Math288 Week10

Claim Frequency Models
Lecture: Week 10
Lecture: Week 10 (Math 288) Claim Frequency Models Spring 2008 - Valdez 1 / 19
Motivation
Compound frequency models

Let Xi be the claim payment made for the ith policyholder and let
N be the random number of claims. The insurer’s total (or
aggregate) claim is
N
X
S = X1 + · · · + XN = Xi .
i=1
This is called the compound frequency model. Other names used in

the actuarial literature are collective risk model and aggregate
claims model.
If N , X1 , X2 , ... are independent and the individual claims Xi are
i.i.d., then S has a compound distribution.
N : frequency of claims; X: the severity of claims.
Central question is to find the probability distribution of S.
Motivation
Approaches to find distribution of S

Finding (explicitly) the distribution of S is not as straightforward.
Some frequently used algorithms include, for example:
use law of total probability:
∞
X
P (S = s) = P (S = s |N = n ) · P (N = n)
n
∞
X
= P (X1 + X2 + · · · + Xn = s) · P (N = n).
n
use Normal approximation based on the Central Limit Theorem

(CLT).
use Panjer’s recursion algorithm - equation (11.25) of textbook
which will be discussed later. This requires special form of the
distribution of N .
Motivation
Using Normal approximation

In using the Normal approximation, we will need the mean and
variance of the aggregate claims S. They can be derived as
follows:
Mean of S:
E(S) = E[E(S |N )] = E(X) × E(N ).
Variance of S:
Var(S) = E[Var(S |N )] + Var[E(S |N )]
= E(N )Var(X) + [E(X)]2 Var(N ).
The probability can then be computed using:
!
s − E(S)
P (S ≤ s) ≈ P Z≤p ,
Var(S)
where Z is standard Normal.
Motivation
An example
Assume that number of claims has a Poisson distribution with λ = 12
and individual claim amounts are Uniform(0,1).
Approximate P (S < 10) using the Normal approximation.
Some discrete distributions
Some familiar discrete distributions

Some of the most commonly used distributions for number of claims:
Bernoulli
Binomial
Poisson
Geometric
Negative Binomial
Some discrete distributions Bernoulli random variables
Bernoulli random variables

X is Bernoulli if it takes only one of two possible outcomes:

1, if a success
X= .
0, otherwise
p usually denotes the probability of a success, i.e. P (X = 1) = p.

We write X ∼ Bernoulli(p).
Mean E(X) = p and variance Var(X) = p(1 − p)
Moment generating function:
MX (t) = E(eXt ) = pet + (1 − p)
Some discrete distributions Binomial random variables
Binomial random variables

Consider experiment of n independent trials, each trial results in
either a “success” (w.p. p) or “failure” (w.p. 1 − p).
If N is the number of successes out of the n trials, then N has a
Binomial distribution with pmf:

n k n!
P (N = k) = p (1−p)n−k = pk (1−p)n−k , for k = 0, . . . ,
k k!(n − k)!
Binomial
P r.v. is also the sum of (independent) Bernoulli’s with
N = nk=1 = Xk where each Xk ∼ Bernoulli(p).
Mean E(X) = np and variance Var(X) = np(1 − p)
Recursive formula for computing probabilities:
n−k p
P (N = k + 1) = pk+1 = pk .
k+11−p
Some discrete distributions Poisson random variables
Poisson random variables

X ∼ Poisson(λ) if pmf is
λk
pk = P (X = k) = e−λ , for k = 0, 1, 2, . . .
k!
Mean and variance are equal: E(X) = Var(X) = λ
λ
pk+1 = pk , for k ≥ 0.
k+1
Moment generating function of a Poisson:
t −1)
MN (t) = E(eN t ) = eλ(e .
Decomposition property of the Poisson

Suppose a certain number, N , of events will occur and
N ∼ Poisson(λ).
Suppose further that each event is either a Type 1 event with
probability p or a Type 2 event with probability 1 − p.
Let N1 and N2 be the number of Types 1 and 2 events,
respectively, so that N = N1 + N2 .
Result: N1 and N2 are independent Poisson random variables with
respective means
E(N1 ) = λp and E(N2 ) = λ(1 − p).
Proof to be provided in class.

