Probability of Ruin

ACTL3162 General Insurance Techniques (2015) / 5.
Solvency and Ruin Theory
ACTL3162 General Insurance Techniques

5. Solvency and Ruin Theory
A/Prof Benjamin Avanzi
School of Risk and Actuarial Studies
UNSW Australia Business School
b.avanzi@unsw.edu.au
S2 2015
1/67
References: MW 10, 5.05.2 / FV / (A 13) / (D) / (K)
ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Plan
1 Solvency considerations
Balance sheet and solvency
Risk moduels
Insurance liability variables
2 Ruin theory in discrete time
Surplus process and ruin
Lundberg bound
3 Ruin theory in continuous time
Surplus process
The stability problem
The probability of ruin
Applications to reinsurance
de Finettis modification
4 Dependence modelling and copulas
Introduction to Dependence
What is a copula?
Archimedean copulas
Simulation of copulas
Fitting copulas: case study
2/67

Solvency considerations
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
3/67

Balance sheet
Balance sheet: we would like At Lt , with
At : assets at time t
Lt : liabilities at time t
Let
Cet = At Lt
be the continuous time surplus process. At first sight it is
reasonable to require

h
i
h
i

Pr inf Cet 0 Ce0 = co = Pr inf At Lt 1 p.
t
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c0

Risk measures
The requirement above with time horizon 1,
Pr [A1 L1 ] 1 p,
c0
is that of a Value-at Risk VaR1p (L1 A1 ) on security level 1 p

More generally, one requires
(L1 A1 ) 0.
Solvency II uses VaR99.5% . There are other, arguably better ones,
such as the TVaR (used, e.g., in the Swiss Solvency Test). For
given portfolio of insurance business, one can adjust c0 and
investment strategy A0 accordingly.
4/67

Market consistent values

The main difficulty is to model L1 A1 , both of which are
stochastic and not independant.
A1 is typically well defined and corresponding to assets which
have a market value.
However, L1 does not have a market value. For comparability,
we need to determine market-consistent values in a
marked-to-model approach.
We split
L1 = X1 + L+
1,
where X1 are payments done over the next year, and L+
1 what
remains to be paid at the end of the year.
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Market consistent values: L+

1
L+
1 is hard to determine:
We need a market-consistent value for those outstanding
claims liabilities
This is different from the IBNR R(1) (we will discuss those in
Module 7):
R(1) are calculated on a nominal basis (no discounting). A
market-consistent value must include discounting.
2 R(1) are conditional expectations, given the information
available at time 1. A market-consistent value must include a
loading to recognise the uncertaintly that is associated to
those future cash flows.
1
Think of it as a transfer value, or run-off value.

6/67

Risk moduels
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
7/67

Risk moduels
Asset deficit ADt

Let
ADt = Lt At = Xt + L+
t At
be the asset deficit as of time t.
Obviously, we want (ADt ) 0.
In practice, its modelling is broken down into modules, which
are then re-aggregated using correlation matrices.
Most relevant to us:
Market risk: volatility of market prices of financial instruments
Insurance risk: typically split into branches. GI comprises: (i)
reserve risk, (ii) premium risk.
Credit risk: conterparty default risk
Operational risk: risk of loss arising from inadequate or failed
interal processes, or from personnel and systems,
or from external events
7/67

Risk moduels
Asset deficit AD0 and its evolution over one time period
We decompose
AD0 = L0 A0 ,
where
+
CY
L0 = LPY
0 + L0 = L0
CY
A0 = c0 + APY
0 +
At the end of the year, we have A1 and

Op
+,PY
+,CY
PY
CY
L1 = X1 + L+
=
X
+
X
+
X
+
L
+
L
1
1
1
1
1
1
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Risk moduels
Asset deficit AD1
AD1 =

+,CY
X1PY + X1CY + X1Op + L+,PY
+
L
A1
1
1
(split into payments and outstanding loss liabilities)

=

+,CY
CY
+
X
+
L
+ X1Op A1
X1PY + L+,PY
1
1
1
(split into PY risk and CY risk)
Market risk: all

Insurance risk: all but X1Op and A1
Credit risk: mainly A0 (! reinsurance)
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Operational risk: X1Op

Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
10/67

Market-consistent values
We focus here on insurance liabilities:

