0 INTRODUCTION

Chapter 7 Ruin theory

0 Introduction

In the last two chapters we used the collective risk model to look at the aggregate claims S arising during a xed period of time. In this chapter we will extend this model by treating S(t) as a function of time. This gives us the equation S(t) = X1 + X2 + + XN (t) where N (t) denotes the number of claims occurring before time t. We can use this time dependent model to describe the cash ows of an insurer and to determine properties of the probability of ruin in both the short term and the long term.

1 BASIC CONCEPTS

1
1.1

Basic concepts
Notation

In Chapters 5 and 6 the aggregate claims generated by a portfolio of policies over a single time period were studied. In the actuarial literature, the word risk is often used instead of the phrase portfolio of policies. In this chapter both terms will be used, so that by a risk will be meant either a single policy or a collection of policies. In this chapter this study will be taken a stage further by considering the claims generated by a portfolio over successive time periods.

1 BASIC CONCEPTS

Some notation is needed. N (t): the number of claims generated by the portfolio in the time interval [0, t], for all t 0 Xi: the amount of the i-th claim, i = 1, 2, 3, . . . S(t): the aggregate claims in the time interval [0, t], for all t 0. {Xi} is a sequence of random variables. i=1 {N (t)}t0 and {S(t)}t0 are stochastic processes. It can he seen that
N (t)

S(t) =
i=1

Xi

with the understanding that S(t) is zero if N (t) is zero. The stochastic process {S(t)}t0 as dened above is known as the aggregate claims process for the risk. So we have just taken the idea of a compound distribution and generalized it to cover dierent time periods. The insurer of this portfolio will receive premiums from the policyholders.

1 BASIC CONCEPTS

It is convenient at this stage to assume, as will be assumed throughout this chapter, that the premium income is received continuously and at a constant rate. Let c denote the rate of premium income per unit time, so that the total premium income received in the time interval [0, t] is ct. It will also be assumed that c is strictly positive.

1 BASIC CONCEPTS

1.2

The surplus process

Suppose that at time 0 the insurer has an amount of money set aside for this portfolio. This amount of money is called the initial surplus and is denoted by U . It will always be assumed that U 0. The insurer needs this initial surplus because the future premium income on its own may not be sucient to cover the future claims. We are ignoring expenses. The insurers surplus at any future time t(> 0) is a random variable since its value depends on the claims experience up to time t. The insurers surplus at time t is denoted by U (t). Then we can write: U (t) = U + ct S(t) where U (0) = U . Notice that the initial surplus and the premium income are not random variables since they are determined before the risk process starts. (t 0)

1 BASIC CONCEPTS

For a given value of t, U (t) is a random variable because S(t) is a random variable. {U (t)}t0 is a stochastic process, which is known as the cash ow process or surplus process. See Fig. 1 on page 4. It is assumed that claims are settled as soon as they occur and that no interest is earned on the insurers surplus. It is also assumed that there are no expenses associated with the process (or, equivalently, that S(t) makes allowance for expense amounts as well as claim amount), and that the insurer cannot vary the premium rate c. We are also ignoring the possibility of reinsurance.

1 BASIC CONCEPTS

1.3

The probability of ruin in continuous time

Speaking loosely for the moment, when the surplus falls below zero the insurer has run out of money and it is said that ruin has occurred. Still speaking loosely, ruin can be thought of as meaning insolvency, although determining whether or not an insurance company is insolvent is, in practice, a very complex problem. Another way of looking at the probability of ruin is to think of it as the probability that, at some future time, the insurance company will need to provide more capital to nance this particular portfolio. The following two probabilities are dened: (U ) = P[U (t) < 0, for some t, 0 < t < ] (U, t) = P[U ( ) < 0, for some , 0 < t] (U ) is the probability of ultimate ruin (given initial surplus U ). (U, t) is the probability of ruin within time t (given initial surplus U ).

1 BASIC CONCEPTS

These probabilities are sometimes referred to as the probability of ruin in innite time and the probability of ruin in nite time. Here are some important logical relationships between these probabilities for 0 < t1 < t2 < and for 0 < U1 < U2: (U2, t) (U1, t) (U2) (U1) (U, t1) (U, t2) (U ) lim (U, t) = (U )
t U

lim (U, t) = 0

1 BASIC CONCEPTS

The intuitive explanations for these relationships ewe as follows: The larger the initial surplus, the less likely it is that ruin will occur either in a nite time period or an unlimited time period. For a given initial surplus U , the longer the period considered when checking for ruin, the more likely it is that ruin will occur. The probability of ultimate ruin can be approximated by the probability of ruin within nite time t provided t is suciently large. As the amount of initial surplus increases, ruin will become less and less likely.

