Mathematical Methods in Risk Theory

Actuarial mathematics originated toward the end of the 17th century,
when E. Halley's famous mortality table permitted the mathematical

treatment and calculation of annuity values for the first time. The
underlying model expressed in mathematical language at this time has
been so closely adhered to in life insurance techniques-the classical
field of application for actuarial mathematics -that actuarial theory in
this classical sense has often been characterized as closed in upon
itself.
Nonetheless, a new orientation of actuarial mathematics has taken
place in the past few decades which has introduced fundamental new
accents. The stimulus for this development arose from areas of activity
other than life insurance, viz. from casualty insurance or from the non-
life branches of insurance generally. The development was made possible
by the powerful advances in probability theory and mathematical
statistics since the 1930's and has been iavorably influenced by a parallel
emphasis on mathernatical methods in economic theory. If one seeks
to characterize this "new" actuarial mathematics, one can best do so
by saying that it undertakes to solve the technical problems of all
branches of insurance and that it concerns itself particularly with the
operational problems of the insurance enterprise. Characteristic of the
present stage of development, however, is the fact that the current
profusion of scientific publications in the field of actuarial mathematics
deals above all with detached individual problems. An excellent general
view of this diversity of publications is given by Carl Philipson's biblio-
graphy [60]. H. Seal's book [63] also gives a well-rounded survey of the
literature. The work of Beard, Pentikinen and Pesonen [5] is to be
recommended as an introduction on an easily understandable level to
the new development in actuarial mathematics.
The present book is intentionally not oriented bibliographically. It
attempts to create a synthesis out of a selection made by the author of
modern scientific publications in the field of actuarial mathematics,
with the goal of presenting a unified system of thought.
The construction is so arranged that the mathematical model of the
events dealt with in insurance is presented in the first part. Chapter 1
explains the probability-theoretical fundamentals of risk. The elements
of probability theory which will be necessary for the subsequent deve-
V1 Preface
lopment are recalled here for the reader who is moderately familiar with
the theory on an intermediate level (without the use of measure theory).
Chapter 2 treats the risk process and at the same time tlie tools of the
theory of stochastic processes are elucidated. Chapter 3 explains the
concept of the collective and develops the related risk quantities. Conse-
quences of the mathematical model form the content of the second part.
Chapter 4 deals with premium calculation and Chapter 5 with the
retention problern. Finally, the real operational problems are taken up
in Chapter 6, the subject of which are the risk carrier's stability criteria.
In addition to the probability of ruin criterion, the dividend policy and
utility criteria are also discussed. The general tendency toward forming
a bridge between economic and actuarial theory is particularly visible
in this last chapter.
It should also be mentioned explicitly what the book does not treat
(at least in so far as what the reader may have expected). No statistical
estimatioiz methods are brought up in connection with the mathematical
models developed here. I believe that the Separation of the trains of
thought into
a) construction of models and
b) measurement of the Parameters which appear in the models
should be preserved -as in the classical actuarial mathematics of life in-
surance. The present book therefore deals intentionnally only with point a).
The publication of this book would not have been possible without
the vigorous Support of my colleagues. Dr. H.-U. Gerber assisted with
a preliminary version of the manuscript and also made a real contribution
to the content of section 6.4 with his dissertatioii. My assistants, Messrs.
F. Pfenninger and W. Maurer undertook a careful examination of the
manuscript and the corrections. I should particularly like to thank the
translator, Mr. C. E. Brooks, F. S.A. for his cooperation. Through him
it has been possible to publish the book in the language which will make
it accessible to the largest possible circle of readers. My appreciation is
also due to Mrs. E. Minzloff, secretary at the Mathematical Research
Institute of the Federal Institute of Technology for typing the manuscript
in final form.
Zrich, September 15, 1970

Hans Bhlmann
In nzemory of my father
Table of Contents
Part I . The Theoretical Model
Chapter 1 : Probability Aspects of Risk . . . . . . . . . . . . . . . . . .
1.1. Random variables explained by the example of claim amount . . . . . .
1.1.1. Definition . . . . . . . . . . . . . . . . . . . . . . . . .
1.1.2. Classification and examples of distribution functions . . . . . . .
1.l. 3. Expected values . . . . . . . . . . . . . . . . . . . . . . .
1.1.4. Characteristics of a probability distribution and auxiliary functions
1.1.5. Chebyshev's Inequality . . . . . . . . . . . . . . . . . . . .
1.2. Sequences of random variables explained by the example of claim amount
reproductions . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2.1. Multi-dimensional distributions and auxiliary functions . . . . .
1.2.2. Conditional distribution functions and conditional expectation . .
1.2.3. Independence . . . . . . . . . . . . . . . . . . . . . . . .
1.2.4. Covariance and correlation . . . . . . . . . . . . . . . . . .
1.2.5. The law of large numbers . . . . . . . . . . . . . . . . . . .
Chapter 2: The Risk Process . . . . . . . . . . . . . . . .
2.1. Fundamentals . . . . . . . . . . . . . . . . . . . . . . . . .
2.1.1. Definitions and intuitive description of risk . . . . . . . . . .
2.1.2. Stochastic processes with independent increments . . . . . . .
2.1.3. Markov processes . . . . . . . . . . . . . . . . . . . . .
2.2. The clairn number process . . . . . . . . . . . . . . . . . . . . .
2.2.1. Mathernatical description . . . . . . . . . . . . . . . . . . .
2.2.2. The claim interoccurrence time . . . . . . . . . . . . . . . .
2.2.3. The homogeneous claim number process-operational time . . . .
2.2.4. The case of time-independent intensities of claim frequency: conta-
gion models . . . . . . . . . . . . . . . . . . . . . . . .
2.3. The accumulated claim process . . . . . . . . . . . . . . . . . . .
2.3.1. Definition as random sum and basic representation . . . . . . .
2.3.2. Proof of the basicrepresentation of the accumulatedclaim distribution
2.3.3. The reduced basic representation: time-independent claim amounts
2.3.4. The reduced basic representation: time-dependent claim amounts
2.3.5. An cxampie . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 3 : The Risk in the Collective . . . . . . . . . . . . . . . . . .
3.1. Risk-theoretical definitions . . . . . . . . . . . . . . . . . . . . .
3.1.1. Risk and collective . . . . . . . . . . . . . . . . . . . . .
3.1.2. The structure function . . . . . . . . . . . . . . . . . . . .
3.2. The weighted risk process as description of the risk in the collective . .
3.2.1. Weighted laws of probabiiity . . . . . . . . . . . . . . . .
3.2.2. The risk pattern in the collective. . . . . . . . . . . . . . .
X Table of Contents
3.2.3. The nun~berof claims process in the collective . . . . . . . . . 68

3.2.4. The weighted Poisson and negative binomial distributions . . . . 69
3.2.5. The accunwlated claim process in the collective . . . . . . . . . 73
3.3. Portfolios in the collective . . . . . . . . . . . . . . . . . . . . . 76
3.3.1. Some definitions . . . . . . . . . . . . . . . . . . . . . . 76
3.3.2. Stabilizing in time (Theorem of Ove Lundberg) . . . . . . . . . 77
3.3.3. Stabilizing in size . . . . . . . . . . . . . . . . . . . . . . 80
Part TI . Consequences of the Theoretical Model

Chapter 4: Premium Calculation . . . . . . . . . . . . . . . . . . . . . 85
4.1. Principles of premium calculation . . . . . . . . . . . . . . . . . .
4.1 .1. General . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1.2. Some principles of premium calculation . . . . . . . . . . . .
4.1.3. Discussion of the principles of premium calculation . . . . . . .
4.2. The risk premium and the collective premium . . . . . . . . . . . .
4.2.1. The risk premium . . . . . . . . . . . . . . . . . . . . . .
4.2.2. The collective premium . . . . . . . . . . . . . . . . . . . .
4.2.3. Statistics and collective premium . . . . . . . . . . . . . . .
4.2.4. The dilemma and the connection between risk and collective premium
4.3. The credibility premium . . . . . . . . . . . . . . . . . . . . . .
4.3.1. The credibility premium as sequential approximation to the risk
premium . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.2. A new interpretation of the variance principle for calculation of
premiums . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.3. Construction of the credibility premium . . . . . . . . . . . .
4.3.4. Assumptions for our further investigations . . . . . . . . . . .
4.3.5. Properties of the credibility premium . . . . . . . . . . . . .
4.3.6. The credibility formulae for the three components of the credibility
premmm . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.7. Determining the weights in the credibility formulae . . . . . . .
4.4. A practical example: risk. collective and credibility premium in automobile
liability insurance . . . . . . . . . . . . . . . . . . . . . . . . . 106
Chapter 5 : Retentions and Reserves . . . . . . . . . . . . . . . . . . . 111
5.1. The retention problem . . . . . . . . . . . . . . . . . . . . . . 111
5.1.1. General . . . . . . . . . . . . . . . . . . . . . . . . . . 111
5.1.2. The retention under proportional and non-proportional reinsurance 112
5.2. The relative retention problem . . . . . . . . . . . . . . . . . . . 113
5.2.1. Proportional reinsurance . . . . . . . . . . . . . . . . . . . 114
5.2.2. Non-proportional reinsurance . . . . . . . . . . . . . . . . . 116
5.2.3. The risk with given risk Parameter and the risk in the collective under
non-proportional reinsurance . . . . . . . . . . . . . . . . . 119
5.2.4. Credibility approximation for the relative retention . . . . . . . 121
5.3. The absolute retcntion problem . . . . . . . . . . . . . . . . . . . 124
5.3.1. Exact statement of the problem . . . . . . . . . . . . . . . . 124
5.3.2. The random walk of the risk carrier's free reserves generated by the
risk mass . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.4. Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Table of Contents XI
Chapter 6: The Insurance Carrier's Stability Criteria ............ 131

6.1. The stability problem . . . . . . . . . . . . . . . . . . . . . . . 131
6.1.1. Decision variables . . . . . . . . . . . . . . . . . . . . . . 131
6.1.2. Stability problem and stability cnteria . . . . . . . . . . . . . 132
6.2. The probability of ruin as stability criterion . . . . . . . . . . . . . 133
6.2.1. Planning horizon and ruin probability . . . . . . . . . . . . . 133
6.2.2. Admissible stability policies . . . . . . . . . . . . . . . . . . 135
6.2.3. Hypotheses about the model variables in calculating the probability
of ruin . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
6.2.4. Calculating the probability of ruin in the discrete case with finite
planning horizon . . . . . . . . . . . . . . . . . . . . . . 137
6.2.5. Calculating the probability of ruin with an infinite planning horizon
using the Wiener-Hopf method . . . . . . . . . . . . . . . . 141
6.2.6. Calculating the probability of ruin in the continuous case with
infinite planning horizon using renewal theory methods . . . . . . 144
6.3. The absolute retention when the probability of ruin is chosen as the
stability criterion . . . . . . . . . . . . . . . . . . . . . . . . . 152
6.3.1. Restatement of the problem and assumptions . . . . . . . . . . 152
6.3.2. The optimal gradation of retentions . . . . . . . . . . . . . . 154
6.3.3. The stability condition . . . . . . . . . . . . . . . . . . . . 155
6.3.4. Determining the absolute retention when the risk parameter is known 156
6.3.5. Determining the absolute retention when the risk Parameters are
drawn from one or more collectives . . . . . . . . . . . . . . 159
6.3.6. Practical remark on the probability of ruin as stability criterion . . 163
6.4. Dividend policy as criterion of stability . . . . . . . . . . . . . . . 164
6.4.1. General description of the criterion . . . . . . . . . . . . . . 164
6.4.2. Hypotheses about the model variables when the dividend policy is
used as stability criterion . . . . . . . . . . . . . . . . . . 165
6.4.3. Dividend policy in the discrete case . . . . . . . . . . . . . . 165
6.4.4. Results in the discrete case . . . . . . . . . . . . . . . . . . 166
6.4.5. Barrier strategies in the discrete case . . . . . . . . . . . . . 168
6.4.6. Dividend policy in the continuous case . . . . . . . . . . . . 168
6.4.7. The integro-differential equation of the barrier strategy in the
continuous case . . . . . . . . . . . . . . . . . . . . . . 171
6.4.8. Solving the integro-differential equation for V(Q, a) . . . . . . 172
6.4.9. Asymptotic formula for a, . . . . . . . . . . . . . . . . . . 174
6.4.10. Optimum dividend policy for Q > U , and other evaluations . . . . 177
6.5. Utility as criterion of stability . . . . . . . . . . . . . . . . . . . 178
6.5.1. Evaluating the random walk of free reserves . . . . . . . . . . 178
6.5.2. Equivalent evaluations; definition of utility . . . . . . . . . . . 179
6.5.3. Axioms about utility . . . . . . . . . . . . . . . . . . . . . 182
6.5.4. Existence theorern for an equivalent utility . . . . . . . . . . . 184
6.5.5. Integral evaluation . . . . . . . . . . . . . . . . . . . . . . 188
6.5.6. The problem of risk exchange . . . . . . . . . . . . . . . . . 190
6.5.7. The theorem of Borch . . . . . . . . . . . . . . . . . . . . 191
6.5.8. A consequence of Borch's theorem . . . . . . . . . . . . . . . 195
6.5.9. Price structures with quadratic utility kernels . . . . . . . . . . 197
XI1 Table of Contents
Appendix: The Generalized Riemann-Stieltjes Integral . . . . . . . . . . . . 201

A.1. Preliminary . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
A.2. Definition of the generalized Riemann-Stieltjes integral in two special
cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
A.3. Definition in the general case . . . . . . . . . . . . . . . . . . . 203
A.4. Integrable functions . . . . . . . . . . . . . . . . . . . . . . . 203
A.5. Properties of the generalized Riemann-Stieltjes integral . . . . . . . . 204
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
PART I
The Theoretical Model

Chapter 1
Probability Aspects of Risk

1.1. Random variables explained by the example of claim amount
1.1.1. Definition
A random variable X assumes certain real numerical values in accord-
ance with well-defined probabilities and we therefore speak of the law
of prohability governing a given random variable. This law is described
by means of the variable's (cumulative) distribution function F*(X). The
distribution function is defined as follows:
where the right-hand side of the definition is read as "the probability

that the random variable X assumes a real numerical value less than
or equal to X".
As an illustration let us consider the random variable S, where S
stands for the amount of loss in monetary units ussociated with a claim
event (or more simply, claim amount)-as for example bodily injuries
resulting from a motor accident or damages to buildings caused by fire,
clairn arnount in francs
Fig. 1. Empirical claim amount distribution (motor accident bodily injury claims over
50,000 francs)
4 Chapter 1. Probability Aspects of Risk
etc. We shall usually exclude the case S =O. This is not absolutely neces-
sary, but within the framework of our theory-as from the practical
viewpoint-it is useful to make this exclusion.
Fig. 1 shows us an empirical distribution function related to bodily
injuries in motor accidents producing losses in excess of 50,000 francs.
We can read from the graph for example P [ S > 100,000 francs]=
1- Fs(lOO,OOO)= 0.20. Corresponding to empirical distribution functions
we can develop theoretical distributionfunctions by "smoothing out'' the
former. Deriving theoretical distribution functions from empirical ones
is a statistical problem which will not be dealt within this book. In what
follows it is assumed that the distribution functions employed have
already been "smoothed out". Fig. 2 gives us a theoretical distribution
function for motor accident bodily injury claims in excess of 50,OOO francs.
claim amount in francs
Fig. 2. Theoretical claim amount distribution (motor accident bodily injury claims over
50,000 francs)
It follows directly from the foregoing definition that the distribution

function FX(x)is continuous from the right. All the distribution functions
in the sequel will have this property.
1.1.2. Classification and examples of distribution functions

First of all let us distinguish between
a) continuous distribution functions of type
1.1. Random variables explained by the example of claim amount 5
and
b) step distribution functions of type
Category a) can be further divided into

a,) distribution functions which have a derivative at every point
(F1(x)=f (X)is called the density function), and
a,) functions not having a derivative at every point.
(For the general theory See for example [44].) For our requirements
we shall content ourselves with the types
a,) distribution functions with density functions, and
b) step distribution functions.
Examples of type a,): Distribution functions with density functions
i) The normal distribution
+
(Parameters p and o, - a; < p < m, O<@<m)
Density function :
Graph of the density function:
Distribution function :
The special case p = 0, a = 1 is called the standardized normal distribu-

tion. The normal curve is not suitable as a claim amount distribution
except in quite special cases, but it plays a very important role as an
" approximation curve for large portfolios".
ii) 7he logarithmic normal distribution (log-normal distribution)
(Parameters p and a, - n ; < p < +a;, O < o < m )
Density function:
Chapter 1. Probability Aspects of Risk
The log-normal distribution is very useful for depicting claim

amount distributions. (N.B. "log" denotes the natural logarithm.)
iii) The gamma distribution (T-distribution)
(Parameters y and C, O< y < CG, 0 < C < m )
Density function :
The form of the frequency curve depends basically upon whether the
Parameter y is greater than, less than or equal t o 1. In the case y > 1 the
gamma distribution has a shape similar to the log-normal distribution.
When y = 1 the curve is referred to as an exponential distribution. y < 1
produces a density function which is no longer bounded at the origin.
exponential d~stribution
1.1. Random variables explaiiied by the example of claim amount 7
The gamma distribution is also often used to represent the distribu-

tion of claim amounts.
iv) 7he beta distribution (type I)
(Parameters cc, and 6,O<cc<m, O < < m , O < ~ < C G )
Density function :
f'(4= 6B(%)
1
( (1 - for 0 < x < 6
where
W .
B (a, ) = .
r ( a + )
The r-distribution can be obtained from the B-distribution by taking

the limit (6=/c and +GO). The U-shaped density function for the
case a, < 1 can be used to describe the damage degree distributions.
(The damage degree is the ratio of claim to the value of the insured
object in fire insurance.) The case cc = = 1 is known as the rectungular
distribution or unijorm distribution. The beta distribution type I1 will not
be treated here; it is dealt with e.g. in [41].
V)Cauchy distribution
(Parameterspandd, - m < M < + o o , O < O < c o )
Density function :
0
for - C G < X < + C G ,
z[02+(x- M)2]
bilateral
Cauchy
distribution
20
for M ~ x < c G .
Z[O~+(X-M)~]
A
unilateral
Cauchy
distribution
The Cauchy distribution is similar to the normal curve but converges

much more slowly towards Zero at the tails.
vi) Pareto distribution
(Parameters a and C,0 < a < m, 0 < C< CG)
Density function :
~ ( x ) = ~ . c ' x ( ' + ' )for C~ X<CG.
Graph of the function:
The Pareto distribution likewise converges slowly to Zero for extreme

values and can be used as a claim amount distribution particularly if one
wants to emphasize these extreme values.
Examples of type b): Step distribution functions
Fundamentally all claim amount distributions are step functions,
since claims are always expressed as multiples of some basic unit of
money (centimes, for example); when-as is often the case-continuous
distribution functions (especially those with density functions) are used
to describe claim amount distributions, it should be borne in mind that
these are idealized representations. It is sufficient for the purposes of
this book if we assume that the step functions take positive jumps only at
integral ualues of the abscissa.
units of money
o Jump points. Increases of the function at the jump points are called jump amounts
The usual terminology with regard to step distribution functions

is as follows: The set of all jump points=range of the random variable.
(In accordance with our convention this is a subset of the set of integers
and therefore countable.) A positive jump of the function at the
abscissa k represents the probability that the random variable assumes
the value k-symbolically p,.
The distribution function is then
F(x)= p, (k integer).
ksx
We should mention that the following examples of step distribution

functions are encountered most commonly in connection with distribu-
tions other than those of claim amounts.
vii) The binomial distribution
(n positive integer, 0 < p < 1)
Probabilities :
P,= (i) pk(l-pyPk for k = ~ 1,

, ..., n.
Histogram : For n = 6, p =0.6.
The binomial distribution gives the probability of k successes in n

independent and identically distributed trials. In the special case n= 1
we speak of the Bernoulli distribution.
viii) The Poisson distribution
(Parameter A, 0 < A. < CG)
Probabilities :
Histogram: For A = 1,5.
The Poisson distribution arises as a limiting case of the binomial

distribution ( n p = i , n +CO); it is accordingly also referred to as the
distribution of rare events.
ix) 7he negative binomial distribution

(O<cr<aj,O~p~l)
Probabilities:
Histogram : For cx = 2, p = 0.4.
The special case cr = 1 (where k is often replaced by k - 1 in the litera-

ture) is known as the geometric distribution.
Histogram: For a=1, p=0.4, ~ , = p ( l - ~ )k=0,~ , 1,2, ... .
The negative binomial distribution plays an important role in

actuarial mathematics. (See 2.2.4 and 3.2.4.)
X) 7he logarithmic distribution
(Parameter p, 0 <p < 1)
Probabilities :
Histogram: For p = 0.6.
The logarithmic distribution can be obtained as a limiting case of

the negative binomial distribution. (Consider the conditional distribution
given that k = 0 does not occur and let cl+ 0. The roles of p and 1 - p are
thereby interchanged.)
Concluding remurk on the foregoing distribution functions
The ten examples of distribution functions presented are those
encountered most frequently in the literature of property and casualty
insurance. The reader who is interested in more material on the analytic
forms of distribution functions (especially the problem of fitting distri-
bution functions to actual data) is referred to volume I of [41].
1.1.3. Expected values

In what follows we shall speak of expected values, moments and
auxiliary functions of the distribution function Fx(x) or-what is the
same thing-of the random variable X. Fundamental to the concepts
used in this section is the notion of expectution or expected value. We
define this value as follows:
Definition: J X dFx(x)-symbolically E [X]-is called the expected
value of' the random variable X.
Generalization: g(x) dFx(x)-in symbols E [g(X)]-is the expected
value of the random variable g(X).
Explanation: a) The generalized Riemann-Stieltjes integral is used
here and in what follows. (For an explanation of this see Appendix.)
In particular
i) if F(x) has the density function f (X):
ii) if F(x) is a step distribution function with positive amount jumps pk

at the integral abscissae k:
b) The integration in the above definition is over the range - co

to + CG. (Outside its originally defined range F(x) is taken as constant.)
For simplicity's sake, however, the limits of integration are omitted both
above and hereafter. We are dealing therefore with the improper Riemann-
Stieltjes integral:
b
Jg(x)dF(x)= lim jg(x)dF(x).
a - C O
b-CO
b
C) If lim Ig(X)I dF(x) exists, we say that the expected value of g(X)
a- - m
b-m
exists. (Remark: Absolute integrability must be postulated for the
variable transformation rule (cf. Appendix) to hold.)
d) If the limit indicated under C) does not exist, we say that the
expected value of g(X) does not exist.
Intuitive interpretation of expected value
Let us again consider the random variable S = amount of loss related
to an incurred claim event. Let g(S) be the claim payment which we must
make for a loss amount of S and let F,(x) be (for example) a discrete
function where S takes on positive values only. Then it follows that
Probabilities can be interpreted as idealized relative frequencies, i.e.
prob [S = k] - nk/n, (The symbol

equal to ".)
- is read "as approximately
where nk is the number of claims among n cases of similar type for which
the amount of loss S = k. Thus
E Cg - {C (4
g
total claim payments
n J l n = total number of claims
= average payment per claim.

