ACSC/STAT 4703, Actuarial Models II

Further Probability with Applications to Actuarial

Science
Fall 2017
Toby Kenney
In Class Examples

September 17, 2017 1 / 160

Advantages of Modelling Number of Losses and
Severities Separately

Dealing with changes to exposure (e.g. number of policies)

Dealing with inflation
Dealing with changes to individual policies
Understanding the impact of changing deductibles on claim
frequencies.
Combining data with a range of different deductibles and limits
can give a better picture of the loss distribution.
Consistency between models of non-covered losses to insureds,
claims to insurers, and claims to reinsurers.
The effect of the shapes of separate distributions of number and
severity give an indicator of how each influences the overall
aggregate loss.

September 17, 2017 2 / 160

 Model Choices

Practical Considerations
Scale parameters for severity allow for change of currency or
inflation.
For frequency, models with pgf P(z; α) = Q(z)α can deal with
changes to number of policies sold, or time period.
Modification at zero prevents infinite divisibility. However,
modification at zero may still be appropriate.

September 17, 2017 3 / 160

 9.2 Model Choices

Question 1
Which discrete distributions satisfy

P(z; α) = Q(z)α

for some parameter α?

September 17, 2017 4 / 160

 9.3 The Compound Model for Aggregate Claims

Question 2
Calculate the first three moments of a compound model.

September 17, 2017 5 / 160

 9.3 The Compound Model for Aggregate Claims

Question 3
When an individual is admitted to hospital, the distribution of charges
incurred are as described in the following table:
charge mean standard deviation
Room 1000 500
other 500 300
The covariance between room charges and other charges is 100,000.
An insurer issues a policy which reimburses 100% for room charges
and 80% for other charges. The number of hospital admissions has a
Poisson distribution with parameter 4. Determine the mean and
standard deviation for the insurer’s payout on the policy.

September 17, 2017 6 / 160

 9.3 The Compound Model for Aggregate Claims

Question 4
An individual loss distribution is normal with mean 100 and standard
deviation 35. The total number of losses N has the following
distribution:
n P(N = n)
0 0.4
1 0.3
2 0.2
3 0.1
What is the probability that the aggregate losses exceed 130?

September 17, 2017 7 / 160

 9.3 The Compound Model for Aggregate Claims

Question 5
Aggregate payments have a compound distribution. The frequency
distribution is negative binomial with r = 16, β = 6. The severity
distribution is uniform on the interval (0, 8). Using a normal
approximation, determine the premium such that there is a 5%
probabilty that aggregate payments exceed the premium.

September 17, 2017 8 / 160

 9.3 The Compound Model for Aggregate Claims

Question 6
For a group health contract, aggregate claims are assumed to have an
exponential distribution with mean θ estimated by the group
underwriter. Aggregate stop-loss insurance for total claims in excess of
125% of the expected claims, is provided for a premium of twice the
expected stop-loss claims. It is discovered that the expected total
claims value used was 10% too low. What is the loading percentage
on the stop-loss policy under the true distribution?

September 17, 2017 9 / 160

 9.4 Analytic Results

Question 7
Calculate the probability density function of the aggregate loss
distribution if claim frequency follows a negative binomial distribution
with r = 2 and severity follows an exponential distribution.

September 17, 2017 10 / 160

 9.4 Analytic Results

Question 8
An insurance company models the number of claims it receives as a
negative binomial distribution with parameters r = 15 and β = 2.4. The
severity of each claim follows an exponential distribution with mean
$3,000. What is the net-premium for stop-loss insurance with a
deductible of $500,000?

September 17, 2017 11 / 160

 9.4 Analytic Results

Question 9
An insurance company offers group life insurance policies to three
different companies. For the first company, the number of claims is a
Poisson distribution with parameter λ = 0.4, and claim severity a
gamma distribution with θ = 30, 000 and α = 3. For the second
company, the number of claims is a Poisson distribution with parameter
λ = 3.6 and the severity follows a gamma distribution with θ = 200, 000
and α = 1.4. For the third company, the number of claims follows a
Poisson distribution with λ = 85 and claim severity follows a gamma
distribution with θ = 45, 000 and α = 2.2. What is the probability that
the aggregate claims from all these policies exceed 10,000,000?

September 17, 2017 12 / 160

 9.5 Computing the Aggregate Claims Distribution

Question 10
Suppose that the total number of claims follows a negative binomial
distribution with r = 2 and β = 3. Suppose that the severity of each
claim (in thousands of dollars) follows a zero-truncated ETNB
distribution with r = −0.6 and β = 7. What is the probability that the
aggregate loss is at most 3?

September 17, 2017 13 / 160

 The Recursive Method

Theorem
Suppose the severity distribution is a discrete distribution with
probability function fX (x) for x = 0, 1, . . . , m (m could be infinite) and
the frequency distribution is a member of the (a, b, 1)
class with
probabilities pk , k = 0, 1, 2, . . . satisfying pk = a + kb pk −1 for all
k > 2.
Then the aggregate loss distribution is given by
 
by
(p1 − (a + b)p0 )fX (x) + x∧m
P
y =1 a + x fX (y )fS (x − y )
fS (x) =
1 − afX (0)

September 17, 2017 14 / 160

 9.6 The Recursive Method

Question 11
Let the number of claims follow a Poisson distibution with λ = 2.4 and
the severity of each claim follow a negative binomial distribution with
r = 10 and β = 2.3. What is the probability that the aggregate loss is
at most 3?

September 17, 2017 15 / 160

 9.6 The Recursive Method

Question 12
An insurance company offers car insurance. The number of losses a
driver experiences in a year follows a negative binomial random
variable with r = 0.2 and β = 0.6. The size of each loss (in hundreds
of dollars) is modelled as following a zero-truncated ETNB distribution
with r = −0.6 and β = 3. The policy has a deductible of $1,000 per
loss. What is the probability that the company has to pay out at least
$400 in a single year to a driver under such a policy?

September 17, 2017 16 / 160

 9.6 The Recursive Method

Question 13
The number of claims an insurance company receives is modelled as a
compound Poisson distribution with parameter λ = 6 for the primary
distribution and λ = 0.1 for the secondary distribution. Claim severity
(in thousands of dollars) is modelled as following a zero-truncated
logarithmic distribution with parameter β = 4. What is the probability
that the total amount claimed is more than $3,000.

September 17, 2017 17 / 160

 9.6 The Recursive Method

Question 14
The number of claims an insurance company receives is modelled as a
Poisson distribution with parameter λ = 96. The size of each claim is
modelled as a zero-truncated negative binomial distribution with r = 4
and β = 2.2. Calculate the approximated distribution of the aggregate
claims:
(a) By starting the recursion at a value of k six standard deviations
below the mean.
(b) By solving for a rescaled Poisson distribution with λ = 12 and
convolving the solution up to 96.

September 17, 2017 18 / 160

 Answer to Question 14

R-Code for (a)

ans<-1
ans<-as.vector(ans)
for(n in 2:2000){
temp<-0
for(i in 1:(n-1)){%
temp<-temp+16*i*(i+1)*(i+2)*(i+3)/(n+240)*0.6875^i*
0.3125^4*ans[n-i]/(1-0.3125^4)
}
ans<-c(ans,temp)
}

September 17, 2017 19 / 160

 Answer to Question 14
R-Code for (b)
ConvolveSelf<-function(n){
convolution<-vector("numeric",2*length(n))
for(i in 1:(length(n))){
convolution[i]<-sum(n[1:i]*n[i:1])
}
for(i in 1:(length(n))){
convolution[2*length(n)+1-i]<-sum(n[length(n)+1-(1:i)
]*n[length(n)+1-(i:1)])
}
return(convolution)
}

d24<-ConvolveSelf(ans2)
d48<-ConvolveSelf(d24)
d96<-ConvolveSelf(d48)
plot(dist1,d96[241:2240])

September 17, 2017 20 / 160

 Constructing Arithmetic Distributions

Question 15
Let X follow an exponential distribution with mean θ. Approximate this
with an arithmetic distribution (h = 1) using:
(a) The method of rounding.
(b) The method of local moment matching, matching 2 moments on
each interval.

September 17, 2017 21 / 160

 9.7 Individual Policy Modifications

Question 16
The loss on a given policy is modelled as following an exponential
distribution with mean 2,000. The number of losses follows a negative
binomial distribution with parameters r = 4 and β = 2.1.
(a) Calculate the distribution of the aggregate loss.
(b) What effect would a deductible of $500 have on this distribution?

September 17, 2017 22 / 160

 9.7 Individual Policy Modifications

Question 17
The loss on a given policy is modelled as following a gamma
distribution with α = 3.4 and θ = 2000. The number of losses an
insurance company insures follows a Poisson distribution with λ = 100.
The company has taken out stop-loss insurance with a deductible of
$1,000,000. This insurance is priced at the expected payment on the
policy plus one standard deviation.
(a) How much does the company pay for this reinsurance?
(b) How much should it pay if it introduces a $1,000 deductible on
these policies?

September 17, 2017 23 / 160

 9.8 Individual Risk Model

Question 18
In a group life insurance policy, a life insurance company insures
10,000 individuals at a given company. It classifies these workers in
the following classes:
Type of worker number average annual average death
probability of dying benefit
Manual Laborer 4,622 0.01 $100,000
Administrator 3,540 0.002 $90,000
Manager 802 0.01 $200,000
Senior Manager 36 0.02 $1,000,000
What is the probability that the aggregate benefit paid out in a year
exceeds $10,000,000?