1 BASIC CONCEPTS

10

1.4

The probability of ruin in discrete time

The two probabilities of ruin considered so far have been continuous time probabilities of ruin, so-called because they check for ruin in continuous time. In practice it may be possible (or even desirable) to check for ruin only at discrete intervals of time. For a given interval of time, denoted h, the following two discrete time probabilities of ruin are dened: h(U ) = P[U (t) < 0], for some t, t = h, 2h, 3h, . . . h(U, t) = P[U ( ) < 0], for some , = h, 2h, 3h, . . . , t h, t Note that it is assumed for convenience in the definition of h(U, t) that t is an integer multiple of h. See Figure 2 on page 7.

1 BASIC CONCEPTS

11

Listed below are ve relationships between dierent discrete time probabilities of ruin for 0 < t1 < t2 < and for 0 < U1 < U2: h(U2, t) h(U1, t) h(U2) h(U1) h(U, t1) h(U, t2) h(U ) lim h(U, t) = h(U )

h(U, t) (U, t) (U, t) involves checking for ruin at all possible times. Since the more often we check for ruin, the more likely we are to nd it, we would expect that (U, t) would be greater than h(U, t). Intuitively, it is expected that the following two relationships are true since the probability of ruin in continuous time could be approximated by the probability of ruin in discrete time, with the same initial surplus, U , and time horizon, t, provided ruin is checked for suciently often, i.e. provided h is suciently small.
h0+

lim h(U, t) = (U, t)

h0+

lim h(U ) = (U )

1 BASIC CONCEPTS

12

1.5

Probability of ruin in the short term

If we know the distribution of the aggregate claims S(t), we can often determine the probability of ruin for the discrete model over a nite time horizon directly (without reference to the models), by looking at the cash ows involved.

1 BASIC CONCEPTS

13

Example on page 9. The aggregate claims arising during each year from a particular type of annual insurance policy are assumed to follow a normal distribution with mean 0.7P and standard deviation 2.0P , where P is the annual premium. Claims are assumed to arise independently. Insurers are required to assess their solvency position at the end of each year. A small insurer with an initial surplus of 0.1m for this type of insurance expects to sell I 100 policies at the beginning of the coming year in respect of identical risks for an annual premium of 5, 000. The insurer will incur expenses of 0.2P at the time of writing each policy. Calculate the probability that the insurer will prove to be insolvent for this portfolio at the end of the coming year. Ignore interest.

1 BASIC CONCEPTS

14

Question 7.3 on page 10. If the insurer expects to sell 200 policies during the second year for the same premium and expects to incur expenses at the same rate, calculate the probability that the insurer will prove to be insolvent at the end of the second year. In fact, the normal distribution is probably not a very realistic distribution to use for the claim amount distribution in most portfolios, as it is symmetrical, whereas many claim amount portfolios will have skewed underlying distributions. The distribution that is perhaps used most often in this model is the Poisson distribution for claim numbers. This means that the number of claims occurring in a time interval (0, t) are P oisson(t), where is the Poisson parameter representing the mean number of claims per unit time. This is called a Poisson process.

1 BASIC CONCEPTS

15

If we use the Poisson distribution to model the number of claims, then the aggregate claim distribution takes the form of a compound Poisson distribution. We can then use an appropriate claim amount distribution to model the size of an individual claim. We then say that the claim amounts come from a Compound Poisson process. We can then nd the mean and variance of the aggregate claim amount for any time period using the formulae from Chapter 5 for the compound Poisson distribution.

2 THE POISSON PROCESS

16

The Poisson process

The Poisson process (t)n P [N (t) = n] = pn(t) = exp{t} n! The Poisson process for the number of claims will be combined with a claim amount distribution to give a compound Poisson process for the aggregate claims. S(t) = X1 + X2 + + XN (t) The following three important assumptions are made: 1. the random variables {Xi} are i.i.d. i=1 2. the random variables {Xi} are independent i=1 of N (t) for all t 0 3. the stochastic process {N (t)}t0 is a Poisson process whose parameter is denoted

2 THE POISSON PROCESS

17

For a compound Poisson process S(t), the mean, the variance and the MGF of the process are given by: E[S(t)] = t E(X) Var[S(t)] = t E(X 2) MS(t)(r) = exp{t[MX (r) 1]} The kth moment about zero of the Xis, if it exists, are denoted mk , i.e. mk = E[Xik ] for k = 1, 2, 3, . . .

2 THE POISSON PROCESS

18

In the following sections, we will discuss: The adjustment coecient and Lundbergs inequality The eect of changing parameter values on nite and innite time ruin probabilities Reinsurance and ruin

3 THE ADJUSTMENT COEFFICIENT AND LUNDBERGS INEQUALITY

19

The adjustment coecient and Lundbergs inequality

Lundbergs inequality

3.1

Lundbergs inequality states that: (U ) exp[RU ] where U is the insurers initial surplus, (U ) is the probability of ultimate ruin and R is a parameter associated with a surplus process known as the adjustment coecient. The value of R depends on the distribution of aggregate claims and on the rate of premium income.