We say that E[g(S)] represents the theoretical mean value of g(S); this
theoretical mean value is precisely the expected value.
Practical application in reinsurance arrangements

Let S again designate the loss amount and let g(S) be that Part of the
claim held for own account by the insurer (retention). Different sorts of
reinsurance agreements can be characterized by different functions g:
g ( S ) = a . S ( 0 5 ~ 5 1 ) proportional reinsurance with a retained
share of a ;
S for S I M excess of loss reinsurance with first
risk M ;
reinsurance arrangement in general.
E [g(S)] =expected claims within the retention,

E [S - g(S)] = expected claims in reinsurance .
Fundamental properties oj'the expected value (see Appendix)
E,) E[a.X]=a.E[X].
E,) E [X + Y] = E [X] + E [Y]. (This can be extended to Sums
having any finite number of terms.)
E,) If X 5 Y, then E [X] 2 E [Y].
Illustration using reinsurance arrangements
E,) Let g(S)= a . S (quota share of lOOa X). From E,) it follows that
In words: i h e expected claims within the retention amount to a times the

total expected loses.
E,) Let g(S) be a function which represents a reinsurance arrange-
ment in general and X=g(S), Y=S -g(S). It follows then from E,) that
ECg(S)I +E[IS-g(S)l =ECSI.
In words: Expected claims for own account plus expected reinsurance
claims = total expected claims.
E,) Let g(S)SS be a function which represents a reinsurance ar-
rangement in general and X=g(S), Y=S. It follows from E,) that
In words: Expected claims within the retention total expected claims.

The conclusions derived from these illustrations of the three funda-
mental properties of the expected value will strike the practician as
1 . 1 . Random variables explained by the example of claim amount 15
trivial. They do show, however, how well the concept of "theoretical

mean value" falls in with the defining integral.
Exercises
1) For which of the distributions i) to X) under 1.1.2 do the expected
values E [ X ] =J X dF(x) exist? Find expressions for these.
2) a) Calculate the expected reinsurance claim under an excess of
loss reinsurance Cover with a first risk of M :
S for S S M
in terms of the claim amount distributions ii), iii), V) and vi). (In the last
case distinguish between a S 1 and cr > 1.)
b) Prove that
for any distribution function (for which F is continuous at M) and

interpret this relation in terms of the mean excess of loss claim.
3) Two portfolios X and Y comprising n resp. m identical and inde-
pendent accident risks are given. Let p stand for the probability that an
insured is struck by an accident and let Z be the sum of both portfolios.
a) Give formulae for the probability of
-k accidents from portfolio X (k = 0, 1, ...,n),
-h accidents from portfolio Y (h = 0, I , ...,m),
-j accidents from portfolio Z ( j= 0, I, . ..,n m). +
b) On the basis of the formulae obtained in 1) verify the relation
To aid in the solution of these exercises the following works are

cited for reference purposes :
Parzen : Modern Probability and its Applications C551 ;
Feller: An Introduction to Probability and its Applications, vol. I [32] ;
Rozanov: Introductory Probability Theory [ 6 1 ] ;
Kendall: The Advanced Theory of Statistics, vol. I [41].
1.1.4. Characteristics of a probability distribution and auxiliary functions

U) Characteristics:
By using the expected value operation E [g ( X ) ]= 1g (X) dF,(x) we
define the following characteristics of a distribution function (resp.
random variable):
i) g (X) = xk:E [Xk] = pk: k-th moment about the origin of F, (X)(also,
more simply: the k-th moment).
Special case : p1 = p expected value of F, (X).
ii) g(x)= (X - E [(X-,U)~]= ak:k-th central moment of F,(x).
Special case: a, = E [(X -p)'] = 0' :variance
o: standard deviation.
In addition to these measures
also plays a useful role.

The following identity is useful in calculating the variance:
Identity :
02=p2 -(P)'; E [(X - P)'] = E [X2] -(E [X])'.
Proof:
E [ ( X - , U ) ~ ] = E [ X ~ ] - ~E[X]+p2
~.
=p2-2.p 2 + p2
An analogous useful formula for the third central moment is the

Identity : a3=p3-3.p.p2+2.p3
E[(X-p)3]=E[X3]-3. E[X]. E[X2] +2.(E[X])3.
Proof:
The intuitive meaning of these characteristics is probably most easily

grasped in the case of a function of three points. Let us imagine a situa-
tion, for example, in which the random variable S of claim amounts can
only assume three values,
S=0.2 C
C can be thought of as representing the amount of insurance under a

fire policy. Our assumption then means that only the damage degrees
20%, 60% and 100% result in claim payment. It is easy to See from this
example how the three-point distribution can be expanded into an
n-point distribution by a refinement of the damage degrees for which
claim payment is made. Suppose that
Then the following characteristic measures of the distribution are pro-

duced by varying the numbers (P p P,). (In order to bring out the
meaning of these characteristics we shall also examine combinations
(pi, p2, p3) which are highly unlikely in fire insurance.) For simplicity's
sake C is taken as 1.
Probability distribution Expected value Variance Skewness
Intuitively we can say that the expected value measures the Center
of gravity of the distribution, if we think of the probabilities pi as weights
at the corresponding points. Analogously, the variance can be regarded
as the moment of inertia about the expected value. It is perhaps even
clearer intuitively if we think of the variance simply as a measure of
dispersion or mean quadratic deviation from the expected value. Finally,
the skewness measures the extent to which the mass of the probability
distribution extends to the left (negative skewness) or to the right (posi-
tive skewness) of the expected value.
For the sake of completeness we also define the median of a distribu-
tion. This is the number M for which F ( M ) ~ and & at the Same time
Tuble of Moments und Auxiliury

Distribution ,functions
Distribution Density function Domain of x Parameters Expected value
i) Normal
distribution
ii) Log-normal
distribution
iii) Gamma
distribution
iv) Beta
distribution
V) Cauchy distribution -cc<x<~ -ccipim does not exist

(bilateral) rr [02 + ( X - M)'] 0<6i<m
U . C=
vi) Pareto --
xl+m
distribution
Distribution functions wich
Distribution Probability Domain of k Parameters Expected value
vii) Binomial 0 , 1 , 2,..., 11 n natural number np

distribution O<p<l
ik
viii) Poisson e-A-
distribution k!
a+k-1 I -P
ix) Negative binomial 0, l,2, ... Otuca U . ---
distribution O<p< l P
X) Logarithmic
distribution
" Not integrable in closed algebraic form.

Observe that for convenience we have often used q = l - p as abreviation.
1.1. Random variables explained by the example of claim amount
Functions for the Examples in 1 .I .2

with density functions
Variance Skewness Characteristic Moment generating

function function
does not exist does not exist e i u ~, 1 4 8 does not exist
does not exist
step distrihution Junctions
Variance Skewness Characteristic Moment generating

function function
20 Chapter 1 . Probability Aspects of Risk
F(M - c ) <+for all E > 0. In the example below is M = 20, since F ( M )= 0.6
and F ( M - E ) <0.3.
Fix) t
A natural generalization of the median is the quuntile Qi(n), which

1 1
is defined as the solution of F ( Q i ( n ) ) z - and F(Qi(n)- E ) <- for all E>O.
n n
b ) Auxiliary functions:
With any distribution function there are associated auxiliary func-
tions which uniquely characterize the former. (For the general theory
the reader is referred to [55].)
i) Moment generating function
+m
M(t)=E[etX]= 1 etXdFx(x), t arealnumber.
-m
This function is said to exist if the defining integral exists for at least one
strictly positive value t , >O. If M(t,) < co also for a strictly negative value
t , <O, then all mornents of Fx(x) exist and the following relations hold:
M'(0) =E [X]
M1'(0) = E [ X 2 ]
M'k'(0) = E [ X k ]
ii) Characteristic function
cp(u)=E [eiuX]=J eiuxdFx(x), U a real number,
i = 1/-i(imaginary unit)
The characteristic function always exists. For the moments of F,(x)-if
these exist-similar relations hold as in the case of the moment generating
function,
(0)= (i)k- E [ X k ].
It is important to note that the relation between the characteristic
function (resp. the moment generating function, ifit exists) und the distribu-
tion function is one-to-one. We can therefore describe a probability

distribution just as well by using one of the auxiliary functions. For a
survey of the theory of characteristic functions the reader is referred
to the work [45]. Moment generating functions are nothing other than
Laplace transforms of distribution functions: the essentials of this subject
are to be found in [27].
1.1.5. Chebyshev's Inequality

Given that the standard deviation (square root of the variance) is a
measure of the distance of the probability muss from the expected value,
the following question suggests itself: What probability Statements can
we make about this distance from a knowledge of the standard deviation
alone? The answer to this question is given by
Chebyshev's Inequality: P[IX-pl > t a ] 5 l / t 2 .
In words: The probability of a deviation of more than t times the standard
deviation is at most l / t 2 .
The proof is straightforward:
Dividing both sides by (t 0)' produces the desired result.

As an illustration we have tabulated several values and compared
these with the actual probabilities according to the normal distribution:
Deviation from the Upper bound of the True probabilities

expected value measured probabilities according according to the
in standard deviations to Chebyshev normal distribution
%
.. ~ ~-~ .-
%
It is clear even from these few values that the estimates given by
Chebyshev's inequality are very crude. They can be improved, however,
if certain information about the type of the distribution function is
available. The reader may consult C373 or [48] for generalizations of
Chebyshev's inequality.
Exercises
1) Calculate several moments and auxiliary functions from the table
under 1.1.4.
2) a) Show that the expected value V has the following property
for all C:
E [(X - S E [(X - c ) ~ ] .
b) Show that the median M of a distribution function has the fol-
lowing property for all C :
C) Discuss the meaning of the expected value and median of a claim

amount distribution.
3) Calculate the first three moments of
the normal distribution,
the gamma distribution,
the Poisson distribution and
the negative binomial distribution
by means of the moment generating (resp. characteristic) function.
4) Consider a portfolio of N independent accident risks, all having
a probability of accident p equal to 1%. Determine a value N by means
of Chebyshev's inequality such that the observed frequency of accident
k / N lies between 0 . 9 5 ~and 1 . 0 5 ~
with a probability greater than 90%.
1.2. Sequences of random variables

explained by the example of claim amount reproductions
1.2.1. Multi-dimensional distributions and auxiliary functions

Instead of considering a single random variable X (as in 1.1), we
shall now examine sequences of random variables
The laws of probability governing such sequences are described by

multi-dimensional distribution functions
1.2. Sequences of random variables 23
The right side of this definition is to be read as the probability of the

event that all the conditions X, 2 X, (k = 1,2, ..., n) are fulfilled simul-
taneousiy.
As an illustration, let us consider the claim amount reproductions of
one and the Same risk, i.e. the claim amounts generated by one and the
Same risk in repeated occurrences of the claim event. For certain risks
these reproductions reveal trivial dependence relations; such is the case,
for example, with an individual death risk where X,=O for all k 2 2 .
Generally speaking dependence relations of a special sort may often be
expected to be present among claim amount reproductions. We have
only to think of the effect of contagion on one hand and of the effect
of intensified claim prevention measures after occurrence of a claim on
the other. Such effects can be recognized by means of the conditional
distribution functions discussed in 1.2.2.
Moreover, when we speak of risk we not only think of a single auto-
mobile driver, for example, who has insured himself against liability
claims, or of a single fire precinct in a fire policy or of a single insured
under accident insurance. Clearly we can also subsume these single risks
in the customary sense of the word under the general concept of risk.
A group insurance policy or a whole reinsurance treaty can equally well
be referred to as one risk, however. The traditional separation of indi-
vidual from collective risks is in our opinion not necessary for the
mathematical theory and indeed is often confusing. In this book there-
fore we shall only speak of risks without distinction; the reader is asked
to wait for exact definitions of the terminology until the beginning of
chapter 2.
The one-dimensional distribution functions F ( x ) which we treated
earlier can be very easily read off from the multi-dimensional distribution
functions Gx ,"(X ..., X,), as can, incidentally, all other distribution
functions of lower dimension. The following relation holds:
In terms of our intuitive interpretation, the left side represents the claim
amount distribution for the k-th claim event and the right side is the
amount distribution for the first n claim events, but with a condition
placed on the k-th claim amount only. A relation which we shall use
often in the sequel follows at once from the foregoing:
It should be emphasized that no assumptions other than the existence

of the first moments are necessary to the validity of this relationship.
Chapter 1 . Probability Aspects of Risk
Example: Consider the two-dimensional log-normal distribution.

Density function :
Distribution function:
We can verify (by completing the square in the exponent) that
where
is the one-dimensional log-normal distribution. Just as the one-dimen-

sional log-normal function is useful for describing single claim amounts,
the multi-dimensional log-normal distribution can be used to advantage
for claim reproduction sequences. Unfortunately the analytical expres-
sions become more and more complicated as the number of dimensions
increases; this disadvantage can be largely overcome by going over to
matrix notation (cf. for example [24]).
Auxiliary functions are also associated with the multi-dimensional
distribution functions G X 1 . . , x n (...,
~ l , X,) in a unique manner:
Characteristic function: (always exists)
Moment generating function: (exists for positive and negative values

of t ..., t, if all moments are finite)
1.2.2. Conditional distribution functions and conditional expectation

Let us begin with an example:
Suppose that the claim amount reproduction pair (X,, X,) is distrib-
uted in accordance with the two-dimensional log-normal distribution
(see 1.2.1). We now wish to determine the distribution of the second
claim amount X, if the first amount is given. (Say X, =S.)
Geometrically, the problem can be expressed as follows: If gxl.,x2is

the density function of the distribution, then gxl,x2(xX,) dx, dx, 1s the
probability that the pair (X X,) lies in the rectangle X, 5 X, < X , + dx,,
x, 5 X, <X, + dx, . We now wish to know the probability that X, 5 X, <
X, + dx, if it is known that the point representing the pair (X X,) lies
in the band S to S + dx,.
According to Bayes' Theorem this conditional probability is equal to
where Bayes' Theorem merely states that the band defined in the entire
probability space (plane) by the condition X , = S now bears the total
probability mass 1 ; this is achieved by multiplying the previous (uncon-
ditional) probabilities in the band by a constant (depending only on S,
not on X,).
and designate the expression on the left as the conditional density ,function
of X, given X,. In the case of the two-dimensional log-normal distribu-
tion this is
which is again a one-dimensional logarithmic frequency function of the

form 1 1
-m[logx2-M12
e
fiz. X,
where
~ = 1 / ( 1 - p ~ ) a ~M=---
, (log S-&)+/L2.
01
From this we obtain

the conditional expected value E [XJX, =SI = exp {M + C L / 2 }
and
the conditional variance Var [X2/X1=SI = [eZz- 11 . exp {2M + C'}.
We note that the conditional expected value (conditional expectation)
-increases with increasing S if p > 0 (positive correlation)
-decreases with increasing S if p < 0 (negative correlation).
The same property of monotonicity holds in respect of the condi-
tional variance.
Proceeding from this example we now give the general definitions:
a) For continuous distribution functions having density functions:
conditional density function
conditional expected value for any function h(x)
E [h(X,)/X, =X,] =j h(t) fXLIXl(t/xI)

dt. (The integral must converge
absolutely.)
By analogy we define
b) for discrete distributions:
conditional probabilities
P[X, =,j, X, = k]
P [X, = k/X, =j] = >
PCX, =jl
conditional expected value for any function h(x)
E [h(X,)/X, =j] =C h(k) P[X2 = k/X, =j]. (The series must be
k absolutely convergent.)
It is likewise possible to define the conditional distribution (resp. the

conditional expected value) for more general distribution functions, but
we can not treat this subject within the framework of this book. The
following two properties are important :
Rule of total probability

P [X, = k] = J P[X, = k/Xl = X ] dFxl(x) -in the case of a discrete con-
ditional distribution with
probabilities P[X2/Xl] ;
fx, (X)= J fxzix1(x/~)
dFxl(y) i n the case of a conditional
distribution with density
function f;(2,XI.
Fundamental property of the conditional expectation
E[h(X,)/X, =X] dFxl(x)=E[h(X,)] (for all h for which the

integrals exist)
or more briefly
E CE Ch(X,)/XlIJ = E Ch(X,)I.
In the last line the conditional expected value E[h(X,)/X,] is to

be considered as a random variable with respect to the conditioning
values of X,. The operation of expectation E ( . ) is then applied to this
variable.
This fundamental property follows very simply from the definitions
by changing the order of integration. (This is permissible because of the
absolute convergence of the integrals.)
Exercises
1) Given that
02 = Var (X,), 02 (X,) = Var (X2/Xl)= E [(X, - E [X2/Xl])2/Xl]
P2 = E [X21 2 P2 (X,) = E CX,/XlI 2
Verify these relations for the two-dimensional log-normal distribution.

Ak
2) a) k claim events occur with the Poisson probability P,= e - L .
k!
Show that if claims are independently only reported with probability p,
the number of reported claims is also Poisson distributed with para-
meter p l .
b) Show that the number of excess claims over a first risk of M of

Poisson distributed claim events is likewise Poisson distributed, provided
that all claim events have the same amount distribution.
3) Let
xk cv
P[X2=k/Xi=x]=e-x--,
k!
fxl(x)=--e-cxx~-l (r-density
function).
Determine
a) P[X,=k] (To what type of distribution does this probability
belong ?);
b) E [X,/X,=k].
C) Interpret X, as the number of accidents in an observation period,
X, as the (unknown) mean accident frequency.
1.2.3. Independence
as a sequence of independent random variables if all the related multi-

dimensional distributions are of "product form", i.e. if
G x l , , , x n (...
~ l,~
xn)=FxI(xi).Fx2(x2).. . - .FX,(x,) for all n .
(In case of a finite number of independent random variables n extends

only up to that number.)
The left-hand side of this equation represents the n-dimensional
probability distribution G,l.,.xn and the right-hand side the product of
all the one-dimensional distributions Fxk.
To justify the term independence let us consider a two-dimensional
distribution function GXlx2(xx2).By using the definitions in 1.2.2 we
can easily establish the following
Lemma: 7he conditional distribution function G X 2 X 1 ( ~ Zis/ equal~ l ) to
the one-dimensional distribution function Fx2(x2)(identicul in X,) if und
only f GXIXL(~l> X,) = Fxl(xl).'Fx2(x2).
With more general methods than those at our disposal it can be
shown that this lemma also holds when the conditional distribution
function cannot be defined by the relatively simple approach of sec-
tion 1.2.2.(See for example [44].) Since the identity G x , , X l ( ~ 2 / FX2(x2)
~~)=
corresponds to the intuitive notion of independence, our definition seems
appropriate. The extension of the concept from two to any number of
variables does not produce any particular difficulties, and in fact the
result just obtained reads as follows in the multi-dimensional case:
Lemma :
This implies in particular that for a sequence of independent random

variables all conditional distributions become unconditional ones.
Finally we note that independence can also be defined by means of
multi-dimensional auxiliary functions. The following criterion holds:
Criterion: For the independence of X ..., X, the following condi-
tions are equivalent :
a) G ~ ~ . . . x , (...
x l xn)=Fxl(x,). F x ~ ( x z.....Fx,(xn)
)
b) cpxl,..xn(~i ... U,,) = cpx,(u1). . .. .cpxn(un) (characteristic functions)
C) Mx,..,x,(tl ... t,) = Mxl(t,).... . M,,(t,,) (moment generating
functions).
With respect to C) we must add "if the moment generating functions
exist". The criterion follows, as it happens, from the definition of the
characteristic (moment generating) function in one direction and from
the uniqueness property in the other.
We note that for sequences of independent random variables it suf-
fices to know the one-dimensional distributions in order to develop uny
multi-dimensional distribution. For the special case in which all the one-
dimensional distributions are equal, it is even sufficient to know one single
distribution function. We shall refer to this latter case by speaking of
independent und identically distributed random variables.
Example: Let X ..., X, be independent and have the Same distri-
bution with the density function
The n-dimensional density function is then
= exp { [i
-
i= 1
(log xi - 2 n}'l[(2nr" . sn x, . x, .. .X,,]
Important properties of independent variables

a) E [g(X) . h(Y)] = E [g (X)] . E [h(Y)] if the expected values of
g(X) and h(Y) exist.
Chapter 1 . Probability Aspects of Risk
b) Cov[X, Y] = E [(X - E[X])(Y- E [Y])] = O if the expected

values of X 2 and
Y 2 exist.
The quantity Cov[X, Y] is called the couariance of X and Y
There remain several important relations for the sums of independent

variables :
C) Var(X+ Y)=Var(X)+Var(Y);
d) c p X + Y (4
= cpx(4 c p Y (4resp. Mx+ Y (0= Mx(t) My (0;
e) F x + y ( x ) = l F x ( x - t ) d ~ y ( t )F,(x-t)d~,(t).
=j
The operation denoted by the right-hand side of e) is called conuolution.
It is often designated by the symbol *; we have then for independent X
and Y
Fx+y(x)=FAx)*Fy(~).
Proof:
C) Var(X+Y)=E[(X+ Y-E[X]-E[Y])2]
=Var(X)+2. Cov(X. Y)+Var(Y)
=Var(X) +Var(Y).
d) Use relation a) with g(x)=eiux,h(y)=eiUY,
or g(x)=erX,h(y)=ery.
e) FX+,(x)=P[X+ Ygx]=1 P [ X s x - t ] dP[Y st]
1
= F,(x - t) dFy(t) and by reversing the roles of X and Y
1
= FY(X - t ) dFx (t).
Conditions a), C),d) and e) can easily be generalized to any number of

independent variables (resp. summands).
Examples
1) The claim reproductions of a given risk are independent and are
all distributed in accordance with the Same function, a r-distribution.
Determine by means of the characteristic functions the distribution func-
tion of the sum of the first n reproductions.
cY
Solution: X, has the density function fxk(x)=--- epcxxY-', X > 0
Tb)
i :Y
and the characteristic function cpxk(u)= 1 - -- .
Sn= C;=, X, then has the characteristic function

-ny
( ( U ) =1 - ) and therefore the density function
2) Let X, again be the k-th element of n claim reproductions which

are independent of each other and equally distributed. Let
E (X,) = exp {P 02/2j+ log-normal distribution.
V a r ( ~ , ) = e x p { 2 ~ + c r ' (ea2-
) 1)
Then
E (Sn) = n . exp { p + 02/2j
Var(Sn) = n . e ~ p { 2 ~ + o ' ) ( e ~ ~ - l ) .
1.2.4. Covariance and correlation

We have just Seen that for independent random variables X and Y
COV(X,Y ) = E [ ( x - E [ x ] ) ( Y - E [ Y ] ) ] = o .
For dependent random variables Schwarz's Inequality always holds
= I / v ~ ~ ( x )Var(Y)=o(X).o(Y).
.
The proof is simple : For any t we have E [(t X + Y)'] 2 0, or
The discriminant (E [XY])2 - E [X2] E [YL] is thus never positive. We

obtain the desired inequality by replacing X and Y by X - E[X] and
Y- E [Y] respectively. It is further easy to See that equality can only occur
if t[X- E(X)] = Y- E(Y) for some t. The case Cov(X, Y)= &a(X).o(Y)
therefore characterizes linear dependence. (" + " if X = a + t Y, " - " if
X = b- t Y for some positive t.) This leads us to introduce the following
measure of dependence :
Definition:
Cov(X, Y ) .
P(X,Y)= 1s called the coeflcient of correlation of X and Y.
a(X) .o(Y)
We have then:
-1f X and Y are independent, then p(X, Y)=O.
(Unfortunately the reverse does not hold.)
-X and Y are linearly dependent if and only if p(X, Y) = 1.
--lSp(X, Y ) S +l.
1.2.5. The law of large numbers
This law is concerned with the asymptotic behavior of the average

of n random variables.
Let X X X . .. , X .. . be a sequence of random variables:
-
Sn = Xi, X,, = Sn/n= [C:= X J l n .
We now define a notion of convergence: If for every E > O
P[I~-z~>~:]+ wheno n+m,
then we say that converges in probability toward the random variable Z .
(If Z is a constant then we speak of convergence in probability toward
this constant.)
Law of large numbers:
" If X X ... , X ... is a sequence of independent random variables
with the Same distribution, then converges in probability toward the

constant E [ X , ] (in so far as the latter can be meaningfully defined)."
From a practical viewpoint the theorem means that in the case of
independent, identically distributed claim reproductions the average
claim approximates the expected value of the single claim with a high
degree of probability. This fact has often been referred to as the theo-
retical cornerstone of insurance. This Statement must however be quali-
fied as an exaggeration in view of the rather narrow field of applications
where the assumptions of independence and identical distribution in
respect of the random variables in question may be assumed to hold.
Fortunately there are results other than the one cited, which is essentially
due to Jakob Bernoulli [6]. We shall now state such a stability theorem
which generalizes the classical result in the sense that independence and
identical distribution of the claim reproductions are no longer required.
We do however require assumptions regarding the existence of the
second moments.
Stability theorem for risks
Let X X ... he a sequence oj random variables
Var (X,)t a i for all I ,
[ ' ( X , , X,)=O (or whut umounts to thr sume thing, Cov(X,, X,)=O)
for ull sufficiently distant indices i, j,
i.e. if li-jl> N .
Then X , converges in prohahility to
limU >
n-t
CE:= 1 E(Xi)l/n
3
provided that this lattrr limit exists.

