the FGM copulas, whose parameter must lie within [1, 1], whereas the Plackett can
take any positive real value. Note that
2 1 2 2 2 ln 1
= ln = .
( 1)2 ( 1)2 ( 1)2
When = 1, this expression is indeterminate. Using de lHospital rule (twice), we get
d2
2 2 ln 1 d2
(2 2 ln 1) 2 2/
lim = lim d2
= lim = 0,
1 ( 1)2 1
d2
( 1)2 1 2

which could be expected since a Plackett copula with = 1 is the independence copula.

96
ACTL3162 General Insurance Techniques Exercises

2. Generation of the Plackett variates


Here is a possible code:

# number of couples
n = 1000

# parameters
theta <- c(.36,1,2.7)

par(mfrow=c(3,2), # margins of plot


pty="s", # to have squares and not rectanges
mar=rep(3,4), # 4 margins around plots
font.lab=3, # to have italics in the labels
mgp=c(2,.5,0)) # margins around title and labels

for (i in 1:3) {
u <- runif(n) # our first independent variables set us
t <- runif(n) # our second independent variables set ts
v <- c(rep(0,n)) # initialise the vector for the vs
#algorithm to create dependent vs out of the ts with Plackett
a <- t*(1-t)
b <- theta[i]+a*(theta[i]-1)^2
c <- 2*a*(u*theta[i]^2+1-u)+theta[i]*(1-2*a)
d <- sqrt(theta[i])*sqrt(theta[i]+4*a*u*(1-u)*(1-theta[i])^2)
v <- (c-(1-2*t)*d)/2/b
# mapping marginals into Paretos
x <- 200*((1-u)^(-1/2)-1)
y <- 200*((1-v)^(-1/2)-1)
# plots for that theta
plot(cbind(u,v),
main=paste("Plot of v against u, case theta=",theta[i]),
pch=20) # for small dots
plot(cbind(x,y),
main=paste("Plot of y against x, case theta=",theta[i]),
pch=20,
xlim=c(0,800),ylim=c(0,800)) #up to the 96% quantile
} # end i loop

par() # reinitialise par() for future use - good practice

3. Generation of the FGM variates

Here is a possible code:

# number of couples
n = 1000

# parameters
theta <- c(-.987,0,.962)

par(mfrow=c(3,2), # margins of plot


pty="s", # to have squares and not rectanges
mar=rep(3,4), # 4 margins around plots

97
ACTL3162 General Insurance Techniques Exercises

font.lab=3, # to have italics in the labels


mgp=c(2,.5,0)) # margins around title and labels

for (i in 1:3) {
u <- runif(n) # our first independent variables set us
t <- runif(n) # our second independent variables set ts
v <- c(rep(0,n)) # initialise the vector for the vs
#algorithm to create dependent vs out of the ts with FGM
a <- 1+theta[i]*(1-2*u)
b <- sqrt(a^2-4*(a-1)*t)
v <-2*t/(b+a)
# mapping marginals into Paretos
x <- 200*((1-u)^(-1/2)-1)
y <- 200*((1-v)^(-1/2)-1)
# plots for that theta
plot(cbind(u,v),
main=paste("Plot of v against u, case theta=",theta[i]),
pch=20) # for small dots
plot(cbind(x,y),
main=paste("Plot of y against x, case theta=",theta[i]),
pch=20,
xlim=c(0,800),ylim=c(0,800)) #up to the 96% quantile
} # end i loop

par() # reinitialise par() for future use - good practice

4. Outputs and discussion


Scatterplots for the Plackett variates:

98
ACTL3162 General Insurance Techniques Exercises

Plot of v against u, case theta= 0.36 Plot of y against x, case theta= 0.36

800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0
0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

Plot of v against u, case theta= 1 Plot of y against x, case theta= 1

800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

Plot of v against u, case theta= 2.7 Plot of y against x, case theta= 2.7
800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

Scatterplots for the FGM variates:

99
ACTL3162 General Insurance Techniques Exercises

Plot of v against u, case theta= -0.987 Plot of y against x, case theta= -0.987

800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0
0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

Plot of v against u, case theta= 0 Plot of y against x, case theta= 0

800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

Plot of v against u, case theta= 0.962 Plot of y against x, case theta= 0.962
800
1.0
0.8

600
0.6

400
v

y
0.4

200
0.2
0.0

0.0 0.2 0.4 0.6 0.8 1.0 0 200 400 600 800
u x

100
ACTL3162 General Insurance Techniques Exercises

First, note:

the three different s considered for each copula correspond to negative dependence,
independence and positive dependence.
we are very close to the maximum negative and positive dependence possible for
FGM copulas: Spearmans rho needs to be within [1/3, 1/3] for such copulas.
Hence, the outputs give an idea of the whole spectrum of dependence FGM copulas
can offer: it is limited. . .

Comparison of u v and x y scatterplots

u v plots: in the independence cases, points are scattered in a random way and
no grouping is observed. For negative dependence, points are grouped more around
the top left and bottom right regions, whereas for positive dependence, points are
grouped more around the bottom left and top right regions, as they should be.
x y plots have been restricted to values up to 800the 96% quantile of the
Pareto(2, 200)in order to have a reasonable view of the observations. Otherwise,
displaying extreme data points results in aggregation of most of the data points
around the origin.
x y plots: if we had been presented with these plots only, it would have been im-
possible (or very difficult) to guess the structure of dependence between the random
variables, even after the modification described in the previous point. It is possible
to recognise some negative dependence when relevant (points are grouped close to
the axes and there are fewer points around the top right region) but the cases of
independence and positive dependence are not clear.
Overall it is more difficult to see the type of dependence in the x y scatterplots
than in the u v scatterplots, and this even though the marginal distributions are
the same. This shows that it is often more useful to plot probabilities rather than the
raw observations in order get some sense about the dependence structure between
random variables.

Comparison between Plackett and FGM copulas:

In both cases, positive or negative dependence are observed in both left and right
tails (there is no such thing as dependence only in one of the tails).
It seems that in the case of FGM copulas the maximum negative dependence is
weaker that the maximum positive dependence, whereas for Plackett copulas it
looks symmetrical.
If we needed a higher level of dependence than [1/3, 1/3], it would not be pos-
sible to use an FGM copula. On the other hand, the family of Plackett copulas is a
comprehensive family, that is, it can model the strongest negative and positive depen-
dence (countermonotonicity and comonotonicity copulas, respectivelythe Frechet
bounds). For instance, a Plackett can achieve a Spearmans rho of -0.8 and 0.8 if
the parameter is 0.0412 and 24.26, respectively. This is illustrated below:

101
ACTL3162 General Insurance Techniques Exercises

Plot of v against u, case theta= 0.0412 Plot of v against u, case theta= 24.26

1.0

1.0
0.8

0.8
0.6

0.6
v

v
0.4

0.4
0.2

0.2
0.0

0.0
0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0
u u

102
Module 6

Premium Calculation Techniques and


Tariffication

6.1 Premium Risk-based Principles


Exercise 6.1: [NLI13, Solution][?, Exercise 13] We would like to insure the following car fleet.
Assume that the car fleet can be modelled by a compound Poisson distribution (Vco means
(i) (i)
i vi i E[Y1 ] Vco(Y1 )
passager car 40 25% 2000 2.5
delivery van 30 23% 1700 2.0
truck car 10 19% 4000 3.0

coefficient of variation).

1. Calculate the expected claim amount of the car fleet.


2. Calculate the premium for the car fleet using the variance loading principle with =
3 106 .

Exercise 6.2: [NLI13.1, Solution] Suppose that we have two independent lines of business, S1
and S2 , who have distributions S1 CompPoi(10, G1 Exp(10)) and S2 CompPoi(20, G2
Exp(20)).

(a) Determine the distribution of the sum S = S1 + S2 .


(b) Calculate the premium using the variance loading principle: = E[S] + Var(S) using
= 0.25.
(c) Now assume
Pn that we have n lines of business (n being large), S1 , S2 , ..., Sn and the sum
S = i=1 Si . Propose a candidate for when using the standard deviation loading
principle: = E[S] + Var(S)1/2 (hint: Central Limit Theorem).

6.2 Simple tariffication methods


Exercise 6.3: [NLI7.3, Solution][?, Example 7.3] Denote Si,j as the claim of risk class (i, j) and
vi,j as the volume of business. Suppose we have the multiplicative tariff structure, i,j = 1,i 2,j

103
ACTL3162 General Insurance Techniques Exercises

for i = 1, 2, ..., I and j = 1, 2, .., J. We wish to find the parameters , 1,i and 2,j > 0 such
that the following expression is minimised,
(Si,j vi,j 1,i 2,j )2
X2 = . (6.1)
vi,j 1,i 2,j

We have a 2 by 4 table of risk classes. For simplicity, we can set vi,j 1 and we need to
determine the positive tariff factors , 1,i and 2,j for i = 1, 2, ..., I and j = 1, 2, .., J, that
minimise
(Si,j 1,i 2,j )2
X2 = . (6.2)
1,i 2,j
The observations of Si,j are given in the following table.

21-30y 31-40y 41-50y 51-60y


owned 1300 1200 1000 1200
leased 1800 1300 1300 1500

Table 6.1: 2 by 4 claims table

6.3 Gaussian approximation


Exercise 6.4: [NLI21, Solution][?, Exercise 21] Provide design matrix Z for the pricing prob-
lem specified by the following risk class specification (assume a multiplicative tariff structure).

21-30y 31-40y 41-50y 51-60y


passager car 2000 1800 1500 1600
delivery van 2200 1600 1400 1400
truck 2500 2000 1700 1600

Exercise 6.5: [NLI21.1, Solution] Using the data from Table 6.1 (assuming a multiplicative
tariff structure). Further assume that wm = 1 and = w1. Also to ensure uniqueness of
solutions, we assume = 1 and 1,1 = 1. We follow a log-linear MLE structure for the claims.

(a) Provide the design matrix Z, the corresponding vector and log-claim vector X.
(b) Using the log-linear MLE formula (Equation (7.9) in ?), determine the tariffication factors.

6.4 Solutions

Solution 6.1: [NLI13, Exercise] Let S = 3i=1 Si be the aggregation of the three individual
P
lines of car fleet business, the moment generating function of S is
( 3 )
X  
MS (r) = exp i vi MY (i) (r) 1 . (6.3)
1
i=1

1. Using the moment generating function of S, the expected claim amount of the car fleet is
3
X (i)
E[S] = i vi E[Y1 ] = 39330. (6.4)
i=1

104
ACTL3162 General Insurance Techniques Exercises

2. Using the moment generating function of S, the variance of the claim amount S is
3
X (i)
Var(S) = i vi E[(Y1 )2 ] = 693705000 (6.5)
i=1

The premium for the car fleet using the variance loading principle with = 3 106 is

39330 + 3 106 693705000 = 41411.12 (6.6)

Solution 6.2: [NLI13.1, Exercise]

(a) Using the aggregation of compound Poisson distributions, the sum S = S1 + S2 also has
a compound Poisson distribution
 
1 2
S = S1 + S2 CompPoi 30, G1 (x) + G2 (x) . (6.7)
3 3

(b) We first determine the expected value and variance of S,


 
1 1 2 1
E[S] = 30 + =2 (6.8)
3 10 3 20
 
1 2 2 2 3
Var[S] = 30 + = . (6.9)
3 102 3 202 10
Then the premium using the variance loading principle is = 2 + 0.25 0.3 = 2.075.

(c) According to the Central Limit Theorem, the sum S = ni=1 Si can be approximated by
P
the normal distribution with mean nE[Si ] = E[S] and variance nVar(Si ) = Var(S). A
natural candidate for is 1.96 (the 97.5% quantile of a standard normal random variable).
Such a premium corresponds to a 2.5% Value-at-Risk.

Solution 6.3: [NLI7.3, Exercise] Note that we need to set = 1 and 1,1 to ensure that we
have unique solutions.
R-code:

# Exercise for simple tariffication method


# first declare the matrix containing observations of S_ij
Sij<-c(1300,1800,1200,1300,1000,1300,1200,1500)
dim(Sij)<-c(2,4)
# define the objective function to be minimised
# note that we set mu and one of the weights to be 1
ObjFun<-function(x){
mu<-1
x1<-x[1]
x2<-x[2]
x3<-x[3]
x4<-x[4]
y1<-1

105
ACTL3162 General Insurance Techniques Exercises

y2<-x[5]
temp<-mu*t(c(x1,x2,x3,x4)%*%t(c(y1,y2)))
sum((Sij-temp)^2/temp)
}
# use optim function to product output
OptimResult<-optim(c(30,30,30,30,1),ObjFun,method = "L-BFGS-B",hessian=T)
OptimResult
# check eigenvalues and they are all positive
eigen(OptimResult$hessian)
# positive definite matrix -> local minimiser

Solution 6.4: [NLI21, Exercise]

passenger car delivery van truck 21-30y 31-40y 41-50y 51-60y


1 1 0 0 1 0 0 0
2 1 0 0 0 1 0 0
3 1 0 0 0 0 1 0
4 1 0 0 0 0 0 1
5 0 1 0 1 0 0 0
6 0 1 0 0 1 0 0
7 0 1 0 0 0 1 0
8 0 1 0 0 0 0 1
9 0 0 1 1 0 0 0
10 0 0 1 0 1 0 0
11 0 0 1 0 0 1 0
12 0 0 1 0 0 0 1

There are multiply ways to convert the table above to be the design design matrix Z (as long
as it is full rank). If we choose to have an intercept term, then we need to drop one of the
three car-type columns and one of the four year-type columns (to ensure full-rankness). Here
we drop the columns truck and 51-60y. The resulting design matrix is

1 1 0 1 0 0
1 1 0 0 1 0

1 1 0 0 0 1

1 1 0 0 0 0

1 0 1 1 0 0

1 0 1 0 1 0
Z= . (6.10)
1 0 1 0 0 1

1 0 1 0 0 0

1 0 0 1 0 0

1 0 0 0 1 0

1 0 0 0 0 1
1 0 0 0 0 0

Solution 6.5: [NLI21.1, Exercise]