+,PY
PY
LIns
+ X1CY + L+,CY
= L1 X1Op
1 = X1 + L1
1
Introducing deflators s (random) leads to
LIns
=
1
1 X
1 X
E [s Xs |F1 ] = X1 +
E [s Xs |F1 ]
1
1
s1
if s and Xs are uncorrelated :

1 X
=
E [s |F1 ] E [Xs |F1 ]
1
s1
X
=
P(1, s)E [Xs |F1 ]
s1
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s2

Simplification
Denote:
p(1, s) = E [P(1, s) |F0 ]
xs
= E [Xs |F0 ]
We then use the approximation

P(1, s)E [Xs |F1 ]
= [p(1, s) + (P(1, s) p(1, s))] [xs + (E [Xs |F1 ] xs )]
p(1, s)xs (expected value as of time 0)
+ (P(1, s) p(1, s)) xs (discounting uncertainty)
+p(1, s) (E [Xs |F1 ] xs ) (insurance cash flows uncertainty)
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AD1 after simplification

We have then
AD1 =
p(1, s)xs + (P(1, s) p(1, s)) xs A1
s1
( = market and credit risks Z1 )

X
+
p(1, s) (E [Xs |F1 ] xs )
s1
( = insurance risk Z2 )
+X1Op
( = operational risk Z3 )
Hereafter we focus on Z2 .
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Insurance risk Z2
We consider Z2 = Z2PY + Z2CY where
h
i

X
Z2PY =
p(1, s) E XsPY |F1 xsPY
s1
Z2CY
h
i

p(1, s) E XsCY |F1 xsCY
s1
Assume that the proportion of cash flows paid in year s s is

deterministic. Then
i
h
X
Z2PY =
p(1, s)sPY X1PY + R(1) R(0)
s1
Z2CY =
X
s1
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p(1, s)sCY [E [S1 |F1 ] E [S1 |F0 ]]

Insurance risk on PY
Let
h
i
CDR1 = X1PY + R(1) R(0) ,
which has expected value E [CDR1 ] = 0. Process:
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Calculate MSEP for each LoB
Specify a correlation matrix between the LoB
Aggregate (1) with the help of (2) and obtain an overall

variance
Fit a translated gamma or lognormal to (3), assuming that the

mean is R(0) , to approximate the distribution of CDR1

Insurance risk on CY
Aggregate claims
E [S1 |F1 ]
result from the premium exposure CY . This is called the premium
liability. It is split into two independent random variables:
Slc : large claims (> threshold M), modelled with compound
Poisson model (CRM) per LoB with Pareto claims severities.
Then use Panjer or FFT.
Ssc : small claims, whose moments are aggregated using an
appropriate correlation matrix, and then fit to with a gamma
or lognormal distribution.
Note an assumption is required to aggregate Z2CY and Z2PY into Z2 .
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Ruin theory in discrete time
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
16/67

Surplus process
We extend the definition of the surplus to more than one year, and
define the surplus
Ct =
(c )
Ct 0
t
X
= c0 +
(u Su ),
u=1
with
c0 is the initial capital
(t , St )t=1,2,3,... is an iid sequence with t > 0 and St 0.
Furthermore, we assume that
Xt = t St
are independant and stationary increments.
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Ruin
We hope
Ct 0 for all t 0.
If not, then the ruin time is defined such that
= inf {s N0 ; Cs < 0} .
Ruin with occur within t periods of time with probability

(c0 )
t (c0 ) = Pr[ t|C0 = c0 ] = Pr
inf Cs < 0 ,
s=0,...,t
and the probability that it ever happens is

(c0 ) = Pr[ < ] = lim t (c0 ) [0, 1].
c0
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Theorem 5.4
Depending on the sign of E [X1 ], the process behaves differently:
1
if E [X1 ] < 0, the process blows down to ;
if E [X1 ] > 0, the process blows up to ;
if E [X1 ] = 0, the process either blows up or down to .
So what?
1
if E [X1 ] < 0 then (c0 ) = 1 for any c0 0;
if E [X1 ] > 0 (Net Profit ConditionNPC), then (0) < 1.
Furthermore, it is obvious that under the NPC