Proof: a) We know from Chebyshev's inequality that
The theorem follows directly if we show that Var(Sn)/[c2.n2] + 0.

b) Var(Sn)= E [(C:=
1 (Xi-'
=CE[(Xi-ECxil). (xi-ECxjl>].
i, j
Eliminating the vanishing terms on the right-hand side, we have
Var (Sn)= CS N E [(Xi

li.jl
- E [X,]) (Xj- E [Xj])].
There remain at most n . ( 2 N + 1) summands and thus Var(S,)o

(2 N + 1) n oi, therefore:
Var (Sn)/[c2. n2] (2 N + 1) o:/[c2 . n] +0 when rz +co.
Remarks.
a) The convergence behavior of Var(Sn)/n2 measures the velocity
with which stability is attained.
b) Our estimate for Var(Sn)makes no distinction between positively
and negatively correlated quantities. Quite generally
It is apparent immediately that Var(Sn)zx;=, Var(Xi) in the case in

which all the quantities are negatively correlated; stability is thus
achieved without any additional condition being required and this euen
more rapidly than in the case of independent variables. Negatively cor-
related variables, however, almost never appear in insurance.
C) The estimate which we have just made is meaningful in the case
of positive correlation. Here the speed of convergence decreases with
the number N, i.e. with greater distance between the independent varia-
bles. Independence characterizes then (negative correlation excepted)
the case of fastest convergence.
Let us conclude with an interpretation. It is due to the convergence
of the average claim toward a fixed quantity that we can expect-for
large numbers-to offset the effects of chance (claim amounts) by
fixed quantities (premiums). The speed of this convergence naturally
plays a decisive role in this connection. In particular, we are con-
stantly confronted in practice with the question of what large, finite
number of random variables approximates the asymptotic result with
sufficient accuracy. Chebyshev's inequality can provide a rough answer
to this question. There are more refined methods, however, which we

shall discuss later On.
Exercises
1) A and B are two events such that P[A] = 114, P[B/A] = 112 and
P [A/B] = 114. We define random variables X and Y such that X = 1 if
A occurs and X=O if A does not occur; Y= 1 if B occurs and Y=O if B
does not occur. Calculate E(X), E(Y), Var(X), Var(Y), p(X, Y). Are X
and Y independent?
2) Let Sn be the sum of n independent, identically distributed X,:
1 with probability p
Sn=xk!, X,, where X, =
0 with probability q= 1- p .
a) Show that Sn is binomially distributed.
S -np
b) Develop the characteristic function cpn(u)of -E---and show that
fi
cpn(u)+ e-U2i2 when n+co
(Central limit theorem for (0, 1)-random variables).
c) Determine $,(U), the characteristic function of S and show that
( U )-+ e when n +co,
provided n p = A is constant (Poisson convergence theorem).
3) Let X X X ... be independent claim amount reproductions
and suppose that X , has the density function
1
(i.e.y, varies with k and c is constant). It is assumed that y = lim -
n+a> n
y,C;=,
exists. Determine then for S,=C;=, X,.
a) Var(S,), E(Sn);
b) the frequency function of xYn(x).
C) Show that Sn/n converges in probability toward y/c (law of large
numbers for gamma-distributed random variables).
d) Show that for cpn(u),the characteristic function of
(Central limit theorem for gamma distributed random variables).

(Use the fact that for large N : (1 - x / ~ / N-exp
)~ { x n + x2/2).)
Chapter 2
The Risk Process
2.1. Fundamentals
2.1.1. Definitions and intuitive description of risk

The proper definition of risk has been widely discussed in insurance
circles. The actuary accustomed to the axiomatic method is at an
advantage in these discussions, for he characterizes the risk not by
"what it is", but by the properties which it has. The basic characteristics
of a risk reside in its properties as
-payer of premiums,
-producer of claims.
A risk is thus described by a functional pair ( 4 , S,), where
8 = premium earned in the time interval (0, t ] ,
S, = sum of claim amounts incurred in (0, t ] .
Both of these can be random functions (stochastic processes) or
functions not dependent upon chance. We normally think of 4 as being
independent of chance, but of S, as being stochastic. In the case of
premiums which depend on claim experience (profit commission, bonus-
malus, etc.), however, 4 also becomes a stochastic process.
For use in practice we regard a definition of risk as being acceptable
if it allows us to express 4 and S, with reasonable exactness and parti-
cularly if it is simple to employ and useful as a basis for predicting future
experience.
From this point of view an individual automobile liability policy can
just as well be spoken of as a risk as an entire portfolio of such policies,
or the area insured by a large industrial complex against fire as well as
the totality of all fire insurance policies in a given country or section of
a country.
What is essential for the mathematical analysis of a risk is actually
only the difference 4-S, of the two defining functions. In what follows
we shall always assume that 4 is a deterministic function; this can in
fact be achieved in every case. For if 4 depends explicitly upon the claims
36 Chapter 2. The Risk Process
experience up to time t (i.e. upon all S, where ~ i t and

) is therefore
stochastic, then we can define new functions
P* ( t )= E [ P ( t ) l ,
+
S* ( t )= S ( t )- P(t) E [P(t)],
where E represents the expected value operation. We therefore have
where P* ( t )is now deterministic, i.e. no longer dependent upon chance.

We call 4 the premium function of the risk.
The random process S, is called the accumulated claim process. (In
the literature this process is very often also referred to as risk process.)
It is usually broken down into a number of claims process 4, which
gives the number of claims which occur up to time t , and a random claim
amount Y, related to a claim incurred at time t. The accumulated claims
up to time t can then be represented as a random sum S , = x Y,i (tiA,),
where A, stands for the random Set of points of time at which claims
occur-up to time t at the latest-or what is the same thing, the set of
jump discontinuities in the claim number process which do not lie to
the right oft.
The following figure illustrates graphically what we have just said:
It is noteworthy that the sum Xi (ti A,) is random in two respects.

It has a random number of terms Y,, which is determined by A,, and each
of these in turn also represents a random variable. In what follows below
we shall concentrate upon the study of the accumulated claim process S ,
and shall return to the premium function 4 in due Course. In the following
(sections 2.1.2 and 2.1.3) we summarize briefly without proofs some
important notions and results from the theory of stochastic processes.
For a more complete presentation of this theory the reader is referred
to [32], C441 or [56].
2.1. Fundamentals 37
2.1.2. Stochastic processes with independent increments
A stochastic process is a family of random variables {X,; t z O )

where time is the index variable. The value of the random variable X ,
at each point of time t is determined by chance. In other words chance
selects a real function X , from the set of all possible real functions on
[0, CO).In our context such a function is referred to as a samplin~function.
Two realizations of such a random function are represented in the

figure above.
For our requirements (description of the accumulated claim S,)
we shall only consider sampling functions which are step functisns.
These are defined by the jump points and the amount jumps at these
points.
Pdm u n t
~'~arnount,
lump
jurnp
1 grd arnount lump
jurnp points
The amounts jumps can be positive or negative, as is clear from the

C
t
above figure, representing positive or negative claims.

We now give the definition of processes with independent increments.
These form the foundation upon which the classical collective risk theory
is built. (See for example Cramer [23].)
Definition: { X , ; t z O ) is a process with independent increments if for

all intervals ( a i ,b,] which do not overlap
X,,-X,,, X b 2 - X a 2 , ... > X b n - X a n
are independent random variables.
Terminology: X,, - X,, is called the increment in the interval (U,,bi].
incrernent
Definition: { X , ; t r O } is a process with stationary increments if

Fxt+ Xf(X) is independent of t ,
i.e. if all increments of intervals of the same length have the same
distribution.
The following two theorems will be particularly important to us.
7beorem I : Suppose that { X , ; t >= 0 ) is a counting process with independ-
ent increments, i.e. the sampling functions are step functions with constant
positive amount jump 1. l f E(X,)=m(t) is a continuous, monotonically
increasing function of t , then m ( t ) can always he introduced as the new
time variable in accordance with the relation ( f o r simplicity's sake we
assume m (0)= 0 )
X =X with t ( T ) = infis, m(s)= T }

S
so that
a) {XI .r 2 0 ) has stationary increments,
b) { X ,J T 2 0 ) has independent increments,
- 7k
C) P[Xr=k]= e r - k=O, 1,2, ... (i.e. is Poisson distrib-
k! uted).
2.1. Fundamentals 39
Remark: ~ = m ( tis) called operutionul time. The Passage of time is

no longer measured in years, hours and seconds, but in expected number
of claims.
Proof: See for example [33], p. 178.
The second theorem we Want to mention is
Theorem I I : Assume thut , f i r the stochustic process { X ,; t 2 0 )
a) X,=O;
b) { X , ;t z O ) has independent stationury increments;
C) ( X , ; t 2 0 ) has only step sampling functions;
d) the expected numher of jump discontinuities in euch finite interval
is finite.
lhen W
P[X,Ix]= C
k= 0
ecAf-
k!
~ * k ( ~ )
or in terms of charucteristic functions

(Px,( U ) = e i f l x ( u ) - - 'I
where ~ ( uis) the charucteristic function of F(x).

Proof: See 1171.
Both theorems characterize the distribution law of the process.
Theorem I1 is particularly important in this respect. It determines the
distribution law up to the free choice of the function F ( x ) and of i.
The
.
four conditions provide for necessity and sufficiency, a ) playing the
subordinate role of a standardization. The type of distribution function
appearing in theorem I1 is called compound Poisson in this book. (Note
the differences in terminology used by various other writers such as
Philipson [59] and Hofmann C391 for example, whereas our terminology
coincides with that of Feller [32].)
Remark: If we choose F(x)=O for X < 1 and F(x)= 1 for X 2 1, then
we obtain again the usual Poisson distribution for X,
with the characteristic function

( P x , ( U ) =e ~ r ( e l u 1)
-
2.1.3. Markov processes

Markov processes are a generalization of the processes with in-
dependent increments. The probability of the future process variables
depends thereby only upon the last known value of the process (in the
present or the past). This property is known as the Markov condition M:
P C X r m + , I x m +...,X,"
l, s~~/x~,=xi,...,X,~=x,l
(M)
... > X * , ~ X ~ / X , ~ = ~ , I ,
=PCXtm+,5xm+Lr
where the sequence
is ordered according to natural order of time.

The probability law governing a Markov process is appropriately
described by the transition probabilities
It follows directly from the Markov condition that the transition

probability must satisfy the Chapman-Kolmogorov equation
When the process takes on only a countable number of values, the

transition probability is conveniently written in the form
P[X, = ak/X,,= ai] = pjk(t', t)
and the Chapman-Kolmogorov equation then reads
Transition probabilities in the discrete case are in this book assumed

to have the following continuity properties:
a) pjk(tf,t) is continuous for all pairs (t', t)
1 ifj=k
b) lim pjk(t,z)=pjk(t,t)=
1-t 0 if j + k .
Transition probabilities are called stationary if
Q(tt,t;y,x)=Q(t'+h,t+h;y,x) forall h>O
or in the discrete case
pjk(tl,t)=pjk(tf+h, t + h) for all h>O
Then we can also write (with a slight abuse of notation)
pjk(tr,t)=pjk(t - L'),
since the transition probability depends only upon the time difference.
2.2. The claim number process 41
For a more detailed description of Markov processes, See e.g. [56]

or [32]. It is left to the reader to prove that every process with independent
increments satisfies the Markov condition M and is therefore itself a
Markov process. (See exercise 1) below.)
Exercises
1 ) Show that every process with independent increments is a Markov
process.
2) Suppose that two compound Poisson processes having charac-
teristic functions
X
&) = e " [ ~ ( u ) - ' l resp. e"'[$'"'- 'I
are identical. What is the relation between A,p, ~ ( uand ) $(U)'!

3) Let S , = z Yji ( t i A , ) be an accumulated claim process where
P[Y,,5 X ] = F ( x ) which is independent of ti.Suppose that { Y,,, Ti,
... ,X,)
are independent random variables not depending on A, and that
P[A, has k elements] = e-" -.(1tIk

k!
Show that S, has a compound Poisson distribution, i.e. that
2.2. The claim number process
2.2.1. Mathematical description

In 2.1.1 the claim number process was described by an intuitive
approach. We shall now define the claim number process as the stochastic
process {W; t Z O ) , where N, stands for the number of claims in (0, t].
The set A, which appears in the definition of the accumulated

claim process in 2.1.1 can be obtained as follows from the process N,:
A, = Cjump discontinuities of NT with t 5 t). In this connection we define
42 Chapter 2.The Risk Process
the claim event in such a way that only one such event can occur at a
given point of time. Cumulative (simultaneous) claims are counted in
this sense as one single claim event.
In the classical collective risk theory it is assumed at this point that
the claim number process has independent increments. If we now apply
theorems I or I1 of section 2.1.2, we discover (after changing over to
operational time) that N, is a Poisson process, i.e.
We shall not make the assumption of independent increments here,

but rather begin with the much weaker and more realistic working
hypothesis that {Nt;tr 0) is a Markov process. Intuitively we are making
the following assumption: The total number of claims determined in the
past does play a role as far as the future number of claims is concerned;
it is of no significance, however, when these claims have occured in the
past.
We thus describe the law of probability of the claim number process
{ N t ; tZO} by the transition probability
which is the probability of k claims between t (exclusive) and t + h

(inclusive) given that n claims have already occurred up to point of
time t (inclusive).
It follows directly from the nature of the claim number process that
a) pnm(t,t+h)=O for m < n .
For simplicity's sake we shall also assume the existence of the following
limits for all t and n. (For a discussion of the existence of these limits
See Chung [20].)
C) lim pn,n+k('rtf h, =0 for k>,2 (uniformly in k).

11-0 h
Relations b) and C) mean intuitively that for small time intervals the
probability of a claim occurring is proportional in first approximation
to the length of these intervals and that the sampling functions of the
claim number process have only positive jumps of amount 1.
2.2. The clairn number process
It follows easily from b) and c) that
The function A,(t) is called the intensity oj'j'requency of the n-th claim
(transition from n - 1 to n claims). Observe that in the case of stationary
transition probabilities the intensities of frequency are no longer depend-
ent upon time. Knowing these intensities enables us to calculate all of
the transition probabilities by use of Kolmogorov's (forward) dijj"erentia1
equation system (see e.g. [32]):
with the boundary conditions

1 for s = t , m=n
o for s = t , m + n .
The condition of standardization
is not always satisfied by the solutions of this differential equation system.

This is discussed at the end of this section. But finally it should be noted
that the system of differential equations has a recursive character and
only appears to be partial. In actual fact t plays the role of a Parameter.
By integration we obtain the explicit solutions
which can be easily verified by insertion into the system. From this it
follows in particular that the pnm(t,S ) are always non-negatizie for any
given Set of non-negative intensities of frequency A,(s) m= I , 2, . . . and
also that they are differentiable in t and .Y.
Chapter 2. The Risk Process
The question remains whether
pnm(t,s) = 1 for all n, t, and s z t

always holds. The answer is in the negative but the following statement
is always true for arbitrary given non-negative intensities of frequency
Am(s),m = l , 2, ... :
~ ~ = , p f l m ( t , s ) 5forall
l n,t,andszt.
This is seen as follows:
Let
Obviously S(t, s) is non-negative and monotonically increasing

with k as a sum of non-negative summands.
We designate lim S(t, s) by S,(t, s), provided this limit exists.
k+ ai
Observe from the above system of differential equations for p(t, s)

that we have
a
-S(t, s)= Ak+l(~)
pnk(t,S) for arbitrary n, k, t and s z t
as -
with the boundary condition

S(t, s)= 1 for s = t ,
which together with the non-negative character of S(t, s) immediately
yields
0 5 S(t, s) 5 1 for arbitrary n, k, t, s z t
and hence
0 5 S,(t, s) 5 1 as was to be shown.
We then distinguish the two essentially different cases
a) S,(t, s)= 1 for all n, t, s: normal case
b) S,(t, s) < 1 for at least one combination n, t, s: case of exploding
number of claims.
Intuitively, b) refers to the situation where with positive probability
infinitely many claims occur in a finite time interval. In practice this is
of Course not realistic, but the case b) is nevertheless important for our
practical applications: It characterizes those intensities of frequency Am(s)
m = 1,2, ... which should be ruled out a priori in any reasonable model.
From this angle it is important to characterize the cases a) and b) by
the intensities of frequency directly. The following theorem (due to
Feller [32]) provides this characterization in the case of time-independent
intensities of frequency.
(The rest of the section may be omitted at first reading.)
2.2. The clairn nurnber process 45
Iheorem: rlhe "normal case" Sn(t,s)= 1 for all n, t, s applies if und only
" 1
if E --
m = 1 Am
diverges (Am,m = l,2, ... are the non-negative time-independent
claim frequencies).
Proof: From the foregoing differential equation (plus boundary con-
ditions) for S(t, s) we get
S
1 - S(s) = Ak+, J p , k ( ~dz

) (We omit the first time point t , from which
o the transition probabilities become inde-
pendent in the case of time-independent
frequencies of transition.)
which decreases monotonically with k to ,u(s); hence
and
m
If 1
m=n+l
l/Am diverges, ~ ( s must
) be Zero, which implies that Sn(s)=1.
Conversely
remains bounded if 1
l/Am converges; hence S(T) cannot converge
to 1 (which by the theorem of dominated convergence (cf. Appendix)
X
would imply the erroneous Statement s 5 (l/A,) is bounded for all s).
In the case of time-dependent intensities of frequency no simple
characterization is known, but the following theorem is useful:
rlheorem: Let {Nt; t 2 0) be a number of claims process with intensities
of frequency Ai(z) (i= 1,2, ...) und {&*; t 2 0) another number of claims
process with intensities of jkequency AXT)(i= 1,2, ...).
7hen
Ai(z)rA;(z) for all i Z N , t s z s s
implies
S , ( t , z ) ~ S ~ ( t , z )for all n r N , t j z s s .
(Sm Sn are defined as before for the processes Nt und N,*.)

