KWAME NKRUMAH UNIVERSITY OF SCIENCE AND

TECHNOLOGY

STOCHASTIC ANALYSIS OF GENERAL INSURANCE CLAIMS

USING MARKOV CHAIN MONTE CARLO METHOD

By
OSSEI KOFI TUFFUOR
(B.Sc. Actuarial Science)

A THESIS SUBMITTED TO THE DEPARTMENT OF MATHEMATICS,

KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY IN
PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE
OF MSC ACTUARIAL SCIENCE

October, 2016
 Declaration
I hereby declare that this submission is my own work towards the award of the
MSc degree and that, to the best of my knowledge, it contains no material previ-
ously published by another person nor material which had been accepted for the
award of any other degree of the university, except where due acknowledgement
had been made in the text.

Ossei Kofi Tuffuor(PG 8736012) ..................... ..................

Student Signature Date

Certified by:
Dr. Peter Amoako-Yirenkyi ..................... ..................
Supervisor Signature Date

Certified by:
Dr. R. K. Avuglah ..................... ..................
Head of Department Signature Date

i
 Dedication
This thesis is dedicated to my uncle Yaw Kwarteng Dwira and my family.

ii
 Abstract
Motor insurance companies need to utilize past and current claim amounts in
predicting future liabilities. It is therefore necessary that, motor insurance com-
panies develop actuarial models using Bayesian and Markov Chain and Monte
Carlo procedures. This thesis focuses on developing stochastic models for insur-
ance claim amounts using Bayesian statistics. Motor insurance claim numbers
usually follow compound Poisson distribution. This research work, however ex-
amines the claim amount distributions. The methodology requires intensive use
of Bayesian and Markov Chain Monte Carlo techniques through a software called
WinBUGS. Two distributions usually fitted to claim amounts are examined and
the issues encountered when using Bayesian and Markov Chain Monte Carlo
techniques in this context are investigated.

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 Acknowledgements
All thanks and appreciation to God Almighty for His life and strength through
this program. His eternal love has made this thesis successful.

This research work would not be complete without financial aid. I am highly
grateful to my uncle Yaw Kwarteng Dwira for his financial support and prayer.
God richly bless him.

I am particularly grateful to my supervisor Dr. Amoako-Yirenkyi for his over-

whelming contribution, advice and assistance towards this thesis.

Also to those who contributed to this work, Dr. Ebenezer (Kumasi Polytech-
nic), Nana Kena Frempong my family and colleagues. I appreciate you all.

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Contents

Declaration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

Dedication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii

Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv

Table of Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii

List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Background of study . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Problem statement . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Research objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.4 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.5 Justification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.6 Limitatons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.7 Organisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Theoretical Background . . . . . . . . . . . . . . . . . . . . . . . 8

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 2.3 Bayesian and Markov Chain Monte Carlo (MCMC) Applications
in Actuarial Science . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Review of the Motor Insurance in Ghana . . . . . . . . . . . . . . 18
2.5 Estimation Models in Europe . . . . . . . . . . . . . . . . . . . . 20
2.6 Estimation Models in Ghana . . . . . . . . . . . . . . . . . . . . . 22

3 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.2 Type and Source of Data . . . . . . . . . . . . . . . . . . . . . . . 23
3.3 Description of Model . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4 Markov Chain Monte Carlo . . . . . . . . . . . . . . . . . . . . . 25
3.4.1 Metropolis-Hastings Algorithm . . . . . . . . . . . . . . . 26
3.4.2 Gibbs Sampler . . . . . . . . . . . . . . . . . . . . . . . . 28
3.5 Models and Loss Distribution . . . . . . . . . . . . . . . . . . . . 30
3.6 Loss Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.6.1 Pareto Distribution . . . . . . . . . . . . . . . . . . . . . . 31
3.7 Lognormal Distribution . . . . . . . . . . . . . . . . . . . . . . . . 32
3.7.1 Prior Distribution . . . . . . . . . . . . . . . . . . . . . . . 33
3.8 Testing for Convergence . . . . . . . . . . . . . . . . . . . . . . . 34
3.8.1 Visual Inspection . . . . . . . . . . . . . . . . . . . . . . . 35
3.8.2 Autocorrelation . . . . . . . . . . . . . . . . . . . . . . . . 36
3.8.3 Gelman and Rubin Multiple Sequence Distributions . . . . 36
3.8.4 Other Convergence Tests. . . . . . . . . . . . . . . . . . . 38
3.9 Prior Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.10 Selection of Priors . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

4 Results and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 41

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
4.2 Preliminary Analysis . . . . . . . . . . . . . . . . . . . . . . . . . 41
4.3 Running the Model using WinBUGS . . . . . . . . . . . . . . . . 42

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 4.4 Checking Convergence for Poisson-Pareto Model . . . . . . . . . . 43
4.4.1 Visual Inspection . . . . . . . . . . . . . . . . . . . . . . . 43
4.4.2 Gelman Rubin Statistics . . . . . . . . . . . . . . . . . . . 44
4.4.3 Autocorrelation . . . . . . . . . . . . . . . . . . . . . . . . 45
4.4.4 Monte Carlo Error Estimation . . . . . . . . . . . . . . . . 46
4.5 Prior Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
4.6 Model 1: Poisson-Pareto Model . . . . . . . . . . . . . . . . . . . 47
4.7 Model 2: Poisson-Lognormal Model . . . . . . . . . . . . . . . . . 49
4.7.1 Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.7.2 Monte Carlo Error Estimation . . . . . . . . . . . . . . . . 53
4.8 Poisson-Lognormal Model . . . . . . . . . . . . . . . . . . . . . . 53
4.8.1 Model Comparison . . . . . . . . . . . . . . . . . . . . . . 54
4.9 Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4.9.1 Deviance Information Criterion (DIC) . . . . . . . . . . . 55

5 Conclusion and Recommendations . . . . . . . . . . . . . . . . . . 57

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.2 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
5.3 Recommendation . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

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List of Tables

4.1 Descriptive statistics of the data . . . . . . . . . . . . . . . . . . . 41

4.2 Monte Carlo parameters . . . . . . . . . . . . . . . . . . . . . . . 47
4.3 Gamma Prior (1, 0.001) . . . . . . . . . . . . . . . . . . . . . . . 47
4.4 Exponential Prior (1, 0.001) . . . . . . . . . . . . . . . . . . . . . 47
4.5 Node Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.6 Monte Carlo Error . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.7 Node Statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.8 Deviance Information Criterion . . . . . . . . . . . . . . . . . . . 56

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List of Figures

3.1 Trace plot of a parameter,α . . . . . . . . . . . . . . . . . . . . . 35

4.1 History plot of α . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

4.2 History plot of β . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
4.3 History plot of θ . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.4 Plot of α, β & θ chain . . . . . . . . . . . . . . . . . . . . . . . . 45
4.5 Plot of α, β & θ chain . . . . . . . . . . . . . . . . . . . . . . . . 46
4.6 Traces of α, β & θ chain . . . . . . . . . . . . . . . . . . . . . . . 48
4.7 Convergence of Poisson - Lognormal model . . . . . . . . . . . . . 50
4.8 Brooks Gelman Rubin test . . . . . . . . . . . . . . . . . . . . . . 51
4.9 Autocorrelation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
4.10 Poisson - Lognormal model . . . . . . . . . . . . . . . . . . . . . . 53

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 Chapter 1

Introduction

1.1 Background of study

A general insurance is an insurance that is not classified as life insurance. It is

also called property or casualty insurance in North America and non-life insur-
ance in Europe and some African countries such as Ghana, South Africa, Egypt
etc. The risk of property loss prevalently occur in Ghana, which one party (the
insurer) provides cover to the other party(insured).

In general insurance industry, insurers are keen on the non-life claims for the
year which is subdivided into three broad sections namely the number of claims,
the size of the claims and the aggregate claims. When such accidents occur and
are reported to the insurance companies, the duty to pay the insured lies on the
insurer. It is therefore necessary that the insurer sets aside some funds known as
reserves. This funds cushion the insurer from insolvency. The pecuniary loss is
therefore transferred from the insured to the insurer.

Insurance companies like any other corporate institutions are charged to sus-
tain a good profit-loss ratio on its balance sheet and ultimately make profit.
Insurance companies are challenged with a strenuous task of fitting a resilient
model to estimate claims. In this thesis, Bayesian & Markov Chain Monte Carlo
techniques would be used to undertake such analysis. Risk management is very
key in all sectors of insurance. Several risks are estimated to facilitate decision
making by the insurer. Over the last thirty years, Pentikainen in 1975 contended
that actuarial procedures must be widened to full scale risk control procedures.

1
Pentikainen et al.(1982) and Daykin et al. (1994) recommended that the abil-
ity to meet maturing financial obligations as they come due (solvency) must be
examined via several detailed methods that mitigate insolvency. These methods
comprise catastrophic risk, model building and variations in risk exposure. In
view of this, the European union in 2012 adopted a policy tagged solvency 2.
This policy aimed at enhancing risk control which was the in the new regulatory
the subject matter for discussion in the European Union Insurance companies
model appraisal.

Bayesian techniques have numerous applications in the field of actuarial science

over the last twenty years and more specifically with the setting up of The Inter-
national Society for Bayesian Analysis (ISBA). Bayesian techniques became more
useful in development of models that are well suited for insurance risk assessment.
In the early 90’s, the development of Bayesian methods become very common.
Hitherto, the application of classical methods for evaluating risk was prevalent.
The classical approach had several limitations, the most common stems from the
definition. Classical statistics stipulates that the probability of occurrence is its
prolonged run of frequencies in a succession of independent trials. For instance, in
insurance the probability that the insured party made claims before is irrelevant.

In the field of actuarial science, Bayesian statistics is gradually dominating the

basics of calculating risk. In actuarial science many issues that are related to
the discipline are exceptionally solved by using Bayesian methods (Klugman,
1992). A frequent field that usually employs Bayesian and Markov Chain Monte
Carlo (MCMC) techniques as its key actuarial philosophy is the credibility the-
ory. Bayes theorem is the formal mechanism of incorporating prior information
into modeling. This theorem mixes the prior subjective information with the
observed data in the experiment, producing a posterior distribution, this distri-

2
bution is called the prior distribution with the likelihood distribution.