3 THE ADJUSTMENT COEFFICIENT AND LUNDBERGS INEQUALITY

20

If we can nd a value for R, then Lundbergs inequality tells us that we can nd an upper bound for the probability of ruin. See a gure, which shows a graph of both exp[RU ] and (U ) against U when claim amounts are exponentially distributed with mean 1, and when the premium loading factor is 10%.

3 THE ADJUSTMENT COEFFICIENT AND LUNDBERGS INEQUALITY

21

R can be interpreted as measuring risk. The larger the value of R, the smaller the upper bound for (U ) will be. i.e. Larger values of R imply smaller ruin probabilities. R is a function of the parameters that aect the probability of ruin. See a graph of R as a function of (premium loading factor), when Xi Exponential(1/10) and Xi = 10. RExponential < REqual

3 THE ADJUSTMENT COEFFICIENT AND LUNDBERGS INEQUALITY

22

3.2

The adjustment coecient compound Poisson processes

When S(t) is a compound Poisson process, then R is dened in term of , MX (t) and the premium income per unit time c. The following assumption will also be made: c > m1 so that the insurers premium income (per unit time) is greater than the expected claims outgo (per unit time). R can be found by solving the equation: MX (R) = + cR or MX (R) = 1 + (1 + )m1R (c = (1 + )m1)

3 THE ADJUSTMENT COEFFICIENT AND LUNDBERGS INEQUALITY

23

It can be shown that there is indeed only one positive root of MX (R) = + cR. See a graph of g(r) = MX (r) cr g(0) = 0 d g(r) dr =
r=0

d MX (r) c dr

= m1 c < 0
r=0

d2 d2 g(r) = 2 MX (r) = E(X 2erX ) > 0 dr2 dr

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES24

Eect of changing parameter values on ruin probabilities

Introduction

4.1

The eect of changing parameter values on (U, t) and (U ) will be discussed. It will be assumed that the aggregate claims process is a compound Poisson process with the parameter = 1. The implication is that the unit of time has been chosen to be such that the excepted number of claims in a unit time is 1. (U, 500) is the probability of ruin (given initial surplus U ) over a time period in which 500 claims are expected.

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES25

We also assume that the expected value of an individual claim is 1. This implication is that the monetary unit has been chosen to be equal to the expected amount of a single claim. (20, 500) is the probability of ruin (over a time period in which 500 claims are expected) given an initial surplus equal to 20 times the expected amount of a single claim. It will be also assumed that individual claims have an exponential distribution.

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES26

4.2

A formula for (U ) when F (x) is the exponential distribution

Individual claims amounts are exponentially distributed with mean 1 F (x) = 1 ex The premium loading factor is . (U ) is then: (the derivative of this result is beyond the scope of our discussion.) 1 U (U ) = exp 1+ 1+ If = 0 then (U ) = 1 irrespective of the value of U . This result is in fact true for any form of F (x).

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES27

4.3

(U, t) as a function of t

Assume that = 0.1. See a graph of (15, t) for 0 t 500 (15, t) for 0 t 500 can be worked out using a numerical method. (15) = 0.23248 can be calculated using 0.1 15 1 exp (15) = 1 + 0.1 1 + 0.1 The adjustment coecient R = 0.1/1.1 and exp{15R} = 0.2557 can be calculated using MX (R) m1 MX (R) = = = = 1 + (1 + )m1R 1 0.1 (1 R)1

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES28

(15, t) is an increasing function of t. For small value of t, (15, t) increases very quickly. For large values of t, (15, t) increases less quickly and approaches asymptotically the value of (15). We would expect a much higher probability of ruin before time 50 than before time 25 since the overall performance of the fund could easily change in such a short time period. If premium rates are expected to be protable in the long term (say, at time 400), then a signicant surplus will have built up in most cases and so the probability of ruin at time 425 will not be that much higher than at time 400.

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES29

4.4

Ruin probability as a function of initial surplus U

See a graph of (U, t) for 0 t 500 where = 0.1 and U = 15, 20, 25. Increasing the value of U decreases the value of (U, t) for any value of t. In the case of exponentially distributed individual claim amounts, d (U ) = (U ) dU 1+ Hence (U ) is a decreasing function of U .

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES30

4.5

Ruin probability as a function of premium loading

See a graph of (15, t) for 0 t 500 where = 0.1, 0.2, 0.3. Increasing the value of decreases the value of (15, t) for any value of t. When = 0.2 and 0.3, (15, t) is more or less constant for t greater than about 150. For = 0.2 and 0.3, (and for U=15 and for this S(t)) ruin, if it occurs at all, is far more likely to occur before time 150 than after time 150.