Remark: This theorem allows us to confirm the intuitive conjecture

that if {N,;t z O ) does not explode then neither does the process {&*;
t 2 0 ) . If IN,*; t 2 0 ) is a general number of claims process one may try
to construct a dominating { N , ; t2O) with stationary transition prob-
abilities in order to prove that {N,*; t z O } does not explode.
Proof: We have Seen in this section that
and similarly for the starred process
We write Am(s)for S,,,(t, s)- S,*,(t, s) holding n and t fixed and

obtain
After rearranging the right side we have
with the boundary condition
Ak(s)=O for s = t .
Now An(s)= p(t, s) - p,i,(t, s) 5 0 from the explicit formula for pnn(t,S)
and the assumption A ,(T)2 An+ ,(T).
If Ak-,(s)-0 then
Ak(s)is continuous (even differentiable), starts at time s = t with A k ( t ) = O

and hence has a negative derivative as is Seen from the above inequality.
It therefore never assumes a positive value.
Since Ak_,(s)10implies Ak(s)50, we have finally Ak(s)sO for all
k 2 n as was to be shown.
2.2.2. The claim interoccurrence time

The claim interoccurrence times T, are very useful in describing the
claim number process; these are random variables, as are the quantities W,
(= time of occurrence of the n-th claim event), and are defined as follows:
To each random realization (sampling function) of the claim number
process {W; t 2 0 ) there is associated a sequence
W,({&; t 2 0)) = point of time at which the first claim event in the realiza-
tion {&; t 2 0 ) occurs;
W,({N,; t 2 0))= point of time at which the n-th claim event in the realiza-
tion {Nt;t 2 0) occurs.
Graphically, this has the following appearance:
The W, (n= 1,2, . ..) form a sequence of random variables which

assume values in accordance with the sampling function realized. The
differences T,= W, - W , are called claim interoccurrence times, W, is
called the waiting time to the n-th claim. There is a fundamental relation
between the events, as expressed by
CT,>tl=CNw,+l-Nwn=O1
(which allows us to change our interpretation freely from the claim

number process to the claim interoccurrence times and vice versa).
It also follows from the formulae given in the preceding section that
The claim interoccurrence time T, is thus exponentially distributed with

intensity A,(t). From this fact we can derive the following relation:
Proof :
This relation tells us that the claim interoccurrence time has no memory.
This means that if no further claim is incurred up to time W ,+ s then the
future distribution will be the Same as if the last (n-th) claim had occurred
at time W,+s. This property, which we have derived by analytic devel-
opment, can also be deduced as a direct consequence of the Markou
condition.
The following two theorems are important:
Theorem I : If the claim .frequency intensities are independent qf time,
then the claim interoccurrence times are independent of the points oj'time
at which claims occur.
independent of W,.
Theorem 11 :l f the claim ,frequency intensities are independent of time,

then the claim interoccurrence times are stochastically independent.
Proof:
P[T,>s, T , > t ] = P [ T , > s , T,>t/W,=w,]
This is the proof for T, and T,.In the case of k claim interoccurrence
times the procedure is analogous. We See from these two theorems that
time-independent claim intensities of frequency are very much to be
desired. The next section deals with the question of where and how this
time independence may be attained.
2.2.3. The homogeneous claim number process-operational time

If the intensities of claim frequency An(t)are independent of the time t
the claim number process is said to be homogeneous.
This characterization is equivalent to another:
Definition: The claim number process {N(t);tzO} is homogeneous
if the transition probabilities p(t, t + h) are independent o f t for all n, m
and h.
In other words this definition means that the individual transition
probabilities depend only upon the length of the time interval for the
transition and not upon its position.
That the foregoing definition is equivalent to our Statement that the
intensities of claim frequency are time-independent follows very simply
from the Kolmogorov differential equations referred to in section 2.2.1.
Very often a non-homogeneous claim number process can be made
homogeneous by introducing an operational time. We shall now follow
this through in detail.
Assume that a claim number process {N,;t z 0) is given as well as
a monotonically increasing function of time p(t) with p(O)=O. We then
define a process M, relative to the time p as {M T ~ O }where
,
M,=N,-,, and p-l(z)=inf{t;p(t)=z).

t
The transition from Nt to M, amounts to a distortion of the time axis,

as illustrated in the following diagram:
It must hold thereby that T, = p(t,), T, = p(t,), T, = p(t,), etc.

We may now ask how the basic characteristics of the process Nt are
transformed in the new process M,.
Process Transition probabilities

p(t) is called an operational time if the process M, is homogeneous relative

to the time p.
Before going into the question of the existence of an operational
time we shall elaborate on the concept of homogeneity by means of an
equivalent characteristic property.
n e o r e m : A claim number process is homogeneous if und only if
for suitably chosen constants C,.

Proof: If the claim number process is homogeneous (i.e. if A,(t)=An),
then the above expression for p(t t,) holds for C , = AG, in accordance
with the general form of p on p. 43. If on the other hand this expression
for p,,(tl, t 2 )is valid, then A,(t) is equal to
1 -P&, t+h) -
lim -Cn,
h-0 h
from which the homogeneity of the process follows by definition. On the

basis of this result we now prove the important
Theorem: An operational time for the claim number process exists ij
und only if the intensities ofjrequency are of the form
( A n constant for all n).

I
a) The condition is sufficient: We define p(t)= j y ( s ) ds and shall

0
establish on the basis of the above theorem that the process M, belonging
to p(t) is homogeneous:
The condition of the theorem is thus satisfied for c,=A,.

b) The condition is necessary: Let ~ = p ( tbe ) an operational time.
Then
~ " ' ( 0 ~, ) = e ' ~ ' t Z 0
for certain constants C , . On the other hand, according to the transforma-

tion formula,
with t = p-'(T). Comparing these two formulae, we have
from which
We have thus far shown that the equation (*) holds for t of the form
t = p - ' ( T ) . That it is valid for any value o f t can be seen, however, from
the fact that, if p - ' ( z + O ) + p - ' ( T ) , we conclude from
that the rclation

p-l(r+O)
must hold.
Finally, it can be seen from (*) by differentiation that the condition
of the theorem is satisfied for y ( t )= p f ( t ) ,An+, =C,. (For the reader who
is familiar with measure theory we may add "up to changes of Lebesgue
measure Zero in the /Z,(t)".)
Remark on the "classical case" in collective risk theory: In this case
it is postulated that all the claim frequency intensities are identical, i.e.
A,(t)=A(t) forall n .
Thus an operational time always exists.
2.2.4. The case of time-independent intensities of claim frequency :

contagion models
In section 2.2.2 it was shown that in the case of time-independent
intensities of frequency (i.e. I.,(t)=A, for all n )
a) the claim interoccurrence times are independent of the point of
time at which the claim occurs;
b) the claim interoccurrence times are independent of euch other.

In particular the explicit formulae which we developed in 2.2.1 can
be reduced as follows
We discussed in 2.2.3 the conditions under which the case of time-

independent intensities can be attained by changing over to an opera-
tional time.
Let us now examine the form of the probabilities pnm(h)in the case
of frequency intensities having linear form. More general forms can be
handled basically in the same way, but naturally the expressions thus
developed become progressively more complicated. Observe, however,
that for frequency intensities An with order of growth n l + &((E>O)we are
already in the explosive case (cf. 2.2.2).
Let us assume then that the linear hypothesis holds:
An=a+b.(n-1) for n = l , 2 , 3 , ..
We require that a 2 0 and we distinguish then the cases

I. without contagion: b=O or A n = A
11. with contagion: An+, - A n = b += 0
b >0: positive contagion
b <O: negative contagion.
I . The case without contagion
Here An = A for all values of n. It can easily be verified that the recursion
formulae given at the beginning of this section are satisfied by the
probabilities
The claim number process becomes the homogeneous Poisson process and
we therefore have the case of the classical collective risk theory.
11. 7he case with contagion

By mathematical induction we obtain from the formulae at the begin-
ning of this section the relation
I,+k+ih. An+l...An+k
~ n , n + k ( ~ ) = ~ -
be(2b)...(k b ) - ( e b h - l ) k , b = ~ , - A
2.2. The claim nurnber process 53
where the fraction on the right is set equal to 1 for k=O. The formula is
valid for k = 0 and follows by induction for any other value of k from the
recursion formula at the beginning of 2.2.4. It is easy to see that the
relation holds for both positive and negative contagion-for the latter,
however, only as long as A, >O. From here on we shall discuss the
two cases separately.
11,. Positive contagion ( b> 0 , An = a + b ( n - 1))

Let p(h)= cbh and an=- An+1
b .
Then it follows from the preceding formula that
and therefore
These are the probabilies given by the negative binomial distribution. The
reasoning used here is similar to that of Polya-Eggenberger [30] in terms
of which contagion is explained by an urn model with contagion. It
should be noted that this distribution is satisfied not only by the total
number of claims but also by the conditional distribution given the
number of claims already incurred.
11,. Negative contagion (b<0)
An= a + b(n- 1) if the right side is positive. There is a final index m
such that A,r0; we then set A,=O for all k r 1. Let p(h)=ebh and
An+ 1
CI,=- . Then p(h)=O for s < n, s> m whereas for n s s 5 m- 1 we
-b
have the general formula
p(h) is obtained from the standardization relation p(h)= 1.

For n 5 s 5 m - 1 we therefore have, using an abbreviated notation,
If an is an integer this probability distribution is the usuul binomial

distribution. Otherwise, in terms of the standardization relation given
above, it is a generalization of the binomial distribution. All probabilities
are computed in the same way as in the case where an is an integer. But
whereas p(h)= 0 in the latter, it is now different from Zero and obtained
from the relation p(h)= 1.
It may be well to refer here to the very thorough treatment of conta-
gion phenomena by Kupper [42]. For our purposes we terminate our
discussion of the claim number process at this point.
Exercises
1) Since the Poisson distribution represents the no-contagion case,
can it be derived as a limiting case of the
a) binomial distribution (negative contagion),
b) negative binomial distribution (positive contagion)?
i) How must the Parameters be varied in cases a) and b)?
ii) Take the limit with the help of the characteristic functions.
2) Let us adapt the claim number process to the case of a single
death risk (i.e. A n ( t ) = O for all n r 2 ) .
i) Show that there is always an operational time.
ii) Calculate pol(t, t + h) for the usual time scale,
, p, (h) for the operational time scale.
iii) Interpret the meaning of the operational time scale.
3) Give an interpretation of linear contagion in the homogeneous
case with regard to the effect on the claim interoccurrence times:
i) distribution of claim interoccurrence times,
ii) expected claim interoccurrence times,
iii) sum of the first n claim interoccurrence times (characteristic
function).
4) Prove that if the claim number process has independent increments
then all intensities of frequency are identical.
2.3. The accumulated claim process

2.3.1. Definition as random sum and basic representation
By accumulated claim we understand the summed total S, of alt
claims starting from time t=O. Symbolic description:
Accumulated claim process {S,; t 2 Of

2.3. The accumulated claim process 55
In 2.1.1 we saw that the accumulated claim process can be broken

down into a (double) random sum:
At designates the Set of jump discontinuities of the claim number process

up to time t and Y,, the random-claim amounts.
Having analyzed the claim number process in some detail in section 2.2,
we shall now turn our attention to the claim amount variables and the
interaction of claim number process and claim amount variables which
results in the accumulated claim process.
To this end we make the following postulates:
Postulate A : The accumulated claim process {Sr;t 2 0 ) is a Markov
process. This means that while at any point of time the future develop-
ment of the claim-producing agent ( = risk) depends upon the total of
the claims incurred up to that point, it does not depend upon how this
total arose over time.
Postulate B: The conditional accumulated claim process-given the
points of time {tut ..., t,} at which the first n claims occurred-
depends only upon the claim occurrences in the past, i.e.
PISIsx/{tl, ... , t,}] = P I S t s x / { t l , ... , t,}] if t i s t for i s k
t i > t for i > k .
In addition we shall assume as in section 2.2
Postulate C: The claim number process {NI; t r O } is a Markov
process.
We now define the distribution function of the amount jumps (claim
amount distribution function):
F, (ylx)= P [S, 5 y/S, -,= X and t is a point of jump discontinuity] .
We are thus dealing with the conditional distribution of the amount
jump y-X, given that a jump point occurs and that the accumulated
claim process has the value X before this discontinuity.
The following is then the basic representation of the accumulated
claim distribution G,(x):
Before proving this formula, we require some preliminary explana-

tions:
-Aln' is a random set of n points tl, ... , t , with O< t, < t, < ... < t,s t
which is determined by the claim number process. By using the claim
waiting times (the sums of claim interoccurrence times) Aln) can also be
defined as [ W , = t W,=t ..., Wn=t Wn+,>t].
% j n ' is the class of all the sets Al").
'
I R n = {[.X . ..,X,- ,I) is the set of all ( n- 1)-tuples[ X x 2 , ...,X,- ,I.
The integration is over 'LI)")X IRn-', i.e. over the class of all sets A r )
and all (n - 1)-tuples [ X x 2 , ...,x ~ - ~ ] .
We might add the following constructiue explanation: G,(x/A~"')
t h e distribution function of the sum of the Y,,, (tiAYi)-is obtained
for given AIni from a generalized Chapman-Kolmogorou equation:
from which we have
G,(X) = 2
n= 0 %("I
j G, (x/AY1)dP [ A r i ]
with
or, by integration over 91, (= the union of all the 2l Y'), where Al represents
any element of <II, :
G,(4= 1G,(x/A,)dP(A,).
%,
This constructive explanation is particularly useful when treating the

problem by means of an electronic Computer. The procedure to be fol-
lowed in the numerical calculation is a direct generalization of that for
the compound Poisson distribution, which has been formulated and ex-
amined by various authors within the framework of the classical col-
lective risk theory [8, 31, 571.
It should also be mentioned that the preceding formula is a direct
consequence of postulates A) and B) alone.
2.3.2. Proof of the basic representation of the accumulated

claim distribution
Theorem: The basic representation of the accumulated claim follows

from postulates A ) and B ) of the preceding section.
Proof: It follows from the rule of total probability that
with A r ) = {t t,, ...,t,). We can break down the integrand as follows:

P[S,sx/Aj"'] = 1P[St,4x/Ay), St,-, =Y] . dP[S ,,_,SylAj")]
IR1
By repeating this procedure we obtain
Insertion of this relation into the first formula of the proof yields the
desired result.
2.3.3. The reduced basic representation: time-independent claim amounts

We must not be overly-impressed by complicated formal expressions.
The form of the basic representation derived in the last section-in
spite of its awkward appearance-is not much more difficult to handle
in numerical work than the compound Poisson formula, which plays
such a central role in the classical collective risk theory. We shall never-
theless discuss a reduced basic form at this juncture which Comes quite
close to the compound Poisson formula (and which contains the latter
as a special case).
Let us begin with the case of time-independent amount jump distribu-
tions (claim amount distributions). Thus let
F, (ylx)= F(y/x) independent of t
We find then that
is dependent only upon the number of points in Aj"', and we therefore have
G, (X)= C,"=, p, (t) G (xln) reduced basic representation

where p,(t) = 1d P [Aj"'] =probability of n claims in the time interval(0, t].
!Np
In our terminology we shall speak of the reduced basic form when
the accumulated claim distribution is represented as a weighted sum of
distribution functions, the weight being the probabilities for the number
of claims in the time interval under consideration. The reduced basic
form developed for time-independent amount jump distributions as-
sumes the form of a weighted sum over the convolutions F*"(x) when
the amount jumps are also mutually independent.
because in this case the definition of G ( x / n )coincides with that of F*"(x).

(Cf. the definition of convolution in section 1.2.3.) Notice however that
this correspondence can be reached formally only if we set F(y/x)=
F(y - X ) . We should also note here that the classical collective theory of
risk assumes G,(x) to be of this latter reduced form. The probabilities
pn(t)are thereby even specialized to the Poisson case i.e.
and hence
This latter distribution is referred to as the compound Poisson case in

this book. (For another terminology see e.g. Philipson C591 and Hof-
mann [39].)
2.3.4. The reduced basic representation: time-dependent claim amounts

Although a formal reduced basic representation can be obtained in
every case, only those cases are interesting in practice which become more
easily grasped in reduced form. The considerations of the preceding
section are essentially conditioned by the assumption that the claim
amount distributions do not explicitly depend upon time. If an explicit
time dependence is involved in these distributions, it is fortunately still
possible, however, to reduce the basic representation to a more manage-
able form in certain cases.
We shall show how in the case of time-independent intensities of
frequency (obtainable for example by an operational time through
transformation of the time scale) a reduced basic form can be obtained
at least in the case of linear frequency intensities. Thus we now make a
special assumption about the claim number process or-what Comes to
the same thing-about the differential dP [ A ! ~ 'which ] appears in the
fundamental form. We write AI")= {t,, t,, . .. , t,)-thinkingof the ordered
n-tuple t , < t , < ... < t,-and find for the case of time-independent
intensities of frequency
density function probability ofclairn

of the first claim nurnber (nf I ) later
lnteroccurrence time than r
(Compare the definition of Al"' and its expression in terms of claim

waiting times W,, k Z n + 1 in 2.3.1.)
Thus
If we further assume as in 2.2.4 that the intensities follow a linear pat-

tern, then A,+, - A, = b for all k. In addition we note that G ( x / { t , ,t . . .,t,})
is a conditional probability given the set { t t 2 , ...,t,) = Ajn'. This Set is
of Course not changed by permutation of its elements and accordingly
G ( x / { t t ... , t,)) also remains invariant if the t i are interchanged. We
can therefore also extend the n-tuple integral over the full n-dimensional
cube
{Osti$ t for all i} instead of the area
{ 0 5 t , 5 t 2 5 . . . 5 t n 6 t }andfinally divide by n!:
We shall consider first the case b $. O and revert to the case b = O later.
We now define a probability density function f (T)= b eb'/(ebt- 1) in the
interval CO, t ] . The function G,(x) can then be written as
The probabilities pn(t)are identical with those in 2.2.4 under the discus-
sions of positive and negative contagion. If we now make use of the
definition
and the auxiliary distribution functions
we have
Gi(x)= C,"=, p,(t) G,(x/n), the reduced basic form.
In the case of identical intensities ( b= 0) the same expression holds.
We choose
1 1 '
f E ( x / Y ) =l~
&(x/Y)
0
and find that the p,(t) are the Poisson probabilities e-"- ("' . (This
special case was discovered by Jung [40].) n!
To summarize, we have the following situations in the case of time-
independent intensities of jrequency which follow a linear Pattern:
NO contagion (b =o) Poisson uniform on [o, t ] 1p,(t) Gt(x/n)

Positive contagion (b >O) Negative binomial K , . eb' on 10, t] 1p,(t) Gt(x/n)
Negative contagion (b <0) Binomial K 2 . ebron CO, t l 1P,@) ~ , ( x / n )
2.3.5. An example
We shall now illustrate the mechanism just discussed by means of an
example. Suppose that
-pn(t) is the probability as given by the negative binomial distribution
(positive linear contagion b > 0 ) ;
-&(X)= 1-e-"" is the claim amount distribution; the density func-
tion f,(x) is therefore C t . e-"";
-the claim amounts are independent of each other.
We then find that
2.3. The accumulated claim process
and thus
cb
/,<X>= [[(b - c X) t - 11 e ' b c x ) ' +l]/(b - cx)*.
By convolution we obtain the powers of convolution f;*("'(x) from f,(x)

and thus the frequency function of the accumulated claim distribution
It is interesting that f,(x) follows a Pattern quite different from that

of the original density functions f,(x). While the latter are exponential,
the newly developed function is asymptotically (i.e. for large X) Pareto.
In particular none of the moments for the latter exist.
Graphically represented,f,(x) has approximately the following form:
Exercises
1) Consider the example in 2.3.5 and
a) prove without using the transformation for f,(x) that
b) Show that this phenomenon is due to the small values of t. In

particular all the moments are finite if the process begins at C, > 0.
C) Carry the example through for negative contagion and for no
contagion.
2) Prove the following (without using the theorem in section 2.1.2):
a) If the risk process has independent increments, then all intensities
of frequency are identical (exercise 4 in section 2.2.4).
b) If the risk process has independent increments, then the amount
jumps are also independent of each other. If in addition the process has
stationary increments, then the amount jump distributions are inde-
pendent oft.
C) Show that the following relation must therefore hold for a risk
process with independent and stationary increments:
where the p,(t) are Poisson probabilities (compound Poisson law).

Remark: We have implicitly assumed in 2c) that the (finite)intensities
of frequency exist.
3) Assuming the compound Poisson distribution for the accumulated
claim process, develop expressions for the first three moments of Si in
terms of the Poisson intensity I, and the moments of the claim amount
distribution.
Nt
4) Let S, = 1 Y where Nt represents any counting variable and the
j= 0
5 ( j = 1,2, . . .) are independent and identically distributed. Express
E[S,] and Var[S,] as functions of the expected value and variance of
the two variables Nt and Y j .
Chapter 3
The Risk in the Collective
3.1. Risk-theoretical definitions
3.1.1. Risk and collective

In the preceding chapter we described the risk (and particularly its
claim generating aspects) by means of the risk process. In doing so we
characterized the accumulated claim process S , in terms of the number of
claims process Nt and the distributions of the amount jumps F,(x/y).
Throughout this characterization we treated the probability distributions
or distribution functions involved as given and known.
This assumption-useful though it may be for the development of
our theory -is never fulfilled in practice, however. We can in fact men-
tally associate a number of claims process and amount jump distributions
with any risk, but the form of these functions is always more or less
unknown.
The concept of the collective of risks plays a decisive role in this
connection. Insurance has always been recognized as a spreading of
risks within a collective, and thus in most cases only the theoretical
description of the collective's probability aspects needs to be assumed as
known.
At this point we shall provide exact definitions for these various
concepts. Moreover, we are concerned only with the claim uspect of
the problem, and consequently our definitions will only deal with the
claim aspects of the risk (resp. of the collective).
Risk: Its claim aspect is characterized by
a) ths number of claims process { N t ;t 2 0) with transition probabili-
ties p(t, s) and by
b) the distributions F;(x/y) of the claim amount jumps;
briefly: risk = [N,, F,].
Collective: Set of risks. Each risk is labelled with a parameter (char-
acteristic quantity) 9. This parameter can be defined very generally: in
particular it need not be a real number (It can be for example a real
pair, a real triple, etc.);
64 Chapter 3. The Risk in the Collective
briefly: collective O= 191, the totality of risks identified by the para-

meter 9.
7he risk 9 in the collective O is then denoted by the symbol 9 or, in
somewhat greater detail,
risk 9 = LN,"', F,"']
Perhaps an example will make these definitions clearer: Consider a

collective O of risks 9 characterized by
N,"' the homogeneous Poisson process corresponding to 9 with
probabilities
and by the distributions

4'' which are independent of t and 9, and such that f i ( ' ) ( ~ / ~ ) =
F(x - y) (independence of the claim amounts).
Then the following accumulated claim distribution applies in respect
of the risk with parameter 9 :
We know therefore the form of the distribution function G,(x) (com-

pound Poisson). We think of the parameter 9, however, as being unknown.
This situation is typical of all problems where we are considering a risk
9 in a collective O. It is also to be noted that we know the distribution
of amount jumps exactly for the risk in our example (but not the transi-
tion probabilities of the number of claims process). This is due to the
fact that F,"' does not depend on 9. We say then that the collective is
homogeneous with respect to the claim amounts.
More generally, we say that
a) O is homogeneous with respect to the number of claims (with respect
to the number of claims process) if N,"' possesses the Same transition
probabilities for all $E O ;
b) O is homogeneous with respect to the claim amounts (with respect
to the claim amount distributions) if ~ " ( x / y )is the same function in X
and y for a l l 9 E O ;
C) O is simply homogeneous if both a) and b) hold.
It should be emphasized that a collective need not be homogeneous
in the present representation. Other theoretical models, which postulate
homogeneity as a characteristic property of a collective, are in our
opinion unsuitable for wide areas of practical problems in insurance.
3.2. The weighted risk process as description of the risk 65
3.1.2. The structure function

To the extent that the probability characteristics vary from one risk
to another, a description of the collective's structure is necessary. More
precisely, if 0' is some portion of the collective O, we require an indica-
tion of the probability with which a risk taken at random from the col-
lective falls in the portion O'. The function which provides this informa-
tion is called the structure function.
In many cases it is possible to determine this function approximately
by means of statistical investigations. A good example OS this is provided
by the investigations of Bichsel [7] in connection with the Swiss Auto-
mobile Liability Tarifs 1963: Let the number of claims process Nf9)of
the risk 9 be Poisson with intensity 9 as before. 9 can also be thought
of as the expected number of accidents per year. It seems at least plau-
sible, therefore, to approximate the structure function from the distribu-
tion of the obserued number of claims among the group of Swiss auto-
mobile drivers. We shall revert to the details of this procedure later On.
It happens from time to time, however, that an analysis of this kind
is not possible, simply because there are no observed data available. The
assumption of a structure function can be justified euen in this case. It
then simply amounts to a personal appraisal of the collective's structure
by an underwriter. Such personal appraisals, by the way, have been used
from the very beginnings of insurance, e.g. under the heading of "under-
writing judgement". While this latter concept is often somewhat vague,
however, the structure function creates no conceptual problems.
As we have said previously, the parameter 9 need not necessarily be
a real number (linear parameter), even though it will be in numerous
practical cases. The collective O can then be represented by the real line
(or portions thereof) and the structure function will be the distribution
function U$'= P [9 5 t] on the real axis. Similarly if the parameter is in
vector form-9 = (9 9 ...,9,), where the 9, are real numbers-the
structure function will be a distribution function in real n-space. (Ex-
ample: For n = 2 the structure function is a distribution in the plane.)
3.2. The weighted risk process as description of the risk

in the collective
3.2.1. Weighted laws of probability
a) Distributions: Let {H($, X)} be a family OS distribution functions
for each 9, and U(9) a probability distribution on the Set 0. Then
H(x)= 1H(9, X) dU(9)
8
is also a distribution function (cf. 1441 for example). We call H(x) a

weighted distribution ,function (over the parameter 9). Weighted distribu-
tion,functions have the following properties (presented without proof):
Ist property (moments):
Let pk= 1xkdH(x)
and pk(9)=1xkdH(9, X).
Then pk= j p,(9) dU(9) in so far as the absolute k-th moments
CJ exist.
2nd property (characteristic functions):
Let cp(u)= 1eiuxdH(x)
and q9(u) = 1eiuxdH(S, X).
Then cp (U) = cp, (M) d U(9).
8
b) Processes: Let us now consider a class of stochustic processes

{X:''; tr0).Each event A (=set of sampling functions) defined on the
process then has a probability P")(A) which depends upon 9. The
weighted stochustic process is the process for which
P(A)= 1P'" (A) d U(9).

