# Optimal reinsurance with ruin probability target

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1 Optimal reinsurance with ruin probability target Arthur Charpentier 7th International Workshop on Rare Event Simulation, Sept http ://blogperso.univ-rennes1.fr/arthur.charpentier/ 1

2 Ruin, solvency and reinsurance reinsurance plays an important role in reducing the risk in an insurance portfolio. Goovaerts & Vyncke (2004). Reinsurance Forms in Encyclopedia of Actuarial Science. reinsurance is able to offer additional underwriting capacity for cedants, but also to reduce the probability of a direct insurer s ruin. Engelmann & Kipp (1995). Reinsurance. in Encyclopaedia of Financial Engineering and Risk Management. 2

3 Proportional Reinsurance (Quota-Share) claim loss X : αx paid by the cedant, (1 α)x paid by the reinsurer, premium P : αp kept by the cedant, (1 α)p transfered to the reinsurer, Nonproportional Reinsurance (Excess-of-Loss) claim loss X : min{x, u} paid by the cedant, max{0, X u} paid by the reinsurer, premium P : P u kept by the cedant, P P u transfered to the reinsurer, 3

4 Proportional versus nonproportional reinsurance Proportional reinsurance (QS) Nonproportional reinsurance (XL) reinsurer cedent reinsurer cedent claim 1 claim 2 claim 3 claim 4 claim 5 claim 1 claim 2 claim 3 claim 4 claim 5 Fig. 1 Reinsurance mechanism for claims indemnity, proportional versus nonproportional treaties. 4

5 Classical Cramér-Lundberg framework : Mathematical framework claims arrival is driven by an homogeneous Poisson process, N t P(λt), durations between consecutive arrivals T i+1 T i are independent E(λ), claims size X 1,, X n, are i.i.d. non-negative random variables, independent of claims arrival. Let Y t = N t i=1 X i denote the aggregate amount of claims during period [0, t]. 5

7 A classical solvency problem Given a ruin probability target, e.g. 0.1%, on a give, time horizon T, find capital u such that, ψ(t, u) = 1 P(u + πt Y t, t [0, T ]) = 1 P(S t 0 t [0, T ]) = P(inf{S t } < 0) = 0.1%, where S t = u + πt Y t denotes the insurance company surplus. 7

8 A classical solvency problem After reinsurance, the net surplus is then where π (θ) = E ( N1 i=1 X (θ) i ) S (θ) t and = u + π (θ) t N t i=1 X (θ) i, X (θ) i = θx i, θ [0, 1], for quota share treaties, X (θ) i = min{θ, X i }, θ > 0, for excess-of-loss treaties. 8

9 Classical answers : using upper bounds Instead of targeting a ruin probability level, Centeno (1986) and Chapter 9 in Dickson (2005) target an upper bound of the ruin probability. In the case of light tailed claims, let γ denote the adjustment coefficient, defined as the unique positive root of λ + πγ = λm X (γ), where M X (t) = E(exp(tX)). The Lundberg inequality states that 0 ψ(t, u) ψ(, u) exp[ γu] = ψ CL (u). Gerber (1976) proposed an improvement in the case of finite horizon (T < ). 9

10 Classical answers : using approximations u de Vylder (1996) proposed the following approximation, assuming that E( X 3 ) <, ψ dv (u) 1 ( 1 + γ exp β γ ) µ 1 + γ quand u where γ = 2µm 3 3m 2 2 γ et β = 3m 2 m 3. Beekman (1969) considered ψ B (u) γ [1 Γ (u)] quand u where Γ is the c.d.f. of the Γ(α, β) distribution α = 1 ( ( ) ) 4µm γ et β = 2µγ 1 + γ 3m 2 2 ( m 2 + ( 4µm3 3m 2 2 ) ) 1 m 2 γ 10

11 Classical answers : using approximations u Rényi - see Grandell (2000) - proposed an exponential approximation of the convoluted distribution function ψ R (u) 1 ( 1 + γ exp 2µγu ) quand u m 2 (1 + γ) In the case of subexponential claims ψ SE (u) 1 γµ ( µ u 0 ) F (x) dx 11

12 Classical answers : using approximations u CL dv B R SE Exponential yes yes yes yes no Gamma yes yes yes yes no Weibull no yes yes yes β ]0, 1[ Lognormal no yes yes yes yes Pareto no α > 3 α > 3 α > 2 yes Burr no αγ > 3 αγ > 3 αγ > 2 yes 12

13 Proportional reinsurance (QS) With proportional reinsurance, if 1 α is the ceding ratio, S (α) t = u + απt N t i=1 αx i = (1 α)u + αs t Reinsurance can always decrease ruin probability. Assuming that there was ruin (without reinsurance) before time T, if the insurance had ceded a proportion 1 α of its business, where α = u u inf{s t, t [0, T ]}, there would have been no ruin (at least on the period [0, T ]). then α = u u min{s t, t [0, T ]} 1(min{S t, t [0, T ]} < 0) + 1(min{S t, t [0, T ]} 0), ψ(t, u, α) = ψ(t, u) P(α α). 13