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES31

See a graph of (10) as a function of . (U ) must be a non-increasing function of . For Xi Exponential(), d (U ) = (1 + )1(U ) U (1 + )2(U ) d Hence, (U ) is a decreasing function of .

4 EFFECT OF CHANGING PARAMETER VALUES ON RUIN PROBABILITIES32

4.6

Ruin probability as a function of the Poisson parameter

See a graph of (15, 10) as a function of for = 0.1, 0.2, 0.3. The value of (15, 10) when = 50 is the same as the value of (15, 500) when = 1. cf. (15, 10) with = 50 WITH (15, t) with = 1.

5 REINSURANCE AND RUIN

33

5
5.1

Reinsurance and ruin

Introduction

One of the options open to an insurer who wishes to reduce the variability of aggregate claims from a risk is to eect reinsurance. A reduction in variability would be expected to increase an insurers security, and hence reduce the probability of ruin. A reinsurance arrangement could be considered optimal if it minimizes the probability of ruin. As it is dicult to nd explicit solutions for the probability of ruin, the eect of reinsurance on the adjustment coecient will be considered instead.

5 REINSURANCE AND RUIN

34

If a reinsurance arrangement can be found that maximizes the value of the adjustment coecient, the upper bound for the probability of ultimate ruin will be minimized. As the adjustment coecient is a measure for risk, it seems a reasonable objective to maximize its value. We will consider the eect on the adjustment coecient of proportional and of excess of loss reinsurance arrangements.

5 REINSURANCE AND RUIN

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5.2

Maximizing the adjustment coecient under proportional reinsurance

The insurers premium income per unit time, before payment of the reinsurance premium, is (1 + )m1. The reinsurance premium is assumed as (1+)(1 )m1. The insurers premium income, net of reinsurance, is [(1 + ) (1 + )(1 )]m1

5 REINSURANCE AND RUIN

36

We also assume that . If this were not true, it would be possible for the insurer to pass the entire risk on to the reinsurer and to make a certain prot. This of course ignores commission, expenses and other adjustment to the theoretical risk premium.

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For the insurers premium income, net of reinsurance, to be positive: (1 + ) > (1 + )(1 ) > 1+

The insurers net of reinsurance premium income per unit time must exceed the expected aggregate claims per unit time. Otherwise ultimate ruin is certain. i.e. [(1 + ) (1 + )(1 )]m1 > m1 >

5 REINSURANCE AND RUIN

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When , > 1+ When = , > 0. When > , >

.

5 REINSURANCE AND RUIN 5.2.1 Same loadings =

39

Suppose that F (x) = 1 e0.1x. The distribution of the insurers individual claims net of reinsurance Yi = Xi Exponential(0.1/). P [Y y] = P [X y/] = 1 exp{0.1y/} Hence

+ (1 + )10R =
0

eRx(0.1/)e0.1x/dx

1 1 + (1 + )10R = 1 10R R= for 0 < 1 (1 + )10

It can be seen that R is a decreasing function of .

5 REINSURANCE AND RUIN 5.2.2 Dierent loadings = 0.2 > = 0.1

40

0.1 Suppose that F (x) = 1 e , Mx(t) = 0.1 t The insurers net premium income per unit time is
0.1x

[(1 + ) (1 + )(1 )]m1 = [1.1 1.2 (1 )] 10 = (12 1) The equation dening R is: + (12 1)R = 0.1/ = 0.1/ R 1 10R

2 1 R= for 0.5 < 1 10(122 )

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We should nd the value of that maximizes R. dR 20(122 ) (2 1)10(24 1) = d 100(122 )2 20(122 ) = (2 1)10(24 1) 242 24 + 1 = 0 = 0.9564, = 0.0436 See a graph of R as a function of .

5 REINSURANCE AND RUIN

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5.3

Maximizing the adjustment coecient under excess of loss reinsurance

We consider the eect of excess of loss reinsurance on the adjustment coecient. We assume that insurers premium income per unit time (before reinsurance) is (1 + )m1. reinsurers premium income per unit time is (1+) E(Z) ( ) and Z = max(0, XM ) insurers premium income per unit time (net of reinsurance) is c = (1 + )m1 (1 + ) E(Z)

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43

Equation dening R is
M

+c R=
0

eRxf (x)dx + eRM [1 F (M )]

The equation for R must be solved numerically for given values of and . See a graph of R as a function of M when = = 0.1. R is a decreasing function of M . R goes to as M goes to 0. When > there is a minimum retention level.

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44

See a graph of R as a function of M for the following combinations of and : 1. = 0.1 and = 0.2 2. = 0.1 and = 0.4 For = 0.2, it is possible for the insurer to increase the value of the adjustment coecient by eecting reinsurance. For = 0.4, the insurer should retain the entire risk in order to maximize the value of the adjustment coecient.