September 17, 2017 24 / 160

 9.8 Individual Risk Model

Question 19
Using the same data as in Question 18, estimate the probability by
modelling the distribution of the aggregate risk as:
(a) a normal distribution
(b) a gamma distribution
(c) a log-normal distribution

September 17, 2017 25 / 160

 9.8 Individual Risk Model

Question 20
Using the same data as in Question 18, estimate the probability using
a compound Poisson approximation, setting the Poisson mean to:
(a) equal the Bernoulli probability
(b) match the probability of no loss

September 17, 2017 26 / 160

 9.8 Individual Risk Model

Question 21
An insurance company has the following portfolio of car insurance
policies:
Type of driver Number Probability mean standard
claim of claim deviation
Safe drivers 800 0.02 $3,000 $1,500
Average drivers 2100 0.05 $4,000 $1,600
Dangerous drivers 500 0.12 $5,000 $1,500
(a) Using a gamma approximation for the aggregate losses on this
portfolio, calculate the cost of reinsuring losses above $800,000, if the
loading on the reinsurance premium is one standard deviation above
the expected claim payment on the reinsurance policy.
(b) How much does the premium change if we use a normal
approximation?

September 17, 2017 27 / 160

 9.8 Individual Risk Model

Question 22
An insurance company assumes that for smokers, the claim probability
is 0.02, while for non-smokers, it is 0.01. A group of mutually
independant lives has coverage of 1000 per life. The company
assumes that 20% of lives are smokers. Based on this assumption, the
premium is set equal to 110% of expected claims. If 30% of the lives
are smokers, the probability that claims will exceed the premium is less
than 0.2. Using a normal approximation, determine the minimum
number of lives in the group.

September 17, 2017 28 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Question 23
An insurance company is modeling claim severity. It collects the
following data points:

325 692 1340 1784 1920 2503 3238 4054 5862

6304 6926 8210 9176 9984
By graphically comparing distribution functions, assess the
appropriateness of a Pareto distribution for modeling this data.

September 17, 2017 29 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Answer to Question 23
1.0
0.8
0.6
F(x)

0.4
0.2
0.0

0 2000 4000 6000 8000 10000

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16.3 Graphical Comparison of Density and Distribution
Functions

Question 24
For the data from Question 23:

325 692 1340 1784 1920 2503 3238 4054 5862

6304 6926 8210 9176 9984
Graphically compare density functions to assess the appropriateness
of a Pareto distribution for modeling this data.

September 17, 2017 31 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Answer to Question 24
0.00015
0.00010
Density

0.00005
0.00000

0 2000 4000 6000 8000 10000

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16.3 Graphical Comparison of Density and Distribution
Functions

Question 25
For the data from Question 23:

325 692 1340 1784 1920 2503 3238 4054 5862

6304 6926 8210 9176 9984
By Graphing the differnce D(x) = F ∗ (x) − Fn (x), assess the
appropriateness of a Pareto distribution for modeling this data.

September 17, 2017 33 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Answer to Question 25
0.10
0.05
0.00
D(x)

−0.05
−0.10
−0.15

0 2000 4000 6000 8000 10000

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16.3 Graphical Comparison of Density and Distribution
Functions

Question 26
For the data from Question 23:

325 692 1340 1784 1920 2503 3238 4054 5862

6304 6926 8210 9176 9984
Use a p-p plot to assess the appropriateness of a Pareto distribution
for modeling this data.

September 17, 2017 35 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Answer to Question 26

●
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0.8

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0.6

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F(x)

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0.4

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●
0.2

0.2 0.4 0.6 0.8 1.0

F*(x)

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16.3 Graphical Comparison of Density and Distribution
Functions

Question 27
An insurance company is modelling a data set. It is considering 3
models, each with 1 parameter to be estimated. On the following slides
are various diagnostic plots of the fit of each model.
Determine which model they should use for the data in the following
situations. Justify your answers.
(a) Which model should they choose if accurately estimating
(right-hand) tail probabilities is most important?
(b) The company is considering imposing a deductible, and therefore
wants to model the distribution very accurately on small values of x.

September 17, 2017 37 / 160

 Models

1e−03
1.0

Model I
Model II

8e−04
Model III
0.8

6e−04
0.6
F(x)

f(x)

4e−04
0.4

Model I

2e−04
Model II
0.2

Model III

0e+00
0.0

0 1000 2000 3000 4000 0 1000 2000 3000 4000

x x

September 17, 2017 38 / 160

16.3 Graphical Comparison of Density and Distribution
Functions

Question 28
For each of the models on the following three slides, determine which
of the statements below best describes the fit between the model and
the data:
i The model distribution assigns too much probability to high values
and too little probability to low values.
ii The model distribution assigns too much probability to low values
and too little probability to high values.
iii The model distribution assigns too much probability to tail values
and too little probability to central values.
iv The model distribution assigns too much probability to central
values and too little probability to tail values.

September 17, 2017 39 / 160

 Model I

1.0

7e−04
6e−04
0.8

5e−04
0.6

4e−04
F(x)

f(x)

3e−04
0.4

2e−04
0.2

1e−04
0e+00
0.0

0 1000 2000 3000 4000 0 1000 2000 3000 4000

x x
0.08

1.0
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D(x)

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0 1000 2000 3000 4000 0.0 0.2 0.4 0.6 0.8 1.0

x F(x)

September 17, 2017 40 / 160

 Model II

1.0

7e−04
6e−04
0.8

5e−04
0.6

4e−04
F(x)

f(x)

3e−04
0.4

2e−04
0.2

1e−04
0e+00
0.0

0 1000 2000 3000 4000 0 1000 2000 3000 4000

x x

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0 1000 2000 3000 4000 0.0 0.2 0.4 0.6 0.8 1.0

x F(x)

September 17, 2017 41 / 160

 Model III

1e−03
1.0

8e−04
0.8

6e−04
0.6
F(x)

f(x)

4e−04
0.4

2e−04
0.2

0e+00
0.0

0 1000 2000 3000 4000 0 1000 2000 3000 4000

x x

1.0
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0 1000 2000 3000 4000 0.0 0.2 0.4 0.6 0.8 1.0

x F(x)

September 17, 2017 42 / 160

16.3 Graphical Comparison of Density and Distribution
Functions
Question 29
An insurance company wants to know whether an exponential
distribution is a good fit for a sample of 40 claim severities. It estimates
θ = 5.609949, and draws the following p-p plot:
1.0
0.8
0.6
Fn(x)

0.4
0.2
0.0

0.0 0.2 0.4 0.6 0.8

F*(x)

How many of the samples they collected were more than 10?
September 17, 2017 43 / 160
16.3 Graphical Comparison of Density and Distribution
Functions
Question 30
An insurance company wants to know whether an exponential
distribution is a good fit for a sample of 40 claim severities. It estimates
θ = 5.609949, and draws the following p-p plot:
1.0
0.8
0.6
Fn(x)

0.4
0.2
0.0

0.0 0.2 0.4 0.6 0.8

F*(x)

How many of the samples they collected were less than 3?

September 17, 2017 44 / 160
16.3 Graphical Comparison of Density and Distribution
Functions
Question 31
An insurance company wants to know whether a Pareto distribution
with θ = 15 is a good fit for a sample of 30 claim severities. It
estimates α = 0.8725098 and draws the following plot of D(x):
0.15
0.10
0.05
0.00
D(x)

−0.05
−0.10
−0.15
−0.20

0 20 40 60 80

How many of the samples they collected were less than 10?
September 17, 2017 45 / 160
 16.4 Hypothesis Tests

Hypothesis Tests
We test the following hypotheses:
H0 : The data came from a population with the given model.
H1 : The data did not come from a population with the given model.

September 17, 2017 46 / 160

 16.4 Hypothesis Tests
Kolmogorov-Smirnov test
D = max |Fn (x) − F (x)|
t6x6u

Anderson-Darling test
u
(Fn (x) − F (x))2
Z
2
A =n f (x) dx
t F (x)(1 − F (x))

Chi-square Goodness-of-fit test

Divide the range into separate regions, t = c0 < c1 < · · · < cn = u.
Let Oi be the number of samples in the interval [ci−1 , ci ).
Let Ei be the expected number of sample in the interval [ci−1 , ci ).
n
X (Oi − Ei )2
X2 =
Ei
i=1
September 17, 2017 47 / 160
 16.4 Hypothesis Tests

Question 32
For the data from Question 23:

325 692 1340 1784 1920 2503 3238 4054 5862

6304 6926 8210 9176 9984
Test the goodness of fit of the model using:
(a) The Kolmogorov-Smirnov test.
(b) The Anderson-Darling test.

