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# SOA 08 Annual Meeting & Exhibit

October 19-22, 2008
Session 20, Disability Modeling—Designing Effective
and Efficient Models

Moderator
Scott D. Haglund, FSA, MAAA
Authors
Lijia Guo, ASA, MAAA
Trevor C. Howes, FSA, FCIA, MAAA

Lijia Guo, Ph.D., ASA, MAAA
Society of Actuaries
2008 Annual Meeting, Session 20
October 20, 2008
Lijia Guo

SOA 2008 Annual Meeting

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Agenda
y Introduction
y Generalized Linear Models
y Data Mining (DM)
y Fully Stochastic Models & Risks Integration
y Summary

Lijia Guo

SOA 2008 Annual Meeting

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Why Stochastic Modeling
y Pricing & Underwriting
y Produce a full distribution of possible outcomes
y Confidence levels of held reserves
y Consider the volatility of the unpaid claims
y Individual lines
y Correlation across the various lines
y VAR, CTE

y Regulatory and compliance
y
y
y

Solvency II
IFRS / Fair value accounting
Public companies (SEC)

y ERM
y
y

Financial and capital management
Operational/strategic excellence
Lijia Guo

SOA 2008 Annual Meeting

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Stochastic Modeling
y
y
y
y

Generalized Linear Models (GLM)
Data Mining (DM)
Fully Stochastic Models (FSM)
y Contingent claim Model (Stochastic Process)
y Other Statistics Methods

Lijia Guo

SOA 2008 Annual Meeting

3

Agenda
y Introduction
y Generalized Linear Models
y Data Mining (DM)
y Fully Stochastic Models & Risks Integration
y Summary

Lijia Guo

SOA 2008 Annual Meeting

4

Stochastic Models ‐ GLM
E[Yi ] = μ i = g −1 (∑ X i , j β j + ξ i )
j

Var[Yi ] = φV ( μ i ) / ω i
μi

•For each observation i, from distribution with mean
•Y has distribution from the exponential family
•g – is called the link function

V ( x) = 1. V ( x) = x. Var (Y ) = k μ 2 For Normal: . Var (Y ) = σ 2 φ = 1.Stochastic Models ‐ GLM The identity link: g(Y) = Y The log link: g(Y) = ln(Y) The inverse link: g(Y) = The logit link: g(Y) = 1 Y Y ln( ) 1− Y Stochastic Models ‐ GLM Var[Yi ] = φV ( μi ) / ωi For Poisson: φ = σ 2 . Var (Y ) = μ For Gamma: φ = k . V ( x) = x 2 .

/Lapse ⎛ x ⎞ ln⎜ ⎟ ⎝1− x ⎠ x(1‐x) 1 0 .Stochastic Models ‐ GLM Y Claim  Frequency Claim # Average  Claim  Amount g lnx lnx lnx Error Poisson Poisson Gamma Binomial φ 1 1 Estimated 1 V(x) x x ω Exposure 1 x2 # claims ξ 0 ln(exposure) 0 Stochastic Models – GLM Applications Prob.

amount of data.f3.Stochastic Models – GLM Applications What to do with continuous variables? – Age. Claim Size… Stochastic Models ‐ GAM •GLMs are special case of GAMs •Example LN(E[PP]) =  + f1(age) + f2(gender) +f3(Income) +f4(marital) •The functions f1. polynomial. and  functional form better Lijia Guo SOA 2008 Annual Meeting 11 .f4 can be anything ‐GLM ‐ Categorical.f2. transforms ‐Non‐parametric functional smoothers ‐Decision trees •Balance degrees of freedom.

