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Probability of Ruin in Insurance Theory

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8 views7 pages

Probability of Ruin in Insurance Theory

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lapel94551
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© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1

WST322 2013
Chapter 9 Ruin Theory

INTRODUCTION

Previously: S = X1 + X2 + ...XN Now: S(t) = X1 + X2 + ... + XS(t) is a


function of time; N (t) is the number of claims in [0, t] i.e. a Poisson process;
S(t) is the aggregate claims received in [0, t] i.e. a compound Poisson process.
Then {S(t)}t≥0 and {N (t)}t≥0 are stochastic processes.

ˆ We use S(t) to calculate the probability of ruin

ˆ premium security loading = additional amount charged on an insurance


premium to reduce the likelihood of an insurance company being ruined

ˆ f (h) is o(h) if f (h)


h
→ 0 as h → 0

ˆ Assume: The premium income is received continuously and at a con-


stant rate c > 0 i.e. total premium in [0, t] is ct

THE SURPLUS PROCESS

Initial surplus U ≥ 0: Amount the insurer sets aside at time 0 for the
risk in case the future premium income alone is not sufficient to cover future
claims

Surplus at time t: Cash flow process/Surplus process U (t) = U + ct −


S(t), t ≥ 0, so that {U (t)}t≥0 is a continuous time stochastic process

PROBABILITY OF RUIN IN CONTINUOUS TIME

Ruin When U (t) falls below 0

 Want to keep the P[ruin] as small as possible or at least below a predeter-


mied bound, otherwise the insurer will need to provide more capital

P[ultimate ruin] = P[ruin in infinite time]: Ψ(U ) = P [U (t) < 0 for some t, 0 <
t < ∞]

P[ruin] = P[ruin in finite time]: Ψ(U, t) = P [U (τ ) < 0 for some τ, 0 < τ ≤


t]

Probabilities are most often approximated instead of obtaining them exactly.


2

Important Relationships For 0 < t1 ≤ t2 < ∞ and 0 ≤ U1 ≤ U2 :

 Ψ(U2 , t) ≤ Ψ(U1 , t)

 Ψ(U2 ) ≤ Ψ(U1 )

 Ψ(U, t1 ) ≤ Ψ(U, t2 ) ≤ Ψ(U )

 lim t → ∞Ψ(U, t) = Ψ(U )

 limU →∞ Ψ(U, t) = 0

PROBABILITY OF RUIN IN DISCRETE TIME

For a given interval of time h:  Ψh (U ) = P [U (t) < 0 for some t, t =


h, 2h, 3h, ...]  Ψh (U, t) = P [U (τ ) < 0 for some τ, τ = h, 2h, 3h, ..., t − h, t]
where t is a multiple of h

Important Relationships For 0 < t1 ≤ t2 < ∞ and 0 ≤ U1 ≤ U2 :

 Ψh (U2 , t) ≤ Ψh (U1 , t)

 Ψh (U2 ) ≤ Ψh (U1 )

 Ψh (U, t1 ) ≤ Ψh (U, t2 ) ≤ Ψh (U )

 limt→∞ Ψh (U, t) = Ψh (U )

 Ψh (U, t) = Ψ(U, t)

 limh→0+ Ψh (U, t) = Ψ(U, t)

 limh→0+ Ψh (U ) = Ψ(U )

THE POISSON AND COMPOUND POISSON PROCESS

The Poisson Process: {N (t)}t≥0 is a Poisson process with parameter λ:

1. N (0) = 0

2. N (t) is an integer for t ≥ 0

3. For s < t, N (s) ≤ N (t) i.e. nondecreasing


3

4. For s < t, N (t) − N (s) = number of claims in (s, t]

⇐⇒

1. N (0) = 0, N (S) ≤ N (t) for s < t

2. – P [N (t + h) = r|N (t) = r] = 1 − λh + o(h)


– P [N (t + h) = r + 1|N (t) = r] = λh + o(h)
– P [N (t + h) > r + 1|N (t) = r] = o(h)
– independent of t i.e. time-homogeneous; λ is the average rate of
claims occurrence

3. For s < t, the number of claims in (s, t] is independent of the number


of claims up to time s.

So N (t) ∼ P oisson(λt); time to the first claim T1 ∼ exp(λ); time between


claims Ti − Ti−1 ∼ exp(λ). (Proofs on page 11-14 not required, done in
WST312).

The Compound Poisson Process:  {Xi }∞ i=1 are iid and independent of N (t), t ≥
0  {N (t)}t≥0 is a Poisson process with parameter λ,  so that {S(t)}t≥0 is
a compound Poisson process with parameter λ and for a fixed t,

S(t) ∼ CompP oisson(λt, FX (x))

So
E[S(t)] = λtm1 , var(S(t)) = λtm2 , MS(t) (r) = eλt(MX (r)−1)

We assume c > λm1

A TECHNICALITY

1. Assume: ∃ γ (0 < γ ≤ ∞) such that MX (r) is finite ∀ r < γ and


limr→γ − MX (r) = ∞

2. Result: limr→γ − (λMX (r) − cr) = ∞


4

THE ADJUSTMENT COEFFICIENT AND LUNDBERG’S INEQUALITY

Ψ(U ) ≤ e−RU

where

Ψ(U ) probability of ultimate ruin

RHS upper bound for the probability of ultimate ruin

R adjustment coefficient Measure of risk. Inverse relationship with Ψ(U ).


