ACTL3162 General Insurance Techniques

Module 1: Introduction1

1
1/15 References: MW Ch1
 Plan

1 Nature of general insurance

2 Probability theory and statistics

2/15
 Nature of general insurance

Nature of general insurance

General insurance (in UK and Australia) is also called ‘non-life

insurance’, or ‘property and casualty insurance’ (in US)
It includes: car, liability, property, workers compensation,
marine, credit, legal, travel, accident and health, . . .
It provides financial protection against random events that
might cause serious financial damage.

It is a swap of deterministic for random:

An upfront deterministic premium is paid.
In return, (random) insurance claims will be paid for insured
(random) events that cause financial damage.
The conversion is an actuarial problem

3/15
 Nature of general insurance

Non-life insurance and the law of large numbers

Why insurance works?

The weak law of large numbers (LLN): For a all  > 0,
" n  #
1 X 
lim Pr  Yi − E [Yi ] ≥  = 0
 
n→∞ n 
i=1

If the insurance company pools similar risks whose individual

insurance claims are represented by Y1 , · · · , Yn and assume
that these claims are uncorrelated and identically distributed,
then the LLN means that the total claim amount becomes
more “predictable” with increasing portfolio size n.
Therefore, the insurance premium can be calculated quite
accurately if the portfolio size is large.
LLN is considered to be the theoretical cornerstone of
insurance.
4/15
 Nature of general insurance

Risk components
Risk components from the insurance company point of view.
Pure randomness
Each individual risk is uncertain/random.
The risk can be controlled if the volume of the insurance
portfolio is large.

Model risk
All models are wrong, some are useful
1 model world 6= real world
2 even if model was right, wrong parameters
3 non-stationarity: risk factors change over time so the past
observations do not appropriately describe what may happen in
the future.

=⇒ We need a margin to provide financial stability

5/15
 Nature of general insurance

Premium components

gross premium = pure risk premium

+risk margin
+profit margin
−financial gains on investments
+underwriting expenses
+loss adjustment expenses (LAE)
(+taxes)

6/15
 Probability theory and statistics

Probability theory and statistics

Please review:

Random variables and distribution functions

Terminology in statistics

Basics on Moodle ‘ACTL All Students Site’

7/15
 Probability theory and statistics

Continuous vs discrete random variables

Random variables are either

discrete
distribution function (df) is Pr[X ≤ x] ≡ FX (x) (cadlag)
probability mass function (pmf) is Pr[X = x]
continuous
cumulative distribution function (cdf) is FX (x) (cadlag)
probability density function (pdf) is defined by

dFX (x)
fX (x) ≡ .
dx
This is NOT a probability.
mixed

8/15
 Probability theory and statistics

The Riemann-Stieltjes integral

The Riemann-Stieltjes notation allows to write expressions for any

type of rv. For instance,
Z ∞
E [g (X )] = g (x) dFX (x) ,
−∞

where dFX (x) is to be interpreted as

fX (x)dx for the continuous bits of F , and
FX (x) − FX (x − 0) = Pr[X = x] (remember F is cadlag) for
the discrete bits of F .

9/15
 Probability theory and statistics

Moments of random variables

There are two types of moments
the moments around the origin: E [X k ], k > 0
k = 1: the mean
Z ∞
E (X ) = µX = xdFX (x)
−∞

the central moments: E (X − E [X ])k , k > 0

 
k = 2: the variance
h i
2
Var (X ) = σX2 = E (X − µX ) = E X 2 − µ2X

Some extremely useful formulas:

E [S] = E [E [S|N]] (Law of Iterated Expectations)
Var (S) = Var (E [S|N]) + E [Var (S|N)] (DVR)
Cov (X , Y ) = E [Cov (X , Y |Z )] + Cov (E [X |Z ], E [Y |Z ]) (DCR)
Cov (X , Y ) = Cov (X , E [Y |Z ])
10/15
 Probability theory and statistics

Tail value method of calculating expectation

For positive random variables we have

 R∞
E [X ] = P 0 [1 − FX (x)] dx if X is continuous
∞
0 [1 − FX (x)] if X is discrete

11/15
 Probability theory and statistics

Descriptive statistics
Some indicators are functions of the moments
Coefficient of variation (measure of spread):
σX
Vco(X ) = .
µX
Skewness (measure of... skewness!):
h i
E (X − µX )3
ςX = .
σX3

If symmetric, ςX = 0 [vice versa not true]

ςX > 0 indicates heavy right-tail [skewed to the right]
ςX < 0 indicates heavy left-tail [skewed to the left]

12/15
 Probability theory and statistics

Descriptive statistics

Excess Kurtosis (measure of peakedness)

h i
E (X − µX )4
γ2 (X ) = − 3.
σX4

γ2 (X ) = 0 mesokurtic [like Normal, Binomial(p = 0.5)]

γ2 (X ) > 0 leptokurtic [fatter tails]
γ2 (X ) < 0 platykurtic [thinner tails]
Note that these indicators have no units, which allows comparisons
between distributions.

13/15
 Probability theory and statistics

Generating functions
Probability generating function pgf—only for discrete rv!
 
pX (t) = E t X
= Pr[X = 0] + Pr[X = 1]t + Pr[X = 2]t 2 + Pr[X = 3]t 3 + . . .

Moment generating function mgf

 
MX (t) = E e tX
t2 t3 tk
= 1 + E [X ]t + E [X 2 ] + E [X 3 ] + . . . + E [X k ] + . . .
2 6 k!
and thus
dk

k

E [X ] = k MX (t)
dt t=0
14/15
 Probability theory and statistics

Generating functions
Cumulant generating function cgf

κX (t) = ln [MX (t)]

t2  t3 t4
= E [X ]t + Var (X ) + E (X − µX )3 + γ2 (X ) [Var (X )]2 + . . .∗

2 6 4!
and thus
dk
h i 
k
k = 2 and 3∗ .

E (X − µX ) = k κX (t) ,
dt t=0

∗ CAUTION: the second and third cumulants are the second

and third central moments, but NOT the following ones!
Cumulants are additive: the k-th cumulant of a sum
is the sum of the k-th cumulants (conditions?)
15/15