Green& Silverman Lijia Guo SOA 2008 Annual Meeting 12 Agenda y Introduction y Generalized Linear Models y Data Mining y Fully Stochastic Models & Risks Integration y Summary Lijia Guo SOA 2008 Annual Meeting 13 .Stochastic Models ‐ GAM • Error Criteria ∑ {Yi – g(ti) } ² + λ ∫ { g” (t)} ² dt  ‐ λ is smoothing parameter • Applications – P&C • Reference:  ‐ Nonparametric Regression and Generalized Linear Models.

y Knowing your goals y Identifying responsive potential customers y Identifying existing customers that more likely to terminate y Identifying low risk purchaser y Identifying the factors that cause large claims y Indentifying interactions among risk factors y y y y Choosing the right methods Understanding the limitations  Validation and testing Make crucial business decisions Lijia Guo SOA 2008 Annual Meeting 14 Data Mining ‐ Data y Identifying Data y Internal Sources y Demographic data y Transactional data y Survey data y External Sources y Databases y Survey Data y Competitor  y Preparing Data  y Transforming Data Lijia Guo SOA 2008 Annual Meeting 15 .Stochastic Models – Data Mining y An information discovery process.

Introduction – DM Process Lijia Guo SOA 2008 Annual Meeting Stochastic Models – Data Mining y y y y y Decision Trees  Logistic regression Neural Networks Fuzzy Logics Genetic Algorithms  Clustering  Associated discovery  Sequence Discovery  Bayesian analysis  Visualization  Hybrid Algorithms • • • • Problems with standard algorithms Advanced algorithms Discovery-driven approaches Mixture of algorithms 16 .

What is the best method for you? y Model Assessment y Goodness‐of‐fit y Prediction accuracy y y Sensitivity and Specificity ROC curve y Model diagnostics y y y Pearson Residuals Deviance Residuals Hat Matrix Diagonal Lijia Guo SOA 2008 Annual Meeting 18 Model Validation y Cross validation y Avoid misleading y Improve the accuracy y Bootstrap validation y More robust solutions y Confidence measure y Sliding Window validation – for time‐series data y Non‐stationary y Slow‐varying  Lijia Guo SOA 2008 Annual Meeting 19 .

such that Z ⊂ X..X} where F(X ) ≈ Y y Find               and F*...xN } ‐‐ Given {Y. y Find F.DM in Variable Selection y Improving model accuracy and efficiency y Reducing model complexity/over fitting y Problem  X = {x1 . such that  F *( X ) ≈ Y 20 Case Study ‐ DM in Underwriting y Data: Group Health with over 100 input variables y Goal: Practical guide for underwriters to use for rates  adjustments  y Principle Components Analysis applied  y Regression Tree y Final model uses about 10% of the original variables y Improved profitability by 50% Lijia Guo SOA 2008 Annual Meeting 21 . x2 .

1148     23.1129     0. Slice SIZE = 1.65  … Variable 9  0.02702701 PROFIT_MARGIN 0.8% .1771      54.99999999 PROFIT_MARGIN Partial Dependence Tw o Predictor Dependence For PROFIT_MARGIN AVG_SALARY 0. if AS > 421 +1.00 5000 10000 15000 20000 AVG_SALARY -0.4066  0.3704  Multiplicative 0.2417  0.Regression Tree Example Profit=6.05 -0.00  Variable 2              0.3714  0. otherwise -1.1% .37  Pair Variables                  Variable 1 & Variable 2 Variable 2 & Variable 3       … Variable 4 & Variable 7 Lijia Guo Additive   0.5% +0.2679     0. Slice SIZE = 0.23  Variable 3         0. otherwise Tw o Variable Dependence for PROFIT_MARGIN.2% .2690     100.3847  0.05 0.2779     0.1456     0.2592  SOA 2008 Annual Meeting 23 .3203 75.5% .05 25000 22 Case Study ‐ Stats and Variable Importance Input                        Additive       Multiplicative    Importance Variable 1 0.00 -0. if male young than 30 -0.10 Lijia Guo SOA 2008 Annual Meeting Partial Dependence Tw o Variable Dependence for PROFIT_MARGIN.05 5000 10000 15000 20000 25000 0.

Desirable Features of a Data Mining  Method y Any nonlinear relationship can be approximated y A method that works when the form of the nonlinearity is  unknown y The effect of interactions can be easily determined and  incorporated into the model y The method generalizes well on out‐of sample data Lijia Guo SOA 2008 Annual Meeting DM Applications in Insurance y y y y y y y y y Underwriting Pricing/Rate Making Claim Scoring Risk Management Policy Level Analysis Cluster Analysis Variable Selection Effect of Plan design on utilization and distributions Trends and Projections 24 .

