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Insurance Applications of Insurance Applications of Bivariate DistributionsBivariate Distributions
David L. Homer & David R. David L. Homer & David R. ClarkClark
CAS Annual MeetingCAS Annual Meeting
November 2003November 2003
AGENDA:AGENDA:
Explain the Insurance problem Explain the Insurance problem being addressedbeing addressed
Show the mathematical Show the mathematical “machinery” used to address the “machinery” used to address the problemproblem
Provide a numerical exampleProvide a numerical example
AGENDA:AGENDA:
Explain the Insurance problem Explain the Insurance problem being addressedbeing addressed
Show the mathematical Show the mathematical “machinery” used to address the “machinery” used to address the problemproblem
Provide a numerical exampleProvide a numerical example
The PlayersThe Players::
Insured: Dietrichson DrillingInsured: Dietrichson DrillingA large account with predictable A large account with predictable
annual annual losseslosses
Insurer: Pacific All Risk Insurance Co.Insurer: Pacific All Risk Insurance Co.
Actuary:Actuary: YouYou
The Pricing Problem:The Pricing Problem:
Pacific All-Risk Insurance Company Pacific All-Risk Insurance Company sells a product that provides sells a product that provides coverage on bothcoverage on both
Specific Excess – individual losses above Specific Excess – individual losses above 600,000600,000
Aggregate Excess – above the sum of all Aggregate Excess – above the sum of all retained losses capped at 3,000,000 in retained losses capped at 3,000,000 in the aggregatethe aggregate
3,000,000 8,000,000
1,000,000
600,000
Aggregate Losses
Per-
occ
urr
en
ce
Retained by the insured
Per-Occurrence Layer
Stop Loss Layer
Policy Structure proposed for our insured Dietrichson Drilling
How do we price this product?How do we price this product?
Expected Losses are straight-Expected Losses are straight-forwardforward
Expected Losses for the two Expected Losses for the two coverages are additivecoverages are additive
Separate distributions are straight-Separate distributions are straight-forwardforward
A combined distribution is NOTA combined distribution is NOT
AGENDA:AGENDA:
Explain the Insurance problem Explain the Insurance problem being addressedbeing addressed
Show the mathematical Show the mathematical “machinery” used to address the “machinery” used to address the problemproblem
Provide a numerical exampleProvide a numerical example
How do we estimate a single How do we estimate a single distribution?distribution?
Define frequency and severity Define frequency and severity distributions, then:distributions, then:
Heckman-MeyersHeckman-Meyers Recursive methods (Panjer)Recursive methods (Panjer) SimulationSimulation Fast Fourier Transform (FFT)Fast Fourier Transform (FFT)
Key Elements of FFT Technique:Key Elements of FFT Technique:
Discretized severity vector Discretized severity vector x=(xx=(x00 ,…,x ,…,xn-1n-1)) FFT formulaFFT formula
IFFT formulaIFFT formula
1
0
)/2exp()(~ n
jjkk
nijkxxFFTx
1
0
)/2exp(~1)~(
n
jjkk
nijkxn
xIFFTx
Convolution Theorem:The transform of the sum is equal to the product of the transforms.
To sum up j independent identical variables:
kkk yFFTxFFTyxFFT )()()(
jkk
j xFFTxFFT )()( *
Probability Generating Function:Probability Generating Function:
The PGFPGFN N is a short-cut method for
combining the distributions for each possible number of claims.
It does all of the convolutions for us!
)()Pr()(0
j
NjN tEjNttPGF
Putting it all together we obtain the Putting it all together we obtain the aggregate probability vector aggregate probability vector zz from from the severity probability vector the severity probability vector xx and and the claim count the claim count PGFPGFN N ::
)))((( xFFTPGFIFFTz N
Bivariate case is the same, but using Bivariate case is the same, but using a MATRIX instead of a VECTOR.a MATRIX instead of a VECTOR.