Bayesian estimation and inference are very helpful in analysis and statistical
modeling. For instance, the Bayes procedure give confidence intervals on pa-
rameters and probability estimates for the hypothesis that are in alignment with
rational explanations. Thus, insurers are particularly encouraged to create mod-
els that can that can handle their claims which may occur in the upcoming years.
Especially claims that were paid in previous years. This would aid the insurer in
setting reserves to honour future liabilities.

Several methods have been deployed to estimate the claim size such as Bornhuettor-
Ferguson, the Chain ladder method and the average cost per claim. However,
these procedures do not estimate confidence intervals, standard deviations or
other relevant claim estimates. Actuarial models are built to represent the claim
amounts which can remedy such difficulties. The Markov Chain Monte Carlo
and Bayesian statistics would be used to evaluate the parameters that are not
known from the data. Insurance by its nature is fundamentally unpredictable
enterprise. In non-life insurance, the possibility of automobile accidents occur-
ring are unforeseeable. Thus claims are anticipated to be paid whenever such
incidence occur. Insurance relieves the insured party of risk and passes such loss
to the insurer, in return for series of payments called premium which is related
to the total expenditure fulfilling the conditions of the policies.

Moreover, the insurer must guarantee that it has substantial reserves to settle
the claims. It is appropriate for the insurer to develop actuarial models that can
handle such valuations. This comprises of building one model for the severity
of claims and another for the frequency of claims and joining both models to
derive the aggregate claim model. A useful model for insurance risk which is
termed as the collective risk models, treat the resultant claim loss as a compound

3
distribution with two parts; one denoting the occurrence (incidence) of events
and another describing claim amounts. The likelihood nature of the dual compo-
nents is fundamental assumption of a pragmatic risk model, both processes are
assumed to be independent, therefore they can be analyzed separately from each
other (Burnecki,Hardle and Weron, 2004).

In non-life insurance, it is always imperative insurers use erstwhile data not only
for reserves but also for pricing, reinsurance and to some extent obtaining good
credit-rating. In Ghana, insurance companies use individual claim size for these
purpose pertaining to any loss distribution. Nevertheless, the implementation
are restricted within some confines notably when surveying lengthy data. Again,
Young and Rosenberg (1999, page 132) stipulated the product of the Bayesian
procedures and its unique nature are self-explanatory and simple for risk analyst
than end product from classical statistical procedures, this is because actuaries
are inclined to reasoning in probability. Basically that is unfeigned.

In recent times, computers have made the computations easier with a software
labelled WINBUGS which is at an open source on the internet with user manu-
als simplified for novice. This thesis would also be a manual to help implement
Bayesian and MCMC techniques in WINBUGS for insurance companies. How-
ever, there are more room for modifications as the user desires.

1.2 Problem statement

Estimating future number of claims, the claim sizes and aggregate claims esti-
mates have been problematic in Ghana and this negatively affects the insurers in
holding reserves to cushion the insurer from insolvency. In Ghana, the national
regulator called the National Insurance Commission (NIC) in the year 2014 closed
down Industrial & General Insurance. According to NIC, the move was neces-
sitated by Industrial & General Insurances’(IGI) inability to settle and pay claims.

4
Classical approach which basically relies on the sample size is often used in Ghana.
In some cases, the classical approach does not factor in previous knowledge of the
data. Nonetheless, in many circumstances they are impossible to estimate huge
data let alone estimate claim determinants and predict future reserve amount.
Usually non-life insurers fit Poisson distribution to the number of claims but can-
not fit robust distribution to the claim sizes. Hence deriving a robust model has
been problematic.

1.3 Research objectives

The general objective of the thesis is to evaluate Bayesian & Markov Chain Monte
Carlo methods and its application in aggregate insurance claims models with the
specific objectives being the following;

• To fit probability distribution model to the frequency of claims incurred

monthly

• To fit another distribution to the severity, combine them to fit appropriate

model for the aggregate claims.

1.4 Methodology

The data used in this thesis is motor insurance data obtained from a renowned
insurance company in Ghana. The entries in the data are loss amount for the
last 10 years from non-life insurance. Bayesian technique is utilized to undertake
the analysis.

The Bayesian method is applied to the aggregate risk model utilizing simula-
tion inclined methods and inferences concerning the aggregate claims are made
based on the predictive distributions. The Bayesian technique is applied via com-

5
puter software called WINBUGS.The Gibbs sampling procedures are employed in
situations where the conjugate priors are utilized to derive the Bayesian inference.

1.5 Justification

General and non-life insurance policies are highly patronized in Ghana, it is im-
perative that insurers are previewed to the expected number of claims they face
in the future. The insurer can estimate the reserve to be held and hence cush-
ion the insurer against insolvency. Again, this thesis would be a relevant tool in
the hands of insurers to evaluate its performance more so for financial planning,
budgeting and resource allocation.

1.6 Limitatons

Casual variables that change on frequent basis such as price, promotions and
bonuses are not easily integrated into the analysis. The research is limited to
events that have pecuniary effect such as loss of property and destruction which
by assumption occur independently and are randomly distributed.

1.7 Organisation

This study has been organized and grouped into the following sections.

• Chapter one consists of the introduction of the study.

• Chapter two consists of the literature review of the study.

• Chapter three covers the methodology of the study.

• Chapter four covers data analysis and discussion of results

• Chapter five covers conclusion and recommendation

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 Chapter 2

Literature Review

2.1 Introduction

This chapter of the study seeks to find out what others have written about the
subject matter. The section primarily deals with what others have done in re-
lation to the subject matter. The core of this thesis discuses actuarial models
for the frequency of claims and severity of claims in motor insurance in relation
to Bayesian and MCMC techniques. Based on the models the aggregate severity
of claims must be evaluated that forms the basis for its premium calculation,
reserving, reinsurance, credit rating etc. Different distributions are designated
to the claim amount and number of claims which was utilized by Frigessi and
Dimakos (2002) for estimating the insurance premiums. The procedures relies
mainly on the supposal that claim amount and number of claims are indepen-
dent. Therefore, the structure is modeled with Markov Random Field that was
unconventional complying to Besag et al. (1991).

Bayesian and Markov Chain Monte Carlo techniques are utilized, since the ran-
dom parameters are employed to set the uncertainty of the parameters. Willmot
and Panjer (1983) expressed in the context: “The functional actuarial explana-
tion is that the risk is initially chosen from the pool of risk in conformity with the
distribution and the performance of the chosen risk is monitored. The statistical
explanation is basically “Bayesian”.

Markov Chain Monte Carlo (MCMC) is utilized for the estimation of the pa-
rameters and hence enhances the target Bayesian inference with reference to the

7
Markov Chain Monte Carlo output of the models for claim severity and fre-
quency of claims therefore the posterior predictive distribution of the aggregate
claim severity are obtained using simulation based procedures. The policyhold-
ers are comprehensive, third party only and third party (fire and theft). The
presumed best fit models are compared using the deviance information criterion
(DIC) advocated by Spiegelhalter et al. (2002).

2.2 Theoretical Background

England and Verall (2002) fitted different probability for the payment of claims
in the general insurance industry. The distributions used by England and Verall
were particularly helpful in binomial models. Other papers using Bayesian meth-
ods which includes earlier research by Ntzoufras and Dellaportas (2002) de Alba
(2002) used Bayesian methods to model outstanding liabilities constituting claim
frequency uncertainties. In this thesis, model and parameter likelihood were fac-
tored into the analysis following the application of Bayesian modeling method
that was used Gelman et al. (2004, section 6.7). The explicit use of probabil-
ity to estimate uncertainty is an indispensable characteristic of Bayesian analysis.

In Bayesian inference, originates from utilization of the proposition established

by Reverend Thomas Bayes in 1764. The Metropolis-Hastings algorithm which
was also was instituted by Hastings as the generalization of the Metropolis algo-
rithm in 1970 (Metropolis et al., 1953). Geman and Geman (1984) also proposed
the Gibbs sampler as a special case of the Metropolis-Hastings algorithm. Scoll-
nik (2001) contributes an explicit demonstration on assuming Bayesian Inference
using Gibbs Sampling (BUGS) in actuarial modeling. This takes into account
the accident and development year for the modeling process in addition to the
parameter error to calculate reserve.

Turner et.al (2010) stated that the current financial crisis, that commenced in

8
2007, exhibited the peril of depending on easier models and surged increasing
demand for dependable and the quantitative peril control. In fact, complex sys-
tems are undesirable in insurance discipline however, as financial system becomes
more complex, it’s utilization becomes inevitable. The Bayesian method renders
the platform to widen the evaluation to more complicated models. The pre-
cise sample is delicate element since it avoids valuation errors. Again, Bayesian
technique has the ability to incorporate prior knowledge in the model for analysis.

Generally, unpredictability in actuarial uncertainty arises from the primary sources,

specifically, the elementary framework, the stochastic nature of the model and the
parameter estimates of the model (Draper, 1995;Cairns, 2000). In the research
work “Quantifying the model and the uncertainty of the parameter in general
insurance”, Cairns(2000) chose Bayesian procedures and based his research on
the exhibition that modifying the results of modeling task is always relevant
when considering the uncertainty of the parameter and the model utilizing the
Bayesian methodology. Similarly, Hardy (2002) utilized the Bayesian model in
risk control calculations for equity-linked general insurance to study uncertainty
of the parameters and the model. The most common simulation procedure used
in Bayesian technique is the Markov Chain Monte Carlo procedure, that is em-
ployed when they are inapplicable or accomplishable through computations to
sample undeviating from the posterior distribution.

The Markov Chain Monte Carlo procedures are employed in numerous and broad
field of insurance that goes beyond Bayesian statistics and they are immensely
strong and very dependable when circumspectly adopted. In particular, the
Bayesian procedures facilitates uninhibited path to estimate forecast distribu-
tions that are much more enlightening than uncomplicated density point esti-
mates. Klugman (1992) and Dickson et al. (1998), with available obsolete claim
data, Bayesian future forecast are based on the posterior predictive densities of

9
the overall claim count and the overall claim amount. Therefore, the predic-
tive distributions include both the unpredictability of the stochastic model and
the parameter uncertainty, Cairns (2000). Again, using Bayesian prediction, the
credibility intervals for the essential features of the overall claim count and the
total claim amount, such as the mean, median, standard deviation, quartiles, etc.