106
ACTL3162 General Insurance Techniques Exercises

(a) From Table 6.1, we can construct the following categorical variables

owned leased 21-30y 31-40y 41-50y 51-60y X = log(Rij )


1 1 0 1 0 0 0 log(1300)
2 1 0 0 1 0 0 log(1200)
3 1 0 0 0 1 0 log(1000)
4 1 0 0 0 0 1 log(1200)
5 0 1 1 0 0 0 log(1800)
6 0 1 0 1 0 0 log(1300)
7 0 1 0 0 1 0 log(1300)
8 0 1 0 0 0 1 log(1500)

Since we let = 1 and 1,1 = 1, this is equivalent to the normalisation of 0 = 0 and


1,1 = 0. So the design matrix Z and have the following form

0 1 0 0 0
0 0 1 0 0
0 0 0 1 0 1,2

0 0 0 0 1 2,1

Z = 1 1 0 0 0 2,2 (6.11)

2,3
1 0 1 0 0
1 0 0 1 0 2,4

1 0 0 0 1

(b) We consider the following log-linear model for X

Xi,j = log(Ri,j ) N (0 + 1,i + 2,j , 2 ). (6.12)

In order to obtain M LE , we have the formula

M LE = (Z 0 1 Z)1 Z 0 1 X, (6.13)

which yields
1,2

0.2227

2,1 7.2215
M LE = 2,2 = 7.0187
. (6.14)


6.9276

2,3
2,4 7.0903
Since we assume that 0 = 0 and 1,1 = 0, we now have a complete set of tariffication
factors,
= exp(0 ), 1,i = exp(1,i ) and 2,j = exp(2,j ). (6.15)

21-30y 31-40y 41-50y 51-60y


owned 1,1 = 1
leased 1,2 = 1.2495
2,1 = 1368 2,2 = 1117 2,3 = 1020 2,4 = 1200

107
Module 7

Generalised Linear Models (GLMs)

7.1 Components of a GLM


Exercise 7.1: [glm1, Solution] For the following members of the exponential dispersion family,
give the density (including the domain), the mean and the variance:

1. Normal(, 2 )
2. Poisson()
3. Binomial(m, p)
4. Negbin(r, p)
5. Gamma(, )
6. Inverse Gaussian(, )

Exercise 7.2: [glm2K, Solution] [?, Problem 8.6.8] The following is an extract from ?, pp.193
4.

The Esscher transform with parameter h of a continuous distribution f (y) is the


density
ehy f (y)
fh (y) = R , (8.41)
ehz f (z)dz
provided the denominator is finite, i.e., the mgf with f (y) exists at h. A similar
transformation of the density can be performed for discrete distributions. In both
cases, the mgf with the transformed density equals mh (t) = m(t + h)/m(h). For a
density f in the exponential dispersion family, the cgf of fh has the form
b( + (t + h)) b() b( + h) b()
h (t) =

b( + h + t) b( + h)
= , (8.42)

which is again a cgf of an exponential dispersion family member with parameter
h = + h and the same .
It can be shown that the Esscher transform with parameter h < transforms

108
ACTL3162 General Insurance Techniques Exercises

1. N (0, 1) into N (h, 1);


2. Poisson(1) into Poisson(eh );
3. binomial(m,1/2) into binomial (m, eh (1 + eh )1 );
4. negative binomial (r, 1/2) into negative binomial (r, 1 eh /2) when < h <
log 2;
5. gamma (1,1) into (1,1 h) when < h < 1);

6. inverse Gaussian (1,1) into inverse Gaussian ( 1 2h,1 2h) when , h <
1/2.

So we see that all the examples of distributions in the exponential dispersion family
that we have given can be generated by starting with prototypical elements of each
type, and next taking Esscher transforms . . . .

Prove the six statements immediately above about Esscher transforms.

Exercise 7.3: [glm3, Solution] [Jiwooks Final Exam Question 2002 - modified] The density
of the Binomial distribution is given by
n!
f (y; p) = py (1 p)(ny) .
(n y)!y!
Show that the Binomial distribution is a member of the exponential dispersion family with
density  
y b()
f (y; , ) = exp + c(y; ) .

Give expressions for b(), c(y; ) and .

List the three constituent parts of a generalized linear model.

Find the expression for the deviance of a binomial model.

7.2 Deviance and Scaled Deviance


Exercise 7.4: [glm4K, Solution] [?, Problem 8.4.1] Verify that
   
D L(y; ) 2X yi
= 2 log = yi log (yi i )
L(y; y) i i

is the scaled deviance for a Poisson distribution.

Exercise 7.5: [glm5K, Solution] [?, Problem 8.4.2] Verify that


   
D L(y; ) 2X yi (yi i )
= 2 log = log +
L(y; y) i i i

is the scaled deviance for a gamma distribution.

Exercise 7.6: [NLI22, Solution][?, Exercise 22] Calculate the deviance statistics for the Poisson
and the gamma model, see also ?, equation (3.4).

109
ACTL3162 General Insurance Techniques Exercises

Exercise 7.7: [glm6K, Solution] [?, Problem 8.6.6] Show that in general, the scaled deviance
equals
D 2X
= wi {yi (i i ) [b(i ) b(i )]}.
i

Exercise 7.8: [glm7, Solution] Show that the deviance for an Inverse Gaussian distribution
has the following form:
n
X 1 (yi bi )2
D= 2 .
i=1

b i y i

7.3 Fit a GLM and Evaluate the quality of a model


Exercise 7.9: [glm8, Solution] Question #9, ACTL3003/5106 Final Exam 2005.

Exercise 7.10: [glm9, Solution] [Institute question, April 2006] An insurance company has a
set of n risks (i = 1, 2, ..., n) for which it has recorded the number of claims per month, Yij , for
m months (j = 1, 2, ..., m).
It is assumed that the number of claims for each risk, for each month, are independent Poisson
random variables with
E (Yij ) = ij .
These random variables are modelled using a Generalized Linear Model, with

log ij = i , for i = 1, 2, ..., n.

1. Derive the maximum likelihood estimator of i .

2. Show that the deviance for this model is


n X m  
X yij
2 yij log (yij y i )
i=1 j=1
y i

1
Pn
where y i = m j=1 yij .

3. A company has data for each month over a 2 year period. For one risk, the average
number of claims per month was 17.45. In the most recent month for this risk, there were
9 claims. Calculate the contribution that this observation makes to the deviance.

Exercise 7.11: [glm10, Solution] [Institute question, Sep 2003] There are m male drivers in
each of three age groups, and data on the number of claims made during the last year are
available. Assume that the numbers of claims are independent Poisson random variables. If
Yij is the number of claims for the jth male driver in group i (i = 1, 2, 3; j = 1, 2, ..., m), let
E(Yij ) = ij and suppose log (ij ) = i .

1. Show that this is a Generalized Linear Model, identifying the link function and the linear
predictor.

2. Determine the log-likelihood, and the maximum likelihood estimators of i for i = 1, 2, 3.

110
ACTL3162 General Insurance Techniques Exercises

3. For a particular data set with 20 observations in each group, several models are fitted,
with deviances as shown below:
Link function Deviance

Model 1 log (ij ) = i 60.40



, if i = 1, 2
Model 2 log (ij ) = 61.64
, if i = 3

Model 3 log (ij ) = 72.53

i. Determine whether or not model 2 is a significant improvement over model 3, and


whether or not model 1 is a significant improvement over model 2.
ii. Interpret these three models.

Exercise 7.12: [glm11, Solution] An insurance company tested for claim sizes under two
factors, i.e. CAR, the insurance group into which the car was placed, and AGE, the age
of the policyholder (i.e. two-way contingency table). It was assumed that the the claim size
yi follows a gamma distribution, i.e.
   
1 yi i i yi i
f (yi ) = exp for yi 0, i > 0, i = 1
(i ) yi i i

with a log-link function. Analysis of a set of data for which n = 8 provided the following SAS
output:

Observation Claim size CAR type Age group Pred Xbeta Resdev
1 27 1 1 25.53 3.24 0.30
2 16 1 2 24.78 3.21 1.90
3 36 1 1 3.41 1.03
4 45 1 2 38.09 3.64 1.11
5 38 2 1 40.85 3.71 0.46
6 27 2 2 36.97 3.61 1.73
7 14 2 1 2.45 0.69
8 6 2 2 14.59 2.68 2.55

Calculate the fitted claim sizes missing in the table.

111
ACTL3162 General Insurance Techniques Exercises

Exercise 7.13: [glm12R, Solution][R ] In this question, the vehicle insurance data set1 is used,
car.csv. This data set is based on one-year vehicle insurance policies taken out in 2004 or
2005. There are 67856 policies of which 4624 had at least one claim.

The data frame car.csv contains claim occurrence clm, which takes value 1 if there is a
claim and 0 otherwise. The variable veh value represents the vehicle value which takes value
from $0 $350, 000. We will not be concerned about other variables at the moment.

In this question, we will build a logistic regression model to apply to the vehicle insurance
data set. Previous study has shown that the relationship between the likelihood of occurrence
of a claim and vehicle value are possibly quadratic or cubic.

1. Suppose the relationship between vehicle value and the probability of a claim is cubic,
formulate the model and test significance of the coefficients.

2. Use AIC to determine the which model is the best model. Linear, quadratic or cubic.

Exercise 7.14: [glm13R, Solution][R ] Third party insurance 1 is a compulsory insurance for
vehicle owners in Australia. It insures vehicle owners against injury caused to other drivers,
passengers or pedestrians, as a result of an accident.

In this question, the third party claims data set Third party claims.xls is used. This data
set records the number of third party claims in a twelve-month period between 1984-1986 in
each of 176 geographical areas (local government areas) in New South Wales, Australia.

1. Now consider a model for the number of claims (claims) in an area as a function of the
number of accidents (accidents). Produce a scatter plot of of claims against accidents.
Do you think a simple linear regression model is appropriate?

2. Fit a simple linear regression to the model and use the plot command to produce residual
and diagnostic plots for the fitted model. What do the plots tell you?

3. Now fit a Poisson regression model with claims as response and log(accident) as the
predictor (include offset=log(population) in your code). Check if there is overdisper-
sion in the model by computing the estimate of .

4. Now fit the regression model by specifying family=quasipoisson. Comment on the


estimates of the parameters and their standard errors.

7.4 Solutions
Solution 7.1: [glm1, Exercise] See the lecture notes (or Table 3.1 in ?). The density and the
mean are given in the table and the variance can be derived easily from the table with:

2 = V () .

Try to map some of the densities into the exponential family formulation.

1
?

112
ACTL3162 General Insurance Techniques Exercises

Solution 7.2: [glm2K, Exercise] (8.6.8) Although this has not been discussed in lecture, it
should not be a difficult exercise to show that exponential dispersion is preserved under
Esscher transformation. The proof is straightforward using the cgf argument in (8.42), although
mgf can also be used. Now, to prove the statements in Remark 8.6.10, start from

mh (t) = mY (t + h) /mY (h) ,

or equivalently in terms of cgf, we have

h (t) = log mh (t) = Y (t + h) Y (h) .

For example, in the Poisson case from Table A, we have

h (t) = et+h 1 eh 1 = eh et 1
  


which is clearly the cgf of a Poisson eh . As yet another example, in the Gamma(1, 1) case
from Table A, we have
   
1 1
h (t) = log log
1th 1h
 
1h
= log
1ht

which is clearly the cgf of a Gamma(1, 1 h) . For inverse Gaussian (1,1), we have
p
h (t) = (1 1 2(t + h)) (1 1 2h)
p
= 1 2h 1 2(t + h)

r
1 2t 2h
= 1 2h(1 )
1 2h

r
2t
= 1 2h(1 1 ).
1 2h

Solution 7.3: [glm3, Exercise] You ought to be able to verify that the Binomial belongs to
the family of Exponential Dispersion with
 

 n!
b () = n log 1 + e , c (y; ) = log , and = 1.
(n y)!y!

You should also be able to show that


p
= log = log .
1p n

The three components of a generalized linear model are: (1) Stochastic Component: The
observations Yi are independent and each follows an Exponential Dispersion P distribution. (2)
Systematic Component: Every observation has a linear predictor i = j xij j where xij
denotes the jth explanatory variable, and (3) Link function: The expected value E (Yi ) = i
is linked to the linear predictor i by the link function i = g (i ). Now to find the deviance of

113
ACTL3162 General Insurance Techniques Exercises

the binomial (deviance is also the scaled deviance since = 1, we have


Q   yi
n!
bi (nyi )
(ny )!y !
bi
n
(1 n
)  yi  nyi !
D i i i Y
bi n bi
= 2 log Q yi (nyi ) = 2 log

n! yi yi

(ny )!y ! n
(1 n ) i
yi n yi
i i
i
X 

bi
 
n bi

= 2 yi log + (n yi ) log
i
yi n yi
n     
X yi n yi
= 2 yi log + (n yi ) log .
i=1

b i n
b i

Solution 7.4: [glm4K, Exercise] (8.4.1) We know that if D denotes the deviance, the scaled
deviance is
D  
= 2 log L/ b Le

by definition, where L
b is the likelihood computed using the MLEs b under the current model
replacing the , while L is the likelihood computed with the replaced by the estimates under
e
the full model, hence the actual observations y, in view of the remarks just below (8.22). To
show that (8.23) results from this is basic algebra. To see this, note that
n
Q bi yi
e bi /yi ! n  yi !
D i=1
Y
bi
e(bi yi )

= 2 log n
= 2 log
yi
eyi yiyi /yi !
Q
i=1
i=1
n   
X
bi
= 2 (b
i yi ) + yi log
i=1
yi
n   
X
bi
= 2 i yi ) yi log
(b .
i=1
yi

Solution 7.5: [glm5K, Exercise] (8.4.2) To show that (8.26) results, following the discussion in
the previous problem, we can verify that, for exponential dispersion models, the scaled deviance
can be expressed as
D  
= 2 log L/L b e

     
X yi i i
n e b b i b bi
e
= 2 .
i=1

For Gamma, we have () = 1/ and b () = log () = log , we then have


n  
D X yi (1/bi 1/yi ) log yi log
bi
= 2
i=1

n  
2 X yi bi
= log (yi /b
i ) .
i=1
bi
Now, if the scale parameter were different for each observation according to some weight wi ,
then it is easy to verify.