This result can be extended to several types, say 1, 2, . . . , k, with
N = N1 + · · · + Nk .
Example 11.2
Suppose you have a portfolio of m independent and homogeneous risks
where the total number of claims from the portfolio has a Poisson
distribution with mean parameter λ.
Suppose the number of homogeneous risks in the portfolio was changed
to m∗ .
Prove that the total number of claims in the new portfolio still has a
Poisson distribution. Identify its mean parameter.
Some discrete distributions Negative binomial random variable
Negative binomial random variable

Consider an experiment where the r.v. N gives the number of
failures that occur before the r-th success is obtained, where each
trial has a probability p of a success.
N has a Negative Binomial distribution and written N ∼ NB(p, r)
with its pmf expressed as

n+r−1 r
P (N = n) = p (1 − p)n , for n = 0, 1, 2, . . .
r−1
rq rq
Mean is E(X) = and variance is Var(X) = 2 .
p p
Moment generating function of a Negative Binomial:
r
Nt p
MN (t) = E(e ) = .
1 − qet
Some discrete distributions Recursive property
Recursive property of the Negative Binomial

We can calculate probabilities of the N.B. using the recursive formula:
r+k
pk+1 = (1 − p) · pk .
k+1
Proof will be provided in class.
Some discrete distributions Geometric random variable
Geometric random variable

The Geometric distribution is a special case of the Negative
Binomial with r = 1.
N is said to be a Geometric r.v. and written as N ∼ Geometric(p)
if its pmf is therefore expressed as
P (N = n) = p(1 − p)n , for n = 0, 1, 2, . . . .

q q
Mean is E(X) = and variance is Var(X) = 2 .
p p
Derive its m.g.f. (use the N.B.).
pk+1 = (1 − p) · pk ,
starting with p0 = p.
Some discrete distributions Special class of distributions
Special class of distributions

The (α, β, 0) class of distributions satisfies the recursion equations
of the general form:

β
pk+1 = α + · pk .
k+1
The three distributions (including Geometric as special case of

N.B.) are the only distributions that belong to this class:
Binomial, Poisson, and Negative Binomial.
It can be shown that the applicable parameters α and β are:
Distribution Values of α and β
Binomial(n, p) p
α = 1−p , β = p(n+1)
1−p
Poisson(λ) α = 0, β = λ
Neg Bin(p, r) α = 1 − p, β = (r − 1)(1 − p)
Some discrete distributions Special class of distributions
Example 11.5
Suppose N is a counting distribution satisfying the recursive
probabilities:
pk+1 4 1
= − ,
pk k+1 3
for k = 1, 2, . . .
Identify the distribution of N .
Panjer’s recursion formula
Panjer’s recursion formula

Let the aggregate claims S have a compound distribution with
integer-valued non-negative claims with pdf pX (x) for
x = 0, 1, 2, ... and let the number of claims, N , belong to the
(α, β, 0) class of distributions.
Then, for the probability of total claims s > 0, we have:
s
1 X βk
pS (s) = α+ pX (k) · pS (s − k).
1 − α · pX (0) s
k=1

P (N = 0), if pX (0) = 0
For s = 0, we have pS (0) = .
MN [log p(0)], if pX (0) > 0
Panjer’s recursion formula If N is Poisson
If N is Poisson
In the special case where N has a Poisson(λ) distribution, we have:
Starting value:

P (N = 0), if p(0) = 0
pS (0) = .
MN [log p(0)], if p(0) > 0
With Poisson(λ):
s
1X
pS (s) = λk · pX (k) · pS (s − k).
s
k=1
Panjer’s recursion formula An illustrative example
An illustrative example
Suppose S has a compound Poisson distribution with λ = 0.8 and
individual claim amount, X, has distribution
x P (X = x)
1 1/4
2 3/8
3 3/8
Compute pS (s) = P (S = s) for s = 0, 1, ..., 6 using Panjer’s recursion

formula.

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Claim Frequency Models

Compound frequency models

This is called the compound frequency model. Other names used in

Approaches to find distribution of S

use Normal approximation based on the Central Limit Theorem

Using Normal approximation

Some familiar discrete distributions

Bernoulli random variables

p usually denotes the probability of a success, i.e. P (X = 1) = p.

MX (t) = E(eXt ) = pet + (1 − p)

Binomial random variables

Poisson random variables

Decomposition property of the Poisson

E(N1 ) = λp and E(N2 ) = λ(1 − p).

Proof to be provided in class.

Negative binomial random variable

Recursive property of the Negative Binomial

Geometric random variable

P (N = n) = p(1 − p)n , for n = 0, 1, 2, . . . .

Special class of distributions

The three distributions (including Geometric as special case of

Panjer’s recursion formula

Compute pS (s) = P (S = s) for s = 0, 1, ..., 6 using Panjer’s recursion

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