Bayesian estimation were examined by Guttman and Draper (1971) for the bi-
nomial sample size n based on r independent binomial observations, each with
parameters n and pi. The pi unknown case arises in capture-recapture experi-
ments for estimating population size n. The difficulty is that dissimilar models
could fit the dataset suitably and still produce rather totally different forecasts. A
recent encompassing Bayesian research paper pertaining to the capture-recapture
issues as demonstrated by earlier research works by Smith (1991) and King and
Brooks (2001). Madigan (1997) clearly reported model unpredictability tasking
prior distribution across discontinuous models and the section distributions of
the data surveillance with regards to duplicated sampling. Johnson and Feinburg
(1999) examined several classical and Bayesian remedies to such difficulties, with
prime interest on procedures to allow heterogeneity in catch ability for all the
subjects. Fienberg and Dobra in (2001) employed a complete Bayesian require-
ment of Rasch model to compute the magnitude of the World Wide Web (www).

The prevalent peril model for the total claims A = C1 + · · · + CN , where C1 , C2

denote the values of sequential claims (suppose independent and identically dis-
tributed), is a two-fold stochastic system with a count distribution g(n | Θ) and
a claim distribution f (z | θ). The Bayesian model is basically focused primarily
at assessing the posterior distribution of γ, Θ and the predictive distribution of
A, with the available archival data on the claims and the sum of the claims fre-
quency at different timing (Rytgaard, 1990). The Bayesian and Markov Chain
Monte Carlo techniques could permit, in proposition, the practise of the Bayesian

10
model. Verrall (1990) conducted an experiment with Bayesian and Markov Chain
Monte Carlo techniques on chain ladder methods for non-life insurance analysis,
that must be explained as the two-way model: log(Xij = γ + αi + βj + εij )
nonetheless efforts were not created to handle the variance that are unknown in
a complete Bayesian fashion.

Other relevant references in the Bayesian publications that can have influence in
the future usance of the Bayesian procedures in the actuarial fields are Bernardo
and Munoz (1993), in their research Bayesian examination of the population
density datasets are studied; Chen and Berger (1993), made the usage of a multi-
nomial framework to forecast the structure of a retirement activity; Schluter et
al. (1997), used the Bayesian techniques formed for queuing risky motor traffic
accident topographic points; Denison et al. (1998) focuses on issues relating to
evaluating a broad category of curves employing the piecewise polynomials, and
Walker et al. (1999) in related research works, a nonparametric procedure is used
to estimate predictive survival curves.

It is well known that insurance risk models and queuing systems are mathemat-
ically closely related. Therefore, numerous Bayesian and Markov Chain Monte
Carlo are utilized for queuing systems existing in the literature; Armero & Ba-
yarri (1994), Rios et al. (1998) Armero & Conesa (2004) and Ausin, Wiper &
Lillo (2004, 2007). Actuaries are prevalently employing the Bayesian and Markov
Chain Monte Carlo methods for studying complex actuarial models. However,
the approach worked perfectly and smoothly with ultra-fast computers coupled
with good processing power and concurrently quick enhancements associated to
stochastic methods, incorporating other procedures, such as Markov Chain Monte
Carlo approaches hence the Gibbs sampling (Gelfand and Smith,1990).

As diversity of the modern utilization of Bayesian citations substantiate, the

11
Bayesian and Markov Chain Monte Carlo methods are so universally applicable
and simple to utilize than the category of other best fit models for the avail-
able data are only restricted by the user’s imagination. MCMC methods have
been used in several recent Bayesian analysis of models with different magni-
tude, taking into account involving for instance integer-valued parameters, nu-
merous change points (McCulloch and Tsay,1994) and finite mixtures (Diebolt
and Robert, 1994). Although standard Markov Chain Monte Carlo theory is not
applicable in situations where the elements of the parameter space is variable, fur-
ther research were conducted involved enhanced and specialized Markov Chain
Monte Carlo algorithms for such analysis.

For instance, Green (1994) offers a ‘reversible jump’ Metropolis-Hastings algo-

rithm for dealing with an unspecified digits of changepoints in Poisson process,
such methods used a similar procedures in comparing competing hypothesis in
pattern theory. Grenander and Miller (1994). Bayesian data analysis offer prag-
matic procedure for illustrating inferences regarding unsighted measure from the
data utilizing the probability models for the sighted and unsighted quantities.
The usage of Bayes and empirical Bayes methods for the studying of Poisson
data in general insurance and the entire actuarial science applications, involving
the consideration of Poisson/gamma models for non- life insurance claims, was
discussed by Makov et al. (1996), Haastrup (2000), Ntzoufras et al. (2005) among
others.

De Alba and Mendoza (1995) presented the Bayesian models for predicting with
firm seasonal structures when the data are primarily integers. Numerous diverse
exercises are mentioned and relevant instances are discussed. The advantage of
using the Bayesian technique is obtaining a full predictive distribution of the re-
quirement needed for reserve, from which the point estimate as well as probability
intervals are obtained. The Bayesian and Markov Chain Monte Carlo techniques

12
are robust stochastic models that make use of prior knowledge, again they can be
employed when there is no consensus on the prior knowledge or the researcher is
totally ignorant of any information, this thesis uses uninformative priors. Infer-
ences under these situations are defined as objective inference (Berger 1995, page
90).

A research was conducted which assumed Gibbs sampling by Geman and Ge-
man in 1984 to remedy elevated-dimensional model improving difficulties that are
inherent in linear structural models. An algorithm was recommended that em-
ployed the TMCMC (Transitional Markov Chain Monte Carlo) algorithm. Other
papers such as (Collins et al. 1974) invented Bayesian structural models up-
dating the insurance data using identified model parameters. A detailed and
complete Bayesian framework for model updating is further discussed by (Beck
and Katafygiotis et al., 1998). Bayesian analysis of IBNR (Incurred but not re-
ported) reserved has been considered before by Jewell in the year 1989 and Verrall
(1990) also researched into Bayesian application on insurance claims.

Jewell (1989) remedied the issue considering that in Incurred but not reported
claims in general insurance is a phenomenon whose chance of occurrence is fixed
exposure internally is unknown primarily due to the random reporting lags. Jew-
ell regards that the raw conceptualization of the Incurred but not reported issue
is normally estimated in the continuous time reflecting primary trait of contin-
uous reporting lags and the Poisson generation of claims. Jewell’s model gave
thought to non-identical sorts of data that are accessible, such as occurrence and
reporting dates should be made accessible. Jewell used a homogenous process
but conceded that this can be unduly limited.

Verrall (1990) examined the topic of forecasting pending insurance claims uti-
lizing the hierarchical Bayesian linear models, deliberating certainty of the chain-

13
ladder procedure is built on a linear models; namely the dual analysis of variance
model (ANOVA). Verrall basically analyzed a Bayesian analysis of the dual Anal-
ysis of variance model to derive Bayesian compound estimates. Bayesian models
are preprogrammed to report all the uncertainty in the parameters. They allow
the actuary to render not only point estimates of the desired reserves, and mea-
sures of dispersion such as the variance, again the complete distribution for the
reserves are all calculated. This makes it feasible to compute other risk measures.

In 1994 a research was conducted which re-examined the development of Bayesian

and Markov Chain Monte Carlo techniques to emphatic data studies by Lindley.
Their research predominantly focused on a dissertation in the 1970’s by Leonard
that progressed from an earlier work by Lindley (1964). Albert’s article on en-
cyclopedia aimed at modern advancements, such as model selection issues. In
fact, all current books printed lately that focuses on the Bayesian approach, have
central prominence on life contingency table, more comprehensive discussion on
categorical data studies and discrete data models are published by O’Hagan and
Forster (2004) and Congdon (2005).

Migon and Moura (2005) proposed a generalized collective risk model under
Bayesian framework to determine the premium for health insurance. They recom-
mended a full Bayesian model to take all uncertainty into account. The premium
is determined based on the past information about the number and size of the
claims and the population at risk, which is classified by time and age of the in-
sured population. The proposed model assumes that the total claim amount is
age dependent and priors are hierarchically distributed for each age class. Migon
et al. (2006) apply a similar methodology to two real data sets collected in Brazil.
They discussed the implementation of the collective risk model under a Bayesian
setting with stochastic simulation techniques.

14
Bayesian and Markov Chain Monte Carlo techniques are the broadly agreed
system for evaluating the data and its undetermined parameters (Andrieu et
al., 2003). In similar usages, ranging from minor to averaged volume datasets,
Markov Chain Monte Carlo & Bayesian methods have tremendously been suc-
cessful in numerous actuarial field especially insurance, pensions and statistical
practice in general. For instance, applied actuarial principles have witnessed a
substantial development in the utilization of Bayesian and Markov Chain Monte
Carlo hierarchical models for evaluating multistage or related dataset in diverse
areas comprising education and health (Louis & Carlin, 2000).

While Bayesian, Markov Chain Monte Carlo procedures and the computing mech-
anisms backing, supporting them have transformed the actuarial applications.Bayesian
& Markov Chain Monte Carlo methods constantly depend heavily on computing
algorithm that calculates thousands and to some extent over millions of laps us-
ing the available data. Moreover, conventional algorithms mostly initiate with
an implied “load data into memory” stage. These traits makes Bayesian investi-
gation of massive datasets computationally heavy.

To date, Bayesian & Markov Chain Monte Carlo applications are prevalent in
actuarial fields among them are loss reserving. However, brief work has been
done from the Bayesian & Markov Chain Monte Carlo viewpoint. In countless
situations, Markov Chain Monte Carlo & Bayesian techniques can render inves-
tigative compact models for variables of the predictive distributions e.g. the
outstanding insurance claims and the predictive distributions inference are inves-
tigated directly from the distribution and the properties, such as quartiles are
utilized for this basis.