8
The probability law of the weighted process is uniquely determined

thereby. In particular, if we choose as A the event X , S x , then it follows
that
P [X, 4 X] = j P'" [Xt 5 X] d U(9)
8
or, if H,(x) resp. H,($, X) denotes the corresponding distribution functions,
Ht(x) is thus a weighted distribution function as introduced under a) for

every value of t.
C) Intuitive interpretation: Weighted distributions are most clearly
understood when interpreted in terms of the following urn model: All
the Parameters 9 from O are placed in an urn and to each there is assigned
a distribution function H(S,X)=P@'[XSX]. The latter describes an
"inner urn". We now make a double drawing:
i) The parameter 9 is drawn from the outer urn with probability
dU(9).
ii) The number X is then drawn from the inner urn labelled by 9 with
probability dH(9, X).
Symbolically the situation looks roughly like this:
Tnstead of the double drawing, however, we could equally as well have

made a single drawing from the weighted urn with distribution function
By analogy we obtain the notion of the weighted stochastic process

by a double drawing:
i) Drawing a Parameter 9 with probability dU(9), and
ii) drawing a sampling function of the process on the basis of the
probabilities defined by P @ ) ( A )on the events A of the process.
3.2.2. The risk pattern in the collective

As we explained at the beginning of this chapter, there exist certain
quantities which characterize the probability law governing the indi-
vidual risk with parameter 9:
{S:''; t r O } , the accumulated claim process of the risk with known
parameter 9;
(4''); t 2 0 1 , the number of claims process of the risk with known para-
meter 9; and
{FfS)(xly);t z O } , the distributions of claim amount jumps of the risk
with known parameter 9.
When 9 is fixed we also speak of fixed basic probabilities resp. fixed
basic distributions.
By weighting over the parameter 9 by means of the structure function
U(9) we obtain
{S,; t Z O } , the weighted accumulated claim process of the risk in the
collective;
{ N t ; t Z O } , the weighted number of claims process of the risk in the
collective; and
{F,(x/y); t Z O } , the weighted distributions of claim amount jumps in the
collective.
(It should be noted, incidentally, that weighting a process usually results
in the loss of the Markov property.)
Descriptively speaking, S Nt, F,(x/y) are then the characteristic ele-

ments, from the point of view of probability theory, of a risk which is
arbitrarily taken out of the collective. This is the usual case encountered
by the practician in the world of insurance, where the characterizing
elements for the single risk are-in accordance with the degree of homo-
geneity in the collective-only "more or less" known.
The recognition of this fact and particularly its Statement in mathe-
matical terms have entered actuarial literature under the head "fluc-
tuating basic probabilities". The terminology-which is self-explana-
tory-is essentially due to Greenwood and Yule [38], 0.Lundberg 1473
and Ammeter [I], who have written the basic works on the subject.
In the following we shall examine the (weighted) number of claims
process and the (weighted) accumulated claim process in the collective.
3.2.3. The number of claims process in the collective

In principle it is no problem to describe this in terms of the theory
of probability. We can determine for each risk 9 the transition probabili-
ties (from the intensities of frequency)
For the risk taken at random from the collective O with structure func-
tion U(9) it holds then that
It is easy to see here that in general the weighted number of claims

process N(t) is no longer a Markov process.
For t, < t, <s we have
- P[N(s)=m; N(t,)= n,; N(t,)=n,]

PCN(t,)= n1, N(t,)= n,l
The last expression on the right-hand side is in general dgferent from
8
P [N(s) = m/N(t,) = n,] =
1P"' [N(t2)= n,] dU(9)
8
In fact both expressions represent weighted averages of pn2,(t2,s),

but the first has the weighting function
So much for the more theoretical aspects of the number of claims

process in the collective. Fortunately there are two cases which are often
sufficient for practical applications in which weighting the probabilities
of the number of claims process produces results which are more easily
manageable.
3.2.4. The weighted Poisson and negative binomial distributions

The results which we shall now present are connected with the
theory of infinitely divisible probability distributions. A probability
distribution is said to be infinitely divisible if its associated characteristic
function q(u) has the following property: For every n there exists a
characteristic function qn(u) such that [q,(u)ln= q(u). This means that
the random variable belonging to q(u) can be broken down into any
number of independent identically distributed summands. L h y [43] and
Chintchin [I91 have found explicit forms for all characteristic functions
which are infinitely divisible. For our purposes the result of Feller is
especially important: For distributions defined on the non-negative
integers, every infinitely divisible characteristic function is compound
Poisson, i. e. has the form
where the characteristic function ~ ( ubelongs

) to some distribution func-
tion. (Compare e. g. [32] or C.561.)
a) Poisson basic probahilities

Let the number of claims process of the risk be Poisson, thus
(Cf. the case without contagion in 2.2.4.) Then we have the following
7heorem: If the structure function U(9) corresponds to an infinitely
divisible distribution, then
is likewise infinitely divisible, its characteristic function being of the form
Remark: One should take care not to draw conclusions about the
probability law of the weighted process {Nt; t 1 0 ) from this theorem; the
latter only refers to the random variable Nt for a fixed time t .
Proof: Let $(U) be the characteristic function of U(9) and <pt(u)that
of the random variables 4.
Thus
1
*(U)= eiU9d U($)
and
) = S l1 dU(9)
< P ~ ( ~ est[p'U-
i.e.
Since $(U) is infinitely divisible, we have, for any value of u (also

complex) for which the integral on the right-hand side exists,
where Un(9)is a distribution function; therefore
We can See from this that q~:;~(u) is also a characteristic function.

Thus cp,(u) is infinitely divisible and can be represented as
(This theorem is also found in Thyrion C661 as a special case.)

Example: (Cf. [2].) If the structure function is a r-distribution, then
so that we See immediately from the characteristic function

that the structure function is infinitely divisible. Thus we must have
From the relation
we can even determine the characteristic function <p,(u)explicitly. We

have
and
where
1 -
C
p(t)=---.
t c+t
1+-
C
N,is thus negative-binomially distributed. (Cf. the table ofcharacteristic

functions in 1.1.4.)The negative binomial distribution can also be written
as a compound Poisson distribution (as can be verified by series expansion),
As amount jump distribution we have then the logarithmic distribu-

tion. This result can be interpreted intuitively as follows: Negative
binomial claim number variables appear as counting variables of the
individual claim cases, provided that the claim events are Poisson and
the claim cases per event logarithmically distributed. This serves as a
model for cumulatioe claims.
b ) Negative binomial basic prohabilities

Let the risk be subject to the following basic probabilities in the
number of claims process:
(Cf. the positive contagion case in 2.2.4.) Note that we allow only the
Parameter 9 to vary, and not p(t) which we assume to be independent of 9.
With analogous means to those used with the Poisson basic proba-
bilities we can show that in the present case too
must belong to an infinitely divisible distribution if U($) is infinitely

divisible.
Moreover, the following relation holds between the characteristic
functions cp,(u) of Nt and $(U) of U($):
where
represents the characteristic function of the logarithmic distribution.

Here also the logarithmic distribution can be thought of as the distribu-
tion of the number of claim cases per claim event.
On the basis of our findings in 2.2.4 it is illustrative to note that in
this last transformation we assume the level of the intensities of frequency
to be variable by variation of 9, but that the differentes between the
intensities are held constant.
Exercises
1) Prove the theorem stated in 3.2.4 for negative binomial prob-
abilities.
2) Let
9+k-1
P'" [Nt = k ] =
and
Determine P [ & = k ] by means of the characteristic functions.

3) a) Prove that the negative binomial distribution is infinitely
divisible.
b) Transform the distribution explicitly into a compound Poisson
function.
4) Determine the expected value and variance of the negative
binomial distribution
a) from its characteristic function,
b) by integrating the moments of the Poisson distribution.
5) Show that for the weighted Poisson distribution
variance
the quotient 2 1 for any structure function U(A).
expected value
3.2.5. The accumulated claim process in the collective

Deriving the distribution function is also straightforward in this
case: To Start with we determine the accumulated claim process of the
risk 9 in accordance with the considerations in 2.3; let this be denoted
by {sj9);tzo}.
We then obtain the accumulated claim process in the collective by
weighting with the structure function U(9). We shall now carry this
through in detail, considering both the reduced and the general basic
representation of the accumulated claim distribution of the risk (cf. 2.3).
a ) The accumulated claim distribution of the risk is in reduced basic

representation form
For the risk with Parameter 9 from the collective O we then have
m
P(" [S, 5 x ] = GIw( X ) = E pja'(t) G:" (xln)
n= 0
(cf. 2.3).
We therefore have as the accumulated claim process in the collective O

with structure function U ( 3 )
This result follows at once if we reverse the order of summation and

integration. (Cf. the theorem on dominated convergence in the Appen-
dix.) In practical applications the special case for which the amount jump
distribution is the Same for all risks (i.e. for which ~ l " ( x / n is
) independent
of 9 ) is of paramount importance. In this case
where
In the special case for which
Pn)(t)=e-sl '( ')" and G,( x / n )= &*" (X)

n!
(cf. 2.3.3 and 2.3.4), GIY)(x) is compound Poisson with characteristic
function <P;8)(U)=est~~f(~)-1~,
where ~ , ( uis) a characteristic function for each t.

We then have as well the following representation theorem:
n e o r e m : Let q ~ , ( u=) 1es"xt'")- ' I d U ( 9 ) and let U ( 9 ) be inflnitely
divisible. l l e n
a) cp,(u) is the characteristicfunction o f an infinitely divisible distribu-
tion, and
b) cp,(u)= e " ( t ) L * ~' I( u(compound
' Poisson).
Proof: It suffices to establish b), from which a) follows directly. Let
Then it follows from the theoi-cni of p. 69 that

C eiuk Pk(t) = e ~ ( t i i ~ t ( ~11) -
k= O
and thus
We now set p, ( ln
:(U))
- and
=)i(~ ) wish to show that ),(U) is a charac-
teristic function; this follows from the relation
where { fk(t);k = 0, 1, . . .) is the probability distribution associated

with p,(u).
Remark 1 : It is shown in 1181 that the following converse of this
theorem also holds:
If
1e S r [ ~ r ( u ) - l Idu(,($)= e ~ ( f ) [ i f ( ~ ) - l l for all t z o ,
then U ( 9 )must be infinitely divisible.
The proof given there is based however on the assumptions that the
amount jump distribution is independent of time and that it has a finite
first moment.
Remurk 2 : The following conditions are equivalent:
A) U ( 9 )is infinitely divisible.
B) po(t)=J ep9' d U ( 9 ) is of the form ew"', where w(O)=O; w ( t ) can
be differentiated as many times as we please with ( - 1)"w'")(t)rOfor all
n r 1.
X
C ) I/,(x)= je-'"' d U ( 9 ) j e - " d U ( 9 ) is a distribution with merely

0 /om
non-negative cumulants for all values o f t .
The equivalence of A) and B) follows from a theorem of Bernstein
(See e.g. Feller [33],p. 425.); that of B) and C ) can be shown as follows:
The n-th cumulant ic, of the distribution Function F ( x ) can be
written as
a,
d" log j e-""-'"du($)

(ds)" r= O
m
dn log e-" d U ( S )
and the equivalence of B) and C) follows from this relation. The two
conditions B) and C ) are found in Thyrion [66] and Pesonen [58].
b ) 7he uccumuluted clnim distribution of the risk is in generul basic

vepresentution form
We then have for the risk with Parameter 9 from the collective O
and thus for the risk in the collective O with structure function U ( 9 )
m
P [S,5X ] =G I ( x=
) 1 1 j G ~ S ' ( ~ /d ~~ ~" '[A:"']
n ' ) dU(9).
n = 0 <U:") 8
This result also follows immediately from the basic representation by

reversing the operations of summation and integration. ( C f .the theorem
on dominated convergence in the Appendix.)
does not depend on the risk Parameter 9, we

Finally, if Gjg)(x/A~"))
omit 9 and have once again
m
P [S, I
X] = G, (X)= 1 rnpj G, (XIA;~))d~ [A;")],
n= 0
where
P [Al"'] = j P'" [Al"'] d U (9).
0
Exercises
1) Carry through the complete proof of the converse of the represen-
tation theorem in 3.2.5.a.
2) Let <p~s'(u)=e3'LX'""1be the characteristic function of the ac-
cumulated claim of the risk 9 and let the structure function be
Develop explicitly an expression for
as the characteristic function of a compound Poisson distribution.
3.3. Portfolios in the collective
3.3.1. Some definitions

If one risk is taken out of a collective at random, we refer to it- as in
the preceding sections-as a risk in the collective. If several risks are
taken out at random, these form a portfolio in the collective.
Just as the (one-dimensional) structurefunction U(9) characterizes the
random choice of a single risk, the (multi-dimensional) portfolio function
U($ 9 . . . ,9,)determines the choice of a portfolio of n risk from the
collective O. We then use the symbols
and
to denote the number of claims process and the accumulated claim process
respectively of the i-th risk in the portfolio. The number of claims process
and the accumulated claim process of the eniire portfolio are then denoted
respectively. These processes are obtained by summation:
and
We can express the probability distributions of S, and N, in the above

processes as follows (carrying through the reasoning for S, only):
p [Sj9'.92. ..., S n ) -
-
= ~ 1 . 9 1$2.. .... 9")
(X)
- j d ~ ( " ~ ~ z ~ . . . . " ) [ SS1~2~' l )y ~ y...,
Sr'sx-y, -...-Y,-~].
IR" - L
The integration at the right is performed over the variables y l , y2, . . . , Y , - ~ .

The explicit references to (9 9 ..., 9,) in the relation indicate that these
parameter values are assumed to be known. In the case of a portfolio
from the collective with portfolio function U($ 9 . .., 9,) we have then
finally as the distribution function for Si
For such a portfolio what can we now say about the stability of the
portfolio processes { N t ;t 2 O ) and { S , ;t r O } ? By stability we understand
the convergence in probability of the average toward a constant; in
principle we can expect two kinds of possible stabilizations:
a) Stabilizing in time: convergence of SJt and Ni/t if t +cc and n
is fixed.
b) Stabilizing in size: convergence of S,/n and NJn if n +n; and t
is fixed.
3.3.2. Stabilizing in time (Theorem of Ove Lundberg [47])

For simplicity's sake let n= 1, i.e. let us consider a portfolio which
consists of a single risk, but which pays premiums over an infinitely long
Span of time. The risk is assumed to be drawn from a collective O with
structure function U($).
What happens to the mean quantities
S,/t = total claim per unit of time and
NJt = number of claims per unit of time
ast-co?
We shall consider in what follows only the quantity S,, since the same
argumentation applies to 4. We have
where P@'[S, 5 X] = G~"(x)is the distribution function of the accumulated

claim S, for known parameter 9.
Let us consider first the following special case
C r
G I ~ ) ( ~ ) = 1 e-Sr (' 'Ih - F * (X)

~ (i.e. let S, be compound
h= o h! Poisson for 9).
The corresponding characteristic function is then

= J eiuxd G@)(x)
ip19)(~) = e9'IX(")-
'I, where ~ ( u=)[ eiuxd F ( X ) ,
and thus the characteristic function corresponding to the distribution
function G,(x)
Finally, for ip,(u/t), the characteristic function of S,/t, we have
Letting now t +CO, we have for a finite first moment E of F(x)
1
1-m
t( U ) - I] =m U -
- i uE (taking the derivative of
+ W
u/t the characteristic
function).
Thus by interchanging the order of the limit and the integration
(cf. Appendix, Section 5),
lim ip,
1-g>
(4)
=[ ciuE9dU(9),
i.e. the distribution function of S,/t tends toward the distribution function
of 9 . E. With the exception of the case in which U($) concentrates the
total mass in one point (homogeneous collective) therefore, we have no
stability in time. This connection is known in the literature as the theorem
of Ove Lundberg [47]. It can be generalized as follows:
7heorem: 1j the following stability property holds for every risk with
parameter S ,from the collective O :
Sj9)/t-+ m(9) in probability as t -+CO, m(9) being a constant depending
only on 9 (Luw of large numbers), then
3.3. Portfolios in the collective 79
Note: 19; m ( 9 ) z x I denotes the Set of all 9 for which m ( 9 ) s x and

H(x)= P [ 9 ; m(9)5x], where P stands for the probability defined on
O by the structure function U($).
Proof: We give the proof for a "continuity point" X, i.e. for the case
For a given value of 9 we have by hypothesis SlW/t+ m(9) in probability

as t +CO, thus
G ~ VX) E (X) +
at all points X, with the possible exception of the jump discontinuity

X = m(9), where Em((x)has the following appearance:
Because of our additional hypothesis (that X is a continuity point),

however, we have
P{[$; m(9)=x])=O,
and thus the limit function can be given any value we like (e.g. 1) on this
Set. We thus obtain by interchanging the order of the limit and the inte-
gration (cf. Appendix, section 5)
lim G, ( t X) = lim G?(t X) d U (9)

1- m t - a,
The proof is thereby completed for all "continuity points" and the
theorem follows at once from this fact for all remaining points.
Interpretation: The structure function U(9) defines a distribution
function Hm((x)on the "mean values" m(9). The average over time SJt
converges then toward a random variable having a distribution identical
with that of these mean values m(9).
The connection between this general theorem and the theorem of
Ove Lundberg can be established by using the relation
which has already been proved.

Chapter 3. The Risk in the Collective
In particular, it follows from this that
which is equivalent to the Statement that Sjg'/t + 9 E in probability for

given 9 (thus m(9)= 9 E in this cuse).
It is important to note the fact that stability over time (i.e. convergence
of the mean with respect to time toward a constant) does not occur for a
portfolio in the collective unless the collective O is homogeneous.
3.3.3. Stabilizing in size

Here also we present the argument only for the accumulated claim
process {Sr;t2O). The latter is the result of summing the n processes
(Sii);t 2 0) (i = 1, ..., n), each of which represents the accumulated claim
process of a risk in the collective. The question as to when S,/n converges
in probability toward a constant c for n + co (t fixed) can be answered
with our stability theorem from 1.2.5. In this theorem the covariances
Cov (Sii),Slj')
play a decisive role. In particular the question arises as to when SIi' and
SI" are independent of each other; the answer is given by the
Auxiliary theorem: Let
a) SIi)and Slj) be independent for known Si (risk i) und 9, (risk j);
b) Si und be tuken from the collective independently of each other.
7hen Sji)und Sf), where i und j designute risks in the collective, are ulso
independent of each other.
Remark: It should be pointed out that condition a) or condition b)
alone is not sufficient.
Proof: We have
where <ps~sjj)(ul, u2) denotes the characteristic function of Sji),S y and

( ~ ~ ~ ~ )u2/9 ~ ! ~9,)
) ( isu the
~ , characteristic function of Sji', Slj) for known
parameters 9, for i and 9, for j.
According to our criterion in 1.2.3, independence is identical with
the condition that the characteristic functions and/or the distribution
functions be factorizable. Therefore by hypothesis
a) <psl1) SI: (U d Q 1 , Q2) = ySI0W Q 1 ) ( ~ (u2/9,)
~ ~ arid
1
b) dU(9 9,)=d U(&) dU(9,).

which establishes the independence.

