Actuarial Applications of a Hierarchical Insurance Claims Model

This paper demonstrates actuarial applications that can be performed when modern statistical methods are applied to detailed, micro-level automobile insurance records. We consider 1993-2001 data consisting of policy, claims and payment files from a major Singapore insurance company. A hierarchical statistical model, developed in prior work Frees and Valdez (2008), is fit using the micro-level data. This model allows us to study the accident frequency, loss type and severity jointly and to incorporate individual characteristics such as age, gender and driving history that explain heterogeneity among policyholders. Based on this hierarchical model, one can analyze the risk profile of either a single policy (micro-level) or a portfolio of business (macro-level). This paper investigates three types of actuarial applications. First, we demonstrate the calculation of the predictive mean of losses for individual risk rating. This allows the actuary to differentiate prices based on policyholder characteristics. The nonlinear effects of coverage modifications such as deductibles, policy limits and coinsurance are quantified. Moreover, our flexible structure allows us to “unbundle” contracts and price more primitive elements of the contract, such as coverage type. The second application concerns the predictive distribution of a portfolio of business. We demonstrate the calculation of various risk measures, including value at risk and conditional tail expectation, that are useful in determining economic capital for insurance companies. Third, we examine the effects of several reinsurance treaties. Specifically, we show the predictive loss distributions for both the insurer and reinsurer under quota share and excess-of-loss reinsurance agreements. In addition, we present an example of portfolio reinsurance, in which the combined effect of reinsurance agreements on the risk characteristics of ceding and reinsuring company are described. ∗