(c0 ) (0) 1.
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Lundberg bound
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
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Lundberg bound
Lundberg coefficient / Adjustment coefficient
Assume there exists an R > 0 such that

MX1 (R) = MS1 1 (R) = 1.
Then, this R > 0 is called Lundberg coefficient. If it exists then it
is unique.
It can be shown that
(c0 ) e Rc0 .
This is called Lundbergs exponential bound.
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Ruin theory in continuous time
Surplus process
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
20/67

Surplus process
Surplus process
We define now the continuous time surplus process
C (t) = c0 + t S(t),
where
c0 is the initial surplus;
is the premium rate: c = (1 + )E [Y1 ]
is the relative security loading ( > 0 under the NPC)
PN(t)
S(t) = i=1 Yi are aggregate losses up to time t
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If furthermore, the losses {Yi } are iid and independent of {N(t)},

PN(t)
and {N(t)} is a Poisson process, that is, i=1 Yi is compound
Poisson, then
{C (t)} is called the Cramr-Lundberg process.

Surplus process
Poisson process N(t)
{N(t)}
15
counting process
step function
10
Poisson process iff

increments
N(t + h) N(t)
Poisson(h)
time between
jumps Wi
exponential(1/)
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Surplus process
35
Compound Poisson process S(t)
30
We define
25
N(t)
S(t) =
Xi .
20
i=1
15
{S(t)} is {N(t)} but
10
step i has height

Xi instead of 1
Increments:
S(t + h) S(t)
CPoisson(h, P(x))
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Surplus process
-5
10
Cramer-Lundberg process U(t)
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Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
24/67


The survival of the insurance company will depend on certain
(decision) variables:
initial surplus (c0 )
loading of premiums ()
reinsurance (e.g. or d see later)
What is the "best" way to choose/monitor these variables? Of
course, this depends on what criterion the assessment is based:
probability of ruingoes back to Lundberg (1909) and Cramr
(1930, 1955)
utilitygoes back to von Neumann and Morgenstern (1944)
present value of dividendsgoes back to de Finetti (1957)
...
24/67

Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
25/67

How to calculate the probability of ruin
There are different ways of calculating :

analytically
(u) is very hard to calculate (in closed form), but possible for
exponential and mixtures of exponential losses
(u, t) is even more difficult to determine
using Panjers recursion via a special trick (assignment 2009,

see reference D)
Monte-Carlo methods (simulations)
In what follows, we assume we are using the Cramr-Lundberg
model.
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The adjustment coefficient

Consider the excess of losses over premiums over the interval [0, t]:
S(t) t.
We define the adjustment coefficient R as the first positive solution
of
h
i
MS(t)t (R) = E e R(S(t)t) = e Rt e t[MY1 (R)1] = 1.
Furthermore
h
i
E e RC (t) = e Rc0 for all t 0

and thus e RC (t) is a martingale.
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1.0
1.5
2.0
2.5
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0.0
0.1
0.2
0.3
0.4
0.5
0.6

A Theorem 13.4.1
If {C (t)} is a Cramr-Lundberg process with > 0, then for c0 0
(c0 ) =
e Rc0

.
E e RC ( ) |T <
Since C ( ) < 0, we have then (Lundbergs exponential upper

bound)
(c0 ) < e Rc0 .
Furthermore, if Pr[Y1 ymax ] = 1 for some finite ymax then
C ( ) > ymax
(c0 ) > e R(c0 +ymax )
Finally,
e R(c0 +ymax ) < (c0 ) < e Rc0 .
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Example
Assume Y1 exp(). Find R and (c0 ).
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Example
30/67

Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
31/67

We have now a model to study options about reinsurance

Based on the probability of ruin criterion, we will adjust the
adjustment coefficient (hence its name..) to meet a goal, such
as
maximise R minimise (c0 )
find the cheapest reinsurance such that (c0 ) is inferior to
some level
Note that even if (c0 ) cant be calculated, you can still play
with R and have qualitative results about (c0 ).
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Numerical example (excess of loss)

Let X exp(1), = 1.25, rins = 1.4. Consider nonproportional
reinsurance:
transferred loss = (X d)+ .
We have then
Z
reins = 1.4
(x d)e x dx = 1.4e d
and
Z
MYret (r ) =
rx x
e e
0
dx +
e rd e x dx =
1 re d(1r )
.
1r
Hence, the (nonlinear) equation for Rret is