September 17, 2017 48 / 160

 16.4 Hypothesis Tests
Answer to Question 32
(b) k
X
A2 = − nF ∗ (u) + (1 − Fn (yj ))2 (log(1 − F ∗ (yj )) − log(1 − F ∗ (yj+1 ))
j=0
k
X
+n Fn (yj )2 (log(F ∗ (yj+1 )) − log(F ∗ (yj+1 )))
j=1

x Fn (x) F ∗ (x) term x Fn (x) F ∗ (x) term

325 0.0714 0.0704 0.0748 4054 0.5714 0.5978 0.1407
692 0.1429 0.1440 0.1190 5862 0.6429 0.7320 0.0267
1340 0.2143 0.2600 0.0726 6304 0.7143 0.7573 0.0323
1784 0.2857 0.3303 0.0204 6926 0.7857 0.7889 0.0532
1920 0.3571 0.3504 0.0803 8210 0.8571 0.8417 0.0309
2503 0.4286 0.4302 0.0876 9176 0.9286 0.8726 0.0215
3238 0.5000 0.5169 0.0822 9984 1.0000 0.8937 0.1124
September 17, 2017 49 / 160
 16.4 Hypothesis Tests

Question 33
Recall Question 27, where a company was deciding between three
models. The D(x) plots are below:
0.08

0.04
0.1
0.06

0.02
0.04

0.00
0.0

−0.02
0.02
D(x)

D(x)

D(x)
−0.1

−0.04
0.00

−0.06
−0.02

−0.2

−0.08
−0.04

0 1000 2000 3000 4000 0 1000 2000 3000 4000 0 1000 2000 3000 4000

x x x

If the company uses the Kolmogorov-Smirnov statistic to decide the

best model, which will it choose?

September 17, 2017 50 / 160

 16.4 Hypothesis Tests

Question 34
An insurance company records the following claim data:
Claim Amount Frequency
0–5,000 742
5,000–10,000 1304
10,000–15,000 1022
15,000–20,000 830
20,000–25,000 211
More than 25,000 143
Use a Chi-square test to determine whether Claim size follows an
exponential distribution.

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 16.4 Hypothesis Tests

Likelihood Ratio test

The Likelihood ratio test compares two nested models — M0 and M1 .

Hypotheses
H0 : The simpler model describes the data as well as the more
complicated model.
H1 : The more complicated model describes the data better
than the simpler model.

We compute the parameters from both models by maximum likelihood.

The test statistic is.

2(lM0 (x; θ0 ) − lM1 (x; θ1 ))

Under H0 , for large n, this follows a Chi-square distribution with
degrees of freedom equal to the difference in number of parameters.

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 16.4 Hypothesis Tests

Question 35
An insurance company observes the following sample of claim data:

382 596 920 1241 1358 1822 2010 2417 2773

3002 3631 4120 4692 5123
Use a likelihood ratio test to determine whether an exponential or a
Weibull distribution fits this data better.

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 Study note: Information Criteria

Basic Idea
For natural measures of fit (log-likelihood, KS test statistic, AD test
statistic, etc.) more complicated models produce better fit.
This is (at least partly) because they are fitting noise in the data.
We can compensate for this by adding a penalty term to penalise
model complexity.

Two Common Approaches

Akaike Information Criterion (AIC): l(θ; x) − 2p
Schwarz Bayesian Criterion(SBC)/Bayesian Information Criterion
(BIC): l(θ; x) − p2 log(n)
where p is the number of estimated parameters, and n is the sample
size.

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 Study note: Information Criteria

Question 36
Recall Question 35, where we had a sample

382 596 920 1241 1358 1822 2010 2417 2773

3002 3631 4120 4692 5123
for which the Weibull distribution has a log-likelihood of −120.7921.
Use AIC and BIC to determine whether an inverse exponential
distribution is a better fit for the data.

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 16.5 Selecting a Model

Comments on Model Selection

Try to pick a model with as few parameters as possible.
(Parsimony)
Choice of model depends on the aspects that are important. Even
if a formal test is used, the choice of which test depends on the
aspects that are important.
Aim is generalisability. The model should apply to future data.
(Models which fit the given data well, but not new data are said to
overfit.)
Trying large numbers of models will lead to one which fits well just
by chance.
Experience is a valuable factor in deciding on a model.
Sometimes knowledge of the underlying process may lead to a
particular model (e.g. binomial).

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 2.2 Automobile insurance
Types of Automobile-insurance coverage
Liability insurance
Medical Benefits
Uninsured and underinsured motorist coverage
Collision insurance
Other than collision (OTC) insurance
Notes
First two coverages often legally required.
Other coverages may be required in order to use car as security
for a loan.
Policy usually covers policyholder and immediate family on listed
vehicles. May also cover invited drivers.
Covers listed vehicles and usually also attached trailers, etc.
Other policies apply to commercial vehicles.
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 2.2 Automobile insurance

Tort system
In this system, fault for an accident is legally determined through a
court case, or settlement. At-fault party is legally responsible for all
costs.

No-fault system
Injured party is covered through their own insurance, with no need to
determine fault for the accident. Many different details for how this
system can work — e.g. threshold no-fault or government monopoly.
Even in this system, determination of fault may be performed to
determine future premiums.

Question 37
What are the advantages and disadvantages of each system?

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 2.2 Automobile insurance

Liability insurance
Covers costs of policyholder’s damage to third parties.
Can cover legal costs of policyholder.
Policy limits usually apply to damage payments, not legal costs.
Insurer may however stop paying legal costs once its damage
payments have already exceeded the policy limit.
This insurance is compulsory almost everywhere, with minimum
legal limits. It may be advisable to buy increased policy limits if
these are low.
Premiums vary with policy limits, location, use of automobile,
driving record of policyholder, age, sex and marital status of the
policyholder.

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 2.2 Automobile insurance

Medical benefits
Sometimes called medical payments, personal injury protection or
accident benefits.
Covers costs (e.g. medical costs, income replacement, survivors
benefits, rehabilitation costs, home care costs) arising from injury
to policyholder (unless another party is liable).
Usually compulsory
May not apply to commercial vehicles where these benefits are
covered by workers compensation.
In tort juristictions, liability insurance is more important (and
accounts for more of the costs). In no-fault juristictions, medical
benefit insurance is more important, and accounts for more costs.

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 2.2 Automobile insurance

Uninsured and underinsured motorist coverage

Covers costs to policyholder if injured by:
an unidentified driver
an uninsured driver
an underinsured driver (if liable driver’s coverage is lower than
policyholder’s)

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 2.2 Automobile insurance
Collision insurance and OTC insurance
Cover damage to policyholder’s vehicle.
loss is defined as lesser of cash value of damaged property or
cost to repair/replace. May include special provisions for cases
where cash value (with depreciation) exceeds outstanding
balance on a loan secured by the property.
Usually include a deductible.
In a tort juristiction, the insurer who pays the benefits can sue the
at-fault driver. If the suit is successful, the insurer will reimburse
the deductible to the policyholder, and use the rest to cover the
payment. This is known as subrogation.
Subrogation reduces the cost of collision insurance, and increases
the cost of liability insurance.
If the insurer decides not to sue, the policyholder can sue for their
deductible, and any costs exceeding the policy limit.
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 2.2 Automobile insurance
Collision insurance and OTC insurance (cont.)
If vehicle is “written-off”, the insurer has the right of salvage — any
scrap value of vehicle belongs to insurer. If scrap value exceeds
amount paid, the insurer must increase its payment accordingly.
Premiums for collision and OTC insurance depend on:
Type of car (based on value of car and cost of repairs).
Use of car
Location.
Driver’s history.
Where allowed by law: age, gender, marital status.
OTC covers fire, weather, vandalism, stone chips, theft, etc.
Usually excludes: war, terrorism, wear & tear, road damage to
tyres, radioactive contamination, and collision.
Comprehensive includes any cause not specifically excluded.
Under specified perils, only a given list of causes are reimbursed.
OTC premiums usually only vary by vehicle type and location.
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 2.3 Homeowner’s insurance
Four Coverages in Homeowner’s Insurance
Coverage A — Damage to home
Coverage B — Damage to garage or other structures
Coverage C — Personal property in home
Coverage D — Living expenses and loss of rental income
Section II — Liability

Doctrine of Proximate Cause

Coverage might be comprehensive or specified perils.
Proximate cause is a legal definition of when one event can be
considered to have caused another. The proximate cause must be
directly linked to the damage by a chain of events without other
independent causes.
For a claim to be payable, an insured peril must be a proximate
cause of an insured loss.
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 2.3 Homeowner’s insurance
Coverage A
Includes a deductible (may decrease to zero for larger losses).
Subrogation can apply here if a third party is liable for the damage.
Policy limits less than 80% of the value of the house (at time of
loss) result in coinsurance for smaller claims.
Increases in house prices could result in a homeowner falling
below the 80% cut-off by accident.
Many insurers offer an option for the premium to increase annually
in line with a specified index, and to waive the 80% requirement.
Question 38
A homeowner’s house is valued at $350,000. However, the home is
insured only to a value of $260,000. The insurer requires 80%
coverage for full insurance. The home sustains $70,000 of water
damage due to a burst pipe. How much does the insurer reimburse?
(There is no deductible for losses above $2,000.)
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 2.3 Homeowner’s insurance

Coverage B — Garage
Usually up to 10% value of house.
More coverage can be purchased for extra premium.

Coverage C — Personal Property

Limit usually 40–50% of house value
Often inside limits on each type of item.
For full insurance on jewellry, silverware or art, policyholder can
provide a schedule showing appraised values of these items. If
lost or stolen, this appraised value is paid by insurer (not the
current market value).
Extends to borrowed property in policyholder’s possession.
Also applies to personal property lost or damaged outside the
home.
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 2.3 Homeowner’s insurance
Coverage D — Accommodation and Loss of Rental Income
Covers fair rental value for alternative accommodation while
repairs are made to home.
Also covers lost rental income from any part of the home that lost
while damage is repaired.