becomesbecomes…
)))((( xFFTPGFIFFTz N
)))((( xNz MFFTPGFIFFTM
AGENDA:AGENDA:
Explain the Insurance problem Explain the Insurance problem being addressedbeing addressed
Show the mathematical Show the mathematical “machinery” used to address the “machinery” used to address the problemproblem
Provide a numerical exampleProvide a numerical example
Pacific All-Risk: Severity DistributionPacific All-Risk: Severity Distribution
Bivariate Severity Mx
0 0.00%
200,000 37.80%
400,000 23.50%
600,000 14.60%
800,000 9.10%
1,000,000 15.00%
Primary
Excess Marginal
0 200,000 400,000 600,000
0 0.00% 0.00% 0.00% 0.00% 0.00%
200,000 37.80% 0.00% 0.00% 0.00% 37.80%
400,000 23.50% 0.00% 0.00% 0.00% 23.50%
600,000 14.60% 9.10% 15.00% 0.00% 38.70%
800,000 0.00% 0.00% 0.00% 0.00% 0.00%
1,000,000 0.00% 0.00% 0.00% 0.00% 0.00%
Excess Marginal 75.90% 9.10% 15.00% 0.00% 100.00%
Pri
mary
Single Claim Severity x
Negative Binomial PGF for claim Negative Binomial PGF for claim countscounts
with Mean=5 and Variance=6:with Mean=5 and Variance=6:
25)56/(5 )2.2.1())15/6(5/6()(2 tttPGF
Bivariate Aggregate Matrix Mz
0 200,000 400,000 600,000 800,000 1,000,0001,200,000
0 1.05% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
200,000 1.65% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
400,000 2.38% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
600,000 3.09% 0.40% 0.66% 0.00% 0.00% 0.00% 0.00%
800,000 3.34% 0.65% 1.07% 0.00% 0.00% 0.00% 0.00%
1,000,000 3.39% 0.96% 1.58% 0.00% 0.00% 0.00% 0.00%
1,200,000 3.22% 1.27% 2.16% 0.26% 0.21% 0.00% 0.00%
1,400,000 2.86% 1.40% 2.44% 0.44% 0.36% 0.00% 0.00%
1,600,000 2.43% 1.45% 2.59% 0.66% 0.54% 0.00% 0.00%
1,800,000 1.97% 1.40% 2.57% 0.90% 0.78% 0.09% 0.05%
2,000,000 1.54% 1.26% 2.38% 1.02% 0.92% 0.15% 0.08%
2,200,000 1.17% 1.09% 2.12% 1.08% 1.01% 0.24% 0.13%
2,400,000 0.86% 0.90% 1.80% 1.08% 1.05% 0.33% 0.20%
2,600,000 0.62% 0.72% 1.47% 1.00% 1.01% 0.38% 0.24%
2,800,000 0.43% 0.55% 1.16% 0.88% 0.93% 0.42% 0.27%
3,000,000 0.29% 0.41% 0.89% 0.75% 0.82% 0.43% 0.29%
Pri
mary
Excess
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%0
200,
000
400,
000
600,
000
800,
000
1,00
0,00
0
1,20
0,00
0
1,40
0,00
0
1,60
0,00
0
1,80
0,00
0
2,00
0,00
0
2,20
0,00
0
2,40
0,00
0
2,60
0,00
0
2,80
0,00
0
3,00
0,00
0
3,20
0,00
0
3,40
0,00
0
3,60
0,00
0
3,80
0,00
0
4,00
0,00
0
Unconditional Distribution;Mean = 391,000
Conditional on Stop-Loss being Hit;Mean = 830,334
Probability Distribution for Per-Occurrence Excess Losses
Expected Per-Occurrence Loss Expected Per-Occurrence Loss
== 391,000391,000 overalloverall
== 830,334830,334 in scenarios where in scenarios where stop loss is hitstop loss is hit
Both coverages go bad at the same Both coverages go bad at the same time!time!
Other Applications:Other Applications:
Generation of Large & Small losses Generation of Large & Small losses for DFAfor DFA
Loss and ALAE with separate limitsLoss and ALAE with separate limits
Any other bivariate phenomenonAny other bivariate phenomenon(e.g., WC medical and indemnity)(e.g., WC medical and indemnity)
Questions or Comments?Questions or Comments?