114
ACTL3162 General Insurance Techniques Exercises

Solution 7.6: [NLI22, Exercise]


(Poisson) Let Xi be the number of claims of in a group of policies with Xi Poi(wi i ), where wi
represents the volume. Since we are more interested in the distribution of the claim frequency
Yi = Xi /wi whose probability mass function is
fYi (yi ; i ) = P(Xi = wi yi )
(wi i )wi yi
= ewi i
(wi yi )!
= exp [wi (yi log(wi i ) i ) log(wi yi )!] . (7.1)
So taking log to the above pmf, the deviance statistics for the Poison model is
X X
D(y, ) = 2 [wi (yi log(wi yi ) yi )] 2 [wi (yi log(wi i ) i )]
i i
X
=2 wi (yi log(yi /i ) yi i ). (7.2)
i

(Gamma) Suppose that claim frequency is modelled by a gamma distribution,


(w)w w1 wy
fY (y) = y e . (7.3)
(w)
We re-parametrise the distribution function via = / and = 1/. Then we have
 w/
1 w
fY (y) = y w/1 ewy/()
(w/)
 
y/ log()
= exp + c(y, , w) . (7.4)
/w
Then the deviance statistics for the gamma model is
!
X  yi /yi log(yi )  X  y/i log(i ) 
D(y, ) = 2
i
/wi i
/wi
X
=2 wi (yi /i 1 log(yi /i )). (7.5)
i

Solution 7.7: [glm6K, Exercise] (8.6.6) Note that the log-likelihood can be expressed as
n  
X yi i b (i )
` (; y) = + c (yi ; /wi )
i=1
/wi

where bold is used to denote vector form. Thus, we have


D h   
e y ` ;
i
= 2 ` ; by

   
X yi i b i
n e e yi i b bi
b
= 2 + c (yi ; /wi ) c (yi ; /wi )
i=1
/w i /w i

n
2 X h e     i
= wi yi i b ei yi bi b bi
i=1

and (8.26) immediately follows.

115
ACTL3162 General Insurance Techniques Exercises

Solution 7.8: [glm7, Exercise] Recall that the scaled deviance for any member of the Expo-
nential Dispersion family has the form
D h  
e y ` ;
 i
= 2 ` ; by

n
2 X h e     i
= yi i b ei yi bi b bi
i=1

where for the Inverse Gaussian, we have verified (in lecture) that
1
= /2 , = / = , and b () = 2 = 1/.
22
Thus, the deviance can be expressed as
n        
X 1 1 1 1
D = 2 yi 2 + yi 2
i=1
2y i y i 2b i
bi
n  n
" 2 #
yi2
  X 
X 1 2yi 1 yi
= 2 1+ 2 = 1
i=1
2y i
b i
b i i=1
y i
bi
n
"  2 # n
X 1 bi yi X 1 1
= = 2
i y i ) 2 .
(b
i=1
yi
b i i=1

b y
i i

This gives the desired result.

Solution 7.9: [glm8, Exercise] See Final Exams solution, Year 2005.

Solution 7.10: [glm9, Exercise]


y
Q ijij eij
1. The likelihood is i,j and the log-likelihood is therefore
yij !
n X
X m
` (i ) = (yij log ij ij log yij !)
i=1 j=1
n X
X m
yij i ei log yij ! .

=
i=1 j=1

Applying first order condition:


m
` (i ) X
= yij mei = 0
i j=1

so that m
i 1 X
e = yij = y i
m j=1
and the MLE is
bi = log y i .

116
ACTL3162 General Insurance Techniques Exercises

2. The deviance is
 Pn Pm 
i=1 j=1 (yij log yij yij log yij !)
2 [` (y; y) ` (y; )] = 2
ni=1 m
P P
j=1 (yij log y i y i log yij !)
n m  
XX yij
= 2 yij log (yij y i ) .
i=1 j=1
yi

3. The contribution to the deviance in this case is


 
yij
Dij = 2 yij log (yij y i )
yi
 
9
= 2 9 log (9 17.45) = 4.98.
17.45

Solution 7.11: [glm10, Exercise]

1. If Y has a Poisson distribution with mean parameter , then its density can be written
as  
y y log
f (y; ) = e /y! = exp log y!
1
which is of the exponential dispersion family form. The link function is the log so that
g () = log and the linear predictor is

= log = i .

So this is a Generalized Linear Model.

2. The likelihood is given by


Y3 Ym yijij eij
i=1 j=1 yij !
so that the log-likelihood is
3 X
X m
(yij log ij ij log yij !) .
i=1 j=1

In terms of i , we re-write this as


3
X 3
X
i
` (1 , 2 , 3 ) = me + yi+ i + constant
i=1 i=1

where yi+ refers to the sum of the observations in the ith group. Differentiating, we get

` (i )
= mei + yi+ = 0
i
so that the maximum likelihood estimator of i is


bi = log (yi+ /m) .

117
ACTL3162 General Insurance Techniques Exercises

3. In comparing the models, notice the nesting: Model 3 is the smallest and is contained in
Model 2 which is contained in Model 1. We may use our Rule of Thumb of significant
improvement if the decrease in deviance is larger than twice the additional parameter.
Here we summarize in table form:
First additional Significant
Model Deviance Difference d.f. D1 D2 > 2 (p q)? improvement?

Model 3 72.53 - -
Model 2 61.64 10.89 1 Yes Yes
Model 1 60.40 1.24 1 No No

So Model 2 is a significant improvement from Model 3, but Model 1 is not a significant


improvement from Model 1.
Now, regarding interpretation of the models: Model 3 says that there is no difference in
the average number of claims for the three age groups. Model 2 says that there is no
difference in the average number of claims between age groups 1 and 2, but that the third
age group may be different. Model 1 gives the possibility of different average number of
claims for each age group.

Solution 7.12: [glm11, Exercise] We know that the linear predictor, for the ith observation,
is X
i = log i = xij j = xTi (in vector form).
j

Thus,
T
E (yi ) = i = exi .
and therefore, the predicted values are

E (y3 ) = e3.41 = 30.27

and
E (y7 ) = e2.45 = 11.59.

Solution 7.13: [glm12R, Exercise]

1. Suppose the cubic model



ln = 0 + 1 x + 2 x2 + 3 x3
1
where x is the vehicle value and is the probability of a claim of the policy.

> car<-read.csv(".../car.csv")
> attach(car)
> names(car)
[1] "veh_value" "exposure" "clm" "numclaims" "claimcst0" "veh_body"
[7] "veh_age" "gender" "area" "agecat" "X_OBSTAT_"
> car.glm<-glm(clm~veh_value+I(veh_value^2)+I(veh_value^3),family=binomial,data=car)
> summary(car.glm)

118
ACTL3162 General Insurance Techniques Exercises

Call:
glm(formula = clm ~ veh_value + I(veh_value^2) + I(veh_value^3),
family = binomial, data = car)

Deviance Residuals:
Min 1Q Median 3Q Max
-0.4093 -0.3885 -0.3729 -0.3561 2.9462

Coefficients:
Estimate Std. Error z value Pr(>|z|)
(Intercept) -2.9247606 0.0476282 -61.408 < 2e-16 ***
veh_value 0.2605947 0.0420331 6.200 5.66e-10 ***
I(veh_value^2) -0.0382409 0.0084167 -4.543 5.53e-06 ***
I(veh_value^3) 0.0008803 0.0002752 3.199 0.00138 **
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

(Dispersion parameter for binomial family taken to be 1)

Null deviance: 33767 on 67855 degrees of freedom


Residual deviance: 33711 on 67852 degrees of freedom
AIC: 33719

Number of Fisher Scoring iterations: 6

The fits shows that all the coefficients are significant as the p-values are all smaller than
0.01.
2. > car.qua<-glm(clm~veh_value+I(veh_value^2),family=binomial,data=car)
> car.lin<-glm(clm~veh_value,family=binomial,data=car)
> car.lin$aic
[1] 33749.12
car.qua$aic
[1] 33718.92
car.cub$aic
[1] 33718.72
The difference between the AIC of the cubic and quadratic models is less than one. This shows
that if we include a cubic explanatory variable, the improvement of the fit quantified by AIC
only decreases by 0.2. Therefore, when evaluating a model by the principal of parsimony, a
quadratic model is preferred. Further, the AIC of the quadratic model is much less than that
of the linear, suggesting that the linear model is inadequate.

Solution 7.14: [glm13R, Exercise]

1. plot(accidents,claims,xlab="Accidents",ylab="Claims")

119
ACTL3162 General Insurance Techniques Exercises

We can clearly see that there is a concentration of points around the origin make it
difficult to discern the relationship between the predictor and response. The data is also
strongly heteroskedasitic, which means more variable for higher value of the predictor.
This is a violation of the homoskedasticity assumption of linear model.
2. > third.lm<-lm(claims~accidents,offset=log(population))
> plot(third.lm)
The residuals vs fitted plot shows that the residual is clearly do not follow a standard nor-
mal distribution and the variance seems to inflate as the fitted value increases. Diagnostic
checks indicate clear violation of the homoskedasticity assumption.
3. > third.poi<- glm(claims ~ log(accidents), family=poisson,offset=log(population))
> summary(third.poi)

Call:
glm(formula = claims ~ log(accidents), family = poisson, offset = log(population))

Deviance Residuals:
Min 1Q Median 3Q Max
-38.957 -3.551 0.116 3.842 45.965

Coefficients:
Estimate Std. Error z value Pr(>|z|)
(Intercept) -7.093809 0.026992 -262.81 <2e-16 ***
log(accidents) 0.259103 0.003376 76.75 <2e-16 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

(Dispersion parameter for poisson family taken to be 1)

Null deviance: 22393 on 175 degrees of freedom


Residual deviance: 15837 on 174 degrees of freedom
AIC: 17066

Number of Fisher Scoring iterations: 4

120
ACTL3162 General Insurance Techniques Exercises

> sum(resid(third.poi,type="pearson")^2)/third.poi$df.residual
[1] 101.7168
The estimate of takes a value of 101.7168. The inflated dispersion parameter suggests
there is overdispersion in the data.
4. > third.qpoi<- glm(claims ~ log(accidents), family=quasipoisson,offset=log(population))
> summary(third.qpoi)

Call:
glm(formula = claims ~ log(accidents), family = quasipoisson,
offset = log(population))

Deviance Residuals:
Min 1Q Median 3Q Max
-38.957 -3.551 0.116 3.842 45.965

Coefficients:
Estimate Std. Error t value Pr(>|t|)
(Intercept) -7.09381 0.27223 -26.058 < 2e-16 ***
log(accidents) 0.25910 0.03405 7.609 1.66e-12 ***
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

(Dispersion parameter for quasipoisson family taken to be 101.7172)

Null deviance: 22393 on 175 degrees of freedom


Residual deviance: 15837 on 174 degrees of freedom
AIC: NA

Number of Fisher Scoring iterations: 4

Model Dispersion parameter 0 (se) 1 (se)


Poisson =1 -7.09381(0.02699) 0.25910(0.003376)
Quasi-Poisson =101.7172 -7.09381(0.27223) 0.25910(0.03405)

The quasi-poisson estimates of are identical to those of the Poisson model, but with
standard errors larger by a factor of 1/2 = 10.085.

121
Module 8

Bayesian Models and Credibility


Theory

Let Xjt denote the claim size of policy j during year t, for 1 j J and 1 t T . This
random variable is function of a risk profile, which cannot be observed and which is assumed to
be the same for a given contract (for given j but across t) but different between policies (across
j).
The unobservable risk profile is modelled as a random variable , and the risk profile of policy
j is a possible outcome j of (but we cannot observe it). Risk profiles across contracts are
assumed to be independent. We will denote

() = E (Xjt |) and 2 () = V ar (Xjt |)

as the expectation and variance of claim sizes, as functions the risk profile, respectively. The
moments of these quantities are key quantities and are denoted

V ar [()] = a and E [()] = m and E 2 () = s2 .


 

Note that when we will need to consider () or 2 () for a particular policy j, we will write
j () or j2 (). Finally, assume that for the same policy (given a certain risk profile ), claim
sizes are independent over time (across t). Claim sizes across policies (across j) are always
independent.
For nonparametric estimates, we will denote
T J
1X 1X
Xj = Xjt and X = Xj
T t=1 J j=1

as the average claim size of policy j and overall average claim size (across j as well), respectively.
Finally Xj,T +1 is the claim size whose expectation we want to estimate for policy j for the T + 1
period.

8.1 Preliminaries
Exercise 8.1: [cre1, Solution] Prove that

Cov (X, Y + Z) = Cov (X, Y ) + Cov (X, Z)

122
ACTL3162 General Insurance Techniques Exercises

and that
Cov (X, Y ) = Cov (X, Y ) .
Also, derive the formula
Cov(X, Y ) = E [Cov(X, Y |Z)] + Cov (E[X|Z], E[Y |Z])
for the decomposition into conditional variances.

Exercise 8.2: [cre.id1, Solution] Show that



a
if i = j, t 6= k,
Cov (Xit , Xjk ) = a + s2 if i = j, t = k,

0 if i 6= j.

Exercise 8.3: [cre.id2, Solution] First show that


s2
Cov(Xjt , X j ) = a + ,
T
and then find Cov(Xj,T +1 , X j ).