1 + (1.25 1.4e d )r
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1 re d(1r )
= 0.
1r

0.35
0.34
Using R, we have
d = 0.9632226
0.33
R_h
and
= 0.3493290,
Rret
0.31
0.32
which is much higher (better)

than the best we could achieve
with proportional reinsurance.
0.7
0.8
0.9
1.0
d
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1.1
1.2
1.3

A Theorem 14.5.1
Theorem 14.5.1 states that if
we are in a Cramr-Lundberg setting
we are considering two reinsurance treaties, one of which is
excess of loss
both treaties have same expected payments and same
premium loadings
then
the adjustment coefficient with the excess of loss treaty will
always be at least as good (high) as with any other type of
reinsurance treaty
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Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
35/67

Using the probability of ruin as a criterion presents some issues:

minimising (c0 ) supposes that companies should let their
surplus grow without limit, which is not realistic
why should an older company hold more capital than a young
one, just because it is older?
furthermore, if some of the surplus is distributed from time to
time, calculations of (c0 ) are wrong
Bruno de Finettis (1957) goal:
to propose an alternative formulation that would avoid
the misconceptions of the classical Cramr-Lundberg
model and that would be sufficiently realistic and
tractable to study the practical problems regarding risk
and reinsurance (our translation)
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Optimal dividend strategies
36/67
One has to find a rational way to model distribution of the surplus

the distribution of some of the surplus (to the shareholders) is
considered as a dividend
the answer to how much and when dividends should be
distributed is called a dividend strategy
Consider the expected present value of dividends paid until ruin
This is the value of the company according to the Gordon
model
shareholders (the decision makers) are likely to want to
maximise this value
This leads to the question of optimal dividend strategies.
optimal with respect to the expected present value of
dividends, rather than the probability of ruin
(which is usually 1 in this context).

Optimal dividends in the Cramr-Lundberg model

The optimal dividend strategy is a barrier strategy (in some cases):
EPV of dividends: V (u; b) =

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10
5
0
X(t)
10
15
Surplus X(t) and dividends D(t)
15
Cramer-Lundberg process U(t)
RT
0
e t dD(t)

Dependence modelling and copulas
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
38/67

Motivation
How does dependence arise?
Events affecting more than one variable
Underlying economic factors affecting more than one risk area
Reasons for modelling dependence:
Pricing:
inflows and outflows of capital
Solvency assessment:
bottom up: risks given capital requirements
Capital allocation:
top down: capital given allocation per risk
Portfolio structure: (or strategic asset allocation)
how does the capital move compared to risks?
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Examples
World Trade Centre causing losses to Property, Life, Workers

Compensation, Aviation insurers
Enron causing losses to the stock market and to Surety Bonds,
Errors & Omissions and Directors & Officers underwriters
Dot.com market collapse causing losses to the stock market
and to insurers of financial institutions and D&O writers
WTC / Enron / stock market losses causing impairment to
reinsurers solvency, so increasing credit risk on payments by
reinsurers
Asbestos affecting many past liability years at once
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Example of real actuarial data

(Avanzi, Cassar and Wong, 2011)
Data were provided by the SUVA (Swiss workers compensation
insurer)
Random sample of 5% of accident claims in construction
sector with accident year 1999 (developped as of 2003)
Two types of claims: 2249 medical cost claims, et 1099 daily
allowance claims
1089 of those are common (!)
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Scatterplot of the log of those 1089 common claims (LHS) et

emprical copula (RHS):
There is obvious right tail dependence.

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Correlation = dependance?
Correlation consumption of cheese (US) and deaths by becoming
tangled in bedsheets (Tyler Vigen, 2015):
Correlation = 0.95!!
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Common fallacies
Fallacy 1: a small correlation (X1 , X2 ) implies that X1 and X2 are
close to being independent
wrong!
Independence implies zero correlation BUT
A correlation of zero does not always mean independence.
See example 1 below.
Fallacy 2: marginal distributions and their correlation matrix
uniquely determine the joint distribution.
This is true only for elliptical families (including multivariate
normal), but wrong in general!
See example 2 below.
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Example 1
Companys two risks X1 and X2
Let Z N(0, 1) and Pr(U = 1) = 1/2 = Pr(U = 1)
U stands for an economic stress generator, independent of Z
Consider:
X1 = Z N(0, 1)
and
X2 = UZ N(0, 1).
Now Cov(X1 , X2 ) = E (X1 X2 ) = E (UZ 2 ) = E (U)E (Z 2 ) = 0
hence (X1 , X2 ) = 0. However, X1 and X2 are strongly
dependent, with 50% probability co-monotone and 50%
counter-monotone.
This example can be made more realistic
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Example 2
Marginals and correlationsnot enough to completely determine

