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The Cramer Lundberg Model

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4. The Cram

erLundberg Model

We have seen that the compound Poisson model has nice properties. For instance

it can be derived as a limit of individual models. This was the reason for Filip

Lundberg [63] to postulate a continuous time risk model where the aggregate claims

in any interval have a compound Poisson distribution. Moreover, the premium

income should be modelled. In a portfolio of insurance contracts the premium

payments will be spread all over the year. Thus he assumed that that the premium

income is continuous over time and that the premium income in any time interval is

proportional to the interval length. This leads to the following model for the surplus

of an insurance portfolio

XNt

Ct = u + ct Yi .

i=1

u is the initial capital, c is the premium rate. The number of claims in (0, t] is a Pois-

son process {Nt } with rate . The claim sizes {Yi } are a sequence of iid. positive ran-

dom variables independent of {Nt }. This model is called the Cram erLundberg

process or classical risk process.

We denote the distribution function of the claims by G, its moments by n =

IIE[Y1n ] and its moment generating function by MY (r) = IIE[exp{rY1 }]. Let = 1 .

We assume that < . Otherwise, no insurance company would insure such a risk.

Note that G(x) = 0 for x < 0. We will see later that it is no restriction to assume

that G(0) = 0.

For an insurance company it is important that {Ct } stays above a certain level.

This sovency level is given by legal restrictions. By adjusting the initial capital it is

no loss of generality to assume this level to be 0. We define the ruin time

0<st

t t>0

4. THE CRAMERLUNDBERG MODEL 65

We denote the claim times by T1 , T2 , . . . and by convention T0 = 0. Let Xi =

c(Ti Ti1 ) Yi . If we only consider the process at the claim times we can see that

n

X

CTn = u + Xi

i=1

is a random walk. Note that (u) = IIP[inf nIIN CTn < 0]. From the theory of random

walks we can see that ruin occurs a.s. iff IIE[Xi ] 0 (compare with Lemma E.1 or

[41, p.396]). Hence we will assume in the sequel that

1

IIE[Xi ] > 0 c > 0 c > IIE[Ct u] > 0 .

Recall that

Nt

hX i

IIE Yi = t .

i=1

The condition can be interpreted that the average income is strictly larger than the

average outflow. Therefore the condition is also called the net profit condition.

If the net profit condition is fulfilled then CTn tends to infinity as n . Hence

lim (u) = 0 .

u

In reality the average number of claims in an interval will not be the same all the

time. There will be a claim rate (t) which may be periodic in time. Moreover,

the number of individual contracts in the portfolio may vary with time. Let a(t) be

the volume of the portfolio at time t. Then the claim number process {Nt } is an

inhomogeneous Poisson process with rate a(t)(t). Let

Z t

(t) = a(s)(s) ds

0

and 1 (t) be its inverse function. Then N

1. Let now the premium rate vary with t such that ct = ca(t)(t) for some constant

c. This assumption is natural for changes in the risk volume. It is artificial for the

66

4. THE CRAMERLUNDBERG MODEL

changes in the intensity. For instance we assume that the company gets more new

customers at times with a higher intensity. This effect may arise because customers

withdraw from their old insurance contracts and write new contracts with another

company after claims occurred because they were not satisfied by the handling of

claims by their old companies.

The premium income in the interval (0, t] is c(t). Let Ct = C1 (t) . Then

N1 (t) t

N

X X

Ct = u + c(1 (t)) Yi = u + ct Yi

i=1 i=1

time but operational time.

The event of ruin does almost never occur in practice. If an insurance company

observes that their surplus is decreasing they will immediately increase their premia.

On the other hand an insurance company is built up on different portfolios. Ruin

in one portfolio does not mean bankruptcy. Therefore ruin is only a technical term.

The surplus will also be a technical term in practice. If the business is going well

then the share holders will decide to get a higher dividend. To model this we would

have to assume a premium rate dependent on the surplus. But then it would be

hard to obtain any useful results. For some references see for instance [43] and [11].

The probability of ruin should be regarded as a measure for the risk and is used

for decision taking; for example, the premium calculation or the computation of

reinsurance retention levels. One therefore freezes the present portfolio and looks

how the surplus would behave in the future. For an actuary it is important to be

able to take a good decision in reasonable time. Therefore it is fine to simplify the

model in order to be able to check whether a decision has the desired effect or not.

In Section 1 about risk models we saw that a negative binomial distribution for

the number of claims in a certain time interval would be preferable. We will later

consider such models. But often actuaries use the CramerLundberg model for their

calculations, even though there is a certain lack of reality. The reason is that this

model is well understood, and the basic properties for a risk also are present in this

simple model.

We first prove that {Ct } is a strong Markov process.

4. THE CRAMERLUNDBERG MODEL 67

time. Then the stochastic process {CT +t CT : t 0} is a CramerLundberg process

with initial capital 0 and independent of FT .

NT +t

X

ct Yi .

i=NT +1

Because the claim amounts are iid. and independent of {Nt } we only have to prove

that {NT +t NT } is a Poisson process independent of FT . Because {Nt } is a renewal

process it is enough to show that TNT +1 T is Exp() distributed and independent

of FT . Condition on TNT and T . Then

= IIP[TNT +1 TNT > x + T TNT | TNT , T, TNT +1 TNT > T TNT ] = ex

follows because TNT +1 depends on FT via TNT and T only. The latter, even though

intuitively clear, follows readily noting that FT is generated by sets of the form

{NT = n, An } where n IIN and An (Y1 , . . . , Yn , T1 , . . . , Tn ).

Let h be small. If ruin does not occur in the interval (0, T1 h] then a new

CramerLundberg process starts at time T1 h with new initial capital CT1 h . Let

(u) = 1 (u) denote the survival probability. Using that the interarrival times

are exponentially distributed we have the density et of the distribution of T1 and

IIP[T1 > h] = eh . We obtain noting that (x) = 0 for x < 0

Z hZ u+ct

h

(u) = e (u + ch) + (u + ct y) dG(y)et dt .

0 0

Letting h tending to 0 shows that (u) is right continuous. Rearranging the terms

and dividing by h yields

Z Z

c = (u + ch) (u + ct y) dG(y)et dt .

ch h h 0 0

Letting h tend to 0 shows that (u) is differentiable from the right and

h Z u i

0

c (u) = (u) (u y) dG(y) . (4.1)

0

68

4. THE CRAMERLUNDBERG MODEL

Replacing u by u ch gives

Z hZ uc(ht)

h

(u ch) = e (u) + (u (c h)t y) dG(y)et dt .

0 0

We conclude that (u) is continuous. Rearranging the terms, dividing by h and

letting h 0 yields the equation

h Z u i

0

c (u) = (u) (u y) dG(y) .

0

We see that (u) is differentiable at all points u where G(u) is continuous. If G(u)

has a jump then the derivatives from the left and from the right do not coincide.

But we have shown that (u) is absolutely continuous, because G(u) can have at

most countably many jumps. If we now let 0 (u) be the derivative from the right we

have that 0 (u) is a density of (u).