By using the auxiliary theorem and the stability theorem of 1.2.5 we
obtain finally the following result:
Theorem: Let
a) S? und ~ j j be
) independent for known 9i (risk i ) und g j (risk j) for
any i, j (i+j);
b) und g j be drawn from the collective independently of euch other
+
(i j).
7hen for increasing n und S, = Sji)
S,/n + lim E (S,)/n in probability.
n- oo
Remark: For identically distributed accumulated claims Sji)

(i= l,2, ... , n) it follows in particular that SJn +E(SIu) in probability.
Identical distribution is however not necessary for the stability in size.
Exercises
1) Prove the theorem of Ove Lundberg with the help of the general
result proved in the text for the case where
( U )= CeiU- 1 I (pure Poisson distribution)
and
2) Suppose that the accumulated claim process SIi) has the charac-
teristic function m
and that Cov (S"', S"') =0 for all i j.+

By using Chebyshev's inequality, give an estimate for S,/n, where
S, =C;= 1 Sj".
PART I1
Consequences of the Theoretical Model

Chapter 4
Premium Calculation
4.1. Principles of premium calculation
4.1.1. General
Premium calculation is based on the assumption that a contingent

claims experience can be compensated by fixed payments; these fixed
payments are known as premiums. In our theoretical model (Part I) we
have described the accumulated claim process S,. (See 2.3 and 3.2.5.)
Now premium calculation is concerned with determining the compensa-
tion in the form of premiums I: for assuming the burden of this process
in the time interval [0, t]. For the sake of simplicity we shall take t = 1
in our development (and then write S instead of SI and P instead of P,)
under the assumption that the premium to be found relates to one year.
The procedure is exactly the Same, however, for any other value of t.
The premium is then calculated on the basis of an "equivalence
principle" (principle of premium calculation). Consistent with the real
meaning of the concept of insurance, only those "equivalence principles"
which are independent of the actual claims experience are admissible.
Expressed more positively, the premium P for the assumption of the
claims experience S should depend only upon the distribution G,(x) of S.'
(In what follows we shall prefer the designation GS(x) to the symbols
G,(x) resp. G(x) used heretofore.) Symbolically: P = S, [G,(x)].
$3 assigns a number P (premium) to every distribution function G,.
The following distinction is important for our further work:
I f G,(x) is the distribution function of the accumulated claims of
the risk (with known risk parameter, cf. 2.3) then P = S, [G,(x)] is
called risk premium.
-1f GS(x) is the distribution function of the accumulated claims of
the risk in the collective (with risk parameter drawn from a collec-
tive, cf. 3.2.5) then P=S,[G,(x)] is called collective premium.
This will not exclude our taking the claims experience into account when, later on,
we are concerned with estimating the premium defined here.
Chapter 4. Premium Calculation
4.1.2. Some principles of premium calculation

A functional $3 such as was described in the preceding section is
called a principle of premium calculation or equivalence principle as
already noted. The following principles are frequently encountered:
a) The expected value principle (level 2):
b) The standard deviation principle (level a):
!fj[Gs(x)]=EIS]+a.o[S] (a>O)
where
a [SI = i / j (X - E [SI)' d ~ ~ ( x )
C) The variance principle (level P):
d) The principle of Zero utility2:
$3 [Gs (X)] = P, such that E [U (P- S)] = u (0)
for a " utility function " u(x) with ul(x)2 0 and u"(x) 5 0. (These hypotheses
tell us that utility increases monotonically and that marginal utility
decreases monotonically-consistent with the usual assumptions of
economic theory.)
This principle requires that the utility u(0) before assuming respon-
sibility for the claims experience be equal to the expected utility
E[u(P-S)] after taking over such responsibility in exchange for a
premium P
1
Special case of the quadratic utility ,function: u(x)= X -- X' (X 5 C);
2c
4.1.3. Discussion of the principles of premium calculation

a) The expected ualue principle is almost always used in life insurance;
in contrast, it is only seldom used in property and casualty insurance.
The main reason for this is probably the apparent heterogeneity of the
.
.-. .-.
' Cf. section 6.5 for a discussion of utility theory.

4.2. The risk premium and the collective premium 87
collectives which occur in non-life insurance-this not permitting an

"average calculation ".
b) The standard deuiation principle is probably the most frequently
used approach in property and casualty insurance. It is linear with
respect to a proportional change in the claims experience, and this is
most likely the reason for its popularity. Moreover, if the probability
distribution of S is normal, then all premiums stand an equal chance
of being exceeded by the related claims experience. This last argument
should not be given too much weight, however, since the individual
premium payer can-and often will-have an accumulated claim
distribution which differs widely from the normal distribution.
C) The variance principle is not as popular as the standard deviation
principle. There are, however-as we shall see-weighty theoretical
considerations in its favor. The property of linearity in the case of a
proportional change in the claims pattern is lost here in any case. On the
other hand we have linearity with respect to the addition of independent
risks.
d) The principle of Zero utility is of great theoretical interest, but it
runs into the practical difficulty of choosing the assumptions for the
utility function. If we take the latter as quadratic, then we have the
variance principle once again as a first approximation.
All of thc principles produce a premium which does not lie below
the expected claims cost. It is therefore usual to divide the premium into
an expected claims Charge and a contingency loading. In what follows we
shall consider premium calculation to be the task of determining the
mean value E[S] and the standard deviation o[S] (respectively the
variance a2[SI) of the accumulated claim process S. Principles a), b)
and C)can be handled in this way with no difficulty. Principle d), on the
other hand, may require that we know the higher moments of the
distribution of S.
We would also like to remark that for the time being we shall leave
the choice of the levels 1,a, and of the utility function u Open. These are
decision variables and are discussed in chapter 6.
4.2. The risk premium and the collective premium
4.2.1. The risk premium

The risk premium is obtained by applying the equivalence principle
(principle of premium calculation) Sj to the distribution function G,(X)
of the accumulated claims of the risk, assuming that this distribution
function is known together with its characterizing Parameter 9.
88 Chapter 4. Premium Calculation
We express this by the form in which we write GS9'(x).We thus have

the following expression for the risk premium P(9)of the risk charakterised
by 9 :
P(9)= 5) [Gr'(x)] (risk premium)
and for the components of the risk premium:
P($)= J X dGY1(x) (expected claim cost produced by the risk),

and
a2(9)=J [X-p(9)I2 dG?)(x) (variance of the claim cost).
From these the risk premium is calculated as

a) P(9)= (1 + l )p (9) in the case of the expected value principle;
+
b) P(9) = p(9) a .G($)in the case of the standard deviation principle;
C) P(9)= p (9)+ - a2(9) in the case of the variance principle.
We should probably mention here, that the premiums actually
encountered in the commercial world ofinsurance represent risk premiums
plus expense and profit margins. These margins will not be examined
further within the scope of this book. The theoretical basis for such
margins must be sought in the realm of economic theory.
4.2.2. The collective premium

By proceeding quite analogously as in the case of the risk premium
we can likewise obtain the collective premium. The difference lies merely
in the fact that we now base the premium calculation principle upon the
distribution of the accumulated claim S of the risk in the collective.
We denote this distribution function by G,(x). If now U($) is the
distribution of the parameter 9 in the collective O (structure function)
then the following relation with the distribution function G?'(x) treated
in 4.2.1 holds:
The building blocks of the premium in the collective are then
p=E[S]=JxdG,(x)
and
o2 =Var [SI =J (X -P)' dGs(x).
The quantities p and a2 of the premium in the collective can either be
derived on the basis of relation A or from the elements p(9) and a2(9)
4.2. The risk premium and the collective premium
of the risk. We have
and
In Summary:
p=E[p(S)] and 02=~[a2(9)]+Var[p(9)]. (B)
The symbols "E" and "Var" in these two formulae are to be understood
as representing the operations expected value and variance with respect
to the structure function, whereas p(9) and a2(9) are the quantities
explained in the preceding section which characterize the risk 9.
Finally, we find for the collective premium P:
a) P = p(1+ 1)in the case of the expected value principle,
b) P = p + M . o in the case of the standard deviation principle,
C) P = p + - a2 in the case of the variance principle.
4.2.3. Statistics and collective premium

Although it is not our purpose within the restricted framework of
this book to deal with the actual statistical problems of quantifying the
Parameters which appear in our model, we must at least point out at
this juncture the function which claim statistics fulfill in principle. In
particular it must be quite clearly understood that claim statistics always
provide information with regard to the collective premium only, thus
allowing us merely to estimate the collective premium. This fact is really
almost self-evident since claim statistics-as known by the actuary-
always give us observed quantities such as claim frequencies, average
claim amounts or similar data for (larger or smaller) groups of risk. In
every case average values over certain groups of risks are determined,
and these are estimates for the corresponding mean values over a collective.
Since as mentioned earlier we shall not treat the statistical problems

here in detail, we shall often assume in the sequel that the collective
premiums are known.
4.2.4. The dilemma and the connection between risk and collective premium
The most typical problem in calculating a premium for a given risk
can be formulated as follows: The risk premium must be determined for a
risk for which the collective premium is known.
As we have Seen, the collective premium is essentially derived from
statistical observation data. It is natural, however, that we wish to know
the "true" risk premium for a given risk. The essential point here is the
fact that this risk premium will simply remain unknown in most cases.
There are only two exceptions to the rule that the risk premium remains
unknown :
a) if the statistical collective is homogeneous: In this case-as can
easily be verified-the risk premium is identical with the collective
premium;
b) if the risk can be observed over a very long Span of time (ideally
over an infinitely long duration) and if the claims experience during this
observation period is stationary. In less abstract terms, this means that
the risk conditions remain unchanged over the Course of time.
It is moreover easy to See on the basis of our definitions that in life
insurance the risk premium can be estimated within groups of reasonable
size because (case a) the working hypothesis ofthe homogeneous collectiue
is more or less acceptable in many cases. This working hypothesis is only
rarely appropriate in non-life insurance, however. Case b) is even more
seldom encountered in practice than (at least approximately) case a).
Although the risk premium may not be obtained from the data
a n d this fact is of primary importance-it plays an important role as
a concept (as idealization). It represents as it were the "theoretically
correct premium" for the individual risk. As we shall See later, this
theoretically correct premium can at least be approximated step-wise
(cf. 4.3). The conceptuul difference between collective and risk premium
is however of fundamental significance. It seems to us that this difference
has not been sufficiently underlined in many earlier theoretical investiga-
tions; indeed, the failure to distinguish conceptually between the two
quantities has been precisely the cause of erroneous conclusions having
serious consequences. Having demonstrated this "dilemma" between
risk and collective premium, we shall now turn to the formal connection
between the two.
4.2. The risk premium and the collective premium 91
The following interpretation seems a natural one when analyzing a

premium calculation principle $.
1st step: The risk premium is given by the application of the prin-
ciple $ to the distribution function GL8)(x)of the accumulated claims
with a known risk parameter 9. Symbolically (cf. 4.2.1): P(9)=5~[GS)(x)l.
2nd step: Now for a given collective O the risk premium P(9) is itself a
random variable with distribution function %(L)= Prob[P(9)SA]. This
distribution function %(L) can be determined from the structure function
U($), since P is a function of 9. One is tempted therefore to apply the
premium calculation principle $ a second time (to compensate the
structure risk) to the distribution function %(L) in order to obtain the
"collective premium ". Symbolically : P* = 8 [&(L)].
Unfortunately, however, the premium P* so obtained is in general not
the Same as the collective premium P defined in 4.2.2. We shall therefore
calculate P* for the expected value, variance and standard deviation
principles and compare the results with the collective premium P as
determined in 4.2.2. If P* = P then the premium calculation principle used
is said to be iterative.
a) Expected uulue principle :
P($) = (1 + A) 1X dGS1(x);
~*=(l+A)1~(9)dU(9)=(l+L)~~jxdG~'(x)d~(9)
=(~+L)~~X~G~(X)=(I+A)P
(Cf. relation A in 4.2.2.)
b) Standard deviution principle:
P(9)=p(Q)+~ ( . a ( 9 ) ;
+
P*=E[/*(~)]+M.[ ~ [ a ( 9 ) ] I/~ar[,u(~Y)+~(.a(@].
If we neglect terms in a2 (U 6 1) then
P* -E [P (191+ [E Co ($11+ f v a r [P ($)I] .
On the other hand we have found the collective premium to be (cf. 4.2.2)
--- --- -
+ +
P = E [p ($)I a . {E [a2 ($)I Var [p (9)] .
C) Variance principle
P(9)=p(9)+.02(9);
+
P* = E [p(9)] + B [E Co2(,Y)] Var C/*($) + . o2(!J)]],
and again by dropping terms in 2 ( < 1)
P* - E [Ag)] + [ E Ca2($11+ Var [P($)]]

The collective premium according to 4.2.2 is
We thus have the following cases:

Expected value principle: P* =kP ,
Standard deviation principle: P* + P
Variance principle : P* - P ,
In words: The variance principle is iterative as a first approximation,
but the expected value principle and the standard deviation principle are
not iterative. It should be noted moreover that the variance principle is
exactly iterative if the risk variance a2(9) is independent of the risk
parameter. This is a progerty of the variance principle which is highly
interesting theoretically and which will lead us to prefer this principle
to the standard deviation principle in the remainder of this chapter.
Exercises
1) Let the accumulated claim distribution of the risk be compound
Poisson, i. e. m
G&"(x)= p?)F*"(x),
n= 0
where =
9"
-- and F(x) is an arbitrary distribution function
n!
with mean value p and variance a 2 (independent of 9). In addition let 9
be distributed with the r-distribution as structure function, i.e. with the
density function
Determine
a) the risk premium according to the expected value, standard
deviation, variance and Zero utility principles (in the last case with a
quadratic utility function),
b) the collective premium according to the same four principles of
premium calculation,
C) the iterative premium P* (with approximations) for the first three
premium calculation principles.
2) Show that for the variance principle the following relations
between the collective premium P and the iterative premium P* hold
generally :
PZP* ifVar[a(9)]+2.Cov[p(S),o(9)]20
and
PSP* if Var[a(9)]+2.Cov[p(9),o(9)]50
4.3. The credibility premium 93
3) Let the accumulated claim distribution of the risk be compound

Poisson as in exercise 1 and in addition time-dependent:
W
Gj9'(x)= pn(t)~ * " ( x ) with pn(t)=e-"---. (9 t)"

n= o n!
Let the structure function likewise be as in exercise 1.
Determine the risk premium and the collective premium for duration
t = 2 for the four premium calculation principles. 1s the premium for
twice a period of time always equal to two times the premium for the
basic period? What inequality relations are involved?
4.3. The credibility premium

4.3.1. The credibility premium as sequential approximation
to the risk premium
We have Seen in 4.2.4 that the risk premium for a giyen risk should
be known in order to underwrite the latter propedy; on the other hand,
however, we are only in a position to determine its collective premium
by statistical means. If we have clairns experience available in respect of
this risk to be assured, then we can-as will be shown-at least approach
the risk premium by successive approximation. Such an approximation
on the basis of actual claims experience involves, it must be noted, a
transformation of the premium from a fixed quantity into a variable
one (dependent upon the actual claims pattern). The theory of "credi-
bility", introduced primarily by the American actuaries, is concerned
essentially with the question of how much weight should be given to this
actual claims experience. For this reason we shall speak here of the
approximation of the risk premium by a function dependent upon the
actual claims as the credibility premium. Many investigations in modern
actuarial literature are devoted to this subject. Especially noteworthy
are the pioneer works of Bailey [3, 43 and Lundberg [47] as well as
the later investigations of Mayerson [49], Bichsel [Y] and the author
[14, 151.
The following basic exercise leads us directly to the credibility
premium :
-Let P(9) be the risk premium determined in accordance with a
given premium calculation principle.
-Let the claims experience of the risk in question be represented by
observations of an n-tuple of random variables S S, , ...,Sn which we
can think of intuitively as the accumulated claim amounts in the years
1,2, .,. ,n. (Note that the symbol Si is used here in a different sense from
that of 2.3; the symbol as used here would represent S i - S , , in the latter
section.)
-We shall assume that the structure function U ( $ )of the collective
and the collective premium P (but not the risk premium P($))are known.
We now wish to find the
-credibility premium P, (Sb S2, ..., Sn) which approximates P ( $ )
in a way yet to be specified. We can think of this as the premium to be
applied for year n + 1 if S S2, ... ,Sn for the years 1,2, . . . , n are known.
We shall attempt to solve this problem in what follows. The simplest
credibility theory is based upon the expected value principle of premium
calculation and it is therefore not surprising that all the works cited at the
beginning of this section ure bused on this principle. We shall now extend
the theory of credibility to the variance principle; naturally the theory
becomes somewhat more complicated thereby. It also becomes far more
useful, however, since it then allows us to approximate not only the
mean claims cost proper to the risk (as in the case of the expected value
principle) but also the related loading for fluctuations.
4.3.2. A new interpretation of the variance principle

for calculation of premiums
In the following we shall base our considerations on the ilnricmce

principle (cf. 4.1). This principle gives us for
the risk premium : P($)= p(9)+ . 02(9, and for
the collective premium: P = E [P($)] + {E [02(9)] + Var [p(9)]),
where
p(9) = 1X dGL8)(x)= expected claims of the risk 9 in the calculation
period, and
02(9)=1[ X dGS)(x)=variance of Maims of the risk 9 in the
calculation period.
E[.] and Var [.I are to be understood with reference to the structure
function U ( $ ) .
We note in passing that the expected value principle is contained in
the variance principle as a special case (=O). (The multiplication by
1 + I can be omitted here with no loss of generality.) Formally we have
(cf. 4.2)
B [G$""(x)]= 9 [S/9] =P($), the risk premium, und
!$ [Gs(x)] =!?J[SI =P, the collective premium.
The risk premium is given when the premium calculation is based on
the distribution of ~ f o given
r 9, and the collective premium when we use
the (unconditional) distribution of S. Explicitly
5j [S/9] = P(9)= E [S/,9] + . Var [S/9] (E [-I91 and Var [./9] for the
distribution for given 9)
und
$[SI = P = E [SI + D -Var [SI (E [-I and Var[-] for the distribution
in the collective as explained below.)
Thus we define for any random variable Y defined in the probability

space below
D,) 5j[S/Y]=P(Y)=E[S/Y]+.Var[S/Y].
The product space Y X Qi appears as the "natural probability space"
for the random variables S and Y (Y= Set of all possible claim amounts
S, O = Set of all possible risk parameters 9).
The probability Win this product space is induced by the infinitesimal

element dG@'(S)dU($). The operations E[-] and Var[.] are to be
understood with reference to this probability (or the conditional prob-
abilitys arising therefrom).
We would mention in particular the case where the random variable
Y is a constant. This is equivalent to the Statement that knowing the
variable provides us with no information. The conditional expected
values E [ S / v and variances Var [ S / v become then the unconditional
quantities E [SI and Var [SI, respectively.
We shall now (in contrast to section 4.2) introduce a slight change
in our definition for the case of the iteration of the variance principle 5
(i.e. application to P(Y)). We shall now calculate the variance Part from
the expected claims E(S/Y) only instead of from P(Y). Thus for any
random variable Z for which the conditional expected values are mean-
ingful the following definition holds:
D,) fi CP(Y)IZI = E [P(W Z I + D . Var [ E CS/Yl/Zl>
where P(Y) is defined by D,).
Definition D,) does not contradict D,); the latter is rather a special
case since
P(S)=$j[S/S] = E [S/S] +. Var[S/S] = S + . O=S
according to D,) and thus by DZ)
which is identical with the right side of D,).

Due to this "new" definition, however, our premium calculation
principle is now iterative (in contrast to the earlier situation, in which it
was "almost" iterative) and the following relation holds:
7hmYm: 3,CP(Y)If(Y)] =3, CSIf Y)] = P ( f (Y))
ifthe conditional expected values und variances of f (Y) are meaningful.
Proof:
3,[P( Y)lf (V1= E [P( Y)lf ( V 1 + .var [ E CSlYllf( Y)]
=E [ E CS/ Y l l f ( Y)] + . E [Var CS1YlIf ( Y)]
From the fundamental relations for conditional expected values (cf.

1.2.2) and conditional variances (cf. 4.2.2) we have immediately
which proves the theorem.

The
Corollary :
3,CP(911= P
is of special interest. In words: The collective premium is identical with
the fixed compensation for the risk premium P(9) for an unknown risk 9.
Proof: Choose f (9)= constant in the preceding theorem (i.e. place
no condition on the values of 9).
4.3.3. Construction of the credibility premium

Let us turn once again to the basic exercise leading us to credibility
theory: Given the claim amounts S S,, ... ,Sn for the years 1,2, ...,n
we require an approximation to the risk premium P(9) for the year n + 1.

Thereby of Course the risk parameter 9 is to be thought of as unknown.
If we now denote by S the random variable of the accumulated claim
amount for the year n+ 1, we have
+
for the risk premium (year n 1): P(9) = $3 [S/9].
By analogy we define
the credibility premium: &,(Sb S 2 , ... , Sn)= 5 [P(9)/S1, S2, ...,Sn].
Intuitively this is the compensation calculated according to our principle
for the unknown risk premium when the information SI, S2, ...,Sn is
given.
These formulae can be understood analogously in the probability
space Y x O (cf. 4.3.2). O is as before the set of all risk Parameters 9,
and iD is the Set of all possible values of the (n+ 1)-tuple of random
variables S,, S2 , ...,Sn, S. The induced probability differential then reads
For the case in which the claim amounts in the past S,, S,, ... , Sn are
independent of the claim amount S in the coming time interval for a
given risk we have the following result which is the cornerstone in the
construction of the credibility premium:
Theorem: Let S und (SI, S, , ...,Sn) be stochastically independent ,for a
giuen parameter value 9. Then
Proof: Because of the property of independence for given 9 we have
by the theorem proved in 4.3.2 (iterative property of the premium

calculation principle 5).
Chapter 4. Premium Calculation
4.3.4. Assumptions for our further investigations

In order to avoid having to repeat the assumptions about the risk
process in the sequel, let us summarize them here once for all: We denote
by S S, , ..., Sn(cf. 4.3.1) the random variables which represent the accu-
mulated claims of a risk in the time intervals (years) 1 to n. Note once again
that our use of the symbol S, here differs from the meaning of 2.3; what we
call S, here, would be S, - S, -, in the earlier section (cf. remark in 4.3.1).
We also assume that we find ourselves just at the beginning of the time
interval n + 1 (year n + 1 which will generate the random accumulated claim
S and for which we wish to have the credibility premium P, (Sb ..., Sn).
Let the probability law of the random variables SI, S,, ..., Sn be char-
acterized for the individual risk by the parameter 9. We assume that the
latter is drawn at random from the collective at the beginning of the
period of insurance and that it applies then over the whole period.
For a given 9 let now S S, , . .., Sn,S be stochastically independent.
We could also express this by saying that the accumulated claim process
for each risk and for given 9 has independent increments. (As we have
remarked earlier, this assumption by no means implies that the accumu-
lated claim process in the collective also has independent increments!)
For the sake of simplicity let us also assume that all the variables SI,
S, , ...,Sn,S for given 9 are distributed according to the same distribution
function. This is the same as the assumption that the accumulated claim
process described in 2.3 has stationary increments.
It is to be expected that both these assumptions can be regarded as
being fulfilled in practice (at least through a skilful transformation of
variables). If the conditional independence of the S variables fails, the
basic concept of insurance as protection against unpredictuble losses is
violated. If the same distribution does not apply throughout, one can often
remove the difficulty by using trend factors or related transformations.
4.3.5. Properties of the credibility premium

The credibility premium
P,+](S,, ..., Sn)=$3[P(S)/S1, ..., Sn1=5[S/S ..., Sn]
L I '
definition by theorem in 4 . 3 . 3
can also be written as

The product space Y X O described in 4.3.3 serves as probability

space for these formulae. The second form can be broken down into
approximation Part E [P(S)/S . .. , Sn]
+
= E [p(S)/S ...,Sn] . E Co2(9)/S1, ...,Sn] and
fluctuation part . v a r Cp(WS1, .. . ,Sn] .
The approximation Part has the following properties:
a) It approximates the risk premium P(3) with minimal Square error
over the entire collective.
b) It is the only approximation of which the mean over the totality
of all risks with the Same claims experience S ... , Snis equal to the mean
risk premium taken over the Same totality.
C) It approaches the risk premium P(3) asymptotically for every risk.
The fluctuation part represents intuitively the compensation calculated
according to the equivalence principle S) (cf. 4.3.2) for the risk which is
still contained in the approximation part. It can be shown that
d) the fluctuation Part approaches Zero asymptotically for every risk.
Finally, we note that for the total credibility premium:
e) The premium is equal to the collective premium when claims
experience is lacking (n=O) and it converges to the risk premium for
very long claims experience (n -+MI).
We shall now prove these properties a) through e) in so far as it is
possible within the scope of this book.
Concerning a): neorem: Let R,(S .. . ,Sn)be an integrable func-
tion with the property
Then Rn ,(SI, .. ., Sn)= E [P(S)/S,, ...,Sn] .