joint distribution
Marginals: Gamma(5, 1)
Correlation: = 0.75
Different dependence structures: Normal copula vs
Cook-Johnson copula
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Example 2 illustration: Normal vs Cook-Johnson copulas

CookJohnson copula
Normal copula
15
15
10
5
0
10
x~Gamma(5,1)
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y~Gamma(5,1)
10
5
0
y~Gamma(5,1)
15
10
x~Gamma(5,1)
15

What is a copula?
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
47/67

What is a copula?
Sklars representation theorem

The copula couples, links, or connects the joint distribution to
its marginals.
Sklar (1959): There exists a copula function C such that
F (x1 , x2 , ..., xn ) = C (F1 (x1 ) , F2 (x2 ) , ..., Fn (xn ))
where Fk is the marginal for Xk , k = 1, 2, ..., n. Equivalently,
Pr (X1 x1 , ..., Xn xn ) = C (Pr (X1 x1 ) , ..., Pr (Xn xn )) .
Under certain conditions, the copula

C (u1 , ..., un ) = F F11 (u1 ) , ..., Fn1 (un )
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is unique, where Fk1 denote the respective quantile

functions. This is one way of constructing copulas.

What is a copula?
Example
Let
F (x, y ) =
(x+1)(e y 1)
x+2e y 1
1 e y
(x, y ) [1, 1] [0, ]

(x, y ) (1, ] [0, ]
elsewhere
Hence
x +1
, x [1, 1]
2
F 1 (u) = 2u 1 = x
F (x) =
G (u) = 1 = e y ,
G
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y 0
(u) = ln(1 u) = y

What is a copula?
Example
Finally,
C (u, v ) =
=
=
=
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(2u 1 + 1)[(1 v )1 1]
2u 1 + 2(1 v )1 1
2u(1 1 + v )
(2u 2)(1 v ) + 2
2uv
2u 2uv 2 + 2v + 2
uv
u + v uv

What is a copula?
Density associated with a copula

For continuous marginals with respective pdf f1 , ...fn , the joint
pdf of X can be written as
f (x1 , ..., xn ) = f1 (x1 ) fn (xn ) c (F1 (x1 ) , ..., Fn (xn ))
where the copula density c is given by
c (u1 , ..., un ) =
n C (u1 , ..., un )
.
u1 u2 un
Observe that the copula c distorts the independence to induce

the actual dependence structure.
If independent, c = 1.
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Archimedean copulas
Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
51/67

Archimedean copulas
The family of Archimedean copulas
C is Archimedean if it has the form

C (u1 , ..., un ) = 1 ( (u1 ) + + (un ))
for all 0 u1 , ..., un 1 and for some function (called the
generator) satisfying:
(1) = 0;
is decreasing; and
is convex.
51/67

Archimedean copulas
The Clayton copula

The Clayton copula is defined by
C (u1 , ..., un ) =
n
X
!1/
uk n + 1
k=1
Archimedean type with:

(t) = t 1, > 1
1/
1 (s) = (1 + s)
The case of n = 2:

1/
C (u1 , u2 ) = u1 + u2 1
.
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Archimedean copulas
The Frank copula
The Frank copula is defined by

Qn

uk
1
k=1 ( 1)
C (u1 , ..., un ) =
log 1 +
.
log
( 1)n1
Archimedean type with:
(t) = log
(s) =
t 1
1
log1
, 0
log 1 e s 1 e
Try the case of n = 2.
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Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
54/67

Simulating random variables with a dependent structure
We will introduce the general conditional distribution method