The difficulty with equation (4.1) is that it contains both the derivative of (u)

and an integral. Let us try to get rid of the derivative. We find

1 u 0

Z Z u Z uZ x

c

((u) (0)) = c (x) dx = (x) dx (x y) dG(y) dx

0 0 0 0

Z u Z uZ u

= (x) dx (x y) dx dG(y)

0 0 y

Z u Z uZ uy

= (x) dx (x) dx dG(y)

0 0 0

Z u Z uZ ux

= (x) dx dG(y) (x) dx

Z0 u 0 0

Z u

= (x)(1 G(u x)) dx = (u x)(1 G(x)) dx

0 0

R

Note that 0 (1G(x)) dx = . Letting u we can by the bounded convergence

theorem interchange limit and integral and get

Z

c(1 (0)) = (1 G(x)) dx =

0

where we used that (u) 1. It follows that

(0) = 1

, (0) = .

c c

Replacing (u) by 1 (u) we obtain

Z u

c(u) = (1 (u x))(1 G(x)) dx

0

Z Z u

= (1 G(x)) dx + (u x)(1 G(x)) dx . (4.2)

u 0

4. THE CRAMERLUNDBERG MODEL 69

Example 4.2. Let the claims be Exp() distributed. Then the equation (4.1) can

be written as h Z u i

0 u y

c (u) = (u) e (y)e dy .

0

Differentiating yields

h Z u i

00 0 u

c (u) = (u) + e (y)ey dy (u) = 0 (u) c 0 (u) .

0

(u) = A + Be(/c)u .

is

(u) = 1 e(/c)u

c

or

(/c)u

(u) = e .

c

Let

(r) = (MY (r) 1) cr (4.3)

provided MY (r) exists. Then we find the following martingale.

Lemma 4.3. Let r IR such that MY (r) < . Then the stochastic process

is a martingale.

PNt

= IIE[er Ns +1 Yi

]erCs (MY (r)1)t+crs

= erCs (MY (r)1)s+crs = erCs (r)s .

70

4. THE CRAMERLUNDBERG MODEL

HrL

0.8

0.6

0.4

0.2

R

-1.0 -0.5 0.5 1.0 1.5 r

It would be nice to have a martingale that only depends on the surplus and not

explicitly on time. Let us therefore consider the equation (r) = 0. This equation

has obviously the solution r = 0. We differentiate (r).

The function (r) is strictly convex. For r = 0

by the net profit condition. There might be at most one additional solution R to

the equation (R) = 0 and R > 0. If this solution exists we call it the adjustment

coefficient or the Lundberg exponent. The Lundberg exponent will play an

important role in the estimation of the ruin probabilities.

r

1 cr = cr = 0 .

r r

For r 6= 0 we find R = /c. Note that

Ru

(u) = e .

c

4. THE CRAMERLUNDBERG MODEL 71

bounds for the adjustment coefficient. Note that the second moment 2 exists if the

Lundberg exponent exists. Consider the function (r) for r > 0.

Z r

0 0

(r) = (0) + 00 (s) ds > (c ) + 2 r ,

Z 0r

r2

(r) = (0) + 0 (s) ds > 2 (c )r .

0 2

The last inequality yields for r = R

R

0 = (R) > R 2 (c )

2

from which an upper bound of R

2(c )

R<

2

follows.

We are not able to find a lower bound in general. But in the case of bounded

claims we get a lower bound for R. Assume that Y1 M a.s..

Let us first consider the function

x RM

1 eRx 1 .

f (x) = e

M

Its second derivative is

f 00 (x) = R2 eRx < 0 .

f (x) is concave with f (0) = f (M ) = 0. Thus f (x) > 0 for 0 < x < M . The

function h(x) = xex ex + 1 has a minimum in 0. Thus h(x) > h(0) = 0 for x 6= 0,

in particular

1

eRM 1 < eRM .

RM

We calculate

Z M Z M

Rx

x RM RM

MY (R) 1 = e 1 dG(x) < e 1 dG(x) = e 1 .

0 0 M M

From the equation determining R we get

RM

1 cR < ReRM cR .

0 = (MY (R) 1) cR < e

M

It follows readily

1 c

R> log .

M

72

4. THE CRAMERLUNDBERG MODEL

We will now connect the adjustment coefficient and the ruin probabilities.

(u0 ) = eRu0 .

Because (0) < 1 we conclude that u0 > 0. Consider the equation (4.2) for u = u0 .

hZ Z u0 i

c(u0 ) = (1 G(x)) dx + (u0 x)(1 G(x)) dx

u0

hZ Z0 u0 i

< (1 G(x)) dx + eR(u0 x) (1 G(x)) dx

Z u0 0

Z Z

R(u0 x) Ru0

e (1 G(x)) dx = e eRx dG(y) dx

0 0 x

Z Z y Z

1

= eRu0 eRx dx dG(y) = eRu0 (eRy 1) dG(y)

0 0 0 R

Ru0

= e (MY (R) 1) = ceRu0

R

which is a contradiction. This proves the theorem.

We now give an alternative proof of the theorem. We will use the positive

martingale (4.4) for r = R. By the stopping theorem

because C < 0. We have got an upper bound for the ruin probability. We would

like to know whether R is the best possible exponent in an exponential upper bound.

This question will be answered in the next section.

4. THE CRAMERLUNDBERG MODEL 73

Example 4.5. Let G(x) = 1 pex (1 p)ex where 0 < < and 0 < p

( )1 . Note that the mean value is p + 1p

and thus

p (1 p)

c> + .

For r <

(1 p)

Z p

MY (r) = erx pex + (1 p)ex dx = + .

0 r r

Thus, we have to solve

p (1 p) pr (1 p)r

+ 1 cr = + cr = 0 .

r r r r

We find the obvious solution r = 0. If r 6= 0 then

p( r) + (1 p)( r) = c( r)( r)

or equivalently

The solution is

r

1 2

r= + + 4 p (1 p)

2 c c c c

r

1 2

= + + 4p ( ) .

2 c c c

Now we got three solutions. But there should only be two. Note that

p 1 p

p (1 p) = c + >0

c c c

and thus both solutions are positive. The larger of the solutions can be written as

r

1 2

+ + + 4p ( )

2 c c c

and is thus larger than . But the moment generating function does not exist for

r . Thus

r

1 2

R= + + 4p ( ) .

2 c c c

From Lundbergs inequality it follows that

74

4. THE CRAMERLUNDBERG MODEL

Consider the equation (4.2). This equation looks almost like a renewal equation,

but Z

(1 G(x)) dx = <1

0 c c

is not a probability distribution. Can we manipulate (4.2) to get a renewal equation?

We try for some measurable function h and h

Z Z u

(1G(x)) dx (4.7)

(u)h(u) = h(u) (1G(x)) dx+ (ux)h(ux)h(x)

u c 0 c

where h(u) = h(ux)h(x). We can assume that h(0) = 1. Setting x = u shows that

h(u) = h(u). From a general theorem it follows that h(u) = eru where r = log h(1).

In order that (4.7) is a renewal equation we need

Z

rx (MY (r) 1)

Z Z

rx

1= e (1 G(x)) dx = e dG(y) dx = .

0 c c 0 x cr

The only solution to the latter equation is r = R. Let us assume that R exists.

