Modeling Property Treaties with

Significant Cat Exposure

Model non-cat & cat LRs separately

Non Cat LRs fit to a lognormal curve

Cat LR distribution produced by commercial
catastrophe model
Combine (convolute) the non-cat & cat loss ratio
distributions

Convoluting Non-cat & Cat LRs

- Example
Non cat
LR
Prob
40%
10%
55%
25%
65%
35%
77%
25%
100%
5%

These probabilities
correspond to
these total LR's

Disretized Cat LR's

0%
30% 60%
60%
20% 15%
6.0%
2.0% 1.5%
15.0%
5.0% 3.8%
21.0%
7.0% 5.3%
15.0%
5.0% 3.8%
3.0%
1.0% 0.8%

100%
5%
0.5%
1.3%
1.8%
1.3%
0.3%

Total Loss Ratios

40%
70% 100%
55%
85% 115%
65%
95% 125%
77%
107% 137%
100%
130% 160%

140%
155%
165%
177%
200%

Truncated Loss Ratio

Distributions
Problem: To reasonably model the possibility of

high LR requires a high lognormal CV

High lognormal CV often leads to unrealistically
high probabilities of low LRs, which overstates
cost of PC
Solution: Dont allow LR to go below selected
minimum, e.g.. 0% probability of LR<30%
Adjust the mean loss ratio used to calculate
the lognormal parameters to cause the
aggregate distribution to probability weight
back to initial expected LR

Summary of Loss Ratio

Distribution Method
Advantage:

Easier and quicker than separately modeling

frequency and severity
Reasonable for most pro-rata treaties
Usually inappropriate for excess of loss contracts
Does not reflect the hit or miss nature of many
excess of loss contracts
Understates probability of zero loss
May understate the potential of losses much
greater than the expected loss

Excess of Loss Contracts: Separate

Modeling of Frequency and Severity
Used mainly for modeling excess of loss contracts
Most aggregate distribution approaches assume
that frequency and severity are independent
Different Approaches

Simulation (Focus of this presentation)

Numerical Methods
Heckman Meyers Fast calculating approximation to
aggregate distribution
Panjer Method

Select discrete number of possible severities (i.e. create 5

possible severities with a probability assigned to each)
Convolutes discrete frequency and severity distributions.

A detailed mathematical explanation of these methods

is beyond the scope of this session.

Software that can be used for simulations

@Risk
Excel

Common Frequency
Distributions
Poisson
f(x|) = exp(-) ^x / x!
where = mean of the claim count
distribution and x = claim count =
0,1,2,...
f(x|) is the probability of x losses, given a
mean claim count of
x! = x factorial, i.e. 3! = 3 x 2 x 1 = 6
Poisson distribution assumes the mean and
variance of the claim count distribution are
equal.

Fitting a Poisson Claim Count

Distribution
Trend claims from ground up, then slot to

reinsurance layer.
Estimate ultimate claim counts by year by
developing trended claims to layer.
Multiply trended claim counts by frequency trend
factor to bring them to the frequency level of the
upcoming treaty year.
Adjust for change in exposure levels, i.e..
Adjusted Claim Count year i =
Trended Ultimate Claim Count i x
(SPI for upcoming treaty year / On Level SPI year i)
Poisson parameter equals the mean of the
ultimate, trended, adjusted claim counts from above

Example of Simulated Claim

Count

Modeling Frequency- Negative

Binomial
Negative Binomial: Same form as the Poisson distribution,

except that it assumes that is not fixed, but rather has a

gamma distribution around the selected
Claim count distribution is Negative Binomial if the
variance of the count distribution is greater than the
mean
The Gamma distribution around has a mean of 1
Negative Binomial simulation
Simulate (Poisson expected count)
Using simulated expected claim count, simulate claim
count for the year.
Negative Binomial is the preferred distribution
Reflects some parameter uncertainty regarding the true
mean claim count
The extra variability of the Negative Binomial is more in
line with historical experience

Algorithm for Simulating Claim

Counts Using a Poisson
Distribution
Poisson
Manually create a Poisson cumulative
distribution table
Simulate the CDF (a number between 0 and
1) and lookup the number of claims
corresponding to that CDF (pick the claim
count with the CDF just below the simulated
CDF) This is your simulated claim count for
year 1
Repeat the above two steps for however
many years that you want to simulate

10

Negative Binomial Contagion Parameter

Determine contagion parameter, c, of claim count
distribution:

(^2 / ) = 1 + c
If the claim count distribution is Poisson,
then c=0
If it is negative binomial, then c>0, i.e.
variance is greater than the mean
Solve for the contagion parameter:
c = [(^2 / ) - 1] /

11

Additional Steps for Simulating

Claim Counts using Negative
Binomial

Simulate gamma random variable with a mean of 1

Gamma distribution has two parameters: and

= 1/c;
= c; c = contagion parameter
Using Excel, simulate gamma random variable
as follows: Gammainv(Simulated CDF, , )
Simulated Poisson parameter =
= x Simulated Gamma Random Variable Above
Use the Poisson distribution algorithm using the
above simulated Poisson parameter, , to simulate
the claim count for the year