Nonetheless, whenever the predictive distributions are not common types, or

if it is not in alignment with the closed system, it becomes feasible to obtain

15
equivalents by utilization of the Monte Carlo simulation procedures. The com-
mon substitute approach for the implementation of unmediate Monte Carlo, the
random values are obtained without deviation from the realized distributions,
that are presumed to be accessible in an expressed type (Turner, 1996, p 54).
One way of analyzing the data when it is not a complicated distribution is to
make use of the Markov Chain Monte Carlo technique.

To terminate the initial running of the data in order to reduce the effect of
all non-spatial risk factors, Dimakos and Frigessi di Ratalma (2002) suggested a
complete Bayesian method to general insurance premium rating, which was based
on hierarchical models with latent variables for both number of claims and claim
severity. Inference is based on the joint posterior distribution and is analyzed by
using Markov Chain Monte Carlo methods, rather than plug in point estimates
of all unknown parameters.Considering all sources of uncertainty simultaneously
when the model is utilized to forecast claims and estimate risk premiums. Numer-
ous models are fitted to both the simulated data and a small portfolio regarding
such as theft from cars. Numerous procedures are utilized in practice to calculate
the reserve, the Bornhuettor-Ferguson, the chain ladder and the average cost per
claim are the prevalent procedures. Provided the data to be analyzed is available,
the claim sizes will also be available and the prime interest is therefore to focus
on the Chain Ladder method.

2.3 Bayesian and Markov Chain Monte Carlo

(MCMC) Applications in Actuarial Science

Implementations of Bayesian and Markov Chain Monte Carlo techniques in life

insurance are more scarce. In a research conducted by Zaglauer and Bauer (2008),
life insurance policies were evaluated in relation to stochastic interest rate. Za-
glauer and Bauer’s methodology was based on Bayesian and Markov Chain Monte

16
Carlo methods in addition to discretization process.

Hardy (2002) employed Markov Chain Monte Carlo and Bayesian techniques
to analyze equity-linked insurance. Again, in 2008 research was conducted by
Goodman and Smith concentrating on models pertaining to large numbers where
models for the utmost values of numerous general insurance claims, Goodman and
Smith (2008) used improved techniques of Bayesian and Markov Chain Monte
Carlo techniques for inference. Bayesian and Markov Chain Monte Carlo tech-
niques are employed entirely in the modeling process, for instance the Gibbs
sampler in the evaluation of the actuarial set model. They recommended actuar-
ial models are utilized for simulating processes to examine the consequence of the
economic and financial cycle on the required pure initial risk reserve and premium.

In 1965 Good commented in his dissertation that, the utilization of Bayesian and
Markov Chain Monte Carlo method for calculating contingency tables and its
related multinomial probabilities, applying Dirichlet prior distribution. Good’s
dissertation was a groundbreaking thesis primarily because of its adaptation of
Bayesian hierarchical and empirical techniques. Good’s concern in this subject
evidently originated from his profession as a serviceman in 1941 World War where
he was the deputy statistician to A Turing on military agency intelligence prob-
lems throughout World War II (Good, 1980).

In life insurance, evaluations comprises of implied alternatives symbolizing a con-

sequential risk to the insurance company underwriting the policies. The interest
over implied alternatives are again represented in a modern control processes: a
major clue of the intentions of the Solvency II scheme is to uplift and render
motivation for insurance companies to quantify and administer risks more appro-
priately. Again, financial accounting demands an assessment of the trading value
of implied alternatives at equitable value, for instance in the European Commis-

17
sion which was researched by Schmeiser (2006) and Ronkainen et al. (2007).

Market coherent valuation of life insurance policies have become famous research
field among actuaries and financial mathematicians; Lukkarinen and Tanskanen
(2003), Bauer et al. (2006) and in the year 2000 Grosen and Jorgensen also did
similar work on the topic area. Gschlobl and Czado (2007) discussed quantita-
tive frameworks for the frequency of insurance claims and the claim amount in
general insurance under Bayesian context. The premium is calculated based on
the simulated aggregate claim amounts. They analyzed the number of claims and
claim amounts separately, which was initially discussed by Frigessi and Dimakos
(2002), by supposing a spatial Poisson regression model representing the number
of claims and a Gamma model for the average claim size per policyholder.

2.4 Review of the Motor Insurance in Ghana

In 2015, insurance companies agreed to sell insurance cover at a cost of GHS 1.30
a day making it the first time that automobile owners can purchase insurance
on a very short-term basis. By this new policy, which was planned to commence
on 08/06/2015, vehicle owners can purchase insurance for at least on a monthly
basis which however covers a cost of ten to twenty per cent more than when one
buys an insurance policy annually. As a result of the contract, the annual charges
for third party insurance will now cost GHS 471 for private cars which hitherto
cost GHS 70 ; while that of commercial taxis has been priced at GHS 576 per
annum.

According to the 2015 motor insurance duties, contracting and enforcement reg-
ulations authorized for implementation by the General Insurance Council, third-
party insurance charges for mini-buses famously called “Trotro” has then again
been set at GHS 586 with motorcycles required to pay GHS 256 for an insurance
premium. The sharp increase in the third party insurance tariffs have multiplying

18
effect on basing comprehensive insurance policy, since there is always third party
element in the charges paid for a comprehensive cover.

Even though the face value of third party insurance has gone up substantially,
insurers have explained to the Business and Financial Times that the increment
will help insurance companies to support third party road accident victims by
paying claims when they are reported. It is understood that all stakeholders,
including the Ghana Insurance Association and National Insurance Commission,
have agreed to the increment as input costs of insurance firms have all gone
up. This is the first time in five years that motor insurance premiums has been
increased and will take effect June 8, 2015. This will aid insurance companies
compensate vehicle passengers that may be involved in an accident.

Initially, motor indemnity cover was purchased by the insured annually and in-
surers believe this new motor underwriting guidelines of selling motor insurance
will make it flexible and allow insurance companies to meet increasing third party
claims. “In 2010, the cedi was trending at GHS 1.47 to a dollar. Today, it cost
GHS 4 to a dollar within the same period, inflation has increased from 8.58 %
to 16.8 %, fuel prices have also increased from GHS 1.75 per liter to GHS 3.3.
Tariffs for utilities have surged, road traffic accidents and injuries are the ever
increasing liabilities assumed by underwriters; all under the third party injury
and death and personal injury claims”. There is no doubt adhering charging
the same premiums would ultimately crumble the motor insurance portfolio and
destabilize the strength to effectively meet its obligations.

Ghana Insurers Association (GIA) has stated that measures are firmly in place
to ensure insurers comply and therefore motor insurance companies would not
be positioned to get “unfair advantage”. We recommend motor insurance com-
panies to abide the strict compliance with the new tariff and underwriting and

19
implementation guidelines. Clandestine monitoring arrangements have been en-
acted, and those underwriters who are detected contravening to the new tariff
regulations will severely be dealt with, the Chief Executive Officer of the Ghana
Insurers Association, Atsu Kosi Menyawovor said in correspondence to insurers
sighted by Business and Financial Times.

2.5 Estimation Models in Europe

In Europe, Bayesian methods are the widely used procedures in risk analysis.
In the framework of Solvency II project, the European Commission charged the
Committee of European Insurance and Occupational Pensions Supervisors to es-
tablish well detailed solvency and governing benchmarks to permit a convergent
and harmonized application across EU of the universal cost-effective propositions
in the evaluation of the general insurance professional provisions and obligatory
solvency capitals. The Solvency 2 draft Directive framework, European Commis-
sion: Solvency II draft directive. Available at: http://ec.europa.eu/ , (2007), the
technical provisions shall have the following definition: “The value of the expert
provisions must correspond to the sum of the satisfactory quantity and uncer-
tainty perimeter; the well suited assessment must be equivalent to probability-
weighted average of upcoming cash revenues, considering the time value of money,
employing the pertinent risk-free interest rate term framework; the risk margin
must certify the expenses of the professional arrangements are approximate to the
value insurance and reinsurance tasks could be anticipated to demand in order
to take over and conform to the reinsurance and insurance obligations”.

Despite the fact that classical or modern experience are regularly recommended
source from which modern anticipations of forthcoming skills may be obtained
for a specific portfolios, present evaluations of cash flows cannot always comprise
replication of present skill and experience. Moreover, granting all this the realized
experience can be significant to the portfolio as it remains amid the realization

20
cycle, the modern portfolio that forms the basis of evaluation are being developed
might vary in numerous disciplines in some instances, it is contended that the
present portfolio is normally divergent than the recognized portfolio.

An actuarial model by Wuthrich in 2008 was one of the pioneer models that
were developed to measure the one year time horizon so as to evaluate the un-
predictability in claims reserves. Wuthrich et al. (2008). With this model and
an available closed-form expression of the one year unpredictability of claims
reserves, is among the numerous standardized methods for analyzing particular
parameters for reserve risk. As an encouragement for modifying the modeling
methodology in non-life insurance, actuarial claims reserving can turn to the re-
cent regulatory standards of Sarbanes-Oxley, [Pub.L. 107-204, 116 Stat. 745,
enacted July 30, 2002] (102). Claims reserves are considered as a significant ac-
count, hence the role of actuarial modelling is in the spotlight since part of the
actuarial process is to perform claims reserving calculations.

The loss distribution method is an easy model that may be modified via imple-
mentation of the Bayesian family. Shevchenko et al. (2006) established Bayesian
framework under loss distribution method model but confined attention to cat-
egory of number and size models to those that accept conjugate distributions.
That allows accessing the posterior distribution simulation easy and the param-
eter estimates could regularly and analytically be obtained. Recent Bayesian
approaches have been extended from limited conjugate modeling, that has been
feasible by the building of advanced simulation techniques for instance the Markov
chain Monte Carlo, sequential Monte Carlo (SMC) algorithms and importance
sampling (IS) [Doucet et al. 2006; Peters, 2005].