Moreover, we need that

Z

xeRx (1 G(x)) dx < (4.8)

0 c

which is equivalent to MY0 (R) < , see below. The equation is now

Z Z u

Ru Ru

(u)e = e (1 G(x)) dx + (u x)eR(ux) eRx (1 G(x)) dx .

u c 0 c

It can be shown that Z

Ru

e (1 G(x)) dx

u c

is directly Riemann integrable. Thus we get from the key renewal theorem

Theorem 4.6. Assume that the Lundberg exponent exists and that (4.8) is fulfilled.

Then

c

lim (u)eRu = .

u MY0 (R) c

Z Z

x Ru

Z Z

Ru

e (1 G(x)) dx du = e du (1 G(x)) dx

0 u c c 0 0

Z

1 1

= (eRx 1)(1 G(x)) dx = = (c ) .

cR 0 R cR cR

4. THE CRAMERLUNDBERG MODEL 75

Z

Rx

Z Z

Rx

xe (1 G(x)) dx = xe dG(y) dx

0 c c 0 x

Z Z y Z

Rx

= xe dx dG(y) = (RyeRy eRy + 1) dG(y)

c 0 0 cR2 0

(RMY0 (R) MY (R) + 1) RMY0 (R) cR MY0 (R) c

= = = .

cR2 cR2 cR

The limit value follows readily.

upper bound for the ruin probability with an exponent strictly larger than R.

The theorem can be written in the following form

c

(u) 0

eRu .

MY (R) c

Thus for large u we get an approximation to (u). This approximation is called the

Cram erLundberg approximation.

MY0 (r) =

( r)2

and thus

c c c

lim (u)eRu =

=

= = .

u

(R)2

c 2 c c c c

( c )

Hence the CramerLundberg approximation

(/c)u

(u) e

c

becomes exact in this case.

Example 4.7. Let c = = 1 and G(x) = 1 13 (ex + e2x + e3x ). The mean

value of claim sizes is = 0.611111, i.e. the net profit condition is fulfilled. One can

show that

(u) = 0.550790 e0.485131u + 0.0436979 e1.72235u + 0.0166231 e2.79252u .

From Theorem 4.6 it follows that app(u) = 0.550790 e0.485131u is the Cramer

Lundberg approximation to (u). Table 4.1 below shows the ruin function (u), its

CramerLundberg approximation app(u) and the relative error (app(u)(u))/(u)

multiplied by 100 (Er). Note that the the relative error is below 1% for u

1.71358 = 2.8.

76

4. THE CRAMERLUNDBERG MODEL

(u) 0.6111 0.5246 0.4547 0.3969 0.3479

app(u) 0.5508 0.4879 0.4322 0.3828 0.3391

Er -9.87 -6.99 -4.97 -3.54 -2.54

u 1.25 1.5 1.75 2 2.25

(u) 0.3059 0.2696 0.2379 0.2102 0.1858

app(u) 0.3003 0.2660 0.2357 0.2087 0.1849

Er -1.82 -1.32 -0.95 -0.69 -0.50

4.7.1. Proportional Reinsurance

Recall that for proportional insurance the insurer covers YiI = Yi of each claim,

the reinsurer covers YiR = (1 )Yi . Denote by cI the insurers premium rate. The

insurers adjustment coefficient is obtained from the equation

(MY (r) 1) cI r = 0 .

Assume that both insurer and reinsurer use an expected value premium principle

with the same safety loading. Then cI = c and we have to solve

(MY (r) 1) cr = 0 .

coefficient under reinsurance. The new adjustment coefficient is larger, hence the

risk has become smaller.

We assume now that there is r such that MY (r) < if r < r and MY (r ) =

. Write c = (1 + ) for some > 0. Suppose the reinsurer charges the premium

(1 + )(1 ). We now want to choose the retention level , such that the

corresponding adjustment coefficient R() becomes maximal. In some sense, this

means that the ruin probability is minimised for large initial capital. In order that

the solution is not trivial, we assume > . R() is determined by the equation

4. THE CRAMERLUNDBERG MODEL 77

equivalently, > 1 /. By the implicit function theorem, we have

{ (1 + ) ( )} = {(1 )(1 + ) + ( )} > 0. Differentiating a second

time yields

for some function h(). Because R2 ()MY00 (R()) > 0, we get that R00 ( ) < 0.

We see that R() has a unique maximum, and R() is increasing on [1 /, 1]

and decreasing on [ 1, 1].

We now write r() = R(). Then we have to solve

We have seen above that r = r( ) is the unique value for which MY0 (r ) = (1+).

Note that such a r < r exists under our assumptions.

r() is increasing on [0, 0 ] where 0 > . We can therefore invert r(), write

(r). We get

( )r

(r) = .

(1 + )r (MY (r) 1)

Thus the optimal retention level is

n ( )r o

= min ,1 .

(1 + )r (MY (r ) 1)

If (r ) 1 then R( ) = r /(r ).

MY (r) = (/( r)) and MY0 (r) = (/( r))+1 / = (1 + )/. Thus

r = (1 (1 + )1/(+1) ). Thus, after some simplifications,

n ( )[1 (1 + )1/(+1) ] o

= min , 1 .

+ ( + 1)(1 (1 + )/(+1) )

If < 1, then

( )

R = .

+ ( + 1)(1 (1 + )/(+1) )

Note that in general there is no closed formula for the adjustment coefficient for

Gamma distributed claim sizes. However, for the maximal adjustment coefficient

we obtain an explicit formula.

78

4. THE CRAMERLUNDBERG MODEL

Under excess of loss reinsurance with retention level M the insurer has to pay

YiI = min{Yi , M } of each claim. The adjustment coefficient is the strictly positive

solution to the equation

Z M

e dG(x) + e (1 G(M )) 1 cI r = 0 .

rx rM

0

There is no possibility to find the solution from the problem without reinsurance.

We have to solve the equation for every M separately. But note that RI exists

in any case. Especially for heavy tailed distributions this shows that the risk has

become much smaller. By the CramerLundberg approximation the ruin probability

decreases exponentially as the initial capital increases.

We will now show that for the insurer the excess of loss reinsurance is optimal.

We assume that both insurer and reinsurer use an expected value principle.

Proposition 4.9. Let all premia be computed via the expected value principle.

Under all reinsurance forms acting on individual claims with premium rates cI and

cR fixed the excess of loss reinsurance maximizes the insurers adjustment coefficient.

assume that the insurer pays YiI = h(Yi ). Let h (x) = min{x, U } be the excess of

loss reinsurance. Because cI is fixed U can be determined from

Z U Z

y dG(y) + U (1 G(U )) = IIE[h (Yi )] = IIE[h(Yi )] = h(y) dG(y) .

0 0

Because ez 1 + z we obtain

(y))

er(h(y)h 1 + r(h(y) h (y))

and

(y)

erh(y) erh (1 + r(h(y) h (y))) .

Thus

Z Z

Mh(Y ) (r) = rh(y)

e dG(y) erh (y) (1 + r(h(y) h (y))) dG(y)

0

Z 0

= Mh (Y ) (r) + r (h(y) h (y)) erh (y) dG(y) .