Exercise 8.4: [cre.id3, Solution] Show that


(
s2
a+ T
if i = j,
Cov(X i , X j ) =
0 6 j.
if i =

Exercise 8.5: [cre.id4, Solution] Show that


s2
 
1
Cov(X j , X) = a+ .
J T

Exercise 8.6: [cre.id5, Solution] Show that


s2
 
1
V ar(X) = a+ .
J T

Exercise 8.7: [cre6R, Solution][R ] Suppose you are given the following observed claims for 3
groups and 6 years:
t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Xj
j = 1 1047 1874 1501 1497 1876 1740 1589
j = 2 2003 1726 1524 1776 1764 2010 1800
j = 3 1597 943 920 1780 980 1010 1205
Test whether the mean claims per group are all equal. What does this imply regarding premium
calculations?

8.2 Exact Bayesian models


Exercise 8.8: [cre3K, Solution] [?, Problem 7.5.2] Suppose that has a gamma(, ) prior
distribution, and that given = , the annual numbers of claims X1 , . . . , XT are indepen-
dent Poisson() random variables. Prove that the posterior distribution of , given X1 =
x1 , . . . , XT = xt , is gamma( + x , + T ), where x = x1 + . . . + xT .

123
ACTL3162 General Insurance Techniques Exercises

Exercise 8.9: [cre4, Solution] [April 2006 Institute of Actuaries CT6 Question] An insurer
has for 2 years insured a number of domestic animals against veterinary costs. In year 1, there
were n1 policies and in year 2, there were n2 policies. The number of claims per policy per year
follows a Poisson distribution with unknown (mean) parameter .
Individual claim amounts were a constant c in year 1 and a constant c(1 + r) in year 2. The
average total claim amount per policy was y1 in year 1 and y2 in year 2. Prior beliefs about
follow a Gamma distribution with mean / and variance /2 . In year 3, there are n3
policies, and individual claim amounts are c(1 + r)2 . Let Y3 be the random variable denoting
the average total claim amounts per policy in year 3.

1. State the distribution of the number of claims on the whole portfolio over the 2 year
period.
2. Derive the posterior distribution of , given y1 and y2 .
3. Show that the posterior expectation of Y3 given y1 and y2 can be written in the form of
a credibility estimate

Z k + (1 Z) c (1 + r)2

specifying expressions for k and Z.
4. Describe k in words and comment on the impact the values of n1 , n2 have on Z.

Exercise 8.10: [cre5, Solution] You are given that an individual automobile insured has an
annual claim frequency distribution that follows a Poisson distribution with mean , where
because of parameter uncertainty, actually follows a Gamma distribution with parameters
and . A total of one claim is observed for the insured over a five-year period.

One actuary assumes that = 2 and = 5, and a second actuary assumes the same
mean for the Gamma distribution, but only half the variance.
Both actuaries determine the Bayesian premium for the expected number of claims in the
next year using their model assumptions.
Determine the ratio of the Bayesian premium that the first actuary calculates to the
Bayesian premium that the second actuary calculates.

8.3 Linear credibility estimation


Exercise 8.11: [cre7, Solution] Assume that a company only has one policy j and the claim
sizes Xj1 , Xj2 , ..., XjT are identically distributed, and conditionally on , Xj1 , Xj2 , ..., XjT are
independent and identically distributed with
E [Xjt |] = () and V ar (Xjt |) = s2 ().
We are interested in a linear estimator for Xj,T +1 of the form

P = g0 + gX j .
Find values for g0 and g such that P is unbiased and such that hit minimisesi the quadratic
2
error with respect to Xj,T +1 . You may assume that minimising E Xj,T +1 P is equivalent
h i2
to minimising E () P .

124
ACTL3162 General Insurance Techniques Exercises

Show that P can be expressed in the form of as credibility formula.

Exercise 8.12: [cre8, Solution] In the Buhlmann model, find the variance of the credibility
premium
P = zX j + (1 z)X
as well as its MSE (remember we want to estimate Xj,T +1 ).

Exercise 8.13: [cre9, Solution] In the Buhlmann model, recall that M SB: mean square be-
tween is
J
T X 2
M SB = Xj X
J 1 j=1
and M SW : mean square within is
J T
1 XX 2
M SW = Xjt X j .
J(T 1) j=1 t=1

Therefore show that


E[M SB] = aT + s2 and that E[M SW ] = s2 .

Exercise 8.14: [cre10, Solution] Show that the credibility factor



Cov XT +1 , X
z=  .
V ar X
can be re-expressed as
T
z= .
T +k
Give the expression for the constant k and explain how it will affect the credibility coefficient
z.
[This is a past exam question]

Exercise 8.15: [cre11K, Solution] [?, Problem 7.4.1] Let X1 , . . . , XT be independent random
2
variables with variances
P 2 V2 ar(Xt ) = s /wt for certain positive
P numbers wt , t = 1, . . . , T . Show
that the variance t t s /wt of the linear combination t t Xt with = 1 is minimal when
we take t wt , where the symbol means proportional to. Hence the optimal solution has
t = wt /w . Prove also that the minimal value of the variance in this case is s2 /w .

Exercise 8.16: [cre12K, Solution] [?, Problem 7.4.2] Prove that in the Buhlmann-Straub
model, we have V ar(X zw ) V ar(X ww ). (Here,
T
X zj
X zw = Xjt ,
z
t=1

T
X wjt
X jw = Xjt
t=1
w j

J
X wj
X ww = Xjw ,
j=1
w
and zj is the credibility factor.)

125
ACTL3162 General Insurance Techniques Exercises

Exercise 8.17: [cre13K, Solution] [?, Problem 7.4.10] Estimate the credibility premiums in
the Buhlmann-Straub setting when the claims experience for three years is given for three
contracts, each with weight wjt 1. The claims on the contracts are as follows:

t=1 t=2 t=3


j=1 10 12 14
j=2 13 17 15
j=3 14 10 6

Exercise 8.18: [NLI23, Solution][?, Exercise 23]

1 2 3 4 5
risk class 1 v1,t 729 786 872 951 1019
S1,t 583 1100 262 837 1630
X1,t 80.0% 139.9% 30.0% 88.0% 160.0%
risk class 2 v2,t 1631 1802 2090 2300 2368
S2,t 99 1298 326 463 895
X2,t 6.1% 72.0% 15.6% 20.1% 37.8%
risk class 3 v3,t 796 827 874 917 944
S3,t 1433 496 699 1742 1038
X3,t 180.0% 60.0% 80.0% 190.0% 110.0%
risk class 4 v4,t 3152 3454 3715 3859 4198
S4,t 1765 4145 3121 4129 3358
X4,t 56.0% 120.0% 84.0% 107.0% 80.0%
risk class 5 v5,t 400 420 422 424 440
S5,t 40 0 169 1018 44
X5,t 10.0% 0.0% 40.0% 240.1% 10.0%

Table 8.1: Observed claim Si,t and corresponding numbers of policies vi,t .

\
\
(a) Choose the data of Table 8.1 and calculate the inhomogeneous credibility estimator ( i)
for the claims ratios under the assumption that the collective mean is given by 0 = 90%
and the variance between risk classes is given by 2 = 0.20.

(b) What changes if the variance between risk classes is given by 2 = 0.05?

Exercise 8.19: [NLI24, Solution][?, Exercise 24] Estimate the prediction uncertainty E[(Xi,T +1
hom
\
\
(i ) )2 ] for the data in Table 8.1 under the assumption that the volume grows 5% in each
risk class.

Exercise 8.20: [NLI25, Solution][?, Exercise 25]


The observed numbers of policies vi and claim counts Ni in 21 different regions are given in Table
8.2. Calculate the inhomogeneous credibility estimators for each region i under the assumption
that Ni |i has a Poisson distribution with mean (i )vi = i 0 vi and E[i ] = 1. The prior
frequency parameter is given by 0 = 8.8% and the prior uncertainty by 2 = 2.4 104 .

126
ACTL3162 General Insurance Techniques Exercises

region i vi Ni
1 50,061 3,880
2 10,135 794
3 121,310 8,941
4 35,045 3,448
5 19,720 1,672
6 39,092 5,186
7 4,192 314
8 19,635 1,934
9 21,618 2,285
10 34,332 2,689
11 11,105 661
12 56,590 4,878
13 13,551 1,205
14 19,139 1,646
15 10,242 850
16 28,137 2,229
17 33,846 3,389
18 61,573 5,937
19 17,067 1,530
20 8,263 671
21 148,872 15,014
total 763,525 69,153

Table 8.2: Observed volumes vi and claims counts Ni in regions i = 1, 2, ..., 21.

8.4 Solutions
Solution 8.1: [cre1, Exercise]
We first have

Cov (X, Y + Z) = E [X (Y + Z)] E (X) E (Y + Z)


= E (XY ) E (X) E (Y ) + E (XZ) E (X) E (Z)
= Cov (X, Y ) + Cov (X, Z)

Remember E[X + Y ] = E[X] + E[Y ] holds irrespective of the dependence structure of X and
Y . Then we have

Cov (X, Y ) = E [X (Y )] E (X) E (Y )


= E (XY ) E (X) E (Y )
= Cov (X, Y ) .

Lastly, we use the fact that E (W ) = E [E (W |Z )].

E [Cov (X, Y |Z )] = E [E (XY |Z )] E [E (X |Z ) E (Y |Z )]


= E (XY ) E [E (X |Z ) E (Y |Z )]
= E (XY ) E (X) E (Y ) + E (X) E (Y ) E [E (X |Z ) E (Y |Z )]
= Cov (X, Y ) {E [E (X |Z ) E (Y |Z )] E [E (X |Z )] E [E (Y |Z )]}
= Cov (X, Y ) Cov [E (X |Z ) , E (Y |Z )] .

127
ACTL3162 General Insurance Techniques Exercises

Notice that when X = Y , then it reduces to the familiar formula for conditional variances:

E [Cov (X, X |Z )] = Cov (X, X) Cov [E (X |Z ) , E (X |Z )]

or
V ar (X) = E [V ar (X |Z )] + V ar [E (X |Z )] .

Solution 8.2: [cre.id1, Exercise]


Using the result of Exercise 8.1, we have

Cov(Xit , Xjk ) = E [Cov(Xit , Xjk |)] + Cov [E(Xit |), E(Xjk |)]
= E [Cov(Xit , Xjk |)] + Cov [i (), j ()] .

Now, when i = j and t 6= k, we have

Cov(Xit , Xjk ) = Cov(Xit , Xik ) = Cov [i (), i ()] = V ar [()] = a.

For the case of i = j and t = k, we have

Cov(Xit , Xit ) = V ar(Xit )


= E [V ar(Xit |)] + V ar [E(Xit |)]
= E s2 () + V ar [()]
 

= s2 + a.

For the last case, since policies are independent across multiple lines (when i 6= j), we have
Cov(Xit , Xjk ) = 0.

Solution 8.3: [cre.id2, Exercise]


Firstly, we have
   
Cov(Xjt , X j ) = E Cov Xjt , X j | + Cov E [Xjt |] , E X j |
1
= E [Cov (Xjt , Xjt |)] + Cov (E [Xjt |] , E [Xjt |])
T !
T  
 1 X 1
since Cov Xjt , X j | = Cov Xjt , Xit = Cov Xjt , Xjt

T T
" # t=1
T
  1X
since E X j | = E Xjt = E[Xjt |]

T t=1

1
= E [V ar(Xjt |)] + Cov (j (), j ())
T
= s2 /T + a.

Then for Cov(Xj,T +1 , X j ), note that Xj,T +1 is not in X j , therefore


   
Cov(Xj,T +1 , X j ) = E Cov Xj,T +1 , X j | + Cov E [Xj,T +1 |] , E X j |
= 0 + Cov (E [Xj,T +1 |] , E [Xjt |])
= Cov (j (), j ()) = a.

128
ACTL3162 General Insurance Techniques Exercises

Solution 8.4: [cre.id3, Exercise]


For the case of i = j, we have
!
 1X
Cov X j , X j = Cov Xjt , X j
T all t
1X
= Cov(Xjt , X j )
T all t
1
= T (s2 /T + a) = s2 /T + a.
T
For the case of i 6= j, since risk profiles across contracts are assumed to be independent,
therefore Cov(X i , X j ) = 0.

Solution 8.5: [cre.id4, Exercise]


We have
     
Cov(X j , X) = E Cov X j , X| + Cov E X j | , E X|
" !# " #!
1 X   1 X
= E Cov X j , Xj + Cov E X j | , E Xj

J
all j
J
all j
1   1    
= E V ar(X j |) + Cov E X j | , E X j |
J " J !#
t=T
1 1 X 1
= E V ar Xjt + Cov (E[Xjt |], E[Xjt |])

J T t=1 J
11 1
= E [V ar (Xjt |)] + V ar (E[Xjt |])
JT J
1 s2
 
= +a .
J T

Solution 8.6: [cre.id5, Exercise]


We have

V ar X = Cov(X, X)
( )
1 X X
= Cov(X i , X j )
J 2 all i all j
  2 
1 s
= J +a (because of the result in Exercise 8.4)
J2 T
1 s2
 
= +a .
J T

Solution 8.7: [cre6R, Exercise] Assuming the standard ANOVA model


Xjt = m + j + jt = mj + jt

129
ACTL3162 General Insurance Techniques Exercises

for j = 1, ..., J and t = 1, ..., T , where the error terms jt N (0, s2 ), we can test equality of
means with
H0 : m1 = m2 = m3
or equivalently
H0 : 1 = 2 = 3 = 0.
Here, J = 3 and T = 6. The test statistic is
1
P 2
M SB J1
T Xj X
j
F = = 2 .
M SW 1
P P
X jt X j
J(T 1) j t

The output from R is given below:

> aov.cred1 <- aov(claims~factor(j))


> summary(aov.cred1)
Df Sum Sq Mean Sq F value Pr(>F)
factor(j) 2 1093732 546866 5.9099 0.01280 *
Residuals 15 1388006 92534
---
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1

The p-value = 1.280% which is less than a level of significance of 5% suggests evidence to
reject the null hypothesis. Alternatively, we may compare this with the F -value from a table:
F0.05 (2, 15) = 3.68. The observed F -statistics of 5.9099 is larger, therefore we reject the null.
The groups are therefore non-homogeneous. This suggests that we should be asking for a
different premium for each group. A premium credibility formula which attaches credibility
factor according to each own groups claim experience would be suitable.