The overarching idea is (for the bivariate case)
simulate two independent uniform random variable u and t
tweak t into a v [0, 1] so that it has the right dependence
structure (w.r.t. u) with the help of the copula
map u and v into marginal x and y using their distribution
function
However, there are some specific, more efficient algorithms

that are available for certain types of copulas (see reference
books)
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Preliminary: the conditional distribution function
We will need the conditional distribution function for V given

U = u, which is denoted by cu (v ) :
cu (v ) = Pr[V v |U = u]
C (u + u, v ) C (u, v )
= lim
u0
u
C (u, v )
=
.
u
In particular, we will need its inverse.
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Example
For the copula

C (u, v ) =
uv
u + v uv
we have
cu (v ) =
cu1 (t) =
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v (u + v uv ) uv (1 v )
=
(u + v uv )2
tu
v
1 t(1 u)
v
u + v uv
2
t

The conditional distribution method

Goal: generate a pair of pseudo-random variables (X , Y ) with d.f.s
F and G , respectively, with dependence structure described by the
copula C .
Algorithm
1
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Generate two independent uniform (0, 1) pseudo-random

variable u and t
Set v = cu1 (t)
Map (u, v ) into (x, v ):

x
= F 1 (u)
= G 1 (v )

Example
Let X and Y be exponential with mean 1 and standard Normal,
respectively. Furthermore, the copula describing their dependence is
such as in the previous example:
C (u, v ) =
uv
u + v uv
Furthermore, you are given the following pseudo-random

(independent) uniforms:
0.3726791, 0.6189313, 0.75949099, 0.01801882
Simulate two pairs of outcomes for (X , Y ).
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Exercise
Use of the conditional distribution method yields
1 We can use the uniforms given in the question such that
(u1 , t1 ) = (0.3726791, 0.6189313)
(u2 , t2 ) = (0.75949099, 0.01801882)
2
Set vi =
ui ti
1(1ui ) ti
for i = 1, 2:
v1 = 0.5788953
v2 = 0.1053509
Mapping (ui , vi ) into (xi , yi ) using

xi = F 1 (ui ) = ln(1 ui ) and yi = 1 (vi ) we have
(x1 , y1 ) = (0.4662971, 0.8648739)
(x2 , y2 ) = (0.3247659, 1.251638)
59/67

Risk moduels
Lundberg bound
Surplus process
What is a copula?
Archimedean copulas
60/67

Insurance company losses and expenses

Data consists of 1 500 general liability claims
Provided by the Insurance Services Office, Inc.
X1 is the loss, or amount of claims paid.
X2 is the ALAE, or allocated loss adjustment expense.
Policy contains policy limits, and hence, censoring.
is the indicator for censoring so that the observed data
consists of
(x1i , x2i , i ) for i = 1, 2, ..., 1500.
60/67

Summary statistics of data
Number
Mean
Median
Std Deviation
Minimum
Maximum
25th quantile
75th quantile
61/67
Loss
1 500
41 208
12 000
102 748
10
2 173 595
4 000
35 000
ALAE
1 500
12 588
5 471
28 146
15
501 863
2 333
12 577
Policy
Limit
1 352
559 098
500 000
418 649
5 000
7 500 000
300 000
1 000 000
Loss
(Uncensored)
1 466
37 110
11 048
92 513
10
2 173 595
3 750
32 000
Loss
(Censored)
34
217 491
100 000
258 205
5 000
1 000 000
50 000
300 000

Figure 2: loss vs ALAE
8
4
log(ALAE)
10
12
LOSS vs ALAE on a log scale
8
log(LOSS)
62/67
10
12
14

Maximum likelihood estimation

Case 1: loss variable is not censored, i.e. = 0.
f (x1 , x2 ) = f1 (x1 ) f2 (x2 )
2
C (F1 (x1 ) , F2 (x2 ))
x1 x2
Case 2: loss variable is censored, i.e. = 1.
P (X1 > x1 , X2 x2 ) =
x2
[F2 (x2 ) F (x1 , x2 )]

x2
= f2 (x2 )
F (x1 , x2 )
x2

= f2 (x2 ) 1
C (F1 (x1 ) , F2 (x2 ))
x2
63/67

Choice of marginals and copulas
Pareto marginals: Fk (xk ) = 1
k
k +xk
k
for k = 1, 2.
For the copulas, several candidates were used:

Copula
Independent
Clayton
Gumbel-Hougaard
Frank
64/67
C (u1 , u2 )
C2 (u1 , u2 ) =
C (u1 , u2 )
u2
C12 (u1 , u2 ) =
2 C (u1 , u2 )
u1 u2
u1 u2
u1
1/
+1
+1
u1 + u2 1
i
h
exp (( log u1 ) + ( log u2 ) )1/

1
(e u1 1) (e u2 1)
log 1 +
e 1
(C /u2 )

log u2
log C
1
( + 1) C (C /u1 u2 )
C
u2
1
C1 C2 [1 + ( 1) / ( log C )]
C
e u1 (e u2 1)
(e 1) + (e u1 1) (e u2 1)
[(e 1) + (e u1 1) (e u2 1)]2
(e 1) e (u1 +u2 )

Parameter estimates
Parameter
Loss (X1 )
ALAE (X2 )
Dependence
Loglik
AIC
65/67
1
1
2
2
Independence
Estimate
s.e.
14 552
1.139
15 210
2.231
na
-31 950.81
42.61
1 404
0.067
1 661
0.178
na
Estimate
Clayton
s.e
14 000
1.143
16 059
2.315
1.563
2 033
0.093
2 603
0.261
0.047
-32 777.89
43.71
Gumbel-Hougaard
Estimate
s.e.
14 001
1.120
14 122
2.108
1.454
-31 748.81
42.34
1 292
0.062
1 409
0.151
0.034
Estimate
Frank
s.e.
14 323
1.106
16 306
2.274
-3.162
1 359
0.064
1 762
0.181
0.175
-31 778.45
42.38

AIC criterion
Akaike Information Criterion (AIC)

In the absence of a better way to choosing/selecting a copula
model, one may use the AIC criterion defined by
AIC = (2` + 2m) /n
where ` is the value of maximised log-likelihood, m is the
number of parameters estimated, and n is the sample size.
Lower AIC generally is preferred.
66/67

Summary
To find the distribution of the sum of dependent random variables

with copulas (one approach):
Fit marginals independently
Describle/fit dependence with a copula (roughly)
Get a sense of data (scatter plots, dependence measures)
Choose candidate copulas
For each candidate, estimate parameters via MLE
Choose a copula based on nll(highest) or AIC(lowest)
Perform simulations to look at the distributions of aggregates
67/67

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ACTL3162 General Insurance Techniques (2015) / 5.

Solvency and Ruin Theory

ACTL3162 General Insurance Techniques

References: MW 10, 5.05.2 / FV / (A 13) / (D) / (K)

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

is that of a Value-at Risk VaR1p (L1 A1 ) on security level 1 p

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Market consistent values

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Market consistent values: L+

Think of it as a transfer value, or run-off value.

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Asset deficit ADt

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

At the end of the year, we have A1 and

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Asset deficit AD1

(split into payments and outstanding loss liabilities)

(split into PY risk and CY risk)

Market risk: all

Operational risk: X1Op

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

if s and Xs are uncorrelated :

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

We then use the approximation

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

AD1 after simplification

p(1, s)xs + (P(1, s) p(1, s)) xs A1

( = market and credit risks Z1 )

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Assume that the proportion of cash flows paid in year s s is

p(1, s)sCY [E [S1 |F1 ] E [S1 |F0 ]]

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

which has expected value E [CDR1 ] = 0. Process:

Calculate MSEP for each LoB

Specify a correlation matrix between the LoB

Aggregate (1) with the help of (2) and obtain an overall

Fit a translated gamma or lognormal to (3), assuming that the

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

and the probability that it ever happens is

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

if E [X1 ] < 0, the process blows down to ;

if E [X1 ] > 0, the process blows up to ;

if E [X1 ] = 0, the process either blows up or down to .

if E [X1 ] < 0 then (c0 ) = 1 for any c0 0;

if E [X1 ] > 0 (Net Profit ConditionNPC), then (0) < 1.

Furthermore, it is obvious that under the NPC

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Lundberg coefficient / Adjustment coefficient

Assume there exists an R > 0 such that

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

If furthermore, the losses {Yi } are iid and independent of {N(t)},

ACTL3162 General Insurance Techniques (2015) / 5. Solvency and Ruin Theory

Poisson process N(t)