0

4. THE CRAMERLUNDBERG MODEL 79

Z

(h(y) h (y))erh (y) dG(y)

0

Z U Z

rh (y)

= (h(y) h (y))e dG(y) + (h(y) h (y))erh (y) dG(y)

0 U

Z U Z

(h(y) h (y))erU dG(y) + (h(y) h (y))erU dG(y)

0 U

Z

= erU (h(y) h (y)) dG(y)

0

= erU (IIE[h(Y )] IIE[h (Y )]) = 0 .

again that the safety loading of the insurer is and the safety loading of the reinsurer

is > . Note that

Z M

r(Y M )

IIE[e 1] = rery (1 G(y)) dy

0

and Z

IIE[max{Y M, 0}] = (1 G(y)) dy .

M

The net profit condition becomes, after dividing by ,

Z M Z Z M

(1 + ) (1 G(y)) dy ( ) (1 G(y)) dy > (1 G(y)) dy ,

0 M 0

or equivalently Z

> (1 G(y)) dy .

M

For the ajustment coefficient we have to find the solution to

Z M Z

ry

r(e (1 + ))(1 G(y)) dy + ( )r (1 G(y)) dy = 0 .

0 M

Z M Z

ry

(e (1 + ))(1 G(y)) dy + ( ) (1 G(y)) dy = 0 .

0 M

80

4. THE CRAMERLUNDBERG MODEL

Z M

0

R (M ) yeR(M )y (1 G(y)) dy + [eR(M )M (1 + )](1 G(M )) = 0 .

0

take reinsurance. Indeed, as M the adjustment coefficient R(M ) tends to the

adjustemt coefficient of the model without reinsurance, and therefore R(M )M .

If the adjustment coefficient does not exist but exponential moments exist, then the

ruin probability decreases exponentially at the rate r , and also r M as

M . Finally, if no exponential moments exist, the adjustment coefficient exists

after reinsurance.

Suppose for the moment that G(y) is differentiable. Then the second derivative

gives

Z M

00

R (M ) yeR(M )y (1 G(y)) dy + R0 (M )h(M )

0

+ R(M )eR(M )M (1 G(M )) [eR(M )M (1 + )]G0 (M ) = 0

Z M

00

R (M ) yeR(M )y (1 G(y)) dy + R(M )eR(M )M (1 G(M )) = 0 ,

0

where we used that eR(M )M = 1 + . We conclude that R00 (M ) < 0. This shows

that R(M ) has a unique local maximum, and hence is unimodal. For M < M , the

optimal retention level, we have R0 (M ) > 0, and thus eR(M )M < 1+. For M > M ,

we have R0 (M ) < 0, and therefore eR(M )M > 1 + . The solution is thus found by

calculating R(M )M , and find the unique value for which R(M )M = log(1 + ).

We consider now the portfolio of the reinsurer. What is the claim number process

of the claims the reinsurer is involved? Because the claim amounts are independent

of the claim arrival process we delete independently points from the Poisson process

with probability G(M ) and do not delete them with probability 1 G(M ). By

Proposition C.3 this process is a Poisson process with rate (1 G(M )). Because

the claim sizes are iid. and independent of the claim arrival process the surplus of

the reinsurer is a CramerLundberg process with intensity (1 G(M )) and claim

size distribution

G(M + x) G(M )

G(x) = IIP[Yi M x | Yi > M ] = .

1 G(M )

4. THE CRAMERLUNDBERG MODEL 81

4.8. The Severity of Ruin, the Capital Prior to Ruin and the Distri-

bution of inf{Ct : t 0}

For an insurance company ruin is not so dramatic if C is small, but it could ruin

the whole company if C is very large. So we are interested in the distribution of

C if ruin occurs. The random variable C is called the severity of ruin. We

further want to know how ruin happens. Thus, we also consider the capital prior to

ruin C . Let

x,y (u) = IIP[ < , C < x, C > y] .

We proceed as in Section 4.3. For h small

Z h hZ u+ct

h

x,y (u) = e x,y (u + ch) + x,y (u + ct z) dG(z)

0 0

i

+ 1Iu+ct>y (1 G(u + ct + x)) et dt .

It follows that x,y (u) is right continuous. We obtain the integro-differential equation

h Z u i

0

cx (u) = x,y (u) x,y (u z) dG(z) 1Iuy (1 G(u + x)) .

0

Replacing u by u ch gives the derivative from the left. But x,y (u) is not dif-

ferentiable at points where G(u) jumps and at u = y. Integration of the integro-

differential equation yields

Z u Z u

c

(x,y (u) x,y (0)) = x,y (u t)(1 G(t)) dt (1 G(t + x)) dt

0 uy

Z u Z x+u

= x,y (u t)(1 G(t)) dt (1 G(t)) dt .

0 (x+u)(x+y)

Because x,y (u) (u) we can see that x,y (u) 0 as u . By the bounded

convergence theorem we obtain

Z

c

x,y (0) = (1 G(t)) dt

x+y

and

Z

(1 G(t)) dt

c x+y

IIP[C < x, C > y | < , C0 = 0] =

c

Z

1

= (1 G(t)) dt . (4.9)

x+y

Rx

1 0 (1 G(t)) dt given that ruin occurs.

82

4. THE CRAMERLUNDBERG MODEL

Remark. In order to get an equation for the ruin probability we can consider the

first time point 1 where the surplus is below the initial capital. At this point, by

the strong Markov property, a new CramerLundberg process starts. We get three

possibilities:

1 < but C1 0.

Ruin occurs at 1 .

Thus we get

u

Z Z

(u) = 1 0+ (u y)(1 G(y)) dy + 1 (1 G(y)) dy .

c c 0 c u

This is equation (4.2). Thus we have now a natural interpretation of (4.2).

Let 0 = 0 and i = inf{t > i1 : Ct < Ci1 }, called the ladder times,

and define Li = Ci1 Ci , called the ladder heights. Note that Li only is

defined if i < . By Lemma 4.1 we find IIP[i < | i1 < ] = /c. Let

K = sup{i IIN : i < } be the number of ladder epochs. We have just seen that

K NB(1, 1 /c) and that, given K, the random variables (Li : i K) are

iid. and absolutely continuous with density (1 G(x))/. We only have to condition

on K because Li is not defined for i > K. If we assume that all (Li : i 1) have the

same distribution, then we can drop the conditioning on K and (Li ) is independent

of K. Then

XK

inf{Ct : t 0} = u Li

i=1

and

K

hX i

IIP[ < ] = IIP[inf{Ct : t 0} < 0] = IIP Li > u .

i=1

We can use Panjer recursion to approximate (u) by using an appropriate discretiza-

tion.

A formula that is useful for theoretical considerations, but too messy to use for

the computation of (u) is the PollaczekKhintchine formula.

K

hX i X n

hX i

(u) = IIP Li > u = IIP Li > u IIP[K = n]

i=1 n=1 i=1

X n

= 1 (1 B n (u)) . (4.10)

c n=1

c

4. THE CRAMERLUNDBERG MODEL 83

Z

f (s) := esx f (x) dx (s IR)

0

If X is an absolutely continuous positive random variable with density f then f(s) =

MX (s). The Laplace transform has the following properties.

Lemma 4.11.

i) If f (x) 0 a.e.

f(s1 ) f(s2 ) s1 s2 .

ii) |f

c|(s1 ) < = |f c|(s) < for all s s1 .

Z

iii) 0

fb (s) = esx f 0 (x) dx = sf(s) f (0)

0

provided f 0 (x) exists a.e. and |f

c|(s) < .

s x0

0

provided f (x) exists a.e., limx0 f (x) exists and |f

c|(s) < for an s large

enough.

s0 x

c|(s) < for some s > 0.