Agenda y Introduction y Generalized Linear Models y Data Mining y Fully Stochastic Models & Risks Integration y Summary Lijia Guo SOA 2008 Annual Meeting 26 Fully Stochastic Model (FSM) y Risk Scenarios y Economic scenarios y Underwriting risk scenarios y Policyholder behavior y Integrating Risks and Correlations y At Product level y At Enterprise level y Model Efficiency and Applications Lijia Guo SOA 2008 Annual Meeting 27 .

000 Deferred annuity  Monthly LTC benefit: min(10.000 y Waiting period: 2 years Lijia Guo SOA 2008 Annual Meeting 29 .Scenarios scenario simulation historical simulation filtered historical simulation volatility scaling EWMA Monte Carlo simulation correlation scaling GARCH Lijia Guo SOA 2008 Annual Meeting 28 Case Study ‐ Insurance Package y y y y Age of insured: 60 Unreduced death benefit 500. %AV). where y I(t) – indexed to the inflation y %AV varies depending on the states of care (ADLs) y Death benefit for disabled: %AV y Maximum LTC benefit: 200.000I(t).

Stochastic Modeling y Risk Measure in  y Credit Risk y Market Risk y Insurance Risk y y y y y y y Mortality Risk y General population y Disabled lives Contingency risks Catastrophe (Influenza  Pandemic) Business continuity Claims Liquidity Reinsurance y Risk based value y Pricing y Underwriting y Reserving Lijia Guo Insurance Package y y y y y Morbidity Risk Lapse Interest risks Underwriting (anti selection) Embedded Options y Risks Interaction/correlation y Claim reserve SOA 2008 Annual Meeting 30 Modeling Insurance Package y Pk y y v ‐ contract premium payable at BOY T ‐ Discount function n     ‐ Term/length of the contract y APV of the policy premium is APV (Pr emiums) = APV ( DB) + APV ( DA) + APV (WB) + APV ( LTCB ) k p x(τ ) = Pr(T ( x) > t ) = (1− k q '(xd ) )(1− k q '(xw) )(1− k q '(xi ) ) y Note the correlations of risks  .

82.22 ε t ≈ N (0.     β1 = .0601.015. Example. σ = . y Where rt is US 1‐ year T‐bill rate in year t.004 LTC Combo ‐ Stochastic Lapse Rate y The lapse rate in year t is y qt( w) = β 1 qt(−w1) + β 2 rt −1 + ε t . β 2 = .1) . m = .LTC Combo ‐ Stochastic Interest Rate y The discount factor for the cash flows at the EOY t is  y vt = y Where rt 1 (1 + r1 )(1 + r2 ) L (1 + rt ) is the interest rate prevailing in year t: drt = q(m − rt )dt + σdz Example q = .

j ) k +1 Pi . mortality  rates are much higher (or lower) than would normally be experienced.LTC Combo ‐ Stochastic Mortality Rate y Mortality Risk: Uncertainty in future mortality rates including increases and  decreases in mortality rates y Lee‐Carter Model y Cairns‐Blake‐Dowd Model y Longevity Risk: Uncertainty in the long‐term trend in mortality rates.   Normally taken to mean the risk that survival rates are higher than  anticipated. y Short‐Term.g. j ) y bk +1 y ‐ LTC benefit paid at different state j of disability. x + k + 1) ) v k +1 k p x(τ ) . j =1. j ( x + k .  influenza pandemic of 1918). 3. (e.. Catastrophic Risk: Risk that over short periods of time. ‐ Transition probability from State i at time z to State j at time t: n APV ( LTCB ) = ∑ ( k =1 3 ∑b j =1 (i. Stochastic Morbidity Models (i . 2.

j (t ) is the force of transition from state i to State j at time t. factor reduction. risk‐factor clustering scenario simulation historical simulation filtered historical simulation volatility scaling EWMA Lijia Guo Monte Carlo simulation correlation scaling SOA 2008 Annual Meeting GARCH 37 .Stochastic Morbidity Models λi . State Transitions in LTC insurance – state of care: Risk Scenarios y Monte Carlo (single and multi‐step) y Historical y Stress scenarios. sensitivity shocks y Additive and multiplicative shocks to any risk factor or risk factor node y Principle component analysis.