21
2.6 Estimation Models in Ghana

In Ghana, the classical or frequentist approach is prevalent in that, the forecast

are based on perpetual term iterated situations. Another major reason that has
contributed to the use of frequentist approach has been obtained by disregarding
any prior information concerning the method being evaluated. Yet, in insurance,
there is some prior knowledge about the process being measured. However, dis-
carding this prior information as insignificant may have economic and monetary
consequences on the insurer.

Lastly, the frequentist approach commonly used by insurers in Ghana, is an effec-

tive tool for addressing the risk classification and related issues where decisions
must be made on the basis of imperfect information.

22
 Chapter 3

Methodology

3.1 Introduction

This chapter describes the research design, study setting, sampling technique,
data collection procedure and ethical consideration. This chapter includes the
model used in analyzing the data of the study.

3.2 Type and Source of Data

The data under consideration is a secondary data obtained from a renowned

insurance company in Ghana. The insurer is an expert in both life and non-life
insurance in Ghana. Nonetheless, for the purpose of this thesis, motor insurance
data would be considered. This comprises of comprehensive, third party only
and third party (fire and theft). The data spans from January 2004 to December
2013.

3.3 Description of Model

In this thesis, Bayesian techniques with Markov Chain Monte Carlo procedure
are utilized. These procedures are input in computer software called WINBUGS.
This Bayesian and MCMC techniques consist of the following steps.

• state a Bayesian model

• develop a Markov chain that has an expected distribution of the joint pos-
terior distribution of interest

23
 • run the chain until output converges in distribution to draws from the target
distribution

• base inference regarding unidentified parameters in the simulated outcome

of the model with successive iterations of the chain.

To initiate the Bayesian technique, the unknown parameters are random vari-
ables. It is assumed Y is a distribution of a continuous random variable that
relies on a given parameter then θ is considered as the realization of the random
variable Θ, which features the prior knowledge called the prior distribution π(θ)
is the probability density function (PDF). The conditional density of Y given θ
is denoted as fY (y | θ), with reference to the available data under consideration
Y = y , the distribution of θ is updated, hence the distribution of f (Θ | y),is
generated known as the posterior distribution and it decreases the quadratic loss
function.
Mathematically;

fΘY (θ, y) = fY |Θ (y | θ)π(θ) (3.1)

Where fΘY (θ, y) is the joint density function of Θ and Y .

Integrating Θ gives the marginal distribution of Y:

Z 0
fY (y) = fY |Θ (y | θ)π(θ)dθ (3.2)
Θ

Moreover,
fΘY (θ, y) = π(θ | y)fY (y) (3.3)

π(θ)fY (y | θ))
π(θ | y) = R (3.4)
f (y | θ0 )π(θ0 )dθ0 )
0
The denominator is integral over the range of θ ,it depends only on y and is
written as
π(θ | y) ∝ π(θ)fY (y | θ) (3.5)

24
That is known as conjugate prior and it’s associated to priors for which the pos-
terior is member of the same family of distribution. The prior is characterized as
uninformative, to reduce the likelihood that it manipulate the data, such prior
distribution is called the vague or uninformative, nevertheless no prior is com-
pletely ignorant. Jeffrey’s prior is aimed at providing uninformative priors.

3.4 Markov Chain Monte Carlo

Lately, a procedure for calculating the probability of uncommon events that is

based on Markov Chain Monte Carlo techniques have been created (T. Gud-
mundsson and H. Hult, June 2014). The fundamental aim is to construct a
Markov chain through a Markov Chain Monte Carlo sampler, employing the in-
variant distribution as the conditional distribution given that the event of interest
happens. Concisely, simulation is defined as the method of sampling the elemen-
tal random factors that produces numerous precedents of the model.

These multiple cases of the framework, termed the sample, the researcher is
previewed on the experiment being modelled and it is utilized to make inferences
concerning the properties. This has established to be the right tool for com-
putation. Generating cases of extremely modified models, multi-dimensional,
non-linear and stochastic models can be estimated in milliseconds. Stochastic
simulation has therefore performed a key role in the scientific progress in recent
decades and simulation itself has advanced into an academic applications in its
own right.

Markov Chain Monte Carlo algorithms are of different forms. However, two
of the algorithms are basic and widely utilized, these common algorithms are
the Gibbs sampler and the Metropolis-Hastings algorithm. Some actuaries have
long contended that Bayesian techniques are the most suitable for a wide range
of issues, pragmatic evaluation procedures were non-existent until Markov Chain

25
Monte Carlo (MCMC) procedures became operational. Relevance sampling is a
suitable tool, but for composite frameworks masterminding a sensible sampling
distribution can be very laborious. The compilation (Gilks et al., 1996) comprises
of a comprehensive inauguration of MCMC techniques along with a different kind
of interesting applications and instances.

Markov Chain Monte Carlo methods is primed at initiating draws from pos-
terior density function, f (θ | X). Importance sampling derives independent
draws and associated weights, Markov Chain Monte Carlo techniques developed a
Markov Chain, obtaining the dependent draws, θ1 , · · · , θM , have stationary den-
sity f (θ | X).

Normally it is simple to develop such Markov chain with less fundamental schemes.
Nonetheless, there occurs a method utilized in developing a powerful chain and as-
sessing for convergence of the chain. This procedure has the strength to tune the
proposal distribution which is usually altered so that proposals are not accepted
or not rejected too often. Another positive of Markov Chain Monte Carlo is there
is no strict requirement to calculate the normalization constant of f (θ | X) which
annuls in numerical calculation.

3.4.1 Metropolis-Hastings Algorithm

This algorithm which is a type of Markov Chain Monte Carlo is frequently uti-
lized in physics, however, Muller P. (1993) and Tierney L. (1994) expounded the
application of the algorithm to statisticians. The algorithm is extremely robust
and dynamic and it is incorporated in a catalogue of ‘top 10 algorithms’ (Dunga-
ree J., Sullivan F. (2000)) and even asserted to be the most robust and versatile
algorithm of all time (Beichl I., Sullivan F. (2000)).

This algorithm could obtain samples from the target probability density π for

26
the uncertain parameters θ necessitating that the density could be estimated
at θ. The Metropolis-Hastings algorithm can thus be viewed as a generic type
of acceptance/rejection sampling with estimates obtained from equivalent distri-
butions which are ‘corrected’ so that they act asymptotically like the random
observations from the target distribution.

Markov chains are a stochastic processes {θ1 , θ2 , · · · , θn } such that π(θt+1 | θt , · · · , θ1 ) =

π(θt+1 | θt ) is always independent of time t. For θt to converge at the equilibrium
distribution, independent of θ0 , the Markov chain should be positive recurrent,
irreducible and aperiodic. To sample π(θ | y), Markov chain that has a poste-
rior distribution π(θ | y) equal to the stationary distribution is created. This
estimation is done by using the Metropolis -Hastings algorithm. It has these
steps;

• Set a initial value θ0

• Propose a new state θi from a distribution q(θ1 | θ0 ), which is called the

proposal distribution.

• The accepted proposal state has probability

π(θ1 | y)q(θ | θ1 )
p = min(1, ), (3.6)
π(θ | y)q(θ2 | θ)

specify θ1 = θ0 with probability p, otherwise set θ1 = θ0

• The routine is repeated for a number of iterations as such the stationary

distribution which equal to posterior distribution is attained.
π(θ0 )fY (y | θ0 )q(θ | θ0 )
p = min(1, ). (3.7)
π(θ)fY (y | θ)q(θ1 | θ)

fy (y) which is the normality constant does not display in p, thus making the
Metropolis Hastings algorithm suitable for Bayesian statistics. WINBUGS (com-
puter software), allows the computation of the Metropolis-Hastings algorithm and
the Gibbs sampling which is special case of Metropolis-Hastings.

27
The prevalent issue with the algorithm is convergence. However, the algorithm
does not automatically signal when the stationary distribution is attained up
to specific parameter error. Nonetheless, numerous diagnostics are utilized to
determine convergence. Gelman-Rubin diagnostics and Geweke convergence di-
agnostics are prevalent testing tools. Ultimately, the following steps are obeyed
when utilizing WINBUGS:

• Choose the initial value as θ0

• N values are generated till the stationary distribution is attained.

• Assessment of the convergence of the claims is done via several diagnostics.

• The first d observations of the process is discarded (burn-in period).

Once the first d iterations have been discarded, the precision of the posterior esti-
mates can be obtained by calculating their Monte Carlo error. In some situations
it is conventional that the algorithm must be re-run till the Monte Carlo error
for every parameter is less than 5% of its standard deviaton.

Lastly, the algorithm does not provide independent sample, hence the chain can
mix weakly and possibly lead to considerable autocorrelations. Thinning is a
procedure to reduce or avoid this.

3.4.2 Gibbs Sampler

This sampler is a peculiar occurrence of Metropolis Hasting Algorithm and is very

popular. The complicatedness of the model and the available data promoted the
use of Gibbs sampling analysis (Geman and Geman, 1984). Gibbs sampling is
a Markovian updating system which was primitively created in 1984 by Geman
and Geman as the suitable technique for resemblance rebuilding. Nonetheless,
the implementation to actuarial modeling has lately been exhibited (Gelfand and

28
Smith, 1990). The numerous capabilities of Gibbs sampling in complicated actu-
arial modeling are now pragmatic and recognized.

Implementation presently comprises of Bayesian cluster examination, change-

points issues, genetic linkage analysis (Mack et al., 1990; Thomas, 1991). Whereas
the applicability of Gibbs sampling is straightforward for fully conjugate Bayesian
models (Gelfand and Smith, 1990; Gelfand et al., 1990), non-conjugacy can cause
computational difficulties. In applying Gibbs to the estimation of generalized
linear models with random influence.

The Gibbs sampler is universally useful whenever the joint parameter distribution
is unknown explicitly but the conditional distribution of every single parameter
given that other relevant information is available. Numerous actuarial implemen-
tations of Markov Chain Monte Carlo use the Gibbs sampler, and that makes it
simple to utilize. The kind of sampling algorithm is well defined as follows.

Let X = (X1 , · · · , Xk ) be a collection of random variables. Given arbitrary

(0) (0) (1)
initial values X1 , · · · , Xk , we draw X1 from the conditional posterior distri-
(0) (0) (1) (1) (0) (0)
bution f (X1 | X2 , · · · , XK ),then X2 from f (X2 | X1 , X3 , · · · , Xk ) and so
(1) (1) (0)
on, until Xk , which comes from f (XK | X1 , · · · , Xk=1 ).