We want to find the Laplace transform of (u). We multiply (4.1) with esu and

then integrate over u. Let s > 0.

Z Z Z Z u

0 su su

c (u)e du = (u)e du (u y) dG(y)esu du.

0 0 0 0

Z Z u Z Z

su

(u y) dG(y)e du = (u y)esu du dG(y)

0 0

Z0 Zy

=

(u)es(u+y) du dG(y) = (s)MY (s) .

0 0

84

4. THE CRAMERLUNDBERG MODEL

(0)) = (s)(1

c(s(s) MY (s))

= c(0) c

(s) = .

cs (1 MY (s)) cs (1 MY (s))

The Laplace transform of can easily be found as

Z

1

(s) = (1 (u))esu du = (s) .

0 s

Example 4.2 (continued). For exponentially distributed claims we obtain

= c / c / (c /)( + s)

(s) = = .

cs (1 /( + s)) s(c /( + s)) s(c( + s) )

and

= 1 (c /)( + s) = c( + s) (c /)( + s)

(s)

s s(c( + s) ) s(c( + s) )

1 1

= = .

c( + s) c /c + s

By comparison with the moment generating function of the exponential distribution

we recognize that

(/c)u

(u) = e .

c

= c p/ (1 p)/

(s)

cs (1 p/( + s) (1 p)/( + s))

c p/ (1 p)/

=

s(c p/( + s) (1 p)/( + s))

and for the Laplace transform of

(s)

s(c p/( + s) (1 p)/( + s))

sp/(( + s)) + s(1 p)/(( + s))

=

s(c p/( + s) (1 p)/( + s))

p( + s)/ + (1 p)( + s)/

=

c( + s)( + s) p( + s) (1 p)( + s)

p( + s)/ + (1 p)( + s)/

= 2 .

cs + (( + )c )s + c ((1 p) + p)

4. THE CRAMERLUNDBERG MODEL 85

where R and R

The denominator can be written as c(s + R)(s + R) are the two

The Laplace transform of can be written in the

solutions to (4.6) with R < R.

form

= A + B

(s)

R+s R +s

for some constants A and B. Hence

(u) = AeRu + BeRu .

constant B can be found from (0). We can see that in this case the Cramer

Lundberg approximation is not exact.

Recall that 1 is the first ladder epoch. On the set {1 < } the random variable

sup{u Ct : t 0} is absolutely continuous with distribution function

c

IIP[sup{u Ct : t 0} x | 1 < ] = 1 (x) .

Let Z be a random variable with the above distribution. Its moment generating

function is

Z

c c c

MZ (r) = eru 0 (u) du = r 1

0 cr (1 MY (r)) c

c c(c ) r

=1 + .

cr (MY (r) 1)

We will later need the first two moments of the above distribution function. Assume

that 2 < . The first derivative of the moment generating function is

MZ0 (r) =

(cr (MY (r) 1))2

c(c ) rMY0 (r) (MY (r) 1)

= .

(cr (MY (r) 1))2

Note that

1

lim (cr (MY (r) 1)) = c .

r0 r

We find

rMY0 (r) (MY (r) 1) MY0 (r) + rMY00 (r) MY0 (r) 2

lim = lim =

r0 r2 r0 2r 2

and thus

c(c ) 2 c2

IIE[Z] = 2

= . (4.11)

2(c ) 2(c )

86

4. THE CRAMERLUNDBERG MODEL

00 c(c ) 1

MZ (r) = 3

rMY00 (r)(cr (MY (r) 1))

(cr (MY (r) 1))

2(rMY0 (r) (MY (r) 1))(c MY0 (r)) .

For the limit to 0 we find

1

lim 3 rMY00 (r)(cr (MY (r) 1))

r0 r

2(rMY0 (r) (MY (r) 1))(c MY0 (r))

1 00

= lim 2 (MY (r) + rMY000 (r))(cr (MY (r) 1))

r0 3r

+ rMY00 (r)(c MY0 (r)) 2rMY00 (r)(c MY0 (r))

+ 2(rMY0 (r) (MY (r) 1))MY00 (r)

3 rMY0 (r) (MY (r) 1)

= (c ) + 2 lim

3 r0 r2

3

= (c ) + 22 .

3 2

Thus the second moment of Z becomes

c(c ) 3 (c )/3 + 22 /2 22

2 c 3

IIE[Z ] = = + .

(c )3 3(c ) 2(c )2

(4.12)

4.10. Approximations to

4.10.1. Diffusion Approximations

(n)

Proposition 4.12. Let {Ct } be a sequence of CramerLundberg processes with

initial capital u(n) = u, claim arrival intensities (n) = n, claim size distributions

G(n) (x) = G(x n) and premium rates

(n)

c (n) (n)

c = 1+ = c + ( n 1) .

n

R R

Let = 0 y dG(y) and assume that 2 = 0 y 2 dG(y) < . Then

(n) d

{Ct } {u + Wt }

in distribution in the topology of uniform convergence on finite intervals where {Wt }

is a (c , 2 )-Brownian motion.

Proof. See [57] or [46].

4. THE CRAMERLUNDBERG MODEL 87

Intuitively we let the number of claims in a unit time interval go to infinity and

(n)

make the claim sizes smaller in such a way that the distribution of C1 u tends

(n)

to a normal distribution and IIE[C1 u] = c . Let (n) denote the ruin time

(n)

of {Ct } and = inf{t 0 : u + Wt < 0} the ruin probability of the Brownian

motion. Then

(n)

Proposition 4.13. Let (Ct ) and (Wt ) be as above. Then

n

and

lim IIP[ (n) < ] = IIP[ < ] .

n

Proof. The result for a finite time horizon is a special case of [89, Thm.9], see

also [57] or [46]. The result for the infinite time horizon can be found in [72].

and IIP[ (1) < ] by IIP[ < ]. Thus we need the ruin probabilities of the Brownian

motion.

Lemma 4.14. Let {Wt } be a (m, 2 )-Brownian motion with m > 0 and =

inf{t 0 : u + Wt < 0}. Then

2

IIP[ < ] = e2um/

and mt + u mt u

2um/ 2

IIP[ t] = 1 +e .

t t

n 2m(u + W ) o

t

exp

2

is a martingale. By the stopping theorem

n 2m(u + W ) o

t

exp

2

is a positive bounded martingale. Thus, because limt Wt = ,

n 2um o h n 2m(u + W ) oi

exp 2 = IIE exp = IIP[ < ] .