Scenario s Interest Rate Spread Mortality Mobidity Total EC • • • • Multiple individual scenario sets by risk types Asset and liabilities cash flows are modeled with the 4 scenario sets EC calculated based on individual distribution Total EC calculated based on the aggregation Lijia Guo SOA 2008 Annual Meeting 38 Integrating Product Risk/Return Enterprise Economic Profit Time Product 1 Product 3 Product 2 25 30 20 Product 4 30 25 35 25 20 20 25 15 20 15 10 15 10 15 10 5 10 5 5 -5 0 0 0 Yr 1 2 3 4 5 6 0 5 Yr 1 2 Lijia Guo 3 4 5 6 7 Yr 1 2 3 4 5 6 -10 Yr 1 SOA 2008 Annual Meeting 2 3 4 5 6 39 7 .

Effect of Risk Aggregation Lijia Guo SOA 2008 Annual Meeting 40 Summary y Stochastic Modeling provides insight into both A&L  y y y y uncertainty Stochastic models are more complex than traditional models  but this makes actuarial analysis and judgment even more  important Regulatory focus on risk management and disclosure is  increasing demand Optimal Risk Adjusted Return ‐ increase enterprise economic  profit Q&A Lijia Guo SOA 2008 Annual Meeting 41 .

L (2003). P and Verrall. “Data Mining in Insurance Seminar”.casact.” Insurance: Mathematics and Economics Guo. “Dynamic Method for the Valuation of Fair Value Insurance Liabilities”.org Lijia Guo SOA 2008 Annual Meeting 42 . Society of Actuaries.soa. “Applying Data Mining Techniques in Property/Casualty Insurance”. www. “Stochastic Modeling in Health Benefits”.casact.soa. www. www. Casualty Actuarial Society . www. L (2007). Society of Actuaries.org Guo.org Guo. L (2003). L (2001). Casualty Actuarial Society.org Guo. “Analytic and Bootstrap Estimates of Prediction Errors in Claims Reserving. R (1999).References England.

FSA.SOA Annual Meeting – Orlando Session 20 October 20. 2008 Disability Modeling: Designing Effective and Efficient Models Trevor Howes.Trevor Howes 2 1 . MAAA Agenda • • • • • Modeling demands Model Efficiency Work Group Mathematical and model techniques Hardware Technology Software Technology Session 20 PD . FCIA.

Trevor Howes 3 Pending Issues Impacting Disability Models • • • • • IFRS (Europe. Parent Corporations) Capital Assessment (Solvency II. US?) ERM and Economic Capital (Management. 2008) Will NAIC adopt IFRS before PBA? Session 20 PD . Asia. proposed Canadian MCCSR) NAIC has adopted a Solvency Modernization Work Plan (June. Canada. Ratings agencies. SEC. seriatim deterministic reserve using gross premium method – Unlocked assumptions appropriate to business and driven by experience – Stochastic Reserves and Capital – Single model for both purposes ? Session 20 PD .Pending Issues Impacting Disability Models • Principle-based Approach to reserves and RBC capital – Robust.Trevor Howes 4 2 .

Trevor Howes 6 3 . probabilistic. more efficient AND … – More granular and policy/plan specific – More precise for all material risks – More adaptable to multiple purposes – More flexible to respond to changes – More easily documented and audited Session 20 PD .Trevor Howes 5 Implications on Modeling • Models must become more effective.Common threads • • • • • • Realistic. risk based focus Blend of deterministic and stochastic 1000’s or 10’s of 1000’s of scenarios Risk of higher volatility of results Need for reliability and robustness Increased scrutiny of actuary’s judgment and quality of models Session 20 PD .