Section II — Liability
Liability could arise if a third party is injured or property is
damaged while on the property.
Only applies in case of negligence by homeowner.
Most claims settled out of court.
Insurance will pay policyholder’s defence costs unless liability
payments already made exceed policy limits.
Limited medical coverage for injured third-parties on a no-fault
basis.
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 2.3 Homeowner’s insurance

Comments on Homeowner’s Insurance

Premiums depend on location, construction and value.
In high-risk areas for floods and earthquakes, these perils are
often excluded.
Coverage for these excluded perils can be purchased for an extra
premium.
Construction may affect the risk of various perils.
Discounts may be offered for security systems or sprinkler
systems, etc.

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 2.4 Tennants package

Tennant insurance
Contains provisions of homeowners insurance relevant to tennants
Includes personal possessions.
Generally lower liability provisions for apartments because
majority of liability arises from incidents on surrounding ground,
covered by landlord’s insurance.
Different policies also available for condominium owners.

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 2.5 Workers’ compensation
Workers’ Compensation
Early type of no-fault insurance.
Prior to 1895, getting compensation was difficult for employees.
Objectives of Worker’s Compensation:
Broad coverage of occupational illness and injury.
Protection against loss of income
Provide medical care and rehabilitation expenses
Encourage employers to provide safer workplaces.
Provide efficient and effective delivery of benefits.
Workers’ Compensation Board controlled by province.
U.S. employers can choose private, self or state insurance.
Employee must work in a covered occupation, and experience an
accident or disease resulting from employment, while employed.
Diseases develop slowly, generally more expensive, often subject
to disagreements about extent to which they are caused by work.
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 2.5 Workers’ compensation

Typical Benefits
Unlimited medical care benefits
Disability income benefits, waiting period 3–7 days, percentage of
salary, depending on degree of disability. Degree of disability is
usually classified as:
Temporary but total
Permanent and total
Temporary and partial
or Permanent but partial
Death benefits
Rehabilitation benefits and services.
Premiums depend on salaries of employees, industry class, etc.

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 2.6 Fire insurance
Fire insurance
Included in homeowner insurance and tennants insurance.
Policies provide protection for commercial properties.
Originally only fire was an insured peril, but many more perils now
covered, even some comprehensive policies.
Covers both direct and indirect loss.
Standard Fire Policy covers direct loss from fire and lightning.
At least one additional form must be added. Common forms:
Include personal coverage
Include commercial coverage
Increase covered perils (e.g. vandalism, malicious mischief, etc.)
Increase covered losses (e.g. living expenses, rental income,
leasehold interests, demolition, business interruption losses)
Allied lines are additional coverage sold in separate policies, e.g.
earthquake, rain, sprinkler leakage, water damage, crop hail.
Larger corporations may design own forms to meet specific needs.
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 2.7 Marine insurance

Ocean Marine Insurance

Covers oceangoing ships and cargo. Covers shipowner’s liability.
Basic policy only covers cargo while loaded onto ship.
Some policies provide warehouse-to-warehouse coverage.

Inland marine insurance

A modification of marine insurance for the trucking industry.
Covers transportation of goods by railway, motor vehicle, ship or
barge on inland waterways (e.g. canals and rivers) or coastal
trade, air, mail, armoured car or messenger.
Also covers infrastructure for transportation — bridges, tunnels,
wharves, docks, communication equipment, moveable property.
May have additional coverage for construction equipment,
personal jewellry and furs, agricultural equipment, and animals.

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 2.8 Liability insurance
Types of Liability Insurance
Included by default in auto and homeowner’s insurance.
Product liability insurance
Errors and omissions Insurance
Medical malpractice insurance
Professional liability insurance
Features of Liability Insurance
Low frequency high value claims.
Claims often reported years after event.
Claims often take many more years to settle after reporting.
Claims-made policy form covers only claims after a specified date
reported during policy period.
Tail coverage sold to cover claims reported after the period.
High litigation cost. Sometimes policy limit applies to legal costs.
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 2.9 Limits to Coverage— Deductibles
Reasons for Using Deductibles
Small claims involve disproportionate administrative costs.
Premium savings.
Moral hazard.
Better expected utility.
Problems with Deductibles
Public relations.
Marketing difficulties.
Insureds may inflate claims to recover deductible.
Types of Deductible
Fixed dollar deductibles Franchise deductibles
Fixed %age deductibles Fixed dollar deductible per year
Disappearing deductibles Elimination period
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 2.9 Limits to Coverage— Policy Limits

Reasons for Policy Limits

Clarifies insurer’s oblications
Reduces risk to insurer, allowing lower premiums.
Allows policyholder to choose appropriate coverage.

Notes on policy limits

Policy may have different policy limits for different parts of claim.
May also have inner limits.
Policy limits apply to damage payments only — they do not
include administrative and legal costs.

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 2.9 Limits to Coverage

Question 39
An insurer sells 100 identical policies. Each policy has a 50%
probability of incurring a loss. If a loss is incurred, the loss follows a
Pareto distribution with α = 2 and θ = 10000.
(a) What is the probability that at least one policy incurs a single loss
exceeding $1,000,000?
(b) If the insurer has a policy limit of $100,000 on the policy, what is the
probability that the aggregate loss exceeds $1,000,000?

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 4.2 How outstanding claim payments arise
Typical Steps in a Claim Payment
1 Claim Event
2 (a) Claim reported to agent. (b) Claim recorded by insurer.
3 (a) Initial payments and settlement offer. (b) Settlement rejected.
4 Court case.
Notes
Common for lengthy delays to occur between steps.
Claims could remain open for 10–20 years.
Time to settlement can vary a lot with line of insurance.
Largest claims often settle last.

Sources of Uncertainty
Eventual cost of claim payments for known claims.
Claims incurred but not yet reported.
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 4.3 Definition of terms

Claim File
Established as soon as field adjuster is aware of pending claim.
Field adjuster estimates expected ultimate claim payment, and
updates the estimate regularly.
Aggregate of individual claim file estimates called case reserves.

Gross IBNR
Additional reserves above case reserves, also called bulk reserve,
including provision for:
Adjustments of case reserves
Claim files which are closed but may reopen.
Claims incurred but not reported (IBNR).
Claims reported but not recorded (RBNR).

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 4.3 Definition of terms
Paid Loss Development
Change in cumulative payments made between valuation dates
called paid age-to-age loss development.
Relative change called paid loss development factor. Can be less
than 1 because of salvage and subrogation.
Difference between cumulative payments made and ultimate
payment amount called age-to-ultimate loss development.

Incurred Loss Development

Incurred age-to-age loss development: change in estimated costs.
Incurred loss-development factor is relative change.
Incurred loss-development factors can be less than 1 if estimates
were conservative or because of salvage and subrogation.
Incurred loss-development factors greater than 1 indicate
inadequate claim file estimates.
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 4.3 Definition of terms
Salvage and Subrogation
Recall that after paying a claim, insurance company acquires rights of
salvage and subrogation (provided the money returned does not
exceed the claim amount). These can reduce the incurred losses.

Loss adjustment expenses

Expenses involved with settling claims — e.g. legal costs.
Allocated loss adjustment expenses (ALAE) relate to specific
claims. These become part of total claim cost.
Unallocated loss adjustment expenses (ALAE) (e.g. rent) are
allocated among calculated reserves following a formula.
Classification can vary between insurers.

Fast Track Reserves

High frequency, low severity lines of insurance use fast track average
reserves based on recent experience and trends for new claim files.
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 4.4 Professional considerations
Setting loss reserves requires detailed knowledge
Company’s business. For example any changes in
Portfolio composition.
Claim administration.
Management.
Reinsurance.
External factors. For example
Inflation.
Legal rulings.
Format and definitions of data used by company. For example,
how are claims separated into claim files? Actuary should
separate data into homogeneous categories. This may involve
splitting separate parts of individual claims.
The actuary must review accuracy of data and compare multiple
methods for estimating reserves. Where methods give conflicting
answers, actuary must explain differences.
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 4.5 Checking the data

Checking for Inconsistencies.

It is important to check for consistency of patterns accross the
data.
Where inconsistencies arise in the data, the actuary must identify
the source of the inconsistency.
Reserving actuary must document the findings and any ensuing
adjustments or subjective changes to the calculations.

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 4.6 Loss reserving methods
Expected Loss Ratio Method
1 Calculate the expected ultimate loss ratio (ultimate claim
payments divided by total earned premiums).
2 Multiply be earned premiums for period.
3 Subtract payments made to date.

Problems with this approach

Danger of manipulation of expected loss ratio.
Expected loss ratio will not apply after changes of premium.
Expected loss ratio might change if portfolio changes.

Why is the method used?