2

88

4. THE CRAMERLUNDBERG MODEL

(u) 0.6111 0.5246 0.4547 0.3969 0.3479

DA 1.0000 0.8071 0.6514 0.5258 0.4244

Er 63.64 53.87 43.26 32.49 21.98

u 1.25 1.5 1.75 2 2.25

(u) 0.3059 0.2696 0.2379 0.2102 0.1858

DA 0.3425 0.2765 0.2231 0.1801 0.1454

Er 11.96 2.54 -6.22 -14.32 -21.78

It is easy to see that {sW1/s m} is a (0, 2 )-Brownian motion (see [60, p.351]) and

thus {s(u + W1/s ) m} is (u, 2 )-Brownian motion. Denote the latter process by

{W s }. Then

= IIP[inf{s(u + W1/s ) : s 1/t} < 0]

= IIE[IIP[inf{m + W s : s 1/t} < 0 | W 1/t ]]

Z m (yu/t)2

Z (yu/t)2

1 2 /t

2u(y+m) 1

= p e 2 dy + e 2

p e 22 /t dy

2

2 /t 2

2 /t

m

m u/t Z 2

2um 1

(y+u/t)

= + e 2 p e 22 /t dy

/ t m 2 2 /t

mt + u

2um

mt u

=1 + e 2 .

t t

Diffusion approximations only work well if c/() is close to 1. There also exist

corrected diffusion approximations which work much better, see [79] or [7].

We find c = 7/18 and 2 = 49/54. This leads to the diffusion approxi-

mation (u) exp{6u/7}. Table 4.2 shows exact values ((u)), the diffusion

approximation (DA) and the relative error multiplied by 100 (Er). Here we have

c/() = 18/11 = 1.63636 is not close to one. This is also indicated by the figures.

4. THE CRAMERLUNDBERG MODEL 89

In the case of exponentially distributed claim amounts we know the ruin probabilities

explicitly. The idea of the deVylder approximation is to replace {Ct } by {Ct } where

{Ct } has exponentially distributed claim amounts and

IIE[Ct u] = (c )t = c t,

2

Var[Ct ] = Var[u + ct Ct ] = 2 t = t

2

and

6

IIE[(Ct IIE[Ct ])3 ] = IIE[(u + ct Ct IIE[u + ct Ct ])3 ] = 3 t = t.

3

The parameters of the approximation are

32

= ,

3

2

= 2 93

= 22

2 23

and

32

= c + 2 .

c = c +

23

Thus the approximation to the probability of ultimate ruin is

c u

(u) e .

c

There

q is also a formula for the probability of ruin within finite time. Let =

c). Then

/(

c)u 1

Z

(

/

(u, t) e f (x) dx (4.13)

c 0

where

ct cos x (

exp{2 +

c + )t u( cos x 1)}

f (x) = 2

1 + 2 cos x

(cos(

u sin x) cos(

u sin x + 2x)) .

90

4. THE CRAMERLUNDBERG MODEL

(u) 0.6111 0.5246 0.4547 0.3969 0.3479

DV 0.5774 0.5102 0.4509 0.3984 0.3520

Er -5.51 -2.73 -0.86 0.38 1.18

u 1.25 1.5 1.75 2 2.25

(u) 0.3059 0.2696 0.2379 0.2102 0.1858

DV 0.3110 0.2748 0.2429 0.2146 0.1896

Er 1.67 1.95 2.07 2.09 2.03

need 3 = 251/108. The approximation parameters are = 0.622472

= 1.17131,

and c = 0.920319. This leads to the approximation (u) 0.577441e0.494949u . It

turns out that the approximation works well.

c

F (u) = 1 (u)

is a distribution function and that

Z

c2

z dF (z) =

0 2(c )

and that

22

Z

c 3

z 2 dF (z) = + .

0 3(c ) 2(c )2

The idea is to approximate the distribution function F by the distribution function

F (u) of a (, ) distributed random variable such that the first two moments

coincide. Thus the parameters and have to fulfil

c2

= ,

2(c )

( + 1) c 3 22

= + .

2 3(c ) 2(c )2

The BeekmanBowers approximation to the ruin probability is

(u) = (1 F (u)) (1 F (u)) .

c c

Remark. If 2 IIN then 2Z 22 is 2 distributed.

4. THE CRAMERLUNDBERG MODEL 91

(u) 0.6111 0.5246 0.4547 0.3969 0.3479

BB1 0.6111 0.5227 0.4553 0.3985 0.3498

Er 0.00 -0.35 0.12 0.42 0.54

BB2 0.6111 0.5105 0.4456 0.3914 0.3450

Er 0.00 -2.68 -2.02 -1.38 -0.83

u 1.25 1.5 1.75 2 2.25

(u) 0.3059 0.2696 0.2379 0.2102 0.1858

BB1 0.3076 0.2709 0.2387 0.2106 0.1859

Er 0.54 0.47 0.34 0.19 0.04

BB2 0.3046 0.2693 0.2383 0.2110 0.1869

Er -0.42 -0.11 0.18 0.40 0.59

solve the equations

( + 1)

= 1.90909 , = 7.71429 ,

2

which yields the parameters = 0.895561 and = 0.469104. From this the

BeekmanBowers approximation can be obtained. Here we have 2 = 1.79112

which is not close to an integer. Anyway, one can interpolate between the 21 and

the 22 distribution function to get the approximation

to 1 c/() (u). Table 4.4 shows the exact values ((u)), the BeekmanBowers

approximation (BB1) and the approximation obtained by interpolating the 2 dis-

tributions (BB2). The relative errors (Er) are given in percent. One can clearly see

that all the approximations work well.

Let us now consider subexponential claim size distributions. In this case the Lund-

berg exponent does not exist (Lemma F.3).

92

4. THE CRAMERLUNDBERG MODEL

1 x

Z

(1 G(y)) dy

0

is subexponential. Then

(u)

lim R = .

u

u

(1 G(y)) dy c

Remark. Recall that the probability that ruin occurs at the first ladder time

given there is a first ladder epoch is

1

Z

(1 G(y)) dy .

u

Hence the ruin probability is asymptotically (c )1 times the probability of

ruin at the first ladder time given there is a first ladder epoch. But (c )1 is

the expected number of ladder times. Intuitively for u large ruin will occur if one of

the ladder heights is larger than u.

Proof. Let B(x) denote the distribution function of the first ladder height L1 , i.e.

1 x

Z

B(x) = (1 G(y)) dy .

0

Choose > 0 such that (1 + ) < c. By Lemma F.6 there exists D such that

1 B n (x)

D(1 + )n .

1 B(x)

From the PollaczekKhintchine formula (4.10) we obtain

(u) X n 1 B n (u)

= 1

1 B(u) c n=1 c 1 B(u)

X n

D 1 (1 + )n < .

c n=1 c

Thus we can interchange sum and limit. Recall from Lemma F.7 that

1 B n (u)

lim = n.

u 1 B(u)

Thus

n

(u) X n X X n

lim = 1 n = 1

u 1 B(u) c n=1 c c n=1 m=1 c

X X n X m /c

= 1 = = = .

c m=1 n=m c m=1

c 1 /c c

4. THE CRAMERLUNDBERG MODEL 93

u (u) App Er

1 0.364 8.79 103 -97.588

2 0.150 1.52 104 -99.898

3 6.18 102 8.58 106 -99.986

4 2.55 102 9.22 107 -99.996

5 1.05 102 1.49 107 -99.999

10 1.24 104 3.47 1010 -100

20 1.75 108 5.40 1013 -99.997

30 2.50 1012 1.10 1014 -99.56

40 1.60 1015 6.71 1016 -58.17

50 1.21 1016 7.56 1017 -37.69

1 B(zx) 1 G(zx)

lim = z lim = z (1) .

x 1 B(x) x 1 G(x)

and thus > 1. Because

Z

1

dy =

x +y 1 +x

we obtain

/( 1) 1 1

(u) = .

c /( 1) + u c( 1) + u

Choose now c = 1, = 9, = 11 and = 1. Table 4.5 gives the exact value

((u)), the approximation (App) and the relative error in percent (Er). Consider

for instance u = 20. The ruin probability is so small, that it is not interesting for

practical purposes anymore. But the approximation still underestimates the true

value by almost 100%. That means we are still not far out enough in the tail. This

is the problem by using the approximation. It should, however, be remarked, that

for small values of the approximation works much better. Values (1, 2) are

also more interesting from a practical point of view.

