Asset and Liability Management for Actuaries

Chapter 3 – Liability Management

Group 2 - Risk Pooling

BURAN Matteo, BYTYQI Valton, COLTELLI Simone, ESHONKULOV Alisher

 Risk pooling - law of large numbers

 Risk pooling: large number of small, similar (or identical), independent contracts

 In insurance, economies of scale are thought to be grounded in theory because they are implied by the law of
large numbers (LLN)

 LLN: 𝑋 = 𝑋 + ⋯+ 𝑋 ⇒ 𝑋 𝜇
→

 Variance decreases when n gets larger

 An insurer’s portfolio containing a large number of risks with the same expected loss can get more precise
estimates and less reserves
 Insurer’s relative risk

 Portfolio losses: with average loss

 Variance:

 Standard deviation: ̅
 Risk pooling and modeling

 Pooling effects from creating underwriting portfolios:

 Production law of insurance business

 No fundamental differences with diversification effects in asset management

 Modeling essentials:

 Specification of assumptions
 Definition of appropriate risk measures

 Types of analysis:

 Constant capacity
 Marginal analysis – increasing capacity
 Constant capacity (I)

 Idea: comparison of the risk structure when subscribing one risk (n=1) vs
subscribing multiple risks (n>1)

Example 1 (insurance of one risk, e.g. a ship or a house)

 Total loss ( ) Single loss ( ) (same distribution)

 (premium calculation with safety loading c>0)

 (ruin probability)
 Constant capacity (II)

 If claims are normally distributed we can apply the transformation:

∗
∗

to get

 Result: safety level (ruin probability) depends on the volatility of losses and safety loading
 Constant capacity (III)
Example 2 : Insurance of n shares, each for one nth

Assumptions : - Individual claims ( ) are independent and identically distributed

Assumptions : - Claims are normally distributed

E( 1) = E( 2) = …. = E( 𝑛)

2(
1) = 2(
2) = …. = 2(
𝑛)

- The total claim amount results from = 𝑖

- As in the case of only one risk, the premier calculation can be derived as follows:

= 𝑖] + with safety loading

 Constant capacity (IV)
Example 2 : Insurance of n shares, each for one nth (II)

In the case that for n risks, the insurance company insures one nth per each contract, the
variance of the total loss results from :
2 = 2[
𝑖] = 2[
𝑖]

2[
Since single claims are identically distributed : 𝑖] = n 2( 𝑖 )

One thus receives the “nth root law”: 2 = 2(

𝑖)

One thus receives the “nth root law”: ( 𝑖)

 Constant capacity (V)
Example 2 : Insurance of n shares, each for one nth (III)

For the ruin probability, the following relationship holds:

= P[ ] = 1 - P[ ] =

From previous slide : ”: ( 𝑖)  =

( )

Result : For c > 0, the ruin probability decreases with increasing n (effect of pooling)

The probability of ruin

decreases to 0 with increasing n
 Marginal analysis – “Increasing” capacity (I)

View on risk pooling effects

2 = 2[
𝑖] = n 2( 𝑖 )

2 = 2[
𝑖] = (n+1) 2( 𝑖 )

2 > 2

 The variance clearly increases with increasing n

 Marginal analysis – “Increasing” capacity (II)

“Marginal consideration” by Albrecht (1982)

• Consideration of premiums

• Assumption : Single claims (Xi) are independent and identically distributed

• Employed risk measure : one-period ruin probability:

Where :
𝑖 = single claim amount (stochastic)
= total stochastic loss of a portfolio of n deterministic members
= gross risk premier of the collective
 Marginal analysis – “Increasing” capacity (III)

Two definitions of the pooling effect (Albrech, 1982)

Definition A:
n∞
For increasing n, the ruin probability approaches 0: 0

Definition B:

The average premium for a pool member is decreasing with growing pool size

while
 Marginal analysis – “Increasing” capacity (IV)
 1: Proportional Growth of loading
Pooling always results in casa of independence risks, if the following premium income can be collected
Premium principle:
𝜋 𝐿 =𝐸 𝐿 + 𝑛𝑐

Ruin probability:
𝑅 𝑛, 𝜋, 𝐿 = 𝑃𝑟𝑜𝑏 𝐿 > 𝜋𝐿 = 1−𝑁 → 0 , for n → ∞

Premium of 1 member of pool:

1
𝜋 = 𝜋 𝑋 = 𝐸 𝐿 + 𝑛𝑐 = 𝐸 𝑋 +𝑐
𝑛
 Marginal analysis – “Increasing” capacity (V)
 2: Under-proportional Growth of loading
Collective safety loading only grows under-proportional according to:
Premium principle:
𝜋 𝐿 =𝐸 𝐿 +𝑐 𝑛

Ruin probability:
𝑐
𝑅 𝑛, 𝜋, 𝐿 = 𝑃𝑟𝑜𝑏 𝐿 > 𝜋𝐿 =1−𝑁
𝜎[𝑋 ]
For growing pool size, the riun prob. Does not approach zero, but a risk pooling effect.