For new lines of business without past data, it may be the only
available method.
Can be used as a backup check for other methods.
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 4.6 Loss reserving methods
Question 40
An insurance company has three types of claims with different
expected loss ratios as shown in the following table:
Claim Type Policy Earned Expected Losses paid
Year Premiums Loss Ratio to date
2014 $200,000 0.79 $130,000
Collision 2015 $250,000 0.79 $110,000
2016 $270,000 0.77 $60,000
2014 $50,000 0.74 $36,600
Comprehensive 2015 $60,000 0.72 $44,300
2016 $65,000 0.75 $41,400
2014 $300,000 0.73 $86,000
Bodily Injury 2015 $500,000 0.73 $85,000
2016 $600,000 0.72 $12,000
Use the expected loss ratio method to estimate the loss reserves
needed.
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 4.6 Loss reserving methods

Question 41
The following table shows the paid losses on claims from one line of
business of an insurance company over the past 6 years.
Development year
Accident year 0 1 2 3 4 5
2011 5,826 659 2,910 845 1,349 120
2012 7,327 2,896 1,540 963 −348
2013 8,302 1,719 1,380 2,031
2014 8,849 1,701 673
2015 9,950 320
2016 11,290
Assume that all payments on claims arising from accidents in 2011
have now been settled. Estimate the future payments arising each
year from open claims arising from accidents in each calendar year.
(That is, fill in the empty cells in the table.)

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 4.6 Loss reserving methods

Answer to Question 41
We first construct the cumulative loss payments in the following table:
Accident Development year
year 0 1 2 3 4 5
2011 5,826 6,485 9,395 10,240 11,589 11,709
2012 7,327 10,223 11,763 12,726 12,378
2013 8,302 10,021 11,401 13,432
2014 8,849 10,550 11,223
2015 9,950 10,270
2016 11,290

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 4.6 Loss reserving methods

Answer to Question 41
The corresponding loss development factors are
Accident Development year
year 1/0 2/1 3/2 4/3 5/4
2011 1.113 1.449 1.090 1.132 1.010
2012 1.395 1.151 1.082 0.973
2013 1.207 1.138 1.178
2014 1.192 1.064
2015 1.032

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 4.6 Loss reserving methods

Answer to Question 41
The corresponding loss development factors are
Accident Development year
year 1/0 2/1 3/2 4/3 5/4
2011 1.113 1.449 1.090 1.132 1.010
2012 1.395 1.151 1.082 0.973
2013 1.207 1.138 1.178
2014 1.192 1.064
2015 1.032

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 4.6 Loss reserving methods— Chain ladder or loss
development triangle method
Approaches
Average
5-year average
Mean — weighted by claim payment amounts.
Pros and Cons of Incurred Loss Triangles
Incurred loss estimates represent the company’s best estimate of
losses, including information not reflected in paid loss data.
Paid loss data are objective, incurred loss data are subjective.
Incurred loss estimates react immediately to changes.
Problems with chain ladder approach
Too many parameters for the data.
Unstable — changes in methodology or a few large claims can
have excessive influence on estimated reserves.
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 4.6 Loss reserving methods
Bornhuetter-Ferguson method
1 Calculate the expected ultimate claim payments (using expected
ultimate loss ratio times earned premiums)
2 Calculate loss development factors using chain-ladder method
3 Work backwards from expected ultimate payments using loss
development factors to get expected loss development.

Question 42
Recall Question 41, where the average loss development factors were
Year 1/0 2/1 3/2 4/3 5/4
Average 1.113114 1.200218 1.11665 1.052196 1.010355
Suppose the expected loss ratio is 0.72, and the earned premiums are
Accident Year 2012 2013 2014 2015 2016
Earned Prem. 180,000 205,000 210,000 220,000 270,000
Use the Bornhuetter Fergusson method to calculate the loss reserves
needed for each accident year.
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 4.6 Loss reserving methods

Question 43
An actuary is reviewing the following loss development triangles:
No. of closed claims Total paid losses on closed
claims (000’s)
Acc. Development Year Ult. Acc. Development Year
Year 0 1 2 3 4 Year 0 1 2 3 4
2012 250 335 370 395 400 400 2012 723 2,087 2,263 2,822 4,783
2013 280 385 400 450 460 2013 1,509 2,641 2,948 5,256
2014 330 395 470 500 2014 1,745 3,214 3,754
2015 320 460 540 2015 3,094 3,244
2016 360 580 2016 2,824
Calculate tables of percentage of claims closed and cumulative
average losses.

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 4.6 Loss reserving methods

Answer to Question 43
percentage of claims closed cumulative average payment per claim

Acc. Development Year Acc. Development Year

Year 0 1 2 3 4 Year 0 1 2 3 4
2012 62.5 83.8 92.5 98.8 100 2012 2,892 6,230 6,116 7,144 11,958
2013 60.9 83.7 87.0 97.8 2013 5,389 6,860 7,370 11,680
2014 66.0 79.0 94.0 2014 5,288 8,137 7,987
2015 59.3 85.2 2015 9,669 7,052
2016 62.1 2016 7,844

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 4.6 Loss reserving methods

Question 44
For the loss development triangles from Question 43:
Percentage of closed claims Total paid losses on closed
claims (000’s)
Acc. Development Year Acc. Development Year
Year 0 1 2 3 4 Year 0 1 2 3 4
2012 62.5 83.8 92.5 98.8 100 2012 723 2,087 2,263 2,822 4,783
2013 60.9 83.7 87.0 97.8 2013 1,509 2,641 2,948 5,256
2014 66.0 79.0 94.0 2014 1,745 3,214 3,754
2015 59.3 85.2 2015 3,094 3,244
2016 62.1 2016 2,824
Adjust the total paid losses to use the current disposal rate.

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 4.6 Loss reserving methods

Answer to Question 44
Acc. Development Year
Year 0 1 2 3 4
2012 728 2,053 2,227 2,851 4,783
2013 1,480 2,595 2,728 5,256
2014 1,855 2,980 3,754
2015 2,954 3,244
2016 2,824

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 4.6 Loss reserving methods

Notes on using separate frequency and severity

Easier to see some patterns or trends.
Can use this to adjust for different speeds of finalisation.
Note that payments in this table represent payments made on
closed files, and do not include partial payments on open files.
When calculating the average, usually exclude claims on which no
payment was made. If this is not possible, it is important to be
consistent between different years.

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 4.7 Discounting loss reserves

Discounting Reserves
Discounting future payments is a basic actuarial principal.
However, many juristictions forbid discounting loss reserves.
One argument in support of this is that it incorporates a
contingency loading in the reserves.
On the other hand, it may be better to incorporate an additional
contingency loading.
Timing of payments needs to be considered.
Often a final small reserve should be retained for claims that take
an extremely long time to settle. Estimating the timing of this can
be difficult.
Investment management is more complicated, and tax issues also
arise.

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 4.7 Discounting loss reserves

Question 45
Recall that in Quesion 41 we calculated the following expected
payments.
Accident Development year
year 0 1 2 3 4 5
2012 12506
2013 14133 14279
2014 12532 13186 13323
2015 12326 13764 14483 14632
2016 12567 15083 16843 17722 17905
Using a discount rate of 7%, calculate the expected reserves needed
to cover these payments.

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 4.7 Discounting loss reserves

Answer to Question 45
The discounted values of all expected future payments are:
Accident Development year
year 0 1 2 3 4 5
2012 11,688
2013 13,100 12,370
2014 11,726 11,436 10,799
2015 11,272 11,777 11,486 10,846
2016 12,464 13,680 14,293 13,940 13,163

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 Credibility Theory

Example
An insurance company offers group life insurance to all 372
employees of a company.
The premium is set at $1,000 per year.
The company notices that the average annual total claim over the
past 7 years is $126,000 — Far lower than the total premiums
charged.
The company contacts the insurers and asks for a reduction in
premiums on the basis that premiums are much larger than the
average claim.

(a) Is this request reasonable?

(b) What would be a fair reduction in premium?

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 17.3 Full Credibility

Definition
We assign full credibility to a policyholder’s past history if we have
sufficient data to use the policyholder’s average claim for our premium
estimate.

Criterion for Full Credibility

Let ξ be the (unknown) expected claim from a policyholder. We pick
r > 0 and 0 < p < 1. We assign full credibility to X if

P(|X − ξ| < r ξ) > p

That is if with probability p, the relative error of X as an estimator for ξ

is less than r .

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 17.3 Full Credibility

Question 46
Recall our earlier example:
An insurance company offers group life insurance to all 372
employees of a company.
The premium is set at $1,000 per year.
The average annual total claim over the past 7 years is $126,000.
Suppose that all policies have a death benefit of $98,000, and deaths
of each employee are independent.
(a) Should the insurers assign full credibility to this experience? (Use
r = 0.05 and p = 0.95.)
(b) How many years of past history are necessary to assign full
credibility?

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 17.3 Full Credibility

Question 47
Recall our earlier example:
An insurance company offers group life insurance to all 372
employees of a company.
The premium is set at $1,000 per year.
The average annual total claim over the past 7 years is
$1,260,000.
Suppose that all policies have a death benefit of $98,000, and deaths
of each employee are independent.
If the standard for full credibility is measured in terms of number of
claims, instead of number of years, what standard is needed in this
case, and how does the standard vary with number of years.

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 17.3 Full Credibility

Question 48
A car insurance company is reviewing claims from a particular brand of
car. It finds that over the past 3 years:
it has issued 41,876 annual policies for this type of car.
The average annual aggregate claim per policy is $962.14.
The standard deviation of annual aggregate claim per policy is
$3,605.52
(a) Should it assign full credibility to the historical data from this type of
car?
(b) How many policies would it need in order to assign full credibility?