Remark. The conditions of the theorem are also fulfilled for LN(, 2 ), for

LG(, ) and for Wei(, c) ( < 1) distributed claims, see [35] and [62].

94

4. THE CRAMERLUNDBERG MODEL

Consider the function

The function is defined at least for 0. We will first find a differential equation

for f (u).

Lemma 4.17. The function f (u) is absolutely continuous and fulfils the equation

hZ u i

0

cf (u) + f (u y) dG(y) + 1 G(u) f (u) f (u) = 0 . (4.14)

0

f (u) = eh eh f (u + ch)

Z h hZ u+ct i

+ et f (u + ct y) dG(y) + et (1 G(u + ct)) et dt .

0 0

We see that f (u) is right continuous. Reordering of the terms and dividing by h

yields

c f (u + ch)

ch h

Z h hZ u+ct

1 i

+ f (u + ct y) dG(y) + (1 G(u + ct)) e(+)t dt = 0 .

h 0 0

Letting h 0 shows that f (u) is differentiable and that (4.14) for the derivative

from the right holds. Replacing u by u ch shows the derivative from the left.

This differential equation is hard to solve. Let us take the Laplace transform

R

with respect to the initial capital. Let f (s) = 0 esu f (u) du. For the moment

we assume s > 0. Note that (see Section 4.9)

Z

f0 (u)esu du = sf (s) f (0) ,

0

Z Z u

f (u y) dG(y)esu du = f (s)MY (s)

0 0

and Z Z y

1 MY (s)

Z Z

su

dG(y)e du = esu du dG(y) = .

0 u 0 0 s

4. THE CRAMERLUNDBERG MODEL 95

h

1 MY (s) i

c(sf (s) f (0)) + f (s)MY (s) + f (s) f (s) = 0 .

s

Solving for f (s) yields

cf (0) s1 (1 MY (s))

f (s) = . (4.15)

cs (1 MY (s))

We know that f (s) exists if > 0 and s > 0 and is positive. The denominator

cs (1 MY (s))

is convex, has value < 0 at 0 and converges to as s . Thus there exists a

strictly positive root s() of the denominator. Because f (s) exists also for s = s()

the numerator must have a root at s() too. Thus

cf (0) = s()1 (1 MY (s())) .

The function s() is differentiable by the implicit function theorem

s0 ()(c MY0 (s())) 1 = 0 . (4.16)

Because s(0) = 0 we obtain that lim0 s() = 0.

s

cs =0

+s

which admits the two solutions

p

(c ) (c )2 + 4c

s () =

2c

where s () < 0 s+ (). Thus

/( + s+ ()) /( + s)

f (s) = = .

cs s/( + s) c( + s+ ())(s s ())

It follows that

f (u) = es () u .

c( + s+ ())

Noting that

d

IIE[ 1I{ <} ] = lim IIE[ e 1I{ <} ] = lim IIE[e 1I{ <} ]

0 0 d

we see

Z Z

su d d

IIE[ 1I{ <} | C0 = u]e du = lim f (u)esu du = lim f (s) .

0 0 d 0 0 d

We can find the following explicit formula.

96

4. THE CRAMERLUNDBERG MODEL

Z u

1 h 2 i

IIE[ 1I{ <} ] = (u) (u y)(y) dy . (4.17)

c 2(c ) 0

Proof. We get

f (s) =

d cs (1 MY (s)) s()2

((1 MY (s()))s()1 (1 MY (s))s1 )

. (4.18)

(cs (1 MY (s)) )2

1

s0 (0) =

c

and we have already seen that

1 MY (s()) 1 MY (s)

lim = lim = lim MY0 (s) = .

0 s() s0 s s0

Moreover,

lim = lim

0 s()2 s0 s2

sMY00 (s) 2

= lim = .

s0 2s 2

Z

IIE[ 1I{ <} | C0 = u] esu du

0

2 s1 (1 MY (s))

=

2(c )(cs (1 MY (s))) (cs (1 MY (s)))2

2 c

= 2

2(c ) cs (1 MY (s))

1 c 1 c

c cs (1 MY (s)) s cs (1 MY (s))

1 h 2 (s)

i

= (s) (s) .

c 2(c )

4. THE CRAMERLUNDBERG MODEL 97

2

IIP[t < < ] < .

2(c )2 t

Proof. Because (u) and (u) take values in [0, 1] it is clear from (4.17) that

2

IIE[ 1I{ <} ] < .

2(c )2

By Markovs inequality

1 2

IIP[t < < ] = IIP[ 1I{ <} > t] < IIE[ 1I{ <} ] < .

t 2(c )2 t

2 2

IIE[ 1I{ <} | C0 = 0] = 1 =

2(c )2 c 2c(c )

and

2

IIE[ | < , C0 = 0] = .

2(c )

Z u

h 2 Ru R(uy) i

= 1 e e 1 eRy dy

c 2(c ) c 0 c c

h c i

= 1 eRu eRu (eRu 1) u

c (c ) c c c c

1

= 2 eRu (u + c) = (u)(u + c) .

c (c ) c(c )

u + c

IIE[ | < ] = .

c(c )

98

4. THE CRAMERLUNDBERG MODEL

We consider now the probability of ruin within finite time (u, t). But first we want

to find the conditional finite ruin probability given Ct for some t fixed.

y

IIP[Cs 0, 0 s t | Ct = y] = .

ct

Proof. Consider

Nt

X

Ct C(ts) = cs Yi .

i=N(ts) +1

= IIP[Cs Ct , 0 s t | Ct = y] .

permutations of {1, 2, . . . , n}. Then

k

1 hX X i

IIE[Ss | St = y, Nt = n, Ns = k] = IIE Y(i) St = y, Nt = n, Ns = k

n! i=1

n

k(n 1)! hX i ky

= IIE Yi S = y, N = n, N = k = .

t t s

n! i=1

n

Because, given Nt = n, the claim times are uniformly distributed in [0, t] (Proposi-

tion C.2) we obtain

n

X n s k t s nk ky

IIE[Ss | St = y, Nt = n] =

k=0

k t t n

n

X n 1 s k t s nk sy

= y= .

k=1

k1 t t t

sy

IIE[Ss | St = y] =

t

and

s(ct y) sy

IIE[Cs | Ct = y] = IIE[cs Ss | St = ct y] = cs = .

t t

4. THE CRAMERLUNDBERG MODEL 99

hy C i y C IIE[(C C ) | C , C = y]

s v s v v t

IIE Cv , Ct = y =

ts ts

y Cv (s v)(y Cv )/(t v) y Cv

= =

ts tv

and the process

y Cs

Ms = (0 s < t)

ts

is a conditional martingale. Note that limst Ms = c. Let T = inf{s 0 : Cs = y}.