(depends on the distribution of aggregate claims and on the rate of
premium income)

U initial surplus

ˆ When U is large, Ψ(U ) ≈ e−RU thus can be used an an approximation

FOR THE COMPOUND POISSON PROCESS (no proof)

R is the unique positive root of λMX (r) − λ − cr = 0

λ+cr
If c = (1 + θ)λm1 then MX (r) = λ
= 1 + (1 + θ)m1 r is independent of the
Poisson parameter
5

UPPER BOUND

2θm1
R< if c = (1 + θ)λm1
m2

LOWER BOUND Only if there is an upper bound on the individual claim,


say M , e.g. U (0, M ).

( )
1 c
R> ln if c = (1 + θ)λm1
M λm1
6

FOR THE GENERAL AGGREGATE CLAIMS (no proof)

For  {Si }∞
i=1 iid, each the aggregate claims from a risk in time period i with
density h(x),  c the constant premium with c > E[Si ],  ∃ γ > 0 such that
limr→γ − E[er(Si −c) ] = ∞, then
R is the unique positive value that satisfies E[eR(Si −c) ] = 1.

RUIN AND REINSURANCE In order to reduce the variability of ag-


gregate claims from a risk and therefore increase the insurer’s security and
decrease the probability of ruin. We maximize the adjustment coefficient in
order to minimize the upper bound for the probability of ultimate ruin.

MAXIMIZING R UNDER PROPORTIONAL REINSURANCE

premium income before reinsurance: (1 + θ)λm1


reinsurance premium: (1 + ξ)(1 − α)λm1
premium income with reinsurance: [(1 + θ) − (1 + ξ)(1 − α)] λm1 must
ξ−θ
be positive i.e. α > 1+ξ and must be greater than αλm1 (expected
aggregate claims) so α > 1 − θξ
7

MAXIMIZING R UNDER EXCESS-OF-LOSS REINSURANCE

premium income before reinsurance: (1 + θ)λm1

reinsurance premium: (1 + ξ)λE[Z] where Z = max{0, X − M }

premium income with reinsurance: c∗ = (1 + θ)λm1 − (1 + ξ)λE[Z] so


that we must solve for R in
[∫ M ]
∗
λ+c R=λ e fX (x)dx + e (1 − FX (M ))
Rx RM
0

Common questions

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The initial surplus U directly impacts the probability of ultimate ruin: a larger initial surplus reduces Ψ(U), the probability of ruin, by providing a financial cushion against unexpected claims. This insight informs insurers' financial decisions by highlighting the importance of maintaining a robust initial reserve to enhance solvency and sustain operations under adverse conditions .

A simple Poisson process models only the number of claims occurring over a period, characterized by a rate λ, indicating the frequency of claims. In contrast, a compound Poisson process considers both the number and the size of claims, resulting in the aggregate claims S(t) being expressed by the sum of random, independently and identically distributed claim sizes {X_i} over a Poisson-distributed count process N(t).

In ruin theory, the Poisson process models the number of claims received over time. Characterized by parameter λ, it details the frequency of claims within given intervals and assumes independence between claim numbers over non-overlapping intervals. This process is integral in forming the compound Poisson process, where aggregate claims S(t) result from a Poisson-distributed number of independent claim amounts .

Continuous premium income contributes positively to the surplus process. It implies that the insurer receives a steady influx of premiums, expressed as ct over time t. This helps counterbalance the claims subtraction (S(t)) from the surplus, U(t) = U + ct - S(t), thereby reducing the probability of ruin by maintaining the surplus above zero .

Premium security loading refers to an additional amount charged on an insurance premium to mitigate the likelihood of an insurance company experiencing ruin. It acts as a buffer by ensuring that premiums are sufficiently high to cover unexpected claims, thus reducing the risk of insolvency .

Lundberg's inequality provides an upper bound for the probability of ultimate ruin in a stochastic process, expressed as Ψ(U) ≤ e^{-RU}, where R is the adjustment coefficient. This inequality helps insurers estimate the risk of insolvency and acts as a safeguard by ensuring the ruin probability remains within a controllable range .

The surplus process in ruin theory is defined as the amount an insurer has at any time t after accounting for initial surplus, premium income, and claims. Mathematically, it is given by U(t) = U + ct - S(t), where U is the initial surplus, ct is the premium income received continuously and at a constant rate over time, and S(t) is the aggregate claims received up to time t .

In continuous time, the probability of ruin, Ψ(U, t), refers to the risk that the surplus becomes negative at least once in the time period (0, t]. It can approach the ultimate ruin probability as time tends to infinity. In discrete time, the probability of ruin, Ψh(U, t), is evaluated at discrete intervals (e.g., t = h, 2h, 3h, ...). The probability in discrete time is often derived as an approximation of the continuous case. Importantly, as the interval h approaches zero, the discrete probability converges to the continuous probability .

Under proportional reinsurance, the adjustment coefficient is maximized by ensuring that the net premium income remains positive, which occurs when α > (ξ - θ) / (1 + ξ). For excess-of-loss reinsurance, maximization involves adjusting the loss limit M and reinsurance terms to solve λ + c*R = λ[∫_0^M e^{Rx}fX(x)dx + e^{RM}(1 - FX(M))], where c* is the premium income adjusted for reinsurance costs .

The adjustment coefficient, denoted as R, inversely relates to the probability of ultimate ruin, Ψ(U). Specifically, the probability of ultimate ruin can be bounded by Ψ(U) ≤ e^{-RU}. A larger adjustment coefficient implies a lower probability of ruin, indicating it is a measure of risk and suggests the financial safety of an insurer .

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