Trevor Howes 7 Model Efficiency Work Group • • • MEWG is a subgroup of the AAA SVL2 Committee created in 2007 Mandate to examine ways to make the complex modeling required under PBA more manageable Techniques being examined could apply generally to all modeling including disability Session 20 PD .Implications on Modeling • Actuaries must become more effective and efficient at modeling – Need more time for interpretation and analysis of model results – Spend less time • • • • building business models entering and verifying assumptions testing and validating documenting Session 20 PD .Trevor Howes 8 4 .

pdf Session 20 PD .Trevor Howes 10 5 .Trevor Howes 9 Modeling Efficiency For Disability • • Scenario design and selection – stochastic analysis of economic risks – e. PBA and Economic Capital Are these relevant or practical for Disability models? – DI has long term interest rate risks – ALM analysis is useful – Useful to link dynamic policyholder behavior to economic scenarios Session 20 PD .g.actuary.org/risk/pdf/bibliography.Modeling Efficiency Bibliography • • Actuarial Modeling Techniques – Scenario design and selection – Mathematical or model design – Model data building Technology Solutions – Hardware design – • Software design Website link: http://www.

Modeling Efficiency For Disability • • • Scenario testing requires detailed models reflecting realistic cash flows Full multi-state model vs. full Monte Carlo – Replicating portfolios – Predictive models – Low relevance to Disability models Session 20 PD .Trevor Howes 11 Modeling Efficiency For Disability • Mathematical or model design – Closed form solutions to option pricing – Low discrepancy sequences (QuasiMonte Carlo) vs.Trevor Howes 12 6 . claims costs – Economic risks impacted by claim runoff – Termination rates may vary by scenario – Required to properly understand the business Magnifies need for model efficiency Session 20 PD .

Modeling Efficiency For Disability • Model data building techniques – Most common solution to runtime and technology constraints – Build compressed model using • • – Grouped data at selected model points Representative plans and risk classes Critical area for Disability models due to runtimes and data heterogeneity Session 20 PD .Trevor Howes 14 7 .Trevor Howes 13 Modeling Efficiency For Disability • Drawbacks of compressing in force disability insurance data – – Low compression ratios Result distortion (model error) • – – • Especially if risk class substitution High effort to create and validate Complicates multiple uses of model Preferable to use full seriatim or dynamic option to build and select compressed version as needed Session 20 PD .

adjusting compression – Automate compression if possible as part of data extract load & transformation Session 20 PD . auditability.Trevor Howes 16 8 .Modeling Efficiency For Disability • Building compressed models – New techniques (Cluster Analysis) – Adjust compression ratio by block according to sensitivity/significance – Calibrate and test according to purpose – Generate both full seriatim and compressed models for comparison testing. IT infrastructure and support) – Increased reliability. software.Trevor Howes 15 Technology – hardware solutions? • • For Stochastic analysis. may need further 100 to 1000X improvement while also meeting requirements for – Reasonable total cost (hardware. validation. control – Increased actuarial productivity and value Will technology enable efficient disability models in foreseeable future? Session 20 PD .

0 2003 Pent 4 2.53GHz . you could purchase desktop PCs based on: – 1998 (Pentium II. 400 MHz) – 2003 (Pentium 4.Trevor Howes 18 9 .172 5.Trevor Howes 17 PC Performance 1998 . 2.2 Estimates based on seriatim actuarial projection model Session 20 PD .017 59.53 GHz) – 2008 (Core 2 Quad. over past 10 years.000 1. 2.66 GHz) Session 20 PD .66GHz .Technology performance review • • Technology has delivered incredibly consistent performance improvements For example.2008 Year Processor Benchmark Benchmark Time Speed 1998 Pent II 400MHz 1.8 2008 Core2 Quad 2.

Trevor Howes 20 10 .2 Session 20 PD .0 2003 Pent 4 2.2008 Year Processor Approx Cost Benchmark Value 1998 Pent II 400MHz \$4500 1.PC Performance per \$1 1998 .5 2008 Core2 Quad 2.Trevor Howes 19 Historical Technology Improvements • • • Miniaturization has enabled – higher transistor counts – faster response – increased clock speeds – more instructions per second – faster buses Reduced voltages to manage heat Faster and denser memory and drives Session 20 PD .53GHz \$2100 12.66GHz \$2000 133.