September 17, 2017 103 / 160

 17.4 Partial Credibility

Question 49
Recall our original example:
Group life insurance for 372 employees of a company.
The premium is set at $1,000 per year.
The average annual total claim over the past 7 years is $126,000.
All policies have a death benefit of $98,000, and deaths of each
employee are independent.
In Question 46, we determined that this was not sufficient to assign full
credibility to the data, and that 1191.034 years of claims data would be
needed for full credibility.

How much credibility should we assign to this data, and what

should the resulting premium be?

September 17, 2017 104 / 160

 17.4 Partial Credibility

Question 50
For a particular insurance policy, the average claim is $230, and the
average claim frequency is 1.2 claims per year. A policyholder has
enrolled in the policy for 10 years, and has made a total of 19 claims
for a total of $5,822. Calculate the new premium for this policyholder if
the standards for full credibility are:
(a) 421 claims for claim frequency, 1,240 claims for severity.
(b) 1146 claims for claim frequency, 611 claims for severity.
(c) 400 years for aggregate losses

September 17, 2017 105 / 160

 17.5 Problems with this Approach

Problems
No theoretical justification.
Need to choose r and p arbitrarily.
Doesn’t take into account uncertainty in the book premium.

September 17, 2017 106 / 160

 17.5 Problems with this Approach

Question 51
An insurance company sells car insurance. The standard annual
premium is $1,261. A car manufacturer claims that a certain model of
its cars is safer than other cars and should receive a lower premium.
The insurance company has issued 3,722 policies for this model of car.
The total aggregate claims on these polices were $3,506,608. The
variance of the annual aggregate claims on a policy is 8,240,268.
Calculate the Credibility premium for different values of r and p.

September 17, 2017 107 / 160

 17.5 Problems with this Approach

R-code for Question 51

#Limited Fluctuation Credibility Premium as r changes
p<-0.05
r<-(1:1000)/100000
Z<- 20.02297*r/qnorm(1-p/2)
Z<-pmin(Z,1)
plot(r,Z*3506608/3722+(1-Z)*1261,type=’l’)
pdf("LFCredibilityChangeRPp=0.05.pdf")
plot(r,Z*3506608/3722+(1-Z)*1261,type=’l’,ylab="
Credibility Premium")
dev.off()

September 17, 2017 108 / 160

 17.5 Problems with this Approach
Answer to Question 51
1265

1265
1260

1260
1255

1255
Credibility Premium

Credibility Premium
1250

1250
1245

1245
1240

1240
1235

1235
1230

1230
0.000 0.002 0.004 0.006 0.008 0.010 0.000 0.002 0.004 0.006 0.008 0.010

r r

p = 0.05 p = 0.01
1265

1265
1260

1260
1255

1255
Credibility Premium

Credibility Premium
1250

1250
1245

1245
1240

1240
1235

1235
1230

1230

0.00 0.02 0.04 0.06 0.08 0.10 0.00 0.02 0.04 0.06 0.08 0.10

p p

r = 0.005 r = 0.001
September 17, 2017 109 / 160
 17.5 Problems with this Approach
Answer to Question 51

0.005
0.004
0.003
r

0.002
0.001
0.000

0.000 0.002 0.004 0.006 0.008 0.010

September 17, 2017 110 / 160

 18 Greatest Accuracy Credibility

Assumptions
Each policyholder has a risk parameter Θ, which is a random
variable, but is assumed constant for that particular policyholder.
Individual values of Θ can never be observed.
The distribution of this risk parameter Θ has density (or mass)
function π(θ), which is known. (We will denote the distribution
function Π(θ).)
For a given value Θ = θ, the conditional density (or mass) of the
loss distribution fX |Θ (x|θ) is known.

September 17, 2017 111 / 160

 18.2 Conditional Distributions and Expectation

Conditional Distributions (revision)

fX ,Θ (x, θ)
fX |Θ (x|θ) = R
fX ,Θ (y , θ) dy
fX |Θ (x|θ)fΘ (θ) = fΘ|X (θ|x)fX (x)

Conditional Expectation (revision)

E(X ) = E(E(X |Θ))

Var(X ) = E(Var(X |Θ)) + Var(E(X |Θ))

September 17, 2017 112 / 160

 18.2 Conditional Distributions and Expectation

Question 52
An insurance company models drivers as falling into two categories:
frequent and infrequent. 75% of drivers fall into the frequent category.
The number of claims made per year by a driver follows a Poisson
distribution with parameter 0.4 for frequent drivers and 0.1 for
infrequent drivers.
(a) Calculate the expectation and variance of the number of claims in a
year for a randomly chosen driver.
(b) Calculate the expectation and variance of the number of claims in a
year for a randomly chosen driver who made no claims in the previous
year.

September 17, 2017 113 / 160

 18.3 Bayesian Methodology

Question 53
The aggregate health claims (in a year) of an individual follows an
inverse gamma distribution with α = 3 and θ varying between
individuals. The distribution of θ is a Gamma distribution with
parameters α = 3 and θ = 100.
(a) Calculate the expected total health claims for a random individual.
(b) If an individual’s aggregate claims in two consecutive years are
$112 and $240, calculate the expected aggregate claims in the third
year.

September 17, 2017 114 / 160

 18.3 Bayesian Methodology

Question 54
The number of claims made by an individual in a year follows a
Poisson distribution with parameter Λ. Λ varies between individuals,
and follows a Gamma distribution with α = 0.5 and θ = 2.
(a) Calculate the expected number of claims for a new policyholder.
(b) Calculate the expected number of claims for a policyholder who has
made m claims in the previous n years.

September 17, 2017 115 / 160

 18.3 Bayesian Methodology

Question 55
The number of claims made by an individual in a year follows a
Poisson distribution with parameter Λ. Λ varies between individuals,
and follows a Pareto distribution with α = 4 and θ = 3. [This has mean
1 and variance 2, like the Gamma distribution from Question 54.]
Calculate the expected number of claims for a policyholder who has
made m claims in the previous n years.

September 17, 2017 116 / 160

 18.3 Bayesian Methodology

Answer to Question 55
Pareto Prior Gamma Prior
1 2 3 4 1 2 3 4
0 0.433 0.294 0.224 0.182 0 0.333 0.200 0.143 0.111
1 0.926 0.607 0.458 0.369 1 1.000 0.600 0.429 0.333
2 1.479 0.940 0.700 0.561 2 1.667 1.000 0.714 0.556
3 2.087 1.289 0.951 0.758 3 2.333 1.400 1.000 0.778
4 2.749 1.654 1.208 0.958 4 3.000 1.800 1.286 1.000
5 3.457 2.034 1.472 1.163 5 3.667 2.200 1.571 1.222
6 4.207 2.426 1.742 1.370 6 4.333 2.600 1.857 1.444
7 4.992 2.829 2.018 1.581 7 5.000 3.000 2.143 1.667
8 5.807 3.242 2.298 1.795 8 5.667 3.400 2.429 1.889
9 6.648 3.664 2.583 2.011 9 6.333 3.800 2.714 2.111

September 17, 2017 117 / 160

 18.4 The Credibility Premium

Problems with Bayesian Approach

Difficult to Compute.
Sensitive to exact model specification.
Difficult to perform model selection for the unobserved risk
parameter Θ.

September 17, 2017 118 / 160

 18.4 The Credibility Premium

Approach
Credibility premium is a linear combination of book premium and
personal history.
n
X
α0 + αi Xi
i=1

Coefficients are chosen to minimise Mean Squared Error (MSE)

n
!!2
X
E µ(Θ) − α0 + αi Xi
i=1

September 17, 2017 119 / 160

 18.4 The Credibility Premium

Question 56
Show that the solution which minimises the MSE satisfies:
n
X
E(Xn+1 ) = α0 + αi E(Xi )
i=1
n
X
Cov(Xi , Xn+1 ) = αj Cov(Xi , Xj )
j=1

September 17, 2017 120 / 160

 18.4 The Credibility Premium

Question 57
Suppose the Xi all have the same mean, the variance of Xi is σ 2 , and
the covariance Cov(Xi , Xj ) = ρ. Calculate the credibility estimate for
Xn+1 .

September 17, 2017 121 / 160

 18.4 The Credibility Premium
Question 58
Suppose we have observations X1 , . . . , Xn and Y1 , . . . , Ym , which are
the aggregate annual claims for each of two cars driven by an
individual. We assume:

E(Xi ) = µ
E(Yi ) = ν
Var(Xi ) = σ 2
Var(Yi ) = τ 2
Cov(Xi , Xj ) = ρ for i 6= j
Cov(Yi , Yj ) = ζ for i 6= j
Cov(Xi , Yj ) = ξ

Calculate the credibility estimate for Xn+1 + Ym+1 .

September 17, 2017 122 / 160
 18.5 The Buhlmann Model
Assumptions
X1 , . . . , Xn are i.i.d. conditional on Θ.
We then define:
µ(θ)=E(X |Θ = θ) µ=E(µ(Θ))
ν(θ) =Var(X |Θ = θ) ν =E(ν(Θ))
a=Var(µ(Θ))

Solution
E(Xi ) = µ Var(Xi ) = ν + a
Cov(Xi , Xj ) = a
Recall from Question 57, that the solution to this is:
v


a
n
µ̂ = v µ+

X
n+ a n + va
September 17, 2017 123 / 160
 18.5 The Buhlmann Model

Question 59
An insurance company offers group health insurance to an employer.
Over the past 5 years, the insurance company has provided 851
policies to employees. The aggregate claims from these policies are
$121,336. The usual premium for such a policy is $326. The variance
of hypothetical means is 23,804, and the expected process variance is
84,036. Calculate the credibility premium for employees of this
employer.