Because

0 Ms 1I{T >s} c

on {Ct = y} we have

h i

lim IIE[Ms 1I{T >s} | Ct = y] = IIE lim Ms 1I{T >s} Ct = y = cIIP[T = t | Ct = y] .

st st

Note that by the stopping theorem {MT t } is a bounded martingale. Thus because

MT = 0 on {T < t}

y

= M0 = lim IIE[MT s | Ct = y] = lim IIE[Ms 1I{T >s} | Ct = y] = cIIP[T = t | Ct = y] .

t st st

Denote by F (x; t) the distribution function of St . For the integration we use dF (; t)

for an integration with respect to the measure F (; t). Moreover, let (u, t) = 1

(u, t) = IIP[ > t].

Z ct

1 1

(0, t) = IIE[Ct 0] = F (y; t) dy .

ct ct 0

hC 0i

t

(0, t) = IIE[IIP[ > t | Ct ]] = IIE .

ct

Moreover,

Z ct

IIE[Ct 0] = IIE[(ct St ) 0] = (ct z) dF (z; t)

0

Z ctZ ct Z ctZ y Z ct

= dy dF (z; t) = dF (z; t) dy = F (y; t) dy .

0 z 0 0 0

100

4. THE CRAMERLUNDBERG MODEL

Theorem 4.23. With the notation used above we have for u > 0

Z u+ct

v u v u

(u, t) = F (u + ct; t) 0, t F dv; .

u c c

Cs > 0 for all s [0, t]. Then, noting that IIP[Cs > 0 : 0 < s t | C0 = 0] = IIP[Cs

0 : 0 < s t | C0 = 0],

IIP[T [s, s + ds)] = IIP[Cs (c ds, 0], Cv > 0 for v [s + ds, t]]

= (F (u + c(s + ds); s) F (u + cs; s))(0, t s ds)

= (0, t s)c dF (u + cs; s) .

Thus

Z t

(u, t) = F (u + ct; t) (0, t s)c dF (u + cs; s)

0

u+ct

v u v u

Z

= F (u + ct; t) 0, t dF v, .

u c c

In this section we derive an upper bound for probabilities of the form

IIP[yu < y u]

for 0 y < y < . Assume that the Lundberg exponent R exists. We will use the

martingale (4.4) and the stopping theorem. For r 0 such that MY (r) < ,

= IIE[erC (r) | yu < y u]IIP[yu < y u]

> IIE[e(r) | yu < y u]IIP[yu < y u]

> e max{(r)yu,(r)yu} IIP[yu < y u] .

4. THE CRAMERLUNDBERG MODEL 101

Thus

IIP[yu < y u | C0 = u] < e(rmax{(r)y,(r)y})u .

Choosing the exponent as small as possible we obtain

where

R(y, y ) = sup min{r (r)y, r (r)y } .

rIR

The supremum over r IR makes sense because (r) > 0 for r < 0 and (r) =

if MY (r) = . Since (R) = 0 it follows that R(y, y ) R. Hence (4.19) could be

useful.

For further investigation of R(y, y ) we consider the function fy (r) = r y(r).

Let r = sup{r 0 : MY (r) < }. Then fy (r) exists in the interval (, r )

and fy (r) = for r (r , ). If MY (r ) < then |fy (r )| < . Since

fy00 (r) = yMY00 (r) < 0 the function fy (r) is concave. Thus there exists a unique ry

such that fy (ry ) = sup{fy (r) : r IR}. Because fy (0) = 0 and fy0 (0) = 1 y0 (0) =

1 + y(c ) > 0 we conclude that ry > 0. ry is either the solution to the equation

1

y0 = (MY0 (R) c) .

d

Because f (r)

dy y

= (r) it follows readily that

d

fy (r) T 0 r S R .

dy

We get

fy (r) S fy(r) as r S R .

Because MY0 (r) is an increasing function it follows that

y T y0 ry S R .

Thus

R if y y0 y ,

R(y, y ) = fy(ry) if y < y0 ,

fy (ry ) if y > y0 .

102

4. THE CRAMERLUNDBERG MODEL

If y0 [y, y ] then we got again Lundbergs inequality. If y < y0 then R(y, y ) does

not depend on y. By choosing y as small as possible we obtain

eru IIE[erC (r) ; yu < < ] > e(r)yu IIP[yu < < ]

We see that IIP[ / ((y0 )u, (y0 + )u)] goes faster to 0 than IIP[ ((y0

)u, (y0 + )u)]. Intuitively ruin should therefore occur close to y0 u.

y0

u

in probability on the set { < } as u .

u] exp{Ru} C for some C > 0. Then

h i

IIP y0 > < , C0 = u

u

IIP[ < (y0 )u | C0 = u] + IIP[(y0 + )u < < | C0 = u]

=

IIP[ < | C0 = u]

exp{R(0, y0 )u} + exp{R(y0 + , )u}

IIP[ < | C0 = u]

exp{(R(0, y0 ) R)u} + exp{(R(y0 + , ) R)u}

= 0

IIP[ < | C0 = u]eRu

as u .

Bibliographical Remarks

The CramerLundberg model was introduced by Filip Lundberg [63]. The basic

results, like Lundbergs inequality and the CramerLundberg approximation go back

4. THE CRAMERLUNDBERG MODEL 103

to Lundberg [64] and Cramer [24], see also [25], [47] or [68]. The differential equation

for the ruin probability (4.2) and the Laplace transform of the ruin probability can

for instance be found in [25]. The renewal theory proof of the CramerLundberg

approximation is due to Feller [41]. The martingale (4.4) was introduced by Gerber

[42]. The latter paper contains also the martingale proof of Lundbergs inequality

and the proof of (4.20). The proof of (4.21) goes back to Grandell [48]. Section 4.14

can also be found in [36]. Some similar results are obtained in [4] and [5]. Segerdahl

[78] proved the asymptotic normality of the ruin time conditioned on ruin occurs.

The results on reinsurance and ruin can be found in [88] and [22]. The approach

for proportional reinsurance as well as the example is from [53]. Proposition 4.9 can

be found in [44, p.130].

The term severity of ruin was introduced in [45], the joint distribution of the

severity of ruin and the capital prior to ruin was first investigated in [34]. More

results on the topic are obtained in [32], [68] and [74]. A diffusion approximation,

even though not obtained mathematically correct, was already used by Hadwiger

[52]. The modern approach goes back to Iglehart [57], see also [46], [7] and [72].

The deVylder approximation was introduced in [31]. Formula (4.13) was found by

Asmussen [7]. It is however stated incorrectly in the paper. For the correct formula

see [16] or [68]. The BeekmanBowers approximation can be found in [17].

Theorem 4.15 was obtain by von Bahr [87] in the special case of Pareto dis-

tributed claim sizes and by Thorin and Wikstad [86] in the case of lognormally

distributed claims. The theorem in the present form is basically found in [35], see

also [39].

Section 4.12 is taken from [71]. Parts can also be found in [72] and [16]. (4.15)

was first obtained in [25]. The expected value of the ruin time for exponentially

distributed claims can be found in [44, p.138]. Seals formulae were first obtained

by Takacs [82, p.56]. Seal [76] and [77] introduced them to risk theory. The present

presentation follows [44].

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