Solution 8.8: [cre3K, Exercise] We can write the posterior density as

f|X1 ,...,XT ( |x1 , ..., xT ) = c fX1 ,...,XT | (x1 , ..., xT |) f ()


= c fX1 | (x1 |) fXT | (xT |) f ()
T
Y e xi 1 1
= c e
i=1
xi ! ()
T x
= c e 1 e
= c e(T + ) (x +)1

where c is a constant that makes this a proper density. Clearly this has the form of a Gamma
density with parameters x + and T + .

Solution 8.9: [cre4, Exercise] Exact solutions drawn from the Institute paper/report.

1. The total number of claims has a Poisson distribution with parameter (n1 + n2 ) .

130
ACTL3162 General Insurance Techniques Exercises

2. Let Yi denote the average total claim amount per policy in year i and let Xi denote the
total number of claims in year i. Then Xi has a Poisson distribution with parameter ni
and
n1 n2
X1 = Y1 and X2 = Y2 .
c c (1 + r)
We have
f ( |y1 , y2 ) f (y1 , y2 | ) ()
en1 (n1 )y1 n1 /c en2 (n2 )y2 n2 /c(1+r) e 1
e(n1 +n2 +) (+y1 n1 /c+y2 n2 /c(1+r))1
which implies that the posterior distribution of is Gamma with parameters + y1 n1 /c +
y2 n2 /c(1 + r) and n1 + n2 + .
3. Thus, our predicted value of Y3 , given the observed claims y1 and y2 is given by
c (1 + r)2
E (Y3 |y1 , y2 ) = E (X3 |y1 , y2 )
n3
c (1 + r)2 + y1 n1 /c + y2 n2 /c(1 + r)
= n3
n3 n1 + n2 +
2 2
c (1 + r) + n1 y1 (1 + r) + n2 y2 (1 + r)
=
n1 + n2 +

= c (1 + r)2
n1 + n2 +
!
n1 y1 (1 + r)2 + n2 y2 (1 + r) n1 + n2
+
n1 + n2 n1 + n2 +

so that effectively we have


n1 y1 (1 + r)2 + n2 y2 (1 + r)
k=
n1 + n2
and
n1 + n2
Z= .
n1 + n2 +
4. k is effectively a weighted average of the inflation adjusted average claim amounts for the
previous 2 years, weighted by the number of policies in force. As the number of policies
in force increases, Z becomes closer to 1, and so the more weight is placed on the actual
experience and less on the prior expectations.

Solution 8.10: [cre5, Exercise] It was shown in class that when claim frequency X1 , ..., XT are
independent Poisson() with having a Gamma(, ) prior, then the posterior distribution is
Gamma( + x , + T ) so that the Bayesian premium is given by
+ x
E ( |X1 , ..., XT ) = .
+T
According to the first actuary, = 2 and = 5. The second actuary sets the parameter with
equal mean, but only half the variance. Therefore
2 1

= and 2 =
5
( ) 25

131
ACTL3162 General Insurance Techniques Exercises

so that = 4 and = 10. Since there is only one claim in 5 years, x = 1 and T = 5. The
first actuary sets the premium to
+ x 2+1 3
= =
+T 5+5 10
and the second actuary to
+ x 4+1 5 1
= = = .
+ T 10 + 5 15 3
The ratio is therefore
3/10
= 90%
1/3
which interestingly, despite assuming larger variance, the first actuary has a smaller premium.
Intuitively, this is because as the increasing number of years contributes to larger credibility
attached to ones own claims experience, it also provides a greater number of opportunities
to correct for premium miscalculations in the past. Presumably, at policy inception, the first
actuary will require larger premium than the second actuary, in the absence of any claims
experience. If claims experience becomes more favorable than expected, then there will be
larger correction in premium calculated. And the magnitude of correction increases then with
time, assuming of course, favorable experience continues.

Solution 8.11: [cre7, Exercise]


The MSE of the estimator P can be expressed as
h i2
M SE = E Xj,T +1 P
 2
= E Xj,T +1 g0 + gX j
   2
= V ar Xj,T +1 g0 + gX j + E Xj,T +1 g0 + gX j .

Unbiasedness condition implies the second term is zero. Now, note that
   
V ar Xj,T +1 g0 + gX j = V ar (Xj,T +1 ) 2Cov Xj,T +1 , g0 + gX j + V ar g0 + gX j
= V ar (Xj,T +1 ) 2gCov Xj,T +1 , X j + g 2 V ar X j .
 

Differentiating M SE with respect to g and setting the derivative to 0 yields,


 
2Cov Xj,T +1 , X j + 2gV ar X j = 0

Thus, first order condition implies



Cov Xj,T +1 , X j
g= 
V ar X j

and the unbiasedness condition implies



g0 + gE X j = E (Xj,T +1 ) = E [ ()]

or equivalently
g0 = (1 g) E [ ()] .

132
ACTL3162 General Insurance Techniques Exercises

Thus, the best linear Bayes estimator can be expressed as


 !
Cov Xj,T +1 , X j Cov Xj,T +1 , X j
P =  Xj + 1  E [ ()]
V ar X j V ar X j

where the credibility estimator is given by



Cov Xj,T +1 , X j
z=  .
V ar X j

Using Exercise 8.3 and 8.4 yields the familiar credibility formula:

Cov Xj,T +1 , X j V ar [ ()]
z =  = 1
V ar X j T
E [ 2 ()] + V ar [ ()]
T V ar [ ()] T
= 2
= 2
.
E [ ()] + T V ar [ ()] T + (E [ ()] /V ar [ ()])

Solution 8.12: [cre8, Exercise] From Exercise 8.5 and 8.6, we obtained V ar(X) and Cov(X j , X).
Now, we have the variance of P
 
V ar zX j + (1 z) X
= z 2 V ar X j + 2z (1 z) Cov X j , X + (1 z)2 V ar X
  

a + s2 /T
= z 2 (a + s2 /T ) + 2z(1 z)(a + s2 /T ) + (1 z)2
J
= (a + s2 /T ) z 2 + 2z(1 z) + (1 z)2 /J


The expression in curly braces is inferior to 1 as long as J > 1, which shows that the variance
of the credibility premium is lower than the one of X j . Furthermore, choosing z = 0 or z = 1
yields the variances of X and X j , respectively, as it should.
The MSE (as an estimator for Xj,T +1 ) of the credibility premium can be derived as follows:
h 2 i
E Xj,T +1 zX j (1 z) X
 
= V ar Xj,T +1 zX j (1 z) X
[because unbiasedness of the linear estimator]
  
= V ar (Xj,T +1 ) 2Cov Xj,T +1 , zX j + (1 z) X + V ar zX j + (1 z) X

For the first element, using Exercise 8.2 we have

V ar (Xj,T +1 ) = s2 + a.

For the second element, using Exercise 8.3 we have


  
Cov Xj,T +1 , zX j + (1 z) X = zCov Xj,T +1 , X j + (1 z)Cov Xj,T +1 , X
 1z 
= zCov Xj,T +1 , X j + Cov Xj,T +1 , X j
J
a
= za + (1 z)
J

133
ACTL3162 General Insurance Techniques Exercises

Therefore the MSE becomes


s2 (1 z)2
 
2 a 2
M SE = s + a 2za 2(1 z) + (a + ) z + 2z(1 z) +
J T J
2
 
2(1 z) (1 z)
= a 1 2z + z 2 + 2z(1 z) +
J J
2
  
1 2 (1 z)
+s2 1 + z + 2z(1 z) +
T J
2
2z z 2 (1 z)2
   
2 1z 2
= a 1z +s 1+ +
J T JT
2 2
(1 z)2
 
(1 z )(J 1) 2 2z z
= a +s 1+ + .
J T JT

Solution 8.13: [cre9, Exercise] We have


J
T X h 2 i
E (M SB) = E Xj X .
J 1 j=1

Since E[X j ] = E[X], then we have E[X j X] = 0. Then M SB becomes


J
T X h 2 i
E (M SB) = E Xj X
J 1 j=1
J
T X h 2 i 2
= E Xj X E[X j X]
J 1 j=1
J
T X 
= V ar X j X
J 1 j=1
J
T X  
= V ar X j 2Cov(X j , X) + V ar X
J 1 j=1
J 
s2 s2 s2
   
T X 1 1
= a+ 2 a+ + a+
J 1 j=1 T J T J T
J 
s2
 
T X 1
= 1 a+
J 1 j=1 J T
s2
 
T
= (J 1) a + = aT + s2
J 1 T

which proves the result. Now, for MSW, we have


J T
1 XX h 2 i
E (M SW ) = E Xjt X j
J (T 1) j=1 t=1

134
ACTL3162 General Insurance Techniques Exercises

Similarly since E(Xjt X j ) = 0, we have


J T
1 XX h 2 i
E (M SW ) = E Xjt X j
J (T 1) j=1 t=1
J T
1 XX h 2 i 2
= E Xjt X j E[Xjt X j ]
J (T 1) j=1 t=1
J T
1 XX 
= V ar Xjt X j
J (T 1) j=1 t=1
J T
1 XX  
= V ar (Xjt ) + V ar X j 2Cov Xjt , X j
J (T 1) j=1 t=1
J T
1 XX
(a + s2 ) + a + s2 /T 2 a + s2 /T
 
=
J (T 1) j=1 t=1
J T
1 XX
= s2 (1 1/T )
J (T 1) j=1 t=1
1
= JT s2 (1 1/T ) = s2 ,
J (T 1)
which proves the desired result.

Solution 8.14: [cre10, Exercise] The credibility factor is given by



Cov Xj,T +1 , X j
z=  .
V ar X j

To further simplify, see Exercise 8.3 and 8.4


  s2
Cov Xj,T +1 , X j = a and V ar X j = a + .
T
Thus, we have the familiar credibility formula:

Cov Xj,T +1 , X j a T
z=  = 2 = s2
V ar X j a + sT T+ a

and k is therefore
E [s2 ()] s2
k= = .
V ar [ ()] a
Recall the formula of the credibility premium,

PTcred
+1 = zX j + (1 z)m.

Firstly notice that, if we have more experience in the data(i.e. T increases), then z will increase.
This makes sense as more experience means that we will give more credibility to the individual
mean X j .

If the heterogeneity of the portfolio increases (a %) that is risks are quite different amongst

135
ACTL3162 General Insurance Techniques Exercises

each portfolio, then we will expect k to decrease. Decreased value of k will increase the credi-
bility coefficient z. So if the portfolios we have are quite different from each other, we will use
more information from the individual mean structure X j , i.e. giving it more credibility.

In another situation where if the risk variability decreases within the portfolio(s2 &), then
we will also expect k to decrease which will result in a increasing value of z. This again makes
sense. If each individual portfolio does not vary dramatically, then we will obviously use more
information on the mean structure of individual portfolio X j .

Solution 8.15: [cre11K, Exercise] We minimize the variance:


!
X X
V ar t Xt = t2 V ar (Xt )
t t

where V ar (Xt ) = s2 /wt and subject to the condition = t t = 1. The Lagrangian for
P
this problem can be written as
X
t2 s2 /wt ( 1) .

L=
t

Setting the derivatives of L equal to zero gives for t = 1, 2, ..., T :


L
= 2t s2 /wt = 0

t
and is true if and only if
t
= 2.
wt 2s
Since this equality must hold for every t, t must then be proportional to wt . This implies
jt = wjt /wj . The variance is therefore
T
! T
X X
(wjt /wj )2 s2 /wjt = s2 /wj .

V ar jt Xjt =
t=1 t=1

Solution 8.16: [cre12K, Exercise] In Exercise 8.15 we show that if the variance is of the
form s2 /wt , then the alphas of an estimator of X should be proportional to the inverse: wt
(or equivalently, wt /s2 since s2 is a constant). We have for the unconditional variance of Xij
(whose expectation is the collective premium, which we need in the credibility premium)

V ar(Xij ) = V ar(()) + E[ 2 ()] = a + s2 /wj ,

which is now proportional to zj and not to wjt . The best unconditional expected value of Xij
should then be computed using the zj s, not the wij s, as this will minimise the variance of the
estimator.
wjt wj
Note that X jw = Tt=1 wj Xjt andXww = Jj=1 w
P P
Xjw .