14 Proportional reinsurance (QS) Impact of proportional reinsurance in case of ruin Time (one year) Fig. 2 Proportional reinsurance used to decrease ruin probability, the plain line is the brut surplus, and the dotted line the cedant surplus with a reinsurance treaty. 14

15 Proportional reinsurance (QS) In that case, the algorithm to plot the ruin probability as a function of the reinsurance share is simply the following RUIN <- 0; ALPHA <- NA for(i in 1:Nb.Simul){ T <- rexp(n,lambda); T <- T[cumsum(T)<1]; n <- length(t) X <- r.claims(n); S <- u+premium*cumsum(t)-cumsum(x) if(min(s)<0) { RUIN <- RUIN +1 ALPHA <- c(alpha,u/(u-min(s))) } } rate <- seq(0,1,by=.01); proportion <- rep(na,length(rate)) for(i in 1:length(rate)){ proportion[i]=sum(alpha<rate[i])/length(alpha) } plot(rate,proportion*ruin/nb.simul) 15

16 Proportional reinsurance (QS) Ruin probability (in %) Pareto claims Exponential claims Cedent's quota share Fig. 3 Ruin probability as a function of the cedant s share. 16

17 Proportional reinsurance (QS) Ruin probability (w.r.t. nonproportional case, in %) (tail index of Pareto individual claims) rate Fig. 4 Ruin probability as a function of the cedant s share. 17

18 Nonproportional reinsurance (QS) With nonproportional reinsurance, if d 0 is the priority of the reinsurance contract, the surplus process for the company is S (d) t = u + π (d) t N t i=1 min{x i, d} where π (d) = E(S (d) 1 ) = E(N 1 ) E(min{X i, d}). Here the problem is that it is possible to have a lot of small claims (smaller than d), and to have ruin with the reinsurance cover (since p (d) < p and min{x i, d} = X i for all i if claims are no very large), while there was no ruin without the reinsurance cover (see Figure 5). 18

19 Proportional reinsurance (QS) Impact of nonproportional reinsurance in case of nonruin Time (one year) Fig. 5 Case where nonproportional reinsurance can cause ruin, the plain line is the brut surplus, and the dotted line the cedant surplus with a reinsurance treaty. 19

20 Proportional reinsurance (QS), homogeneous Poisson Ruin probability (in %) Deductible of the reinsurance treaty Fig. 6 Monte Carlo computation of ruin probabilities, where n = 100, 000 trajectories are generated for each deductible. 20

21 Proportional reinsurance (QS), nonhomogeneous Poisson Ruin probability (in %) % 10% Deductible of the reinsurance treaty Fig. 7 Monte Carlo computation of ruin probabilities, where n = 100, 000 trajectories are generated for each deductible. 21

22 Proportional reinsurance (QS), nonhomogeneous Poisson Ruin probability (in %) Deductible of the reinsurance treaty Fig. 8 Monte Carlo computation of ruin probabilities, where n = 100, 000 trajectories are generated for each deductible. 22

23 Proportional reinsurance (QS), nonhomogeneous Poisson Ruin probability (in %) % 20% Deductible of the reinsurance treaty Fig. 9 Monte Carlo computation of ruin probabilities, where n = 100, 000 trajectories are generated for each deductible. 23

24 Références [1] Asmussen, S. (2000). Ruin Probability. World Scientific Publishing Company. [2] Beekmann, J.A. (1969). A ruin function approximation. Transactions of the Society of Actuaries,21, [3] Bühlmann, H. (1970). Mathematical Methods in Risk Theory. Springer-Verlag. [4] Burnecki, K. Mista, P. & Weron, A. (2005). Ruin Probabilities in Finite and Infinite Time. in Statistical Tools for Finance and Insurance, Cízek,P., Härdle, W. & Weron, R. Eds., Springer Verlag. [5] Centeno, L. (1986). Measuring the Effects of Reinsurance by the Adjustment Coefficient. Insurance : Mathematics and Economics 5, [6] Dickson, D.C.M. & Waters, H.R. (1996). Reinsurance and ruin. Insurance : Mathematics and Economics, 19, 1, [7] Dickson, D.C.M. (2005). Reinsurance risk and ruin. Cambridge University Press. 24

25 [8] Engelmann, B. & Kipp, S. (1995). Reinsurance. in Peter Moles (ed.) : Encyclopaedia of Financial Engineering and Risk Management, New York & London : Routledge. [9] Gerber, H.U. (1979). An Introduction to Mathematical Risk Theory. Huebner. [10] Grandell, J. (1991). Aspects of Risk Theory. Springer Verlag. [11] Goovaerts, M. & Vyncke, D. (2004). Reinsurance forms. in Encyclopedia of Actuarial Science, Wiley, Vol. III, [12] Kravych, Y. (2001). On existence of insurer s optimal excess of loss reinsurance strategy. Proceedings of 32nd ASTIN Colloquium. [13] de Longueville, P. (1995). Optimal reinsurance from the point of view of the excess of loss reinsurer under the finite-time ruin criterion. [14] de Vylder, F.E. (1996). Advanced Risk Theory. A Self-Contained Introduction. Editions de l Universit de Bruxelles and Swiss Association of Actuaries. 25

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