September 17, 2017 124 / 160

 18.5 The Buhlmann Model

Question 60
An insurance company offers car insurance. One policyholder has
been insured for 10 years, and during that time, the policyholder’s
aggregate claims have been $3,224. The book premium for this
policyholder is $990. The expected process variance is 732403 and
the variance of hypothetical means is 28822. Calculate the credibility
premium for this driver next year.

September 17, 2017 125 / 160

 18.6 The Buhlmann-Straub Model
Assumptions
Each observation Xi (expressed as loss per exposure) has a
(known) exposure mi . The conditional variance of Xi is vm(θ)
i
.

Cov(Xi , Xj ) = a
v
Var(Xi ) = +a
mi

Solution
v


a mi
α0 = µ αi =
m + va m+ v
a
v


a m
µ̂ = v µ+ X
m+ a m + va
Pn mi
where X is the weighted mean i=1 m Xi .
September 17, 2017 126 / 160
 18.6 The Buhlmann-Straub Model

Question 61
For a group life insurance policy, the number of lives insured and the
total aggregate claims for each of the past 5 years are shown in the
following table:

Year 1 2 3 4 5
Lives insured 123 286 302 234 297
Agg. claims 0 $300,000 $200,000 $200,000 $300,000

The book rate for this policy premium is $1,243 per life insured. The
variance of hypothetical means is 120,384 and the expected process
variance is 81,243,100. Calculate the credibility premium per life
insured for the next year of the policy.

September 17, 2017 127 / 160

 18.6 The Buhlmann-Straub Model

Question 62
A policyholder holds a landlord’s insurance on a rental property. This
policy is in effect while the property is rented out. The company has
the following experience from this policy:

Year 1 2 3 4 5 6
Months rented 3 11 8 12 6 9
Agg. claims 0 $10,000 0 0 $4,000 0

The standard premium is $600 per year for this policy. The variance of
hypothetical means is 832076, and the expected process variance is
34280533 (both for annual claims). Calculate the credibility premium
for the following year using the Buhlmann-Straub model.

September 17, 2017 128 / 160

 18.7 Exact Credibility

Question 63
Show that if the Bayes premium is a linear function of Xi , and the
expectation and variance of X are defined, then the Bayes premium is
equal to the credibility premium.

September 17, 2017 129 / 160

 18.7 Exact Credibility

Question 64
Show that if the model distribution is from the linear exponential family,
and the prior is the conjugate prior, with rπ(θ 1) π(θ0 )
0 (θ ) = r 0 (θ ) , where θ0 and θ1
1 0
are the upper and lower bounds for θ, then the Bayes premium is a
linear function in X .

September 17, 2017 130 / 160

 19 Empirical Bayes Parameter Estimation

Approach
Estimate the distribution of Θ from the data.
Use this estimate to calculate the credibility estimate of µ.

Two possibilities

Either: We do not have a good model for the conditional or prior

distribution. We only need the variances, so we estimate
them non-parametrically.
or: We have a parametric model, such as a Poisson distribution,
which allows us to estimate the variance more efficiently
(assuming the model is accurate).

September 17, 2017 131 / 160

 19.2 Nonparametric Estimation

Question 65
An insurance company has the following aggregate claims data on a
new type of insurance policy:
No. Year 1 Year 2 Year 3 Year 4 Year 5 Mean Variance
1 336 0 528 0 0 172.80 60595.2
2 180 234 0 2,642 302 671.60 1225822.8
3 0 0 528 361 0 177.80 62760.2
4 443 729 1,165 0 840 635.40 192962.3
5 0 0 0 0 0 0.00 0.0
6 196 482 254 303 0 247.00 30505.0
7 927 0 884 741 604 633.60 140653.7
8 0 601 105 130 327 232.60 56385.3
(a) Estimate the expected process variance and the variance of
hypothetical means.
(b) Calculate the credibility premiums for each policyholder next year.

September 17, 2017 132 / 160

 19.2 Nonparametric Estimation

Theorem
σ 2
Let X1 , . . . , Xn all have mean µ, and let Xi have variance m i
where all
Pn
mi are known. Let m = i=1 mi .
We can obtain the following unbiassed estimators for µ and σ 2 :

Pn
i=1 mi Xi
µ̂ =
Pn m
mi (Xi − µ̂)2
σˆ2 = i=1
n−1

September 17, 2017 133 / 160

 19.2 Nonparametric Estimation

Question 66
An insurance company offers a group-life policy to 3 companies.
These are the companies’ exposures and aggregate claims (in
millions) for the past 4 years:
Co. Year 1 Year 2 Year 3 Year 4 Total
Exp 769 928 880 1,046 3,623
1
Claims 1.3 1.5 0.8 1.7 5.3
Exp 1,430 1,207 949 1,322 4,908
2
Claims 1.0 0.9 0.6 1.5 4.0
Exp 942 1,485 2,031 1,704 6,162
3
Claims 1.1 1.4 1.9 2.0 6.4
Calculate the credibility premiums per life for each company in the fifth
year.

September 17, 2017 134 / 160

 19.3 Semiparametric Estimation

Question 67
In a particular year, an insurance company observes the following
claim frequencies:
No. of Claims Frequency
0 3951
1 1406
2 740
3 97
4 13
5 3

Assuming the number of claims an individual makes follows a Poisson

distribution, calculate the credibility estimate for number of claims for
an individual who has made 6 claims in the past 3 years.

September 17, 2017 135 / 160

 19.3 Semiparametric Estimation

Question 68
Assume annual claims from one policyholder follow a Poisson
distribution with mean Λ. The last 4 years of claims data are:

Claims 0 1 2 3 4 5 6 7 8 9
1 year 3951 1406 740 97 13 3 0 0 0 0
2 years 3628 2807 1023 461 104 13 4 0 1 0
3 years 2967 4032 2214 890 734 215 131 22 0 2
4 years 1460 2828 2204 985 747 358 194 43 8 0

Calculate the credibility estimate of Λ for an individual who made 2

claims in the last 3 years of coverage.

September 17, 2017 136 / 160

 19.3 Semiparametric Estimation

Question 69
Claim frequency in a year for an individual follows a Poisson with
parameter Λt where Λ is the individual’s risk factor and t is the
individual’s exposure in that year. An insurance company collects the
following data:
Policy- Year 1 Year 2 Year 3 Year 4
holder Exp claims Exp claims Exp claims Exp claims
1 45 12 10 6 45 14 14 2
2 27 0 12 0 74 0 27 0
3 10 9 293 149 14 6 13 5
4 10 0 14 3 17 2 6 2
In year 5, policyholder 3 has 64 units of exposure. Calculate the
credibility estimate for claim frequency for policyholder 3.

September 17, 2017 137 / 160

 3.2 Objectives of ratemaking

Strict Requirements
Cover expected losses and expenses.
Make adequate provision for contingencies.
Encourage loss control.
Satisfy regulators.

Desirable Objectives
Remain reasonably stable.
Respond to changes.
Be easy to understand.

September 17, 2017 138 / 160

 3.3 Frequency and severity
Components needed to calculate rates
Claim frequency distribution
Loss distribution
Interest rate
Times of payments.

Sources of Uncertainty
For life contingencies, loss is usually specified, so the main
sources of uncertainty are claim frequency, interest rate and times
of payment.
For property or casualty insurance, claim frequency distribution
and loss distribution are important sources of uncertainty.
For lines of insurance where settlement can take a long time (e.g.
liability insurance), time of payment and rate of interest can be a
source of uncertainty.
September 17, 2017 139 / 160
3.4 Data for ratemaking— Three Ways to Record Data
Accident Year
All payments are recorded under the year when the loss occurred.
Data first becomes available on 31st December of that year.
Data originally consists of paid loss amounts plus loss reserves.
Data are updated as claims are settled.
Policy Year
Payments recorded under the year when policy came into force.
Data first available on 31st December of the following year.
Data originally consists of paid loss amounts plus loss reserves.
Has the advantage of being under the same policy basis.
Calendar Year
Payments recorded under the year when the payment is made.
Includes changes to loss reserves.
Advantage is that it is finalised immediately.
September 17, 2017 140 / 160
 3.5 Premium data

Question 70
A home insurance policyholder pays $640 annual premium on 1st
October 2015. What is the earned premium from this policy in
(a) 2015
(b) 2016

September 17, 2017 141 / 160

 3.6 The exposure unit

Exposure Unit
Measure of how exposed to loss the policy is.
Premium calculated as (units of exposure) × (rate per unit)
Examples include car-years, house value, payroll.

Good exposure units should

Accurately measure exposure to loss
Are easy to determine (at time of premium calculation)
Be unable to be manipulated
Be easy to administer
Be easy for policyholder to understand.
Automatically adjust with inflation.

September 17, 2017 142 / 160

 3.7 The expected effective period

Question 71
An actuary is reveiwing claims data from accident year 2016 to
calculate premiums for policy year 2018. She finds that the expected
number of claims per unit of exposure is 0.003, and the expected claim
value per claim in accident year 2016 was $26,000. Payments are
subject to an annual inflation rate of 3%. What pure premium should
she set for 2018?