+
Proof: We transform the probability according to Bayes' rule

(cf. 1.2.2):
dG(")(S,)... dG(')(S,)dU(S)=dW(S/S,, ..., S,)dW(S,, ..., Sn)
and thus the integral to be minimized becomes
But R,(S ..., Sn)plays the role of a constant in the inner integration
and we thus know that setting this equal to the conditional expected
value will produce a minimum. Thus
Concerning b), C) and d): The proof of these statements is beyond the
scope of this book. Statement b) has been proved by the author [15].
Statements C)and d) follow from the fact that for increasing n the a poste-
riori distribution d W(9/Sl, ...,Sn)degenerates more and more toward a
point distribution. Doob C281 has shown that this is the case with prob-
ability 1 (with respect to the structure function) and that the point so
obtained then coincides with the true risk Parameter. (Schwartz [62]
and Freedmann C341 have proved generalizations of this theorem.)
Concerning e):
I f no claims data SI, .. .,Sn are available, we have
which is precisely the collective premium.

-For the asymptotic credibility premium the tendency toward the
risk premium follows from statements C)and d).
The properties of the credibility premium set forth here occupy a
central position in property and casualty insurance, and the significance
of our various premium concepts (risk premium, collective premium,
credibility premium) is really brought to light most clearly in this field.
4.3.6. The credibility formulae for the three components

of the credibility premium
The credibility premium
can be broken down into the three components (by an additional break-
down of the approximation Part as defined in 4.3.5)
a) expected value part,
(a)+ b) = approximation part)
b) variance part, and
C) fluctuation part.
Now it is very important for practical applications-where we often
have no (or no exact) knowledge of the parametric distributions for the
accumulated claim distributions and the structure function-to obtain
manageable formulae for the three components. Such formulae, which
replace the exact form of the credibility premium, are called credibility
formulae in the terminology chosen here. Credibility formulae thus take
the place of the theoretically correct credibility premium. We shall con-

struct the credibility formulae for the approximation part by means of
linearizations of the theoretically correct quantities. The expected quad-
ratic deviation should be kept as small as possible for these linearizations.
a ) Linearization of the expected value part

We approximate E [ p ( 9 ) / S l ,..., Sn] by a + b - ( ~ , + . . . + ~ , ) / n = a + b S
so that
1{ E [ p ( S ) / S ..., S , ] - ~ - ~ . S } ~ ~ W ...,
( S Sn)

=E[{ECp(S)/Sl,..., ~ , l - ( a + b S ) ) ~ ]
becomes minimal; we can determine the constants a and b from this
exercise. It is easy to See that the function a + b - s so found also minimizes
Conversely every pair of constants a, b which minimizes the last line

is also a solution of the original minimum problem.
We now conclude that
a=(l -b). E[p($)]
and then wish to minimize

b2 - E [{S- p ( 9 ) )' 1 +(I - b)' ~ a[ pr($)I
This is achieved if
Compare the relation

v a r [ ~ ] = E [ ~ a r ( S / 9 ) ] + ~ a r [ ~ ( S / $ )in
] 4.2.2and4.3.2
from which
1
+
Var [ S I =-E [a2(S)] Var [ p (S)].
n
We therefore have the linearization (credibility formula)
where b is called the credibility and is calculated from
b= v a r [ P ($11 -
-
v a r [P @)I - n
var[~] 1 n+k
+
- . E [02(9)] Var [p(9)]
n
b ) Linearization of the variance part

Similarly we approximate E [oZ(S)/S... , Sn] by d + C . C2, where
Repeating the operations under U )step by step, we find
Var [02($)I Var [02(9)]

C=
Var [c2] E [Var [ ~ ~ / 9+ Var
] ] [02(9)] '
C is also known as the (variance) credibility.

Approximating the fluctuation part
C)
Finally, we must raise the question as to how large the loading to

compensate the unknown risk 9 should be, if we calculate the related
expected value Part with the linearized formula under a). According to
our premium calculation principle we have for the fluctuation part
and therefore for the fluctuation Part with linearized expected value Part
This last formula does not bring us very much further unless we
average thisfiuctuation part once more over the entire collective. Carrying
this through we have then
If we now Set (according to U ) )

b = --- v a r [P (W >
1
-
n
+
E [02(,!J)] Var [ P (G)]
4.3. The credibility premium
we find after a simple transformation:

fluctuation part - (1 -b) .Var [P($)]
or (1 - credibility) . Var [p(9)].
In Summary, we have the following approximation to the credibility
premium by linearized formulae:
& l ( S l . . . S , ) - b . ~ + ( l -b).E[p(9)] (expected value part)

+ {C. C2+ (1 -C) . E [02($)I (variance part) (B)
+{(l -b).Var[~($)I) (fluctuation part).
4.3.7. Determining the weights in the credibility formulae

By linearization of the credibility premium components we have
made the latter into weighted averages, with the weights b and C. It
should now be our endeavor to interpret these weights in such a way
that they can be determined from statistics about the collective. For
example in the expected value Part E [,U($)]represents exactly the mean
claim cost of the risk in the collective, whereas E [a2 ($)I and Var [P($)]
remain to be interpreted in terms of quantities estimable from the
collective.
U) In the expected value purt

In the preceding section the foilowing expression was derived for the
credibility b:
b = Var [p($)]/Var [SI.
The denominator of this expression is already a quantity estimable from

the collective; it remains to transform the numerator.
We know that (cf. 4.2.2)
1
+
Var [SI =- . E [02(91 Var [P($)]
n
and
Var [SI = E [a2(9)] +Var [p (9)]
from which it follows that
n . Var [SI - Var [SI = (n - 1) . Var [p (91.
Therefore
n . Var [SI - Var [SI
b= where s=(s,+..-+~,)/n, S=S n12.
(n - 1). Var [SI
In this formula we have only quantities estimable from the collective.

It is clear though that statistics on the annual experience and also (for
example) on the n-year averages must be available. The derivation of the
credibility weight b from the annual data alone is only possible if a func-
tional connection (as in the Poisson case) exists between the risk elements
p(9) and 02(9) for the distribution of S for a given risk 9. In the Poisson
case we have 02(9)= p (9)= 9, thus also E [02(9)] = E [p(9)] = E [9] and
1
therefore Var [P($)] = Var [SI -- E [SI. We find thus that
n
n - v a r [SI - E [SI - "excess variance"

b=
n . Var [SI " variance "
The designation "excess variance" is based on the fact that in the pure
Poisson case Var [SI = E [S]/n.
b) In the variance part
Here we have found for the credibility
c = Var [a2($)]/Var [C2],
and we now wish to reinterpret the quantity E[02(9)]. We can do this

similarly as under U), obtaining from the system of equations derived
there
Var [SI - Var [SI = (1 - l/n) E [a2(9)]
and thus
E [02(3)]=-
n
n-1
{Var [SI - Var . [n)
In order to determine c we use the formula (cf. e.g. [24], p. 348)
Var [L2/9]
where E,($) is the k-th central moment of S for a given risk parameter 9
.4(9) - 3,
or, by use of the excess y2 (9)=----
.t
(9)
(It is well-known that every normal distribution has the excess 0.)
Under the simplifying assumption of a "normal excess" y2=0 it

follows that
2 . o4 (9)
Var [C2/$]=
n-1 '
From the decompositions

2
Var [r2]
= Var [02($)I +P. E [04($)I
n-1
and
Var [E;] = Var [02(g)]+ 2 . E [04($)],
where
+S2 )2
(n = 2 in the definition of Z 2 )
we have the result

( n - 1) .Var [ Z 2 ]- Var [C:]
Var [02($)I =
n-2
Thus we finally obtain for the variance credibility C
(n - 1 ) .Var [ Z 2 ]- Var [C;]

C= , n23.
(n - 2) -Var [,Y2]
In this case also we have been able-admittedly by assuming a

normal excess-to calculate the credibility (the weight in the credibility
formula) on the basis of quantities which stem exclusively from the
distribution of the risk in the collective. The same thing can be achieved
if desired by means of the exact formula for Var [Z2/9] by applying the
principles used above in a similar manner. Since the mechanics of the
formulae become extremely complicated in this case, however, we shall
not undertake the derivation here.
In the fluctuation part

C)
Using the formulae for the weight b and for V a r [ p ( S ) ]as derived
under U )
n -Var [SI - Var [SI Var [SI - Var [SI
b= 1-b=
(n-1)-var[S] ' (n - 1 ) . ~ a r [s]
and
n .Var [SI - Var [SI
Var [ P W1=
n-1
we obtain
( n-1
(1 - b ) . ~ a r [ ~ ( 9 ) ] =
r (n . ~ a[SI
(Var [SI - ~ a[SI)
Var [SI
r - Var [SI)
By means of the formulae we have given for the linearized components

of the credibility premium, the latter can now be calculated quite simply.
All that is required for this purpose is statistical data jirom the collective.
For purposes of illustration we shall carry the calculations through
below for a concrete example.
Finally, it should be pointed out that in representing the weights
which were of interest to us by means of quantities from the collective
(e.g. E [SI, Var [C:], etc.) we intentionally put aside the question of how
to estimate this representation as exactly as possible. We are concerned
here merely to show that in principle the weights can be obtained by
using quantities which can be estimated. A highly interesting object of
further research will be the choice of representations which yield optimal
estimates.
4.4. A practical example :risk, collective and credibility premium

in automobile liability insurance
The concept developed here-based on risk, collective and credi-

bility premium-can be applied to any branch of insurance; in fire
insurance, for example, we can identify "collective" with (large) risk
classes and "risk" with the (small) tariff positions. The approach in other
branches is analogous.
Let us now discuss a particularly simple and very good example-
automobile liability insurance. Here we identify "risk" with the indi-
vidual policyowner, whereas "collective" signifies the totality of all
insurance policies in a given country.
For simplicity's sake let us assume that only the number of claims
generated annually depends upon chance; the amount of the individual
claim is taken as fixed (but dependent of Course on known external
features, such as the horsepower of the automobile in question). In this
respect we are following essentially the line of argument given by
Bichsel [7]; the numerical data numbers used here have been taken
from the work cited. The premium calculation is concerned only with
compensating the number of claims. Let the premium calculation principle
be the variance principle (as we have postulated throughout for the
credibility premium).
4.4. A practical example 107
The following data for the year 1961 give the number of automobile
liability policies in Switzerland for private cars which were struck by
k claims.
Number of claims Number of policies Total number of claims

per policy
(k) (n) (k n)
-
ik2 n)
0 103,704 0 0
1 14,075 14,075 14,075
2 1,766 3,532 7.064
3' 255 765 2,295
4 45 180 720
5 6 30 150
6 2 12 72
7 and over 0 0 0
P
-- ~~P~~~
119,853 18,594 24,376

P-
a) 7he collective premium

We shall use the observed data for 1961 to estimate the collective
premium, and we shall ignore the estimation of trends. (This is usually
not to be ignored in practice.) In other words we adopt the standpoint
that the year 1961 can be taken as representative of the succeeding years
as far as frequency of claims is concerned. (Again, we make this assump-
tion in order to make the illustration as straightforward as possible.)
We find that
18,594
k = mean value of k =
119.853
and
P = m e a n value of
from which we have the estimates
E(k)=0.155
and
V% (k)= 0.203 - (0.155)2= 0.179.
We have therefore for the collective premium P
P =(0.155 + .0.179) . (assumed fixed claim payment).
6) 7he risk premium
It will be useful to assume here that the individual risk has a Poisson
distributed claim density
9"
~ [ k = ~ ] = ~ " -
m!
with unknown risk parameter 9. From this assumption we obtain the

risk premium immediately; since in the Poisson case
,u(9)=02(9)=$,
it follows that
P(9) = (1 + ) - 9 . (assumed fixed claim payment)
The parameter 9 must be regarded here-as always with the risk pre-
mium-as unknown. We therefore do not know P($), but we can approx-
imate it by using the credibility premium.
c) The credibility premium
From 4.3.6 we have the approximation
C,) for the expected value part
var ~ ~ ( 9 1 1
b.k+(l-b).~[p(9)], with h=
(114 . E Co2($11 + V a r b (9)l '
In the Poisson case, since p (9)= o2(9)= 9, we have

Var [p (G)] = Var [k] -E [k] , E [02($)I= E [k] ,
and thus (cf. also 4.3.7)
Var [k] - E [k]
b=
Var[k]-E[k]+(l/n).E[k] '
In our numerical example
We therefore have the approximation for the expected value part
This is valid under the assumption that k claims in respect of the given
risk have been observed on average over n years.
C,) For the uariance part the same approximation holds as for the
expected value part. This is so because in the Poisson cciw
-k provides a "better " estimate of 02(9)than does the dispersion Z2
determined from the risk,
o 2(9)= ,u(9) and thus
4.4. A practical exarnple 109
-and finally c must be equal to the credibility weight b just obtained,

since both are unique solutions of the problem of minimizing the same
expected squared deviation.
We thus have also for the approximation of the variance part
C,) For the fluctuation part we have from 4.3.6

(1 - b ) . V a r [ ~ ( W
and thus with the numerical values of our example
Combining these three components C,), C,) and C,) we obtain

P(k1, k2, .-. kn)
3
[assumed fixed claim payment] .

By slightly rearranging the members of this expression, we find that
P(k1, k2 . .., k")
9
[assumed fixed claim payment]

It can be easily seen moreover that for the Poisson case generally
(if the claim amount is assumed to be fixed)
P(kl,k2,..., k,)=[b-k+(l-b)-~[k]+{b.k+(l-b)~ar[k])]
[assumed fixed claim payment] .
It should be noted that k in this formula represents the average
number of claims in respect of the risk, but that E [k] and Var [k] must
be calculated for the risk in the collective.
Exercises
1) Determine the exact credibility premium for the following cases
(as a posteriori expected value or variance respectively) and compare
your results with those obtained by the linearization described in 4.3.6:
a) S S, , ... , Snare independent and identically distributed. Si= ki .S,

where the ki are Poisson distributed with parameter 9 and S is fixed.
The structure function has the density function
( 0 otherwise.
b) S,, S, , .. ., Snare independent and identically distributed. Si= S . k i ,
where the ki are binomially distributed with parameter 9. The structure
function has the density function
1 0 otherwise.
C) S I , S2, ...,Sn are independent and identically distributed. Si is
normally distributed with mean value 9 and fixed variance 0;. The
structure function has the density function
2) Show that the linearized credibility premium (similar to the original

credibility premium)
a) is equal to the collective premium in the absence of claims data,
b) approaches the risk premium asymptotically as n -+CO.
3) Determine the collective, risk and credibility premiums as well as
the credibility formulae under the following assumptions:
a) The accumulated claim distribution for the individual risk 9 in a
year is given by
00
P,[Ssx]= 1P'"[N=k]
k= 0
.GAk(x).
The probability P'" [ N = k] is equal to ('+:-I) pg(l -p)k and the

distribution function G(x) has known central moments E,.
b) The annual claim totals S S, , ..., Snare independent and identi-
cally distributed.
C,) The structure function U(9) is known;
or
C,) the moments of S and s in the collective are known (and analo-
gously the moments of CS and Ci).
112 Chapter 5. Retentions and Reserves
In contrast to this, the retention under a global reinsurance System

is determined only in respect of the accumulated claims experience Jor
the entire risk muss. In symbols,
In what follows we shall deal only with individual reinsurance, which

is by far the most frequent form in practice. The mathematical treatment
of global reinsurance does not give rise to any new problems; on the
contrary, it is simpler because the relative retention problem as defined
below falls away (cf. 5.1.2). For individual reinsurance the functions g i
(i= 1,2, ..., N) are characteristic, as well as the price which the
reinsurer requires for taking over the cession Sii)-gi[Sii)] in the time
interval [0, t]. In order not to complicate our notation unduly, we shall
often work with the interval [0, 11 (one accounting period) and omit the
subscript t = 1 in this case.
5.1.2. The retention

under proportional and non-proportional reinsurance
In practice there are two usual forms of individual reinsurance:

i) 7he proportional case:
The number ai is called the percentage retention, whereas we shall think

of the product ai SIi) simply as the retention. In this case it is also cus-
tomary for the price demanded by the reinsurer for accepting a cession
to be proportional, i.e.
(ai)= (1 - ai) #i),
where C") denotes the price for taking over the risk completely. This
form of reinsurance is also known as "surplus reinsurance".
ii) The non-proportional case:
gi [Sii)] = Sii)- 1
jumps in
max [amount jump - M i O]
,
[Os11
= min [amount jump, M,].

jumps in
[Osil
5.2. The relative retention problem
('I
The connection between Sii) and Rii) can be seen most clearly in the
above diagram (cf. also section 2.3). Each function gi is uniquely charac-
terized once the bound M , is given.
-Mi is called the first risk or (maximum) retention.
T h e price for this type of reinsurance is given in the form of the
function #')(Mi)= where e"'(0) = 8")again denotes the price for
completely taking over Sii).
This form of reinsurance is also called "excess of loss".
In both cases-proportional and non-proportional-the retention
problem amounts to determining for each risk in a given risk mass a
corresponding number ( U , or M,). In this connection, these numbers are
usually broken down as follows:
ai=C.lli ( i = 1 , 2 , ..., N )
and
M,=K.bi ( i = 1 , 2 ,..., N ) .
The problem of determining the factors Ai (resp. bi) is known after

de Finetti C251 as the relative retention problem; if our goal is to determine
the constants C or K we are dealing with the absolute retention problem.
This distinction can be expressed in another manner by saying that the
relaiive retention problem is concerned with finding the gradalion of
retentions, while the absolule problem seeks to determine the level of
the retentions involved.
From this section on we shall be working consistently in the time

interval CO, 11 and shall therefore drop the subscript t.
Chapter 5. Retentions and Reserves
5.2.1. Proportional reinsurance

The task here is to determine the characteristic numbers U , for
proportional reinsurance (proportional retentions) as multiplicative
constants. Undoubtedly the most convenient-and also the most
meaningful-instrument for determining the U , is the minimum vuriance
principle. (Cf. the papers of de Finetti [25] and Vajda 1671.)We proceed
from a risk mass of N risks for which we have for the i-th risk (i = 1,2, . .. ,N )
S"'= random variable denoting the accumulated claim in the period
of calculation [0, I], and
P"'= the reinsurer's price for assuming 100 % of S").
Applying the proportional retentions a,, the quantity
represents a stochastic variable which i g n o r i n g expense considera-

tions-measures the "profit outflow saved" on the retained portion of
the risk mass. The minimum variance principle requires then that for a
given expected vulue oj' this prcfit outflow suved, the variunce be us smull
us possible. Intuitively this means that we seek those reinsurance arrange-
ments which guarantee the given expected "savings" in the retention
with the smallest possible deviations. In symbols,
Var [Z] = minimum ,
under the additional condition that

E [Z] = constant .
It should be pointed out in addition that the problem E [Z] =maxi-

mum under the additional condition that Var [Z] =constant leads to the
Same solution.
By Lagrange's method of multipliers (cf. for examplc [54]) we find
this minimum at those points where the partial derivatives with respect
to u j (j=1,2, . .. , N) of the function
vanish. But we have by the independence of the S"'

N
Var [Z] = 2 U' . Var [Si']
i= 1
and
N N
E [Z] = C a, . (P") - E [S(i)])= 1 U,. Ei),
i= 1 i= 1
5.2. The relative retention problem 115
where L")= P") - E CS")]represents the loading contained in P(')(in mon-

etary units). Thus the function @ can be written explicitly as
N N
@ ( a h a ..., U,)= ~a~.Var[S"']+A.~aiL").
i= 1 i= 1
From
E= r + /i L")= 0
aaj 2 a j ~ a[s")] for all j
it follows then that
This result can be interpreted as follows:

-Depending upon the choice of the constant C, the formula may
produce a value of U , which exceeds 1. In this case a j is to be Set equal to 1.
-De Finetti C251 has shown that, subject to this rule, the a j cal-
culated from the formula are in fact solutions to the problem as posed
above. The proof is somewhat laborious and will not be repeated here.
-The constant C depends upon how large the expected value of the
"saving" should be. This problem will be treated later on under the
heading of absolute retention.
It is important to note that we have thus far given little attention to
the question whether S(j) is the accumulated claim of a risk with known
risk parameter or of a risk in the collective. If we are dealing with a risk
having known risk parameter 9 then
E [S"'] = pi ( 9 )
and
Var [s")]
=a' (9) (cf. 4.2)
If, however, we have to do with a risk in the collective then
E [S")]= E [pi(,Y)]
and
Var [S")]= E [o' ( 9 ) ]+ Var [pi(,Y)] (cf. 4.2).
We thus have for the factors Aj

in the case of the risk with known risk Parameter 9, and
in the case of the risk in the collective.

We shall call the gradation which results from the proportionality
factors developed here a de Finetti solution of the relative retention
problem.
5.2.2. Non-proportional reinsurance

a) For non-proportional reinsurance the assumptions can be most
suitably formulated as follows. Let
-S") be the random variable depicting the accumulated claim of the
risk i in the accounting period [0, 11,
-Mi be the claim bound (first risk) which we are seeking for the i-th
risk, below which claims are paid by the direct insurer (cf. the explana-
tions in 5.1.2), and
-P"'(Mi) be the reinsurer's premium for granting the non-propor-
tional reinsurance of the risk i characterized by Mi.
Suppose that the risk mass again consists of N risks. In addition we
shall assume-using the argument of 2.3-that S") is a random sum of
non-negative independent variables Y,") with identical distribution func-
tion F"'(x). Symbolically
Ai
S")= 1 q(i) (Ai= stochastic counting variable
j= o of the number of claims of the risk i).
The reinsurance arrangement characterized by Mi determines then the

retention variable:
Ai
gi=gi[S(')] = 1min [Mi, ?(")I
j= 0
(cf. discussion and figure in 5.1.2)
or more briefly
Ai
gi = 1 $(,'(Mi)
j= 0
with T(i)(Mi)=min [M,, 1);!]',
where the Yji)(Mi)are independent and identically distributed for any Mi.
We have then the general formulae (cf. exercise 4 in 2.3 and [13])
for the expected value, and
+
Var [gi]= E [ A i ] .Var [q(i'(Mi)] Var [Ai] . E2 [ q i ) ( M i ) ]
for the variance.
It remains to determine E [q("'(Mi)]and Var [?("'(Mi)]. Writing
simply F for F"), we find
This transformation using integration by parts is valid if F ( x ) has no

discontinuity at the points 0 and Mi (cf. Appendix, section 5). In par-
ticular F(0) must be equal to Zero.
Similarly
M, m M,
S
E [ Y , ' ~ ) ( M=
J~]
0
~ F ( x ) M?
+ S ~ F ( x ) = M -;2 1
Mi 0
X F(x)~x.
This formula is likewise valid if F ( x ) has no discontinuity at the points

0 and M i and if F(0)= 0. Thus
Finally, we shall assume that the reinsurance premium is

calculated according to the expected value principle, i.e.
Remark: The discussion which follows is possible in principle using

reinsurance premiums calculated by other methods. In order not to
complicate our work here, we shall not go into this further-the more so
as loadings proportional to the expected value are widely used in rein-
surance practice. Where this is not exactly the case the percentage load-
ings cci defined above-which may depend explicitly upon the risk-may
be obtained by "assessing the actual loadings as a percentage of the
expected value". As a first approximation then (i.e. when the variation
in the g, is not too great) the expected value principle is applicable.
b) We shall use the minimum variance principle here as in the case
of proportional reinsurance.
1 18 Chapter 5. Retentions and Reserves
The random variable

N
denotes the "profit remaining within the retention", where P") stands
for the premium which the direct insurer receives for the risk with
accumulated claim variable S").Since the g i are independent, we have
and
N
Var [ Z ] = 1Var [gi]
i= 1
Our task is again to make Var [ Z ] as small as possible jor given E [ Z ] .