136
ACTL3162 General Insurance Techniques Exercises

Consider the sequence of independent random variables X1w , , XJw . The variance of X jw is

V ar(X jw ) = V ar(E[X jw |]) + E[V ar(X jw |)]


T T
X wjt X wjt
= V ar(E[ Xjt |]) + E[V ar( Xjt |)]
t=1
wj t=1
wj
T T  2
X wjt X wjt
= V ar( E[Xjt |]) + E[ V ar(Xjt |)]
t=1
wj t=1
wj
T T  2 2
X wjt X wjt ())
= V ar( ()) + E[ ]
t=1
w j t=1
w j w j t
T
X wjt
= V ar(()) + 2
E[ 2 ()]
t=1
w j
a
= a + s2 /wj = ,
zj
z
Using the result in Exercise 8.15 above, we can see that when j = zj , the variance of the
linear combination Jj=1 j Xjw is minimized.
P

z
Hence the variance of the linear combination X zw = Jj=1 zj Xjw is the smallest among all the
P
linear combinations. Therefore,
J
X wj
V ar(X zw ) V ar( Xjw ) = V ar(X ww ).
j=1
w

PT wjt PJ wj
Solution 8.17: [cre13K, Exercise] Note that X jw = t=1 wj Xjt and X ww = j=1 w Xjw .
From the formulas we saw in the lecture we get
1 X
se2 = wjt (Xjt Xjw )2 = 8
J (T 1) j,t

and
wj (Xjw Xww )2 (J 1) se2
P
j 11
a= P 2 = .
w j wj /w
e
3
Thus, the Buhlmann-Straub credibility factor is given by
aT
e 11
ze = 2
= .
aT + se
e 19
The credibility premiums are therefore:

b1,T +1 = ze 12 + (1 ze) 12 1 = 12.14


X
3
b2,T +1 = ze 15 + (1 ze) 12 1 = 13.88
X
3
b3,T +1 = ze 10 + (1 ze) 12 1 = 10.98.
X
3

137
ACTL3162 General Insurance Techniques Exercises

Solution 8.18: [NLI23, Exercise] From ?, Theorem 8.17, the inhomogeneous credibility esti-
mator is given by
\
\
( i ) = i,T Xi,1:T + (1 i,T )0 , (8.1)
b

with credibility weight i,T and observation based estimator Xbi,1:T . Since 2 and 0 are given,
2 2
we only need to obtain the estimator for , T = 261.2. Then using the above formula, results
are summarised in the following table,

risk class 1 risk class 2 risk class 3 risk class 4 risk class 5

bi,T 76.94% 88.64% 76.94% 93.37% 61.72%
\
\ 2
( i ) ( = 0.2) 0.9866506 0.3702171 1.1623246 0.8988722 0.7169975
\
\ 2
(i ) ( = 0.05) 0.9512165 0.5048693 1.0550632 0.8990594 0.8148146

R-code:

# r-code for Exercise 23 in NLI


# need MASS package for calculating column and row sums
library(MASS)
# read the data first

v.matrix<-c(729,1631,796,3152,400,786,1802,827,3454,420,872,
2090,874,3715,422,951,2300,917,3859,424,1019,2368,944,4198,440)
dim(v.matrix)<-c(5,5)
S.matrix<-c(583,99,1433,1765,40,1100,1298,496,4145,0,262,326,
699,3121,169,837,463,1742,4129,1018,1630,895,1038,3358,44)
dim(S.matrix)<-c(5,5)
X.matrix<-S.matrix/v.matrix
w.matrix<-v.matrix

tau2<-0.2
mu0<-0.9

# calculating estimator for sigma^2


Xhat<-rep(rowSums(w.matrix*X.matrix)/rowSums(w.matrix),5)
dim(Xhat)<-c(5,5)
s2hat<-rowSums(w.matrix*((X.matrix-Xhat)^2))/4
sigma2hat<-mean(s2hat)

# calculating \hat{alpha}_{i,T}
alphahat<-rowSums(w.matrix)/(rowSums(w.matrix)+sigma2hat/tau2)

# calculating \hat{X}_{i,1:T}
Xhat<-rowSums(w.matrix*X.matrix)/rowSums(w.matrix)

# calculating inhomogeneous credibility estimators


alphahat*Xhat+(1-alphahat)*mu0

tau2<-0.05
mu0<-0.9

# calculating estimator for sigma^2

138
ACTL3162 General Insurance Techniques Exercises

Xhat<-rep(rowSums(w.matrix*X.matrix)/rowSums(w.matrix),5)
dim(Xhat)<-c(5,5)
s2hat<-rowSums(w.matrix*((X.matrix-Xhat)^2))/4
sigma2hat<-mean(s2hat)

# calculating \hat{alpha}_{i,T}
alphahat<-rowSums(w.matrix)/(rowSums(w.matrix)+sigma2hat/tau2)

# calculating \hat{X}_{i,1:T}
Xhat<-rowSums(w.matrix*X.matrix)/rowSums(w.matrix)

# calculating inhomogeneous credibility estimators


alphahat*Xhat+(1-alphahat)*mu0

Solution 8.19: [NLI24, Exercise] From ?, Equation (8.18), the prediction uncertainty has the
following formula is given by,
!
hom 2
\ 2
 
\ 1 i,T
E Xi,T +1 ( i)
= 2
+ (1 i,T ) 1 + P . (8.2)
wi,T +1 i i,T

We have estimators T2 = 261.2, T2 = 0.1021 and wi,T +1 using 5% increment factor. Results
are tabulated below,

risk class 1 risk class 2 risk class 3 risk class 4 risk class 5
hom
\
\
E[(Xi,T +1 (i) )2 ] 0.2482469 0.1062646 0.2676411 0.0597071 0.5744316

R-code:

# r-code for Exercise 24 in NLI


# need MASS package for calculating column and row sums
library(MASS)
# read the data first

v.matrix<-c(729,1631,796,3152,400,786,1802,827,3454,420,872,2090,
874,3715,422,951,2300,917,3859,424,1019,2368,944,4198,440)
dim(v.matrix)<-c(5,5)
S.matrix<-c(583,99,1433,1765,40,1100,1298,496,4145,0,262,326,
699,3121,169,837,463,1742,4129,1018,1630,895,1038,3358,44)
dim(S.matrix)<-c(5,5)
X.matrix<-S.matrix/v.matrix
w.matrix<-v.matrix

sigma2hat<-261.2
tau2hat<-0.1021

# calculating \hat{alpha}_{i,T}
alphahat<-rowSums(w.matrix)/(rowSums(w.matrix)+sigma2hat/tau2hat)

# calculating weight in periodic T+1

139
ACTL3162 General Insurance Techniques Exercises

w.matrix[,5]*1.05

# calculating predictive uncertainty


sigma2hat/(w.matrix[,5]*1.05)+(1-alphahat)*tau2hat*(1-alphahat)/sum(alphahat)

Solution 8.20: [NLI25, Exercise]


In this exercise, we have 21 risk classes and for every risk class we have T = 1 observation.
The data is summarised in Table 8.2 where claims counts are denoted as Ni and the observed
numbers of policies are vi . We consider a BS model on the frequencies Xi = Ni /vi where the
conditional expectation and variance is given by (using the Poisson assumption),

E[Ni |i ]
(i ) = E[Xi |i ] = = i 0 , (8.3)
vi
2 (i ) Var[Ni |i ] i 0
= Var[Xi |i ] = 2
= . (8.4)
vi vi vi

The collective mean is 0 = E[(1 )] = 0 E[1 ] = 8.8%. The prior uncertainty is given by
2 = 2.4104 . The volatility within risk classes also happens to be 2 = E[ 2 (1 )] = 0 E[1 ] =
8.8% (thanks to the Poisson assumption).

region i vi Ni frequency (Ni /vi ) credibility weights credibility estimators


1 50061 3880 0.07750544 0.9927289 0.07758175
2 10135 794 0.07834238 0.9650849 0.07867957
3 121310 8941 0.07370373 0.9969865 0.07374682
4 35045 3448 0.09838779 0.9896456 0.09828023
5 19720 1672 0.08478702 0.9817458 0.08484567
6 39092 5186 0.13266141 0.9907076 0.13224640
7 4192 314 0.07490458 0.9195671 0.07595788
8 19635 1934 0.09849758 0.9816682 0.09830514
9 21618 2285 0.10569895 0.9833217 0.10540377
10 34332 2689 0.07832343 0.9894328 0.07842568
11 11105 661 0.05952274 0.9680372 0.06043295
12 56590 4878 0.08619898 0.9935624 0.08621057
13 13551 1205 0.08892333 0.9736546 0.08889900
14 19139 1646 0.08600240 0.9812020 0.08603995
15 10242 850 0.08299160 0.9654371 0.08316471
16 28137 2229 0.07921953 0.9871362 0.07933248
17 33846 3389 0.10013000 0.9892827 0.10000000
18 61573 5937 0.09642213 0.9940803 0.09637228
19 17067 1530 0.08964669 0.9789679 0.08961205
20 8263 671 0.08120537 0.9575109 0.08149407
21 148872 15014 0.10085174 0.9975431 0.10082016

R-code:

# r-code for Exercise 25 in NLI


# read the data first
v.vector<-c(50061,10135,121310,35045,19720,39092,4192,19635,21618,
34332,11105,56590,13551,19139,10242,28137,33846,61573,17067,8263,148872)

140
ACTL3162 General Insurance Techniques Exercises

N.vector<-c(3880,794,8941,3448,1672,5186,314,1934,2285,2689,661,
4878,1205,1646,850,2229,3389,5937,1530,671,15014)
x.vector<-N.vector/v.vector
# collective mean, vol between, vol within
mu0<-0.088
sigma2<-0.088
tau2<-0.00024
# credibility weights
alpha.vector<-v.vector/(v.vector+sigma2/tau2)
# credibility estimators
ans<-cbind(v.vector,N.vector,x.vector,
alpha.vector,alpha.vector*x.vector+(1-alpha.vector)*mu0)

141
Module 9

Claims Reserving

9.1 Outstanding loss liabilities


Exercise 9.1: [IBNR1K, Solution] [?, Problem 9.2.1] Consider the following simple situation:

0 1 2 3 4
1 A1 A2 A3 B1 E
2 A4 A5 A6 B2
3 C1 C2 C3 X
b34
4 D1 D2 D X
b44
5 F

Here, D is a prediction. Show that


D B
X44 =
A
(where the sum D includes D ) and

D (B + X34 )
X44 =
A + C
indeed produces the same estimate.

Exercise 9.2: [IBNR1Y, Solution] Suppose that an insurer has observations of claims from
year 2009 to year 2011. The observations of the claims arrivals and development are recorded in
two tables: the first one lists the accident date, reporting date, settlement status and settlement
date (if applicable) of each observed claim; the second one records the transaction of the claims.

claim ID accident date reporting date settlement status settlement date


1 2009.01.31 2009.02.01 settled 2010.05.02
2 2009.07.12 2009.12.11 unsettled NA
3 2010.02.15 2010.05.19 settled 2010.06.20
4 2010.12.08 2011.02.08 settled 2011.08.13
5 2011.04.05 2011.06.20 unsettled NA
6 2011.08.22 2011.09.11 settled 2011.12.31

142
ACTL3162 General Insurance Techniques Exercises

claim ID transaction date paid loss (in AUD)


1 2009.03.15 100
1 2010.01.25 50
2 2010.02.20 60
2 2011.05.10 180
3 2010.05.21 160
3 2010.06.13 70
4 2011.03.22 80
4 2010.08.10 40
5 2011.09.06 90
6 2011.10.12 500
6 2011.11.09 200

Construct a 3-by-3 annual loss triangle based on the above two tables.

9.2 Claims reserving algorithms


Exercise 9.3: [IBNR3K, Solution] [?, Problem 9.2.3] Apply the chain ladder method to the
given IBNR triangle with cumulated figures. What could be the reason why run-off triangles
to be processed through the chain ladder method are usually given in a cumulated form?

Year of Development Year


Origin 0 1 2 3 4
1 232 338 373 389 391
2 258 373 429 456
3 221 303 307
4 359 430
5 349

Exercise 9.4: [IBNR4K, Solution] [?, Problem 9.2.4] Apply the arithmetic separation method
to the same data of the previous exercise. Determine the missing values by linear or loglinear
interpolation, whichever seems more appropriate.

Exercise 9.5: [IBNR5, Solution] For a certain portfolio of general insurance policies, denote by
Xij the claims that occur in accident year i, but paid in development year j, where i = 1, 2, ..., t
and j = 0, 1, ..., t 1 with observable claims only for i + j t. The triangle below shows the
observed incremental claims for this portfolio for a 3-year development period:
Accident Development Year
Year 0 1 2
1 2,541 1,029 217
2 2,824 790
3 1,981

1. Give five (5) reasons for the possible delay between the occurrence and the actual payment
of claims that gives rise to Incurred-but-not-Reported (IBNR) reserves.
2. In the Chain Ladder approach of estimating the bottom-half of the claims run-off triangle,
the claims Xij are assumed to be Poisson distributed with mean i j . Derive explicit
forms for the maximum likelihood estimators for the parameters i and j .

143
ACTL3162 General Insurance Techniques Exercises

3. Using the result in (2), calculate the maximum likelihood estimates for i and j for
i = 1, 2, 3 and j = 0, 1, 2 and use these to estimate the bottom half of the triangle.

4. Explain the difference between the Chain Ladder approach and the Arithmetic Separation
Method.

Exercise 9.6: [IBNR7, Solution] Estimate the expected outstanding claims reserve for the
data in the table below (figures in $1000), using the Bornhuetter-Ferguson method. Assume
that an expected loss ratio of 85%, and that the total claims paid are $1, 942, 000.

Development year (DY)


Accident Earned
Year premium 0 1 2 3
2003 860 473 620 690 715
2004 940 512 660 750
2005 980 611 700
2006 1,020 647

9.3 Stochastic claims reserving methods


Exercise 9.7: [IBNR6, Solution] [Jiwooks Final Exam Question 2002] The claim payments
(in incremental form) from a general insurance portfolio are represented by the following table

Development Year
2000 2001 2002
Year of Origin
2000 X00 X01 X02
2001 X10 X11
2002 X20

Based on the following assumptions, we would like to estimate the outstanding claims where:

claim payments for each year of origin and development year have a log-normal distribu-
tion,

i+j j
!
X X
ln (Xij ) Normal + k + k , 2
k=1 k=1

where Xij denotes the claim amount paid in development year j arising from losses occuring
in year of origin i.

claim payments for each year of origin and development year are independent.

the expected value of the logarithm of the claim payments in year of origin 0, Year 2000
and development year 0, Year 2000 is .

the expected change in the logarithm of the claim payments from one accounting year to
the next is given by i for each accounting year i.

144
ACTL3162 General Insurance Techniques Exercises

for each year of origin, the expected change in the logarithm of the claims payment from
development year j 1(j = 1, 2...) to development j is equal to j and this is the same
for each year of origin.

the logarithm of claim payments have the same variance, 2 , regardless of year of origin
or year of development.

The i values allow for any inflation in values from one accounting year to the next. The j
values allow for the settlement pattern of claims over time arising from the same policy year.
The run-off triangle of expected values for the logarithm of the claims payments will then be

Development Year
2000 2001 2002
Year of Origin

+1
2000 +1 +2
+1 +1
+2

+1
2001
+1 +2
+1

2002 +1
+2

From the log-likelihood of the run-off triangle, we have obtained

= 7.0632, 1 = 0.025, 2 = 0.012, 1 = 0.0208, 2 = 0.0123 and 2 = 1.