12

Year 1 Simulated Negative

Binomial Claim Count

13

Year 1 Simulated Negative

Binomial Claim Count
Simulated Poisson Gamma
Simulated Poisson CDF:
Year 1 Simulated Claim Count:
Prob
Claim Poisson
Count ClaimPoisson
Count Probability <= X CountProbability
0
22.39% 22.39% 5
1.40%
1
33.51% 55.90% 6
0.35%
2
25.07% 80.97% 7
0.07%
3
12.51% 93.48% 8
0.01%
4
4.68% 98.16% 9
0.00%

14

1.50
0.808
2
Prob
Count
<= X
99.56%
99.91%
99.98%
100.00%
100.00%

Year 2 Simulated Negative

Binomial Claim Count

15

Year 2 Simulated Negative

Binomial Claim Count
Simulated Poisson Gamma
Simulated Poisson CDF:
Year 2 Simulated Claim Count:

2.20
0.645
3

Prob
Prob
Claim Poisson
Count Claim Poisson
Count
Count Probability <= X Count Probability <= X
0
11.13% 11.13%
5
4.73%
97.53%
1
24.44% 35.57%
6
1.73%
99.26%
2
26.83% 62.40%
7
0.54%
99.80%
3
19.63% 82.03%
8
0.15%
99.95%
4
10.77% 92.80%
9
0.04%
99.99%

16

Modeling Severity
Common Severity Distributions

Lognormal
Mixed Exponential (currently used by ISO)
Pareto
Truncated Pareto.
This curve was used by ISO before moving to the Mixed
Exponential and will be the focus of this presentation.
The ISO Truncated Pareto focused on modeling the
larger claims. Typically those over $50,000

17

Truncated Pareto
Truncated Pareto Parameters
t = truncation point.
s = average claim size of losses below truncation point
p = probability claims are smaller than truncation point
b = pareto scale parameter - larger b results in larger
unlimited average loss
q = pareto shape parameter - lower q results in
thicker tailed distribution
Cumulative Distribution Function
F(x) = 1 - (1-p) ((t+ b)/(x+ b))^q
Where x>t

18

Algorithm for Simulating

Severity to the Layer
For each loss to be simulated, choose a random number

between 0 and 1. This is the simulated CDF

Transformed CDF for losses hitting layer (TCDF) =
Prob(Loss < Reins Att. Pt) +
Simulated CDF x Prob (Loss > Reins Att. Pt)
If there is a 95% chance that loss is below attachment point,
then the transformed CDF (TCDF) is between 0.95 and 1.00.

Find simulated ground up loss, x, that corresponds to

simulated TCDF
Doing some algebra, find x using the following formula:
x = Exp{ln(t+b) - [ln(1-TCDF) - ln(1-p)]/Q} - b

From simulated ground up loss calculate loss to the layer

19

Year 1 Loss # 1 Simulated

Severity to the Layer

Pareto Parameters

B
79,206

Q
1.39

P
0.858

Reinsurance Layer:
750,000
Pareto Probability of Loss < Reins Att Point:
Simulated CDF:
Transformed CDF for Losses Simulated to the Excess Layer:
Simulated Loss:
Simulated Loss to Layer:

20

S
6,090

T
50,000

xs

250,000
96.13%
0.4029
0.9769
397,876
147,876

Year 1 Loss # 2 Simulated

Severity to the Layer

Pareto Parameters

B
79,206

Q
1.39

P
0.858

Reinsurance Layer:
750,000
Pareto Probability of Loss < Reins Att Point:
Simulated CDF:
Transformed CDF for Losses Simulated to the Excess Layer:
Simulated Loss:
Simulated Loss to Layer:

21

S
6,090
xs

T
50,000
250,000
96.13%
0.8400
0.9938
1,151,131
750,000

Simulation Summary

Year 1 Simulation

Year 2 Simulation

Claim Losses
Count to Layer
2 147,876
750,000
Total: 897,876
3 576,745
281,323
54,726
Total: 912,794

Run about 1,000 more years and we have

our aggregate distribution to the excess of
loss layer

22

Common Loss Sharing

Provisions for Excess of Loss
Treaties

Profit Commissions

Already covered
Swing Rated Premium
Annual Aggregate Deductibles
Limited Reinstatements

23

Swing Rated Premium

Ceded premium is dependent on loss
experience
Typical Swing Rating Terms

Provisional Rate: 10%

Minimum/Margin: 3%
Maximum: 15%
Ceded Rate = Minimum/Margin +
Ceded Loss as % of SPI x 1.1;
subject to a maximum rate of 15%.
Why did 100/80 x burn subject to min
and max rate become extinct?
24

Swing Rated Premium Example

Burn (ceded loss / SPI) = 10%. Rate = 3% + 10%

x 1.1 = 14%
Burn = 2%. Rate = 3% + 2% x 1.1 = 5.2%.
Burn = 14%. Calculated Rate = 3% + 14% x 1.1 =
18.4%. Rate = 15% maximum rate

25

26