This framework dictates a Markov Chain, with balanced distribution f (X). After
(t) (t)
t iterations it lands at X (t) = (X1 , · · · , Xk ). Thus, for t large enough, X (t) can
be viewed as a simulated observation from f (X). Provided a suitable burn-in
time is allowed, the sequence X (t) , X (t+1) , · · · can be thought of as a dependent
sample from f (X).

Similarly, assuming the marginal distribution is to be evaluated from a variable

Y which is a function g(X1 , · · · , Xk ) of X. Estimating g at every X (t) renders a

29
sample of Y . Negligible moments or tail areas are estimated by the corresponding
sample quantities.

3.5 Models and Loss Distribution

Compound distributions have many natural applications. However, its applica-

tion is centered on general insurance. In separate motor underwriting policy, it is
desired to model the overall claims during a fixed policy duration for any motor
underwriting contract. Another procedure, that does not comprise of individual
examination of claim amount and number of claims are given by Jorgensen and de
Souza (1994), Jorgensen and Smyth (2002). A compound Poisson model, which
is termed as Tweedie’s compound Poisson model ascribable to its resemblance of
the exponential dispersion models, with the joint distribution been its reference
of the aggregate claim amount and frequency of claims. Smyth and Jorgensen
estimated the rate of claim, this is denoted mostly by the overall costs per expo-
sure unit, Smyth & Jorgensen utilized the Tweedie’s compound Poisson model to
analyze the claim.

In general insurance specifically motor insurance, numerous claims are possi-

ble. Motor insurance, property and casualty insurance are instances. In such
underwriting portfolio, the insurer has keen interest to model the overall claims
during a fixed policy duration for a catalogue of insured that are independent. In
the general insurance market, claims occur over a period of time, so the number
of claims over a period follows a Poisson distribution. In this thesis compound
Poisson distribution would be used to model the claim frequency. The compound
Poisson distribution is a model for representing the overall claims that emerge
from a portfolio of independent insureds. Compound Poisson distribution is a
continuous-time (random) stochastic process with jumps.

Let Ai,t be the size of ith in the year given as t, with ith = 1, 2, 3, 4, 5, · · · , Nt

30
and Nt denote the number of claims in year.

LetXt = Y1,t + Y2,t + · · · + YN,t (3.8)

be the total amount in the year t. It is assumed that:

• Nt ∼ P oisson(θ),for some 0<θ<∞,are independent and identically dis-

tributed for all t

• Yi,t are independent and identically distributed for all t, i.

• Yi,t and Nt are independent for t, i.

The Xt has the form of compound Poisson distribution.

Yi,t has loss distribution, a loss distribution is defined as a distribution that has
long tails to accept large claims and takes positive values.
In this thesis, Theta θ denotes the number of claims. Alpha α and Beta β denote
the claim amounts.

3.6 Loss Distributions

The Log-normal distribution and Pareto distribution are opted for as the preferred
loss distribution.

3.6.1 Pareto Distribution

The Pareto distribution is widely used in general insurance estimation; notable

examples are fire and motor insurance. It is among the heavy tailed models in
practical use and potentially conservative choice in evaluating risk more espe-
cially if the data under consideration has deductibles, the Pareto distribution can
model it suitably. Yi,t has loss distribution; a loss distribution is a distribution
that has long tails to take large claims and more so accepts positive values. As
such the Pareto distribution is a heavy tailed distribution and therefore a suit-
able candidate for modeling large insurance claims even above threshold. It is a

31
mixture of exponential and gamma weights.
Mathematically, the Pareto distribution is defined by the following functions;

P areto(α, β) : f (y | α, β) = αβ α y −(α+1) , y>β, α>0, 0<β<min yi,t .

The first parameter represents the lower bound on the possible values that a
Pareto distributed random variable can inherent. A few well known properties
are as follows ;

αK αK 2
E(X) = α>1; V ar(X) = , α>2
(α − 1) [(α − 1)2 (α − 1)]

3.7 Lognormal Distribution

The lognormal distribution is mostly used to model claim size in general in-
surance. Assuming a positive random variable Z follows a normal distribution.
Hence Z follows a lognormal (α, β 2 ) distribution if its density function is given
by;
1 −(log y − α)2
Lognormal(α, β) : F (y | α, β) = √ exp , (3.9)
y 2πβ 2β

α>0, β>0and y>0.

The lognormal distribution has the following properties;

α2
E(Z) = exp(α + )
2

and variance V ar(Z) = exp(2α + 2β 2 ) − exp(2α + β 2 ). In motor insurance the

lognormal distribution was employed by Henry (1937 ), Bailey (1943) and Hardy
(1968) for the authentic claim size falling under excess of loss reinsurance and
Bickerstaff (1972) for the amount of accident claim. O’Neil and Wells (1972)
reported that the two parameter log-normal distribution mostly fit the damage
claims, especially in motor insurance, the claims are often classified into homo-
geneous categories for instance claims for damage peculiar to motor brands and

32
varieties.

Accident claims categorized by age of driver required the three parameter model.
Some researchers stated that classifying data by logarithmic increment enhanced
the fit and importantly increased the efficiency of the parameter estimates. They
suggested the entropy matrix for classified data, for iterative corrections to a set
of initial estimates. In other related research works of insurance, Finger (1976)
utilized the lognormal for claim amount in liability insurance.

3.7.1 Prior Distribution

Certain Prior distribution is particularly convenient for use with samples from
specific distributions. Therefore, when samples are taken from Poisson distribu-
tions the family of gamma distribution is the conjugate family of prior distribu-
tion.
P osterior ∼ Likelihood × P rior (3.10)

Proof:
Assuming X1 , · · · , Xn from a random sample a Poisson distribution for which the
value of the parameter θ is unknown (θ>0) again, supposing the prior distribution
of θ follows gamma distribution with given parameter α and β(α>0and β>0).
Then the posterior distribution of θ given Xi = xi (i = 1, · · · , n) follows a gamma
distribution with parameters α + ni=1 0 and β + n.
P

Let y = ni=1 then the likelihood function is the joint pdf fn (X | n) of X1 , · · · , Xn

P

is given by;

θx−1 e−θ θxn e−θ

fn (X | θ) = f (X1 | θ) · · · f (Xn | θ) = ,··· , (3.11)
x1 ! xn !
y −nθ
θ e
= (3.12)
x1 ! · · ·!, xn !

33
The prior pdf of θ is

β α α−1 −βθ
p(θ) = θ e f or θ>0 (3.13)
Γ(α)

Since the posterior pdf p(θ | x) is proportional to the prior fn (X | θ)p(θ),

It follows that
p(θ | X) ∼ θy+α−1 e−(β+n)θ f or θ>0 (3.14)

The right side of the equation can be recognized as being Poisson distribution ex-
cept for a constant factor, equal to the pdf of gamma distribution with parameter
α + y and β + n can easily be determined as

(β + n)α+y
(3.15)
Γ(α + y)

However, this prior has a large variance so does not influence the posterior dis-
tribution. A large distribution variance is suggestive of uninformative or vague
distribution which exhibits the parameters.

3.8 Testing for Convergence

A crucial test in the application of Markov Chain Monte Carlo processes is conver-
gence. Convergence determines when it is secure to halt sampling and utilize the
outcome to evaluate and estimate characteristics of the distribution of interest.
Several analysis have been done computing the process to reach convergence.
Therefore several procedures are advocated primed at assessing and speeding
Markov Chain Monte Carlo sampler convergence, involving applying diagnostic
methods to few number of parallel chains, monitoring autocorrelations and cross-
corrections and modifying parameterization or sampling algorithms rightly.

Bayesian analysis employs the MCMC methods to appraise complex and often
high-dimensional integrals in order to acquire posterior distributions for the un-

34
observed quantities of interest in the model (missing data, unknown parameters
and predicted future data). The diagnostic procedures that would be used in this
paper are ;

• Visual inspection of history plots

• Autocorrelation

• Brook-Gelman-Rubin test

• Monte Carlo Error Estimation

3.8.1 Visual Inspection

One way to assess the claims have converged is to sight if the chains have mixed
well or moving around the parameter space. This can be checked through visual
inspection. The inspections must be done for every parameter. For instance, the
figure below shows alpha has converged and can be inspected visually.
The figure below shows the trace plot of a parameter α.

Figure 3.1: Trace plot of a parameter,α

The trace plot does not show obvious pattern and thus mixes well. It can also be
observed that the chain has reached convergence at the 4000th iteration. However;
visual inspection may not be applicable in all states.

35
3.8.2 Autocorrelation

Alternative path to examine the convergence of the chain is by checking the

autocorrelation between the draws of the Markov Chain. At a given lag say K,
the autocorrelation given by ρK measures the relationship between the K th lag
and its draw. It is expressed as;

Pn=k
(Xi − X̄)(Xi+k − X̄)
ρ = i=1 Pn 2
i=1 (Xi − X̄)

The K th lag autocorrelation is always anticipated to decrease as K appreciates

(e.g 2nd and 4th draws must be more correlated than 2nd and 50th draws). As-
suming the autocorrelations are comparatively high for bigger figures of K, that
symbolizes high level of correlation between the draws and also depicts good
mixing hence convergence.

3.8.3 Gelman and Rubin Multiple Sequence Distributions

Procedures (for every parameters)

• Execute m ≥ 2 chains of length 2n from overdispersed initial values

• Dump the starting n draws in every chain.

• Estimate the within-chain and between-chain variance.

• Estimate the evaluated variance of the parameters as a weighted total of

the within-chain and between-chain variance.

• Calculate the potential scale reduction factor.

1. Within Chain Variance

m
1 X 2
W = S (3.16)
m j=1 j

36
 Where
n
1 X
Sj2 = (θij − θ̄j )2
n − 1 i=1

W is the the mean of the variances of every chain and the Sj2 is the expres-
sion for the variance of the j th chain. W underestimates the true variance
of the stationary distribution given that the chains may not have reached
every points of the stationary distribution.