Future Innovations • • • • • • • • New materials (hafnium oxide) Deep UV optical lithography Nanotechnology (molecular level) Helium supercooled transistors Terahertz transistor Trigate transistors (3-d) Biocomputing & neural networks Quantum computing Session 20 PD .Trevor Howes 21 Current Technology Trends • Increased parallelism in processors – • • Multiple instructions executed at once Multiple processor cores on one chip – Faster than multiprocessors – Shorter distances – Shared bus and cache – Interface at higher clock speeds Intel plans chips with 100+ cores Session 20 PD .Trevor Howes 22 11 .

Trevor Howes 24 12 .Personal Grids? • Personal Cluster “deskside” server – 340 Gigaflops of computing power – 8 quad-core processors (32 cores) – 1 Terabyte disk storage – Regular 120V wall plug – Windows CCS O/S installed – Cost: under \$20.000 Session 20 PD .Trevor Howes 23 Parallelism • • • Parallelism requires multithreading Automatic benefit from OS tasks However significant benefit requires specific application design changes – Identify separable non-linear tasks – Manage thread synchronization – Data sharing and management Session 20 PD .

Parallelism and Distributed Processing • Distributed Processing requires – Allocating processing steps to helpers – Distributing work by Cells.Trevor Howes 25 Parallelism and Grids • In “Grid Computing” as typically used – Focus on capturing spare capacity for many applications over large network – Enterprise Grid Managers are not application specific or knowledgeable – May require inserting additional code – Software license and IT support per node – 1000+ processors may achieve runtimes but costly. unreliable Session 20 PD . seriatim policies.Trevor Howes 26 13 . testing targets (scenarios) – Monitoring task completion or failure – Consolidation of results from helpers – Specific application support Session 20 PD . inefficient.

Trevor Howes 28 14 . first principles.Trevor Howes 27 Technology Solution – Hardware? • • • • Will technology enable efficient but complex disability models in foreseeable future? – Not enough for large stochastic applications yet – Quite enough now for seriatim. control and analysis One actuary’s salary plus overhead = cost of farm of 250 + cores? Technology can make actuary more productive depending on application software Session 20 PD . selected scenarios Model efficiency must also consider human costs of maintenance.The Evolution of Grids • Trend now to greater use of dedicated server farms and/or computer clusters – Tightly coupled for efficiency – Easy software installation – Cost effective O/S and IT support • Microsoft CCS 2003 & HPC Server 2008 enables sharing grid and scheduling – Robust and audit friendly – Highly scalable to large farms Session 20 PD . multi-state models.

Technology Solution – Software • Detailed. multi-state model – Optional claims cost approach – Enable selective adjustment of each component of claims cost and understanding impact – Support compound assumptions – Facilitates experience analysis Session 20 PD . source of earnings.Trevor Howes 30 15 .Trevor Howes 29 Technology Solution – Software • Full seriatim business model for both valuation and projection – Optional selective compression – Avoid reconciliation and validation – Enable targeted adjustment of assumptions at granular level – Supports experience analysis. reserve movement Session 20 PD . first principles.

ease of validation. audit – Facilitate assumption query. logic and code – Promote control of code changes.Technology Solution – Software • Multiple purpose. flexibility – Separation of duties.Trevor Howes 32 16 . use of skills Session 20 PD . change – Balance of control vs. multiple basis projection capabilities – Avoid reconciliation and validation – Ease of testing “what if” scenarios.Trevor Howes 31 Technology Solution – Software • Store assumptions in objects separate from model framework. documentation. reporting impact of changes – Both deterministic and stochastic(?) – Staff productivity with one platform to learn and maintain Session 20 PD . stability.

first principles.Technology Solution – Software • Integrated automated model building – Load of source data and transformation to feed model (avoid relying on IT dep’t) – Compress? (if necessary) – Define and apply rules – to assign business to “supercells” • to attach/update assumptions in supercells or at seriatim level (to reduce numbers of supercells) Enable auditable start to end batch process • Session 20 PD . flexible MEWG is studying model efficiency techniques Hardware technology will help Software design is critical to user productivity with models Session 20 PD .Trevor Howes 34 17 .Trevor Howes 33 Efficient and Effective Models • Avoid over simplification of models – • • • Seriatim.