𝜋 𝐿 𝜋 𝐿
< ⟺ 𝑛< 𝑛+1 𝑅 𝑛, 𝜋, 𝐿 ≤𝜀
𝑛+1 𝑛
 Marginal analysis – “Increasing” capacity (VI)
 3: Premium principle not leading to pooling effect

Premium principle:
𝜋 𝐿 =𝐸 𝐿 + 𝑐/ 𝑛

Ruin probability:
𝑅 𝑛, 𝜋, 𝐿 = 𝑃𝑟𝑜𝑏 𝐿 > 𝜋𝐿 =1−𝑁 → [for n → ∞] → 1-N(0)=50%≠ 0
[ ]

𝜋 𝐿 𝜋 𝐿
< ⟺ 𝑛 𝑛 < (𝑛 + 1) 𝑛 + 1 𝑅 𝑛, 𝜋, 𝐿 ≤𝜀
𝑁+1 𝑁

Conclusion: Risk pooling not only depends on pool size and dependence structure, but
also on the method of premium calculation
 Marginal analysis – “Increasing” capacity (VII)
 Influence of the capital reserve
There is an influence of the capital reserve U on the risk pooling effect.

Net Risk Premium (Premium = Expected claim costs):

𝜋 𝐿 =𝐸 𝐿

Ruin probability:
𝑅 𝑛, 𝜋, 𝐿 = 𝑃𝑟𝑜𝑏 𝐿 > 𝜋𝐿 = 1 − 𝑁( ) → [for n → ∞] → 1-N(0)=50%

Conclusion:
o Constant reserve 𝑼𝒏 = U for increasing n produces no risk pooling effect
o Proportional reserve growing in n, has same effect as proportionally increasing safety loading
o 𝑼𝒏 can be determined as desired safety level R = 𝜺 is achieved
o The larger reserve, the smaller the collective risk premium can be (ONLY in TECHNICAL VIEW)
 Remarks on model framework
 Only partial model

 Marginal premiums: safety level of the insurance company affects the willingness of
policyholder to pay

 Shareholder-stake is not considered

 Diversification only occurs in an insurance company; Individual diversification level are

completely ignored

 Risk pooling opportunities would provide added value to the collective members
 Merits of pooling

Definition of pooling effects:

• For fixed safety level -> lower premiums (A)
with an increasing number of insureds
• Fixed premium -> high safety level (B)

Yet, this interpretation can be misleading.

Basic situation (mutual insurance):

Premium calculation:
𝜋 𝐿 =𝐸 𝐿 + 𝑛𝑐, where 𝐿 =∑ 𝑋

Safety level is fixed to 𝜀 :

𝑛𝑐 !
𝑅 𝑛, 𝜋, 𝐿 = 𝑃𝑟𝑜𝑏 𝐿 > 𝜋𝐿 =1−𝑁 =𝜀
𝜎[𝑋 ]
 Merits of pooling

Claim of a pool member using present value calculus:

a) Policyholder claim (debt holder position)

~
𝜋 = 𝑃𝑉 𝑋 − 𝑃𝑉[max 𝐿 − 𝜋(𝐿 ),0 ]

b) Shareholder claim (equity holder position)

1
𝑈 = 𝑃𝑉[max(𝜋(𝐿 )−𝐿 , 0)]
𝑛

By summing up:
𝜋(𝐿 )
𝜋 +𝑈 =𝜋 =
𝑛
Hence, whether risk pooling in the sense of case A or B is fulfilled or not is of no
importance. No additional value can be created from the diversification of
unsystematic risk.
 Merits of pooling - Numerical Example

Assumptions:
• Risk-less rate of return of 0%
• Risk-neutrality
• Claims normally distributed with 𝐸 𝑋 = 30, 𝜎[𝑋 ] = 10

Results for a given safety level 𝜀=1%

n 1 10 50 100 1000 10000

𝜋 53,32 37,39 33,28 32,36 30,74 30,23

c 23,32 7,39 3,28 2,36 0,74 0,23

𝜋 29,97 29,99 29,99 30,00 30,00 30,00

𝑈 23,36 7,40 3,29 2,36 0,74 0,23

sum 53,32 37,39 33,28 32,36 30,74 30,23

Interpretation:
Pooling is beneficial if in general:
- Policyholders are risk averse
- Policyholders cannot perfectly diversify
- The insurer can diversify better than the policyholders
 Risk spreading: Arrow-Lind theorem

• A certain insurance risk can be borne by:

- One single insurer
- Many (re-)insurers who split the risk

• The Arrow-Lind Theorem

The sum of the premiums Π(n) for each of the n identical syndicate members converges to E(X) for large n, i.e.

Π = 𝑛 ∗ Π(n) --> E(X) (“net premium principle”)

Therefore, competitive insurance markets are sometimes assumed risk neutral

 Thank you for your attention

BURAN Matteo, BYTYQI Valton, COLTELLI Simone, ESHONKULOV Alisher