September 17, 2017 143 / 160

 3.8 Ingredients of ratemaking
Loss-Development Factors
Work with incurred lossed (include estimated loss reserves)
Adjust data to reduce impact of large losses.

Trend Factors
Adjust expected premiums to future payment periods.
Cover inflation, changes to court rulings, technical advances, etc.
Usually estimated using least-squares (linear or non-linear)
regression.
Regression may be applied separately to frequency and severity,
or to aggregate losses.
Actuary may choose to assign more weight to more recent data.
Should take into account external factors.
Trends in premium can help estimate loss ratio method.
September 17, 2017 144 / 160
 3.8 Ingredients of ratemaking

Expenses
Usually divided between Loss Adjustment Expenses (LAE) and
other expenses
LAE are divided into allocated (ALAE) and unallocated (ULAE).
Sometimes separate between expenses which are proportional to
gross premiums and expenses proportional to exposure.

Loading for Profit and Contingencies

Loading can be implicit or explicit (usually a percentage of gross
premium).
Implicit approach historically calculated by underestimating
investment returns.
Competition should prevent loading being too much.

September 17, 2017 145 / 160

 3.9 Rate Changes
Overall Rate Change
New Average Loss Cost
Loss cost method: New average gross rate = 1−Expense Ratio
Expected Effective Loss Ratio
Loss ratio method: Rate Change = Permissible Loss Ratio −1

Risk Classification Differential Changes

Rate manual consists of rate for base cell, and for each variable, a
vector of differentials — multiplicative factors.
Question 72
An insurer has three classes of risk - low, medium and high. Its
experience from the previous year is shown in the table below.
Risk Class Current differential Earned premiums Loss payments
Low 0.74 1,300 1,100
Medium 1 4,300 3,900
High 1.46 1,600 1,400
Calculate the new differentials for the coming year.
September 17, 2017 146 / 160
 3.9 Rate Changes

Question 73
An insurer has two risk variables — sex and risk level. Its current base
rate is $46.30 per unit of exposure. Its expense ratio is 20%. Its
experience from the previous year is shown in the table below.
Earned Premiums Loss Payments
Male Female Male Female
Differential 1 0.88 1 0.88
Low 0.74 900 1,100 1,050 850
Medium 1 4,700 4,400 4,100 3,900
High 1.46 1,900 1,400 1,200 1,100
Calculate the new rates for the coming year.

September 17, 2017 147 / 160

 5.1 Individual risk rating plans
Experience rating
Policyholder premium is credibility average of policyholder’s
experience and risk class rate.
Usually set upper bound on impact of policyholder’s experience.
Schedule rating
Minor changes to premiums based on e.g. installing burglar
alarms.
Usually limits set on amount each item can affect premium, and
overall limits for all discounts or surcharges.
Retrospective rating
Premium is retroactively changed by payment of a dividend
depending on individuals losses and losses from their risk class.
Often amount of dividend is only known years afterward, once all
claims are settled.
September 17, 2017 148 / 160
 5.2 Increased limits factors
Increased limits factors
Relative increase in premium caused by increasing policy limit.
Several difficulties in estimating ILF:
Loss development factors increase with policy limit.
Trend factors tend to increase with policy limit.
Risk to insurer increases faster than expected claim.
Some expenses are fixed; some vary with premium; some vary with
policy size.
Historical policy limits affect the data in several ways:
Insurance company records generally censor data at policy limits.
Limit can impact settlement amounts — e.g. lawyers might aim for
policy limit.
Adverse selection
These data issues can be mitigated by only considering policies
with limits at least as high as the limit under consideration,
provided there is sufficient data.
September 17, 2017 149 / 160
 5.2 Increased limits factors

Question 74
An insurance company has the following data on its policies:
Policy limit Losses Limited to
50,000 100,000 500,000 1,000,000
50,000 10,000
100,000 34,000 41,000
500,000 23,000 26,000 31,000
1,000,000 11,000 12,300 13,400 17,000
Use this data to calculate the ILFs.

September 17, 2017 150 / 160

 5.2 Increased limits factors
Loss Development
Loss development factors tend to be larger for larger claims.
They should be estimated from datasets with a single limit.

Trend Factors
Lower policy limits reduce the effects of inflation.
Different trend factors should be calculated for each policy limit.
For higher policy limits, the larger variance and smaller data set
can mean estimates are not credible, so data from other policy
limits may need to be used.

Risk
Higher policy limits increase risk more than premium.
Typically risk load should be increased to compensate for this
increased risk.
September 17, 2017 151 / 160
 5.2 Increased limits factors

Question 75
For a certain line of insurance, the loss amount per claim follows an
exponential distribution with mean aθ, where a is the exposure. The
policy has a limit l, which is currently set at 5θ per unit of exposure.
Losses increase by an inflation rate of 10%. Calculate the percentage
increase in expected total payments per claim.

September 17, 2017 152 / 160

 5.2 Increased limits factors

Question 76
An insurance company models the number of claims on its policies as
following a Poisson distribution with parameter λ = 100. Losses follow
a Pareto distribution with α = 3 and θ = 10, 000. The policies have a
policy limit per claim of $50,000. The insurer models aggregate losses
as following a normal distribution, and sets its total premiums at the
95th percentile of the agregate loss distribution.
(a) Calculate the current risk loading as a percentage of the gross rate.
(b) Calculate risk loading as a percentage of the gross rate if the
company increases the policy limit to $100,000 per claim.

September 17, 2017 153 / 160

 5.2 Increased limits factors

Question 77
An insurance company charges a risk charge equal to the square of
the average loss amount, divided by 50,000. It has the following data
on a set of claims from policies with limit $1,000,000.
Interval No. of claims Total claimed
(0, 10, 000] 2,300 6,850,000
(10, 000, 100, 000] 900 13,600,000
(100, 000, 500, 000] 140 19,400,000
(500, 000, 1, 000, 000] 25 18,600,000
Calculate the ILF from $100,000 to $500,000, and to $1,000,000.

September 17, 2017 154 / 160

 5.2 Increased limits factors

Expenses
Expenses tend to be subdivided into fixed costs and costs that
vary.
Some expenses are proportional to premium, other variable
expenses will increase non-linearly with premium, e.g. adjustment
expenses.

Loss Distributions
Parametric loss distributions make calculating ILFs easier.
To fit parametric distributions case reserves should be used for
open claims, because time to settlement is not independent of
loss size.
Case reserves from very recent claims can be subjective, so it is
often a good idea to ignore data from most recent years.

September 17, 2017 155 / 160

 5.3 Reinsurance
Why Reinsurance?
Insurer’s exposure is too concentrated (e.g. geographically)
leaving insurer vulnerable to catastrophe.
Insurer has limited ability to absorb large losses.
Insurer has financial difficulties.
Insurer wants to increase stability.
Insurer wants to exit a line of business.
Types of Reinsurance
Excess of Loss — if a single loss exceeds the attachment point
reinsurer will pay the excess (up to a limit).
Stop-loss — like excess of loss for portfolio. Attachment point and
limit often defined in terms of loss ratio.
Quota share — proportional reinsurance.
Catastrophe cover — like stop-loss, but relating to losses from a
single event (e.g. earthquake, hurricane).
September 17, 2017 156 / 160
 5.3 Reinsurance

Question 78
An insurance company models its aggregate losses as following an
exponential distribution. It can buy stop-loss reinsurance for a loading
of 100% of the expected claim. The insurance company sets its
premium so that total premiums equal the mean plus one standard
deviation of aggregate payments. Find the attachment point for
reinsurance that minimises the insurer’s premiums.

September 17, 2017 157 / 160

 5.3 Reinsurance

Notes on Reinsurance
For proportional reinsurance, reinsurer pays ceding commission to
cover the ceding company’s expense costs. Otherwise the ceding
company’s expense loading would be too high.

September 17, 2017 158 / 160

 5.3 Reinsurance
Ratemaking for Reinsurance
Treaties on risk-exposed basis (covers losses during time period)
or risk-attaching basis (covers policies written during time period).
Premium based on ceding company’s earned premium for
risk-exposed treaties, paid premium for risk-attaching treaties.
Pricing may be by exposure rating (based on industry averages)
or experience rating (based on ceding company’s experience).
For excess-of-loss reinsurance, ILFs can be used to calculate
expected losses.
Simulation is important to estimate variability in losses.
Catastrophe cover priced using long experience period and
catastrophe models incorporating meteorological, seismic and
engineering data, to assess the likely impact of catastrophes.
Catastrophe cover is high risk. This is reflected by high loading for
profit and contingencies.
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 5.3 Reinsurance
Loss Reserving for Reinsurance
Delays in payment generally longer, because reinsurer deals with
larger policies and because of the delay in notifying the reinsurer.
Common clause for excess-of-loss reinsurance: reinsurer notified
when incurred loss estimates exceed 50% of attachment point.
Ceding company must publish direct (without reinsurance) and net
reserves. Ceding company legally responsible for claim payments
even if it cannot collect its payments from the reinsurer.
Usually company calculates, direct, net and ceded reserves to
compare the approaches and remove inconsistencies.
Reinsurer will usually group by treaty type and coverage type.
May also group by attachment point.
Catastrophes are known about quickly after the event, but the total
reinsured losses will often take a long time to assess. The sudden
demand for repairs, etc. can cause inflation in claim costs.
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