Assuming that 3 = 4 = 0.018, estimate the outstanding claims X12 , X21 and X22 .

Exercise 9.8: [IBNR2Y, Solution] Consider a 3-by-3 incremental loss triangle where we have
I = t = 3 and J = 2 (that is, we observe {xij ; i + j 3, 1 i 3, 0 j 2}, and all the
observations are not cumulative). The exposures of the ith accident period is a known constant
ci (1 i 3). We assume that Xij follows a normal distribution with parameters ij = j ci
and ij = j (1 i 3 and 0 j 2). In other words, the probability density function is of
Xij is

(xij j ci )2
1
2 2
fXij (xij ) = e j . (9.1)
j 2

Furthermore, Xij and Xlk are independent (1 i 3 and 0 j 2).

1. Derive the maximum likelihood estimates of 0 , 1 and 2 .

2. Given the maximum likelihood estimates of j (denoted by j , j = 0, 1, 2), estimate the


mean and variance of the outstanding claims liability.

145
ACTL3162 General Insurance Techniques Exercises

9.4 Claims development result


Exercise 9.9: [IBNR3Y, Solution] Use the ChainLadder package in R and the USAApaid
data, perform the following tasks:

1. calculate the Chain-Ladder reserves;

2. calculate the conditional mean square error of prediction (MSEP) of the reserving esti-
mates with Macks formula;

3. calculate the process uncertainty and parameter uncertainty involved in the above condi-
tional MSEP;

4. calculate the one-year run-off uncertainty with the MW formula;

5. estimate the reserves with a Poisson model and compared the results to the Chain-Ladder
reserves; comment on the comparison.

The USAApaid data required for this exercise comes from the private passenger auto liabil-
ity/medical line of business of the United Services Automobile Association company (https:
//cran.r-project.org/web/packages/ChainLadder/ChainLadder.pdf). This is part of the
Schedule P dataset maintained by the National Association of Insurance Commissioners. The
Schedule P dataset provides real insurance data of nice lines of business over 10 years of all
U.S. general insurers. One can refer to the Casualty Actuarial Society website via http:
//www.casact.org/research/index.cfm?fa=loss_reserves_data for more information and
a clean subset of the data.

Exercise 9.10: [IBNR4Y, Solution][?, Lemma 9.14] Prove Lemma 9.14

Exercise 9.11: [IBNR5Y, Solution][?, Exercise 26] Exercise 26

9.5 Solutions
Solution 9.1: [IBNR1K, Exercise] (9.2.1) This is immediate from, beginning with equation,

b44 = D (B + ) = D (B + C B /A )
X
A + C A + C
D B /A (A + C )
=
A + C
D B
=
A
which gives the result.

Solution 9.2: [IBNR1Y, Exercise] The construction and result of the loss triangle are shown
in the following table.

146
ACTL3162 General Insurance Techniques Exercises

Year Development Year


of Origin 0 1 2
1 100 (50+60=)110 180
2 (160+70+40)=270 80
3 (90+500+200)=790

Solution 9.3: [IBNR3K, Exercise] (9.2.3) First, it can be verified that the row and column
totals are:
Year Development Year Row
of Origin 0 1 2 5 4 Total
1 232 338 373 389 391 391
2 258 373 429 456 456
3 221 303 307 307
4 359 430 430
5 349 349
Column Total 1419 374 95 43 2
You can proceed by estimating the parameters as suggested in the book (or applying the
mechanics of using ratios of cumulative claims as discussed in lecture). We have


b1 = 391.0,
b2 = 458.3,
b3 = 325.1,
b4 = 498.0, and
b5 = 545.5

and
b0 = 0.640, b1 = 0.224, b2 = 0.081, b3 = 0.051, and b4 = 0.0051.
As a result, we have the bottom part of the claims run-off triangle:

Year Development Year Row


of Origin 0 1 2 3 4 Total
1
2 2.3 2.3
3 16.5 1.7 18.2
4 40.3 25.2 2.5 68.0
5 122.0 44.1 27.6 2.8 196.5

Some differences may exist due to rounding. The total IBNR reserve is about 285.

Solution 9.4: [IBNR4K, Exercise] (9.2.4) The factors bj and


bk in the Arithmetic Separation
method are:

b0 = 0.6701, b1 = 0.2111, b2 = 0.0700, b3 = 0.0444, and b4 = 0.0044

and


b1 = 346.2170,
b2 = 413.0731,
b3 = 390.0336,
b4 = 515.2749, and
b5 = 453.

These can be obtained as suggested by the maximum likelihood estimates derived in lecture.
For example, P
i+j=5 xij
X

b5 = P4 = xij = 349 + 71 + 4 + 27 + 2 = 453
j=0 j i+j=5

147
ACTL3162 General Insurance Techniques Exercises

the sum of the claims in the big diagonal, and so on. You must be able to verify the rest. Then,
we can extrapolate the -factors linearly to yield k , for k = 6, ..., 9:

b6 = 518.27,
b7 = 549.85,
b8 = 581.43,
b9 = 613.01 k = 328.79 + 31.58 k)
(b
One can also exponentially extrapolate, leading to
bk = e5.81+0.0759k .


b6 = 526.05,
b7 = 567.53,
b8 = 612.29,
b9 = 660.57
(The value X32 = 4 arouses suspicion.) As a result, the lower right triangle of estimated values
for the first case (linear extrapolation) becomes:
Year Development Year Row
of Origin 0 1 2 3 4 Total
1
2 2.3 2.3
3 23.0 2.4 25.4
4 36.3 24.4 2.6 63.3
5 109.4 38.5 25.8 2.7 176.4

The total IBNR reserve required would be about 267.4. (Try working out the exponential case!)

Alternatively, one can use linear extrapolation based on the last two -factors:
k5

bk = 5
b5 + (b b4 ) = 5
b5 + (b b4 )(k 5); k = 6, ..., 9.
54
One can also use log-linear extrapolation based on the last two -factors:
k5
ln
bk = ln b5 ln
b5 + (ln b4 ) = ln b5 ln
b5 + (ln b4 )(k 5); k = 6, ..., 9.
54

Solution 9.5: [IBNR5, Exercise] IBNR problem.

1. Some possible reasons for delay: (1) delay in assessing exact size or amount of claims; (2)
delay in investigating whether claim is valid; (3) long legal proceedings; (4) claims have
occurred, but not filed later; and (5) claim consists of series of payments (e.g. disability
insurance).
2. First, notice that you can write the probability:
P (X = xij ) = ei j (i j )xij /xij !
for i, j satisfying i + j < t. The full likelihood of all observed values can be written as
Y
L (, ) = ei j (i j )xij /xij !
i,j

Take the log of the likelihood and maximize. The solutions will have the form:
P
j xij
P
xij

bi = P and bj = Pi ,
bj j i
bi

but must imposePb0 + + bt1 = 1. Observe that


P the denominators here are actually
row sums (Ri = j xij ) and column sums (Kj = i xij ), respectively.

148
ACTL3162 General Insurance Techniques Exercises

3. Notice that we can actually write the observed claims in the chain ladder approach as

Accident Development Year


Year 0 1 2
1 1 0 1 1 1 2
2 2 0 2 1
3 3 0

So easily we can verify, together with the assumption that all claims settle after 3 devel-
opment years, i.e. 0 + 1 + 2 = 1, the following:

1 = 2541 + 1029 + 217 = 3, 787


217
2 = = 0.0573
3787
2824 + 790
2 = = 3, 834
1 0.0573
1029 + 790
1 = = 0.2387
3787 + 3834
1981
3 = = 2, 814
1 0.0573 0.2387
2541 + 2824 + 1981
0 = = 0.7040
3787 + 3834 + 2814
Thus using these results to estimate the bottom half, we would have:

X b2 b2 = 220; X
b22 = b3 b1 = 672; X
b31 = b3 b2 = 161.
b22 =

4. The chain ladder method assumes that the claims are Poisson distributed, Xij Poisson(i j ),
where the s denote the accident year effect, and the s.denote the development year
effect. It has no calendar year effect, unlike the Arithmetic Separation method where
the claims are assumed to be Poisson(j k ). Here as in the chain ladder, s.denote
the development year but the s denote the accident year effect. Both methods use
maximum likelihood to estimate their corresponding parameters, although in predicting
unpaid claims, because future calendar years have not occurred yet, in the Arithmetic
separation method, the s may have to be extrapolated from the estimated ones.

Solution 9.6: [IBNR7, Exercise] First calculate the initial expected total loss as 85% of the
earned premium. This gives figure of 731, 799, 833 and 867.
Now calculate the development factors for individual years in the usual way. We find that the
factors are 1.2406, 1.250, 1.0362.
Tackling the years one at a time:
The total expected outgo for Accident Year 2005 is 715 as we are assuming that Accident Year
2005 is fully run-off.
For Accident Year 2006, the expected outgo was initially 799. On this basis we would expect
799
to have paid out 1.0362 = 771.09 so far. So we should have to pay out 799 771.09 = 27.91 in
the future. In fact we have incurred 750, so our final figure would be 750 + 27.91 = 777.91.
For Accident Year 2007, the expected outgo was initially 833. On this basis we would expect to
833
have paid out 1.03621.125 = 714.58 so far. So we would have to pay out 833 714.58 = 118.42
in the future. In fact we have incurred 700 so far, so our finial figure should be 700 + 118.42 =
818.42.

149
ACTL3162 General Insurance Techniques Exercises

For Accident Year 2008, the expected outgo was initially 867. On this basis we would expect
867
to have paid out 1.03621.1251.2406 = 599.50 so far. So we would have to pay out 867 599.50 =
267.5 in the future. In fact we have incurred 647 so far, so our final figure would be 647+267.5 =
915.5.
So the total payout expected is 3225.83, of which we have already paid 1942. So the balance is
1284.

Solution 9.7: [IBNR6, Exercise] (Jiwooks solution to Final Exam Question 2002) Note that
we can write the claims run-off model as:

Development Year
0 1 2
Year of Origin

+1
0 +1 +2
+1 +1
+2

+1
+1 +2
1
+1 +2 +3
+1 +1
+2

+1
+1 +2
2 +1 +2 +3
+2 +3 +4
+1 +1
+2

Firstly,

12 = + 1 + 2 + 3 + 1 + 2
= 7.0632 + 0.025 + 0.012 + 0.018 0.028 + 0.0123
= 7.1097

Hence,
log X12 N ormal 7.1097, 12


So 2
b12 = E (X12 ) = e+ 2
X =7.1097+0.5
= e7.6097 = 2017.67
Secondly,

21 = + 1 + 2 + 3 + 1
= 7.0632 + 0.025 + 0.012 + 0.018 0.0208
= 7.0974

Hence
log X21 N ormal 7.0974, 12


150
ACTL3162 General Insurance Techniques Exercises

So 2
b21 = E (X21 ) = e+ 2 = e7.5974 = 1993.01
X
Lastly,

22 = + 1 + 2 + 3 + 4 + 1 + 2
= 7.0632 + 0.025 + 0.012 + 0.018 + 0.018 0.0208 + 0.0123
= 7.1277

So 2
b22 = E (X22 ) = e+ 2 = e7.6277 = 2054.32
X

Solution 9.8: [IBNR2Y, Exercise]

1. The likelihood function is


3j
2 Y (xij j ci )2
Y 1
2 2
L(0 , 1 , 2 , 0 , 1 , 2 ) = e j . (9.2)
j=0 i=1
j 2

Therefore, the log-likelihood function is


3j 
2 X
(xij j ci )2
X 
log L(0 , 1 , 2 , 0 , 1 , 2 ) = ln j
j=0 i=1
2j2
2 2 P3j
(9.3)
2
i=1 (xij j ci )
X X
= ((3 j) ln j )
j=0 j=0
2j2

Taking the partial derivative of the log-likelihood function with respect to j (j = 0, 1, 2)


gives
P3j P3j
log L(0 , 1 , 2 , ) i=1 (xij ci ) j i=1 c2i
= . (9.4)
j j2
log L(0 ,1 ,2 ,)
Solving j
= 0 gives the maximum likelihood estimate of j , denoted by j ,
P3j
i=1 (xij ci )
j = P 3j 2 . (9.5)
i=1 ci

One can easily check that the second derivative is negative.

(2)

E(X22 + X31 + X32 ) = E(X22 ) + E(X31 ) + E(X32 ) = 2 c2 + 1 c3 + 2 c3 (9.6)

V ar(X22 + X31 + X32 ) = V ar(X22 ) + V ar(X31 ) + V ar(X32 ) = 12 + 222 (9.7)

151
ACTL3162 General Insurance Techniques Exercises

Solution 9.9: [IBNR3Y, Exercise] Please see below the R codes with results.