2. Between-Chain Variance

m
n X
B= (θ̄j − θ̄¯)2
m − 1 j=1

1 Pm
Where θ̄¯ = θ̄j Is the variance of the chain means multiplied by n
m j=1
because each chain is based on n draws.
Estimated Varaince
The variance of the stationary distribution as a weighted average of B and
W.
1 1
V ar(θ) = (1 − )W + B
n n

Due to the overdispersed nature the of starting values, this overestimates

the true variance, but unbiased if the stationary distribution equals the
starting distribution.

3. The Potential Scale Reduction Factor

Potentional scale reduction factor is given by;

r
V ar(θ)
R̂ =
W

When R̂ is high (R̂>1.1 or 1.2), then the chains must be re-run to enhance
convergence. If the parameters are more than one, then it is necessary to
compute the potential scale reduction for all the parameters. The process
is repeated until the potential scale reduction factors are very small.

37
3.8.4 Other Convergence Tests.

A more precise technique is the application of Gelman-Rubin statistics. WIN-

BUGS employs updated form of the original Brooks-Gelman-Rubin (BGR) test.
Nonetheless, there are other convergence diagnostics such as Raftery & Lewis
(1992), Heidelberger & Welch (1983) and Geweke (1992). Another procedure by
which convergence can be tested is by using Monte Carlo standard error, which
are computed in WinBUGS. The batch means method is the procedure used to
compute the Monte Carlo Standard error.

3.9 Prior Sensitivity

Sensitivity of the prior parameter is a crucial part of the general sensitivity set-
ting (Berger et al., 2000; Ruggeri, 2008), as it is crucial in any Bayesian analysis
to assess the prior distribution influence before inferences are made. In order to
check the prior sensitivity, the posterior distribution is studied using a variety of
prior distributions.

There are mainly two procedures for sensitivity analysis. These are the global
and local methods. The global examines a family of all priors in accordance with
the requested prior information and computes the scope of the posteriors as the
prior varies over the family. The scope is typically estimated by determining the
‘extrema” priors in the family that return maximally remote posteriors without
explicitly carrying out analysis for each prior in the family. On the contrary,
the local sensitivity approach is focused on the modification with regard to the
changes in the prior and mostly utilizes differential calculus to gauge it. How-
ever, the global approach is unpragmatic in the Bayesian hierarchical framework
whereas the local approach is a method of choice (Gustafson, 2000;Sivagenesan,
2000;Zhu et al., 2007;Perez et al, 2006;Muller, 2012).

38
The local sensitivity approach is casually used in complex Bayesian techniques.
It informs which parameters are difficult to study from the data and create the
awareness of the priors concentrate at the start of model building. It can also
be used to assist in determining which priors require more concern. A Bayesian
model is said to be sensitive (non-robust) with regard to the prior information
if its posterior distribution changes when the base prior parameter values are
modified thinly. Therefore the construction of Bayesian models without subject-
ing it to prior sensitivity diagnostics would make the model bias and to some
extent questionable. To assert the reliability of the chosen model it is necessary
to conduct the robustness check. Recent practice is to supply two set of numbers

1. Comparisons of marginal priors and Posterior distributions.

2. Comparisons of posterior results over a small number of prior variations,

such as increase of the prior and likelihood.

In this research work, exponential distribution is compared to the base prior

(Gamma distribution) to probe the model robustness.

3.10 Selection of Priors

Bayesian and Markov Chain Monte Carlo Methods are employed to analyze the
data, since very little or no information is available about the real values of the
parameters, vague Gamma priors would be used.

The vague priors used follows Gamma priors;

α ∼ Gamma(1, 0.001),

β ∼ Gamma(1, 0.001)

39
, with the restriction that 0<β<min yi,t = 123, 845.83

θ ∼ Gamma(1, 0.001).

The restriction is placed on beta, β because sampling cannot be conducted beyond

the minimum value of the claim amount. Otherwise, the process would return an
error.

40
 Chapter 4

Results and Analysis

4.1 Introduction

This chapter presents the data analysis and discussion of the results of the study.

4.2 Preliminary Analysis

This preliminary analysis consists of the computation of the descriptive statistics

in relation to the data. The results are displayed in the table 4.1.

Table 4.1: Descriptive statistics of the data

STAT CLAIMS
DATA POINTS 132
MINIMUM GHS 123,845.83
MAXIMUM GHS 2,398,951.14
MEAN GHS 452,170.71
MEDIAN GHS 290,414.59
SUM GHS 59,686,534.24
VARIANCE GHS 1.51303 E+11
STANDARD DEVIATION GHS 388976.7945
SKEWNESS 2.463944143
KURTOSIS 7.48126212

The statistical analysis conducted on the data as displayed in the table revealed
that the motor insurance claims for years spanning from January 2004 to De-
cember 2014, the insurer paid an average claims of GHS 452,170.71. The insurer
paid a minimum and maximum claim of GHS 123,845.83 and GHS 2,398,951.14
respectively. The minimum claim for the duration under study was in February
2005 and the maximum claim was in December 2014. The surge in claims for all
the years especially in the month of December is particularly due to the Christ-
mas festive season when accident are rampant. The standard deviation of GHS

41
388976.7945 is an indication of how the claims are spread over wider range of
values.

A variation of GHS 1.51303 E+11 indicates that the claims are distributed around
the mean and from each other. The standard deviation is large which indicates
that there could be issues with payment of the claims. Skewness of 2.463944143
which is a positive skew is an indication that the tail is on the right side and
fatter on the left side. As a general rule the positive skew depicts that the mean
is greater than the median and both are greater than the mode. Kurtosis of
7.48126212 which also indicates high peaks and fat tails (Leptokurtic).

4.3 Running the Model using WinBUGS

To initiate WinBUGS, it is not required to define the posterior distributions, but

input the likelihood and prior model. This is followed by imputing the data for
the model and stating the initial values manually. However, WinBUGS can auto-
matically generate initial values which can be used for the prior distribution and
can be extended to compute complex models.

In this thesis initial values are generated automatically for alpha, beta and theta.
Then the model is hence initialized, if the three chain that are run in parallel con-
verge and satisfy’s the rule of thumbs, that is right indication that equilibrium
have been reached, before inference can be made. It is therefore necessary that
the various convergence tests are conformed to.

42
4.4 Checking Convergence for Poisson-Pareto Model

4.4.1 Visual Inspection

By visually inspecting the history plots of the parameter α (alpha), that illustrate
that the chains have blended suitably, which also does not show any particular
pattern. It can be observed that the chains have converged by the 1000th iteration.

Figure 4.1: History plot of α

Figure 4.2: History plot of β

43
 Figure 4.3: History plot of θ

4.4.2 Gelman Rubin Statistics

The Gelman-Rubin statistic is a more precise technique to test convergence. Win-

BUGS utilizes an updated form of Gelman-Rubin statistics known as the Brooks-
Gelman-Rubin (BGR) test.

Similarly, the chains are run in collimate, each commencing with arbitrary start-
ing values. The diagnostics is executed by analyzing the ratio of the within-chain
and between-chain variability (R), and the convergence is reached when R ∼ 1.
Their ratio in red, the average within-sample variance is mapped in blue and the
pooled posterior variance is mapped in green. The bottom two lines portray the
within and between-chain variations respectfully whereas the top lines represent
the ratio of the between and within-chain variations.

If the bottom dual lines stabilize and the top lines assemble to 1, then the chains
have converged. This can clearly be observed from the displayed graphs.

44
 Figure 4.4: Plot of α, β & θ chain

4.4.3 Autocorrelation

There are not substantial autocorrelations between the displayed output terms,
therefore systematically reducing the output term utilizing the mth sample (for
m ≥ 1 ). The autocorrelations were high so it was thinned by 10 which decreases
the autocorrelations for every lag ≥ 1. The low autocorrelation is thus accepted

45
representing independent random sample from the required distribution.

Figure 4.5: Plot of α, β & θ chain

4.4.4 Monte Carlo Error Estimation

This is also one of the procedures to check for convergence, an inspection of the
Monte Carlo standard error of the posterior mean. The method deployed to
estimate the Monte Carlo error is the batch method. As a rule of thumb, the
Monte Carlo for the parameters must be less than 5%. In the estimation, it is in

46
fact less than 3% which implies that the chains have converged.

Table 4.2: Monte Carlo parameters

Parameter α β θ
Monte Carlo Error 0.001175 132.3 0.006034

4.5 Prior Sensitivity

In this thesis, exponential distribution with vague priors is used to test the in-
fluence of the prior distribution on the target posterior distribution. Below are
tables that compares the sensitivity of the posterior distribution.

Table 4.3: Gamma Prior (1, 0.001)

Parameter α β θ
Posterior Mean 0.8676 109200.0 12.09

Table 4.4: Exponential Prior (1, 0.001)

Parameter α β θ
Posterior Mean 0.8676 109200.0 12.09

From the prior exponential distribution, the parameter statistics shows clearly
that the convergence and estimated parameters is indifferent to the gamma dis-
tribution. The same could be observed about other test such as Brooks-Gelman-
Rubin test among others. It can be observed that the prior does not have signif-
icant influence on the posterior, hence the chosen prior is robust and insensitive
to the changes in the prior distribution.

4.6 Model 1: Poisson-Pareto Model

Posterior distributions and the trace plots of the Poisson-Pareto Model for the
three parameters.

47
 Figure 4.6: Traces of α, β & θ chain

Inference
From the trace plot and posterior distributions, the parameters are well displayed
in the top left corner of graph. The vertical axis of the trace plot maps the value
of each parameter and the horizontal axis maps the number of iteration. From
the results, the evaluations of the parameters are rightly situated at 0.75 for al-
pha, beta centered at 1.25E+5 this abrupt fall is due to the minimum restriction
on the Pareto distribution and theta is positioned around 12.5. This is coherent
with the condition of simulation process. Nonetheless the parameters are subject
to the variation of the random error, therefore the graphs are unequal.