# install the ChainLadder package


install.packages(ChainLadder)

# load the package and data


require(ChainLadder)
data(USAApaid)

##### CL and MW estimates

# calculate the CL reserves


ResultMCL<- MackChainLadder(USAApaid,est.sigma="Mack")

# show the summarised results


summary(ResultMCL)

# > summary(ResultMCL)
# $ByOrigin
# Latest Dev.To.Date Ultimate IBNR Mack.S.E CV(IBNR)
# 0 886334 1.0000000 886334.0 0.0000 0.000 NaN
# 1 982148 0.9992023 982932.1 784.0531 916.992 1.1695534
# 2 1075537 0.9966965 1079101.8 3564.7739 1327.393 0.3723639
# 3 1138375 0.9927425 1146697.2 8322.1732 1666.579 0.2002577
# 4 1226650 0.9843548 1246146.2 19496.1724 2945.469 0.1510794
# 5 1324732 0.9633905 1375072.8 50340.7522 7486.013 0.1487068
# 6 1320130 0.9164206 1440528.5 120398.4954 19876.901 0.1650926
# 7 1185300 0.8284440 1430754.6 245454.5883 34104.399 0.1389438
# 8 966162 0.6636149 1455907.7 489745.7092 63485.591 0.1296297
# 9 542021 0.3454994 1568804.4 1026783.4153 117999.863 0.1149219
#
# $Totals
# Totals
# Latest: 1.064739e+07
# Dev: 8.442082e-01
# Ultimate: 1.261228e+07
# IBNR: 1.964890e+06
# Mack S.E.: 1.491160e+05
# CV(IBNR): 7.589026e-02

# show the process uncertainty and parameter uncertainty


ResultMCL$Mack.ProcessRisk[,ncol(USAApaid)]

# > ResultMCL$Mack.ProcessRisk[,ncol(USAApaid)]
# 0 1 2 3 4 5
# 0.0000 631.4351 969.2396 1269.0693 2450.1816 6582.9597
# 6 7 8 9
# 17940.2609 31237.4293 58835.1132 109898.2894

ResultMCL$Total.ProcessRisk[ncol(USAApaid)]

152
ACTL3162 General Insurance Techniques Exercises

# > ResultMCL$Total.ProcessRisk[ncol(USAApaid)]
# 10
# 129958.2

ResultMCL$Mack.ParameterRisk[,ncol(USAApaid)]

# > ResultMCL$Mack.ParameterRisk[,ncol(USAApaid)]
# 0 1 2 3 4 5
# 0.0000 664.9542 906.9437 1080.2545 1634.7471 3564.4124
# 6 7 8 9
# 8557.9334 13686.9669 23850.5710 42968.9854

ResultMCL$Total.ParameterRisk[ncol(USAApaid)]

# > ResultMCL$Total.ParameterRisk[ncol(USAApaid)]
# [1] 73119.55

# 1-year CDR
CDR(ResultMCL)

# > CDR(ResultMCL)
# IBNR CDR(1)S.E. Mack.S.E.
# 0 0.0000 0.000 0.000
# 1 784.0531 916.992 916.992
# 2 3564.7739 1035.163 1327.393
# 3 8322.1732 1134.252 1666.579
# 4 19496.1724 2478.155 2945.469
# 5 50340.7522 6874.055 7486.013
# 6 120398.4954 18413.859 19876.901
# 7 245454.5883 28014.262 34104.399
# 8 489745.7092 53622.597 63485.591
# 9 1026783.4153 98121.714 117999.863
# Total 1964890.1331 125036.244 149116.032

##### Poisson fitting

# fit the data by the Poisson distribution


ResultPoisson <- glmReserve(USAApaid)

# show the summarised results


summary(ResultPoisson)

# > summary(ResultPoisson)
# Latest Dev.To.Date Ultimate IBNR S.E CV
# 1 982148 0.9992024 982932 784 2330.911 2.97310136
# 2 1075537 0.9966963 1079102 3565 4509.067 1.26481552
# 3 1138375 0.9927426 1146697 8322 6562.979 0.78863004
# 4 1226650 0.9843550 1246146 19496 9699.278 0.49750094

153
ACTL3162 General Insurance Techniques Exercises

# 5 1324732 0.9633903 1375073 50341 15251.922 0.30297217


# 6 1320130 0.9164209 1440528 120398 23501.424 0.19519779
# 7 1185300 0.8284437 1430755 245455 34460.994 0.14039638
# 8 966162 0.6636147 1455908 489746 53506.953 0.10925450
# 9 542021 0.3454995 1568804 1026783 106222.199 0.10345146
# total 9761055 0.8324323 11725945 1964890 142114.888 0.07232715

One can see that the reserves estimates obtained from the Poisson model and the CL model
are the same. One can prove this by setting = 1 in the over-dispersed Poisson model and
follow the same steps as those in section 9.3.2.

Solution 9.10: [IBNR4Y, Exercise]


The joint likelihood function of observations Dt and parameters is
J1
Y (fj (j 1))j j 1 j fj (j 1)
h(Dt , ) = j e
j=0
(j )
g(C1,0 , . . . , CI,0 )
(9.8)
  Ci,j
j 2 Ci,j
J1 (tj1)I j
1 j C
Y Y j2 2 2 i,j+1
  Ci,j+1 j
e j .
Ci,j
j=0 i=1 2
j

Please note that


(fj (j 1))j 1 j fj (j 1)
(j )
j j e calculates the likelihood of j = j ; there are J of them, with
j = 0, . . . , J;
g(C1,0 , . . . , CI,0 ) represents the likelihood of observing the first column, which we dont
necessarily need to know;
! Ci,j
j 2 Ci,j
j
2
1 j C
j 2 2 i,j+1
j
! Ci,j+1 e j calculates the likelihood of Ci,j+1 given Ci,j . The range of j is
Ci,j

2
j
from 0 to J 1 since the first column is not included here. Given the value of j, the range
of i is from 1 to min(t j 1, I).

Now we can calculate the likelihood of |Dt (proportionally), that is


Ci,j

J1 (tj1)I
2 j2 Ci,j+1
jj 1 ej fj (j 1)
Y Y
j
h(|Dt ) h(Dt , ) j e j
j=0 i=1
! (9.9)
P(tj1)I Ci,j Ci,j+1
J1
Y j + i=1 1 j fj (j 1)+ (tj1)I
P
2 i=1 2
j
= j e j
.
j=0

The likelihood function shows that the posteriors of = (1 , . . . , J1 ) (conditional on Dt ) are


independent Gamma random variables. In particular, the posterior density function is

(tj1)I (tj1)I
X Ci,j X Ci,j+1
fj |Dt Ga j + 2
, fj (j 1) + 2
. (9.10)
i=1
j i=1
j

154
ACTL3162 General Insurance Techniques Exercises

The Bayesian CL predictor for Ci,J , i + J > t I is therefore

(t)
Ci,J =E[Ci,J |Dt ]
=E[E[Ci,J |Ci,J1 ]|Dt ]
=E[Ci,J1 1
J1 |Dt ]
..
.
J1 (9.11)
Y
=E[Ci,ti 1
j |Dt ]
j=ti
J1
Y
=Ci,ti fjt
j=ti

where fjt = E[1


j |Dt ].

Solution 9.11: [IBNR5Y, Exercise]

1. A higher business volume tends to result in lower uncertainty (measured by both total
msep1/2 and CDR msep1/2 ) as a percentage of reserves. This can be explained by higher
diversification of claims associated with a higher business volume.

2. The ratio of the one-year claims development result uncertainy over the total run-off
uncertainty stays relatively stable across varying companies. This is because the ratio
depends on the nature of the business and here we are concerned with the same business
segment of different companies. This shows that knowing the next diagonal releases a
major part of the claims run-off risks, that is, around 80% of the total run-off uncertainty.
(This is similar to Exercise 9.18)

155
Module 10

Game and Decision Theory

10.1 Decision theory


Exercise 10.1: [DnG1, Solution] [Decisions & Games notes, exercise # 2] The loss function
under a decision problem is summarized below:

states
decision
1 2 3
d1 14 12 13
d2 13 15 14
d3 11 15 5

1. Determine the minimax solution to the problem.


2. Given the probability distribution: P (1 ) = 41 , P (2 ) = 14 , and P (3 ) = 21 , determine the
Bayes criterion solution.

Exercise 10.2: [DnG2, Solution] [Decisions & Games notes, exercise # 3] The profit per
client-day made by a privately owned health center depends on the variable costs involved.
Variable costs, over which the owner of the health center has no control, take one of three
levels: 1 =high, 2 =most likely, and 3 =low. The owner has to decide at what level to set
the number of client-days for the coming year. Client-days can be either d1 = 16, d2 = 13.4, or
d3 = 10 (each in 000). The profit in ($) per client-day is as follows:

states
decision
1 2 3
d1 85 95 110
d2 105 115 130
d3 125 135 150

1. Determine the Bayes criterion solution based on the annual profits, given the probability
distribution P (1 ) = 0.1, P (2 ) = 0.6, and P (3 ) = 0.3.
2. Determine both the minimax solution and the maximin solution to this problem.

Exercise 10.3: [DnG4, Solution] [Decisions & Games notes, exercise # 5] A firm is contem-
plating three investment alternatives: stocks, bonds, and a savings account, involving three

156
ACTL3162 General Insurance Techniques Exercises

potential economic conditions: accelerated, normal, or slow growth. Each condition has a
probability of occurrence P (accelerated growth)= 0.2, P (normal growth)= 0.5 and P (slow
growth)= 0.3. It is assumed that the decision maker who has $100,000 to invest wishes to
invest all the fund in a single investment class. The annual returns ($) yielded from the stocks,
bonds, and savings account are as follows:

Economic Conditions
Alternative accelerated normal slow
Investment growth growth growth
Stocks 20,000 13,000 -8,000
Bonds 16,000 12,000 2,000
Savings 10,000 10,000 10,000

1. Determine the Bayes criterion solution.

2. Determine both the minimax regret solution and maximin solution to this problem.

3. Explain briefly when Bayesian decision analysis (i.e. Bayes rule) can be used.

10.2 Game theory


Exercise 10.4: [DnG3, Solution] [Decisions & Games notes, exercise # 4] Consider the fol-
lowing two-person, zero-sum game:

Player B
strategies
x y z
Player A 1 250 300 150
strategies 2 50 165 125
3 100 275 225

1. Using the rule of dominance, reduce the payoff matrix to a 2-by-2 matrix.

2. Solve algebraically for the mixed-strategy probabilities for players A and B and determine
the expected gain for player A and the expected loss for player B. Discuss the meaning
of this solution value.

10.3 Solutions
Solution 10.1: [DnG1, Exercise] Decisions & Games, Exercise # 2: Solution from Institute.
First, check out the table below:

states
decision p1 = 0.25 p2 = 0.25 p3 = 0.5 expected
1 2 3 maximum loss
d1 14 12 13 14 13
d2 13 15 14 15 14
d3 11 15 5 15 9

157
ACTL3162 General Insurance Techniques Exercises

Thus, the minimax solution is d1 . The Bayes criterion solution is d3 since it gives smallest
expected loss. [Refer to bold values.]

Solution 10.2: [DnG2, Exercise] Decisions & Games, Exercise # 3: Solution from Institute.
First convert the table into annual profits as follows:
annual profits
decision p1 = 0.1 p2 = 0.6 p3 = 0.3 expected
1 2 3 maximum regret minimum profit
d1 1360 1520 1760 47 1360 1576
d2 1407 1541 1742 18 1407 1587.9
d3 1250 1350 1500 260 1250 1385
Therefore, Bayes criterion solution is to choose d2 as it gives the largest expected profit. The
minimax is to choose d3 and the maximin solution is to choose d2 .

Solution 10.3: [DnG4, Exercise] Decisions & Games, Exercise # 5: Jiwooks solution, Emil
modified.

1. First, the annual profits:


Economic Conditions
probabilities 0.2 0.5 0.3
Alternative accelerated normal slow Expected
Investment growth growth growth profit
Stocks 20,000 13,000 8,000 8,100
Bonds 16,000 12,000 2,000 9,800
Savings 10,000 10,000 10,000 10,000
where for example, 8,100 = 20,000 0.2 + 13,000 0.5 + (8,000) 0.3. Bayes Decision:
choose Savings.
2. The opportunity loss (amount of regret) are given below:
Economic Conditions
Alternative accelerated normal slow maximum
Investment growth growth growth regret
Stocks 0 0 18,000 18,000
Bonds 4,000 1,000 8,000 8,000
Savings 10,000 3,000 0 10,000
Thus, for minimax Decision: choose Bonds (i.e. choose minimum of maximum regret).
Economic Conditions
Alternative accelerated normal slow minimum
Investment growth growth growth payoff
Stocks 20,000 13,000 8,000 8,000
Bonds 16,000 12,000 2,000 2,000
Savings 10,000 10,000 10,000 10,000
So for maximin Decision: choose Savings.

158
ACTL3162 General Insurance Techniques Exercises

3. Bayes rule can be used when we want to revise probabilities of potential states of nature
based on additional information, experiments and personal judgments.

Solution 10.4: [DnG3, Exercise] Decisions & Games, Exercise # 4: Jiwooks solutions.

1. First, notice that:


Player B
x y z
250 < 300 > 150
1

50 < 165 > 125
Player A 2

3 100 < 275 > 225
So Strategy 1 & 3 dominate 2 for Player A. Strategy x & z dominate y for Player B.
Therefore, a 2-by-2 matrix would be

Player B
x z
Player A 1 250 150
3 100 225

2. If Player B selects strategy x, the possible payoffs for Player A are 250 and 100. Therefore,
if Player A selects strategy 1 with probability p, Player As expected gain is given by

250p + 100(1 p)

On the other hand, if Player B selects z, Player As expected gain would be

150p + 225(1 p)

So, we have

250p + 100(1 p) = 150p + 225(1 p)


225p = 125
125 5 4
p = = ,1 p =
225 9 9
Similarly, for Player Bs expected gain, we need

250p + 150(1 p) = 100p + 225(1 p)


225p 75
3 6
p = ,1 p =
9 9
Hence, Player As gain will be:
5 4
if B selects x : 250 + 100 = 183.33
9 9
5 4
if B selects z : 150 + 225 = 183.33
9 9

159
ACTL3162 General Insurance Techniques Exercises

Player Bs gain will be


3 6
if A selects1 : 250 + 150 = 183.33
9 9
3 6
if A selects 3 : 100 + 225 = 183.33
9 9
No matter what strategy player B chooses, if player A employs the mixed strategy that is
composed with ( 59 1st , 49 3rd ), it is guaranteed for him to obtain 183.33 (in expected value
sense). No matter what strategy player A chooses, if player B employs the mixed strategy
that is composed with ( 93 x, 69 y), it is guaranteed for him to obtain 183.33. Therefore,

The value of the game 183.33


The optimal strategy for player A ( 59 1st , 49 3rd )
The optimal strategy for player B ( 39 x, 69 y)

160