48
The dynamic trace plots oscillates rhythmically and the mean lines of the three
chains lay over, which is an indication of the solid convergence. There are chains
cycling from the mean. For instance at about 9850 in the alpha trace plots it
drops to 0.6, the same can be observed of beta and theta, however it cycles and
reverts to its mean. The density plots depicts most differences among the param-
eters. (Sample: 30,000) indicates the number of iterations in the density plot.
The density plot exhibit non-rational information.

The parameter beta has the largest mean of 109200 followed by theta with mean
value of 12.08 and alpha has the smallest mean of 0.867, but the overall mean
of each parameter is located at the midpoint except for beta that deviates to
the right. Alpha and beta are skewed to the left. The skewness shows a typical
length between the true inherent values and the prior information.

Table 4.5: Node Statistics

NODE MEAN STD MC error MEDIAN 95% Bayesian Interval

Alpha 0.867 0.1088 0.002045 0.8674 (0.657, 1.075)
Beta 109200 11850 229.3 112100 (81620, 123400)
Theta 12.08 1.06 0.0175 12.05 (12.05, 14.23)

4.7 Model 2: Poisson-Lognormal Model

4.7.1 Convergence

By visual inspection of the chains the process has mixed very well.

49
 Figure 4.7: Convergence of Poisson - Lognormal model

It can be observed from Figure 4.7 that the chains have mixed well indicating
convergence.

Brooks Gelman Rubin Test

50
 Figure 4.8: Brooks Gelman Rubin test

In the plots of the Brooks Gelman Rubin statistics, the upper lines are the
ratios of the between and within chain variations and the lower two lines repre-
sent the within and between chain variations respectively. If the bottom two lines
stabilize and the top line assemble to 1, then the convergence of the chains have
been reached as can be seen from the displayed graphs.

51
 Autocorrelation

Figure 4.9: Autocorrelation

The autocorrelations shows a high peak at lag 1, the remaining lags are low which
shows good convergence. Hence thinning is not necessary.

52
4.7.2 Monte Carlo Error Estimation

As stated earlier the Monte Carlo standard error procedure is one of the finest
techniques to check for convergence.

Table 4.6: Monte Carlo Error

Parameter α β θ
Monte Carlo Error 3.519E-4 0.00153 0.006009

In the above table the Monte Carlo error are all less than 5% which shows strong
convergence.

4.8 Poisson-Lognormal Model

Posterior Estimates of the Poisson - Lognormal Model for the three parameters.

Figure 4.10: Poisson - Lognormal model

Inference
Similarly, the dynamic trace and Kernel density plot depicts similar pattern. The

53
density plots of alpha oscillates near 12.8 which is approximate to the actual value
of 12.77. The dynamic trace plots shows that the iterations for alpha are cycling
evenly and does not show pattern. The inconsistent estimates shortly disappear.
In fact, the dynamic trace plot for all the parameters are oscillating finely.

Visually, the posterior distribution are well balanced and does not seem to show
any particular side it skews as compared to the Poisson - Pareto model. However,
there are changes in the posterior distribution as per the kernel density plot. The
mean of beta is centered at about 2.0 and theta at 12.5 which slightly deviates
from the actual value of 12.9. That notwithstanding, the posterior distribution
exhibits the conventional bell form curve for the parameters.

Credible intervals are equivalent to confidence intervals in the classical statis-

tics. Nonetheless they are doctrinally opposite. In classical statistics,the bounds
of confidence intervals are handled as random variables and the parameters as
fixed values. This is in sharp contrast in Bayesian credible interval which treats
the bounds as fixed while the parameters are random variables (Lindley et al.,
1965).

Table 4.7: Node Statistics

NODE MEAN STD MC error MEDIAN 95% Bayesian Interval

Alpha 12.77 0.05921 3.519E-4 12.77 (12.65, 12.88)
Beta 2.208 0.2706 0.00153 2.196 (1.711, 2.769)
Theta 12.9 1.052 0.006009 12.06 (10.11, 14.25)

The posterior estimates of the Poisson - Lognormal model are relatively equal
to that of the Poisson - Lognormal model.

4.8.1 Model Comparison

This section compares the two models and decides the best fit model. The Pos-
terior estimate of theta under both models are approximately equal. This is due
to the fact that theta follows the same compound Poisson distribution. However,

54
the value of alpha observed in the Poisson-Lognormal is higher than the alpha
value observed under the Poisson-Pareto model. The posterior estimate of beta
under the Poisson-Pareto model is extremely higher than the observed beta value
under the Poisson-Lognormal model.

Similarly, the standard deviation of theta under both models are almost the same.
The standard deviation of alpha under the Poisson-Pareto model is also higher
than the observed value under the Poisson-Lognormal model. Lastly, the stan-
dard deviation under Poisson-Pareto model is extremely higher than the observed
value beta under the latter.

4.9 Model Selection

4.9.1 Deviance Information Criterion (DIC)

The analysis of the models based on the mean, standard deviation among others
does not endorse any of models as the best fit model.

The Deviance Information criterion would be employed to undertake the best

fit model selection. The deviance information criterion (DIC) was established by
Spiegelhalter et al. (2002) as a tool for model adequacy and model comparison.
It is given by the expression;

DIC(m) = 2D(θm , m) − D(θ̄m , m)

where D(θm , m) is the usual deviance measure, which is equal to minus twice the
log-likelihood
D(θm , m) = −2logf (y | θm , m)

55
and D(θm , m) is its posterior mean, pm can be interpreted as the number of
effective parameters for model m given by:

pm = D(θm , m) − D(θ̄m , m)

, and θ̄m is the posterior mean of the parameters involved in model m. Let
pm = pD .

Lesser DIC values portray a better-fitting model. Hence the choice of the best
fit model would be affected by D(θm , m), and it reduces as the frequency of the
parameters ascends, and a penalty term pD that regards models that has small
number of parameters.

Assigning this to the Poisson-Pareto (model 1) and Poisson-Lognormal model

(model 2) within WinBUGS, it is observed that the Poisson-Lognormal model
(model 2) has the smaller DIC. The difference between the two models equals
31.44.

Table 4.8: Deviance Information Criterion

MODEL Dbar Dhat pD DIC

MODEL 1 3724.410 3722.240 2.172 3726.580
MODEL 2 3692.140 3689.130 3.007 3695.140

From table 4.8, there is enough evidence that the Poisson-Lognormal model is
the best fit.

56
 Chapter 5

Conclusion and Recommendations

5.1 Introduction

This chapter discusses, concludes and makes recommendations based on the find-
ings of the study.

5.2 Conclusion

In this thesis, Bayesian statistics combined with MCMC techniques have been
used to model insurance claims. Two stochastic models assuming the number
of claims follow Poisson, Pareto and Lognormal models were considered. The
Poisson-Lognormal model fitted the available data better via utilization of De-
viance Information Criterion (DIC). This thesis also proposed to obtain an ap-
propriate distribution to model specific case of total claims in motor insurance.

The procedures used in this thesis are universal and it could be extended to
general insurance for any class of homogenous set of data and may again be ex-
tended to non-life data with deductibles. One of the principal benefits of the
Bayesian statistics and Markov Chain Monte Carlo techniques is that the mean,
variance and percentiles of the data under consideration can be estimated. This
in-turn is very useful in the analysis of VaR (Variance at Risk) or any other risk
measure for general insurance portfolio analysis.

57
5.3 Recommendation

There are numerous areas that could be investigated in relation to the data. For
instance, other loss distributions could be used to find appropriate model for
individual claim size. Employing distributions that have more parameters may
enhance a suitable fit to the available data.

Lastly, alternative distribution for the frequency of claims and its influence on
the distribution of the total claim can be researched into. Since the difference
between the two models is 31.44 which is very marginal, the Posterior p-value
must be calculated to determine the better fit model. And possibly predict future
claims using the Bayesian & Markov Chain Monte Carlo techniques.

58
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71
 Appendix
Below is the Poisson-Lognormal model and direction regarding how it was imple-
mented in WINBUGS. THE POISSON-LOGNORMAL MODEL
model
{
for (i in 1:132) {
y[i] ∼ dlnorm(alpha, beta) ###f or the likelihood
}
for(i in 1:11) {
n[i] ∼ dpois(theta) ###f or the number of claims
}
alpha ∼ dgamma(1, 0.001)
beta ∼ dgamma(1, 0.001)I(, 123845.83) ###f or the priors
theta ∼ dgamma(1, 0.001)
}
list( Load data
y=
c(128871.25,147297.84,138743.73,169892.95,147979.62,129894.97,143092.03,
138893.72,157992.82,168898.45,178902.49,185940.89,148783.92,123845.83,
139937.20,141802.82,139839.23,142013.43,148117.08,150738.23,169839.41,
172317.27,176932.12,187439.13,178702.44,181291.02,193043.78,188892.19,
191893.01,192722.34,195972.13,198372.82,202924.90,211130.76,213212.07,
227237.92,210282.02,212937.90,228839.12,231948.38,223834.92,237934.12,250238.73,
252743.15,254834.01,269282.72,271783.04,273743.16,281283.32,278239.98,282738.16,
285438.29,293437.17,288439.78,281734.26,279982.74,284379.87,287940.87,293349.16,
296349.92,236238.29,273901.67,236227.01,242292.81,252302.92,268298.45,
272972.92,279379.02,286994.13,292389.39,298822.97,301289.45,321288.08,
329208.92,341934.13,338239.13,349349.38,352893.28,354082.39,368983.43,

72
373823.82,382998.34,398237.89,412997.24,433834.83,449923.99,492484.88,
498432.39,483392.01,492817.25,496489.29,499343.59,512432.02,524745.77,
532765.35,554776.98,565828.65,579878.30,581897.72,583877.87,582782.04,
586985.14,598754.91,601895.94,624889.13,656785.43,667788.18,685863.96,
698282.87,702983.56,723292.83,738829.37,749292.38,759297.14,823939.30,
857928.45,862389.93,883987.67,898910.16,927892.34,938839.76,948892.67,953976.89,
966976.34,972892.56,1032923.94,1439983.16,1528390.89,1739982.45,1894982.34,
1983788.82,2398951.14),
n = c(12, 12, 12, 12,12,12,12,12,12,12,12)
)

73