The Lagrange function then has the form
@=Var[Z] + A .E [ Z ]
N N
= C Var [gi]+ 2 . C {P(')(1 + U , )
- + cci . E Csi])
. E [Si']
i= 1 i= 1
and therefore
For the Zeros of this partial derivative we find the equation
C) Tt remains now to introduce the expressions for E [g,] and Var [g,]
found under a) in the relation (G). Now (if F continuous at M,)
and
a
--- Var [g,] = 2 M , E CAj] . Cl- F(M,)]
aMj
M,
+2 [ I - F ( M i ) ] .[Var [Ai] - E [ A i ] ] 1 [ I - F ( x ) ]d x .
0
5.2. The rclative rctention prohlem
By inserting these into (G) we obtain

MJ
M, E CAj] + {Var CAj] - E CAj]} j [I - ~ ( j ) ( x )d]x = K cx, E CAj]
0
Var CAj] - E [Ai] M~

M.=Kc(.-- [I - F'j'(x)] d x .
E[Aj1 0
Using the abbreviation

Var CAj] -E CAj]
F.=-
'J
It should be noted that E ~ = Ofor a Poisson distributed number of

claims variable Ai with known risk parameter. For the risk in the col-
lective ej can be considered as a measure of heterogeneity of the collective.
M.
- - J
For this reason and also because of the fact that j [1 -F'j)(x)] dx
0
(the mean claim amount for the retained portion) usually lies considerably
below the bound Mj in practical applications, the second term in formula
(M) is of relatively little significance.
Finally, it should be pointed out that in the determination of the
bounds Mj, it remains to be verified that our solutions do in fact solve
the minimum variance problem. The proof is very laborious and we shall
not give it here, especially since the gradation of the Mj which we have
found appears to be optimal on intuitive grounds.
5.2.3. The risk with given risk parameter and the risk in the collective
under non-proportional reinsurance
In our treatment of the relative retention problem in non-propor-
tional reinsurance we postponed the discussion of the changes which are
necessary in our considerations according as the latter refer to a risk
with known parameter or to a risk in the collective. We shall go into
this question now.
If we examine the assumptions made under b) in 5.2.2 somewhat
AL
more closely, we find that the representation gi= ?"'(Mi)
with in-
j= 0
dependent and identically distributed ?")(M~)is only possible if the risk
parameter for ?")(Mi) and thus the distrihution function F")(x) are known.
If we do not assume these to be known then some of the considerations
made in 5.5.4 are no longer valid. (We shall not look into the resulting
case here.)
For our present discussion then let us make the following assumption:
Ai
The random variable S") = 1 Y,") is described
j= 0
a) in the case of the risk with known risk parameter 9 by

P [Ai = k] = (9),
-P[Y,")sx] = FC)(x)independent of 9 (homogeneity of the collec-
tive with respect to claim amounts) and
-the convention that the Y,") (j=1,2, .. .) are non-negative, inde-
pendent and identically distributed;
b) in the case of the risk in the collective (structure function U(9)) by
P [Ai = k] = pf' = j pf'(9) dU(9),
-P [q'i)5 X] = F")(x) and
-the convention that the Y,") (j=1,2, ...) are non-negative, inde-
pendent and identically distributed.
If we allow the collectives represented in the risk mass to be hetero-
geneous only in respect of the frequency of clnims then the conclusions
of 5.2.2 are in fact valid for both the risk and the risk in the collective.
The formulae then read
a) for the risk with known risk parameter 9:
where
and
T?($)= 2 [ k - v j ( ~ ) l 2p!j)(,9);
k= 0
b) for the risk in the collective:

E [T; ($)I+ Var [vj(9)] -E [vj (9)]
M.=Ka.- 1 [1 - F"'(x)] dx,
E [vj ($)I o
where E[.] and Var [.I represent the expected value and variance
operations in respect of the structure function.
These formulae are particularly interesting if the claim counting
variable of the risk is Poisson distributed. Then of Course z;(9)=vj(9)
and thus for the risk with known parameter 9
for the risk in the collective we have
5.2.4. Credibility approximation for the relative retention

For both the proportional and non-proportional cases we have found
it advantageous thus far to grade the retentions with formulae based upon
the expected claims experience and its variance. According as we are
dealing with a particular risk characterized by its risk parameter or with
a risk in the collective, these quantities and thus the gradations of
retentions are different.
We are faced here essentially with the same dilemma as in premium
calculation, where the alternatives are a known collective premium and
an unknown risk premium. With the gradation problem for retentions
we have the analogous Situation: We can calculate the relative reten-
tion for the risk in the collective, but because of lack of knowledge
of the risk Parameters we are not in a position to produce the proper
retention for the individual risk-and this is what we would actually
like to use.
Here also we can solve the dilemma at least approximately through
replacement of the expected values and variances in the collective by
their conditional Counterparts. With respect to each risk we can use the
related obseruations. Many of the considerations here are similar in
principle to the premium calculation problem and we shall therefore
content ourselves with mere indications of some of the arguments
involved.
We would also mention the following problematical aspect of this
matter: In what follows we shall adopt the standpoint that only the
ceding company makes use of the credibility approximation for its
retention and that the reinsurer retains its tariff structure unchanged.
This is clearly not always realistic. In actual fact the reinsurer would
react in this game by a skilful variation of its price functions P'j)(aj)and
P'jl(Mj) for the proportional and non-proportional cases respectively.
A theoretical study of this two-person game would certainly be highly
interesting.
Chapter 5. Retentions and Reserves
U ) Proportional reinsurance
We have found the following proportionality factors for the risk in
the collective (cf. 5.2.1):
For the credibility approximation we now change over to the conditional

quantities:
P'j) - E [ p j(9)/S1,..., Sn]
"[OS
2. = P---------
(g)/Sl,... , Sn]+Var C p j ( W S i ,... , Sn1 '
The three new quantities which we have introduced correspond exactly

to the expected value, variance and fluctuation parts of the credibility
premium. The credibility formulae of 4.3.6 with the weights of 4.3.7 also
hold in this case.
b ) Non-proportional reinsurance
Here we have found-by limiting the heterogeneity of the collective
to the frequency of claims alone (cf. 5.2.3)-the following relation for
the risk in the collective:
E [T; ( 9 ) ]+ Var [vj( 9 ) ]- E [vj(9)] M~

M.=Ka.- i [ l - F(j)(x)]d x ,
E Cvj ($11 o
where T; and vj denote the variance and expected value respectively of
the number of claims variables given 9 and cci is the proportional loading
on the expected ualue in the colleclive.
Thus
m
S
P ( J ) ( M ~ ) = ( ~ + Q ~ ) E [ v[~l -( ~~ () j]' .( x ) ] d x .
Mj
Once we have made the observatlons k k , , .. . , k, of the given risk,

we can replace E [vj(S)] by E [vj(S)/kl,... , k,]. Since, as mentioned
initially, the reinsurance premium p'j)(Mj)should remain the same, the
estimate for the loading a j ( k l ,k,, .. ., k,) based on observed values must
satisfy the equation
Thus the proportional loading on the a posteriori expected claims

cost is
5.2. T h e relative retention problern 123
We can now obtain the credibility approximation to the gradations

of retentions changing over to the conditional quantities and using the
loading just developed :
M i = K . a i ( k l , ..., k,)
- E [rj2(9)/ki, ... , k,] +Var [vj(9)/kl, . . .,k,] -E

- [vj(9)/kl, . .., k,]
E Cvj(wk . ..,k,l
M,
j C1 - F"' (X)] dx.
0
Here also the a posteriori expected values and variances which appear
in the formula can be replaced by the approximations of 4.3.6 and 4.3.7.
1) Determine the gradations which result from the de Finetti Solution

to the relative retention problem in proportional reinsurance if
a) all risk Parameters are known and the reinsurance premium P")
is calculated as
a,) P")= (1 + A) . pi(9) (expected value principle with proportional
loading),
a,) P")=pi ($1+ a . (9) (standard deviation principle),
a3) = (9)+ . U ?(9) (variance principle);
b) all risk in the collective are to be considered and
b,) P ( ~ ) = ( I + AE) [ ~ ~ ( G ) ] ,
+ +
b,) P") = E [pi (9)] a / E [o? (9)] Var [pi ($)I,
+
b3) P ( ~ )E=[pi(9)] + {E [o? (9)] Var [pi(9)]).
2) Determine the optimal gradation of retentions in the non-pro-
portional case, if
N,
a) S")= C q(i)is compound Poisson, i.e.
j= 0
-Ni is Poisson distributed with given Parameter 9,

-the q(") are non-negative, independent, identically distributed with
distribution independent of 9;
b) the same assumptions as under a) hold for the risk in the collective
described by a structure function U($).
3) Determine the optimal gradation of retentions in the non-
proportional case, if
N,
a) S")= 1Y,"', where N, can only assume the values 1 (with prob-
j= 0
ability p) and 0 (with probability q = 1- p ) and the qi)are non-negative
and independent and have the Same distribution function F(x), which is
independent of p;
b) the Same assumptions as under a) hold for the risk in the collective
described by a structure function U(p) over the probabilities of a claim
occurring.
5.3. The absolute retention problem
5.3.1. Exact statement of the problem

Following the approach laid out in 5.1 we now have to determine
the level of retention for a given gradution which has been calculated,
for example with the principles of 5.2. This is called the absolute retention
problem.
Let us formulate a gradation as follows:
a) for proportional reinsurance this is given by
V(aj, S(j))=C . yj,3

where
-V= functional which associates a number with the probability
distribution of the accumulated claim process S") and the proportional
retention aj;
-yj=percentage loading on the expected value contained in the
reinsurance premium, i. e. P(j)- E [ S ( j ) ]= P = y - E [S(j)] ;
-C = constant yet to be determined.
b) For non-proportional reinsurance it is
W(Mj, S(j')=K. a j ,
where
-W=functional which associates a number with the probability
distribution of the accumulated claim process S'j) and the bound Mj;
-~ -
At first sight it would seem more natural to describe a gradation of retentions as
follows: u j = C . U(yj, S"') with an appropriate functional U . Our formulation V ( u P)=
C . y, produces this functional U very simply. however e.g. under the assumption of a
monotonically property with respect to thc U, on the basis of the defining relation
C . U(y,, S'J1)=u, with the property that V(u,, S(ji)=C . y j
The monotonicity guarantees the uniqueness of U , .
The advantage of the "less natural" formulation given here-~over and above the Fact
that the formulation of the proportional case becomes symmetric with that of the non-
proportional case~-will become more apparent in the sequel.
5.3. The absolute retention problem 125
cij=percentage loading on the expected value contained in the

reinsurance premium;
K = constant still to be determined.
In this formulation the absolute retention problem consists quite
simply in determining appropriate values of C resp. K.
It is easy to See how the optimal gradations according to the principles
of 5.2 fit the formulation chosen here, for we have to choose V and W
as follows (in keeping with their optimal character we write them as V*
resp. W*) :
V*(aj, S " ) ) = ~ a Caj.

r S(j)]/ECaj. S'j)] (cf. (A) in 5.2.1 and transform
slightly)
and
M,
W*(Mj, S(j))=Mj+ej. j [I-F(~)(x)]dx (cf. (M) in 5.2.2).
0
Moreover, for this choice of V and W for a risk mass which is reinsured
partly on a proportional and partly on a non-proportional basis, the
two constants C and K are identical. For it is easy to See that the two
forms of reinsurance coincide for a risk which always produces the
maximum (full) claim amount, if a claim occurs.
Aj
Let S(j)be equal then to 1
i= 0
Y,(j), where Y,(j) is a fixed number (no longer
a random variable!) independent of i, and choose a j and Mj such that
UJ . .Y(j)=Mj.
t Then
V*(aj, P ) ) =
Var
[ 1a . . X(" ]
J
-
Var [A,] . M)
' = Mj . ( E ~1).
+
E CAj] . Mj
On the other hand in our case
In order to get the risk reinsured in exactly the Same way under
proportional and non-proportional reinsurance (which are the Same
here), K must be equal to C.
We come finally to the following formulation of the absolute retention
problem:
-Let V and W be the functionals as above for proportional and
non-proportional reinsurance respectively.
-Let y, and aj be the percentage loadings on the expected value

contained in the proportional and non-proportional reinsurance
premiums respectively.
-Then let the following gradations of retentions be given:
(By suitably normalizing the functionals as e.g. in the case of the optimal
V* and W* we can always ensure that the Same proportionality constant
appears in both instances.)
-The absolute retention problem consists in determining the con-
stant C.
5.3.2. The random walk of the risk carrier's free reserves generated by
the risk mass
It is characteristic of the absolute retention problem that no solution
is possible without some formulation of the risk carrier's business goals.
This is in contrast to our remarks on gradations of retentions (relative
retention problem), where we merely employed a minimum variance
principle which would probably be acceptable within any-resonable-
framework of business goals.
Before we can formulate these goals, however, we must describe the
consequences of various retentions levels, such consequences arising
from the fact that the risk carrier's free reserves fluctuate in accordance
with these retention levels. We speak of these fluctuations as the "ran-
dom walk" of the risk carrier's free reserves. For a mass of N risks the
latter has the following appearance:
-Let SIi)( i = l , 2, ... , N) be the accumulated claim process of risk i.
For simplycity's sake we shall assume (cf. 2.3.3) that for known risk
parameter this process is compound Poisson, thus that
where N,"' = Poisson process with intensity pi(Si)andthe Y,"'are independ-

ent with the same distribution function F(i)(x/9i).
-For the risk with given risk parameter 9;we thus have
5.3. The absolute retention problem 127
which is the distribution function of the accumulated claim SIi), whereas
represents the characteristic function of the accumulated claim SIi).

-For the risk in the collective (structure function ~ ~ ( 9we) have
) then
for the distribution function of the accumulated claim Sji)and
for the latter's characteristic function.

In this chapter on retentions we have assumed throughout that
(cf. 5.1) the accumulated claim processes (for known risk parameters and
also for risks drawn from one or more collectives) are independent of
each other. We shall now pursue the argument using this assumption for
the case in which all risks are drawn from one or more collectives. (The
known risk Parameter situation is included here as a special case.) First
of all, we must enquire into the probability distribution of the accumulated
claim process for the entire risk muss, i.e. for
Since the SIi) are independent, we have
and
(X*arises by weighting the xi and is thus in turn a characteristic function.)

We thus have the result:
Theorem: l f the accumulated claim processes of the individuul risks
in the risk muss are weighted compound Poisson und independent qf each
other, then the accumulated claim process of the entire risk mass is also
weighted compound Poisson. Formulae ( A )giue the (conditional) intensity
und the (conditional) claim amount distribution for this process.
Over against the accumulated claim process S, we have the accu-
mulated premium income
N
C* = 1p,
i= 1
where C"' is the risk carrier's accumulated premium for risk i in the time
interval [0, t ] . The differente
represents then the random walk of the profit realized on the risks in
question. If we also take into account the risk carrier's available free
reserves Q at time t = O , then
is the random walk of the risk carrier's free reserues. The following
diagram will make these definitions clearer:
The economist would undoubtedly speak of "capital flow" rather

than of the "random walk of free reserves". In any case the setting of
goals which we discussed at the outset consists of indicating (the formula-
tion is still vague for the time being)
a) which paths of the random walk are desirable (acceptable), and
b) how to find a measure for those paths which we regard as unde-
sirable (not acceptable).
We shall treat the problems and solutions which are tied in with
this setting of goals in detail in the next chapter. The solution of the abso-
lute retention problem is hence also deferred to chapter 6.
5.4. Reserves
5.4. Reserves
The notion of reserves in insurance parlance is usually understood

in an accounting sense. A reserve is a setting aside of funds at year end
for a specific purpose, especially for
-unearned premiums,
-pending claims (including those not yet reported) and
-fluctuations in technical results and in the book values of invest-
ments.
We are concerned here with the reserve forfluctuations in the technical
results alone. The reserves for unearned premiums and for pending (and
unreported) claims do raise important and interesting statistical prob-
lems of estimation, but these lie outside the scope of this book. The
extremely important reserve for investment fluctuation must likewise be
passed over, since it is determined by means of economic considerations,
and we cannot pursue the technicalities of investment theory here.
The reserve which remains then for our treatment here-that for
fluctuations in the technical results-is to be understood as the portion
of an insurance carrier's resources which is available to absorb the
fluctuations in its technical operations. We also refer to this reserve as
the free reserves of the risk carrier-making the assumption that the
reserve for fluctuation in investment values (which is normally con-
sidered to be a Part of the free reserves) has already been split off.
In the preceding section we have likewise identified this reserve for
fluctuations in the technical results conceptually with what we have
called the free reserves. At time t = O it amounts to Q and subsequently
e*
to Zt = Q + - S c . For the insurance carrier's operating decisions it is
important to know the probability distribution of 2,. In particular the
initial reserve Q is paramount for this probability distribution.
In order to avoid misunderstanding, let us agree to use the term
reserve in the sequel exclusively in the sense described here. In particular,
the terms "reserve for fluctuations in the technical results" and "free
reserves" will be used as Synonyms.
Exercises
1 ) Let Zt be the random walk of free reserves,
S, the accumulated claim process, subject to the compound
Poisson law of probability : ( U ) = ep'[X'u'-ll,
C* =(1+ A) t the premium income, and

Q the initial reserve.
Show that
2, has independent increments and determine the
distribution function FZt(x),and the
characteristic function cpZt(u).
2) From the process Z, of exercise 1) form the differences
and
where z(n)= time at which the n-th claim occurs in the process S,.
What are the distribution functions of X, and Y,,?
Are ( X , , X,, ...,X,, ...) and (Y,, Y,, ..., Y,, ...) sequences of independ-
ent random variables?
3) Examine the random walk 2, defined above and the sequences
{X,; n = l , 2 , ...) and {Y,,; n= l , 2 , ...) for the case of the risk in the
collective with structure function U ( p ) .The accumulated claim process S,
then has the characteristic function
Chapter 6
The Insurance Carrier's Stability Criteria
6.1. The stability problem
6.1.1. Decision variables

Let us turn once again to the fundamental problems of chapters 4
(premium calculation) and 5 (retentions and reserves). If we review our
earlier treatment of these problems, we See that with the principles
adopted we have only been able to determine the quantities which
interested us-premiums and retentions-up to certain parameter
values which themselves remained undetermined.
a) For the premium we obtained for example (cf. 4.1.2):
P = E [SI + a - a [SI (standard deviation principle),

or
P = E [SI + . a2[SI (variance principle).
The "level" a (resp. ) of the premium represents such a free parameter.

b) Similarly we found for the retention problem (cf. 5.3.1):
V(aj, S"') =C .y (proportional reinsurance) ,

and
W ( M j ,P ' ) = C . a j (non-proportional reinsurance).
Here C represents the free parameter.

C) Finally, similar reasoning in the case of the "random walk of
free reserves" (cf. 5.3.2) leads us to consider Q-the free reserves available
at time t =0-as a relevant free parameter for the stability problem.
We have thus enumerated the three quantities which we shall call
decision variables in the sequel:
a) the loading level (Uor ),
b) the retention level (C), and
C ) the initial free reserves (Q).
132 Chapter 6. The Insurance Carrier's Stability Criteria
We add the following remarks with respect to these three decision

variables :
a) Loading level: From here on we shall denote this quantity simply
by a, regardless of the premium calculation principle employed. Depend-
ing on the latter, therefore, a may be a loading proportional to the
expected value, the standard deviation or the variance of the accumulated
claim S.
b) Retention level: In the terminology of 5.1 determining C amounts
to solving the absolute retention problem. We shall revert to the solution
of this problem in this chapter.
C) Initial free reserves: Let us emphasize once again (cf. 5.4) that
we are dealing here only with the reserve which is set up initially for
fluctuations in the technical results.
Let us also point out that in our description of the relevant decision
variables only those free Parameters occur which are related to the
purely technical insurance operations. General economic or manage-
ment decision variables (such as e.g. those related to the insurance
carrier's investment policy) are intentionally neglected, in keeping
with the limitation to purely uctuarial problems followed in this
book.
6.1.2. Stability problem and stability criteria

Now that we have defined the three decision variables a (loading
level), C (retention level) and Q (initial free reserves) we can designate
a given stability policy of the insurance carrier with a triple of real
numbers
The insurer's stability problem is to choose the "bestV-in a sense

yet to be defined-of all possible stability policies [U C Q,].
The rule explaining what is meant by "best" is called the stability
criterion.
Three different stability criteria are to be found in the literature:
I) the probability of ruin criterion
(Lundberg [46], Cramer [21, h ] ) ,
11) the dividend policy criterion
(de Finetti [26]),
111) the utility criterion
(von Neumann-Morgenstern [53], Borch [12]).
6.2. The probability of ruin as stability criterion
6.2.1. Planning horizon and ruin probability
In 5.3.2 we described the random walk of free reserves as a set of

random paths. (A random path means henceforth a realization of the
random walk.) We shall now say-in the sense of the criterion of the
probability of ruin-that such a random path is acceptable if its ordinate
is not negative at the points in which we are interested. Consistent with
the usual (but rather unfortunate) terminology, we describe as ruin the
case in which a negative ordinate appears at one of the points of time in
which we are interested. In this case the practician will not speak of
"ruin" but rather of a "need for additional capital"; the latter is far from
being the same thing as ruin in practice. Thereby we must distinguish the
following cases as regards the points of time in which we are interested:
1) Finite planning horizon T: We are interested only in time points
in the interval CO, T].
2) Infinite planning horizon: We are interested in time points in the
interval [0, GO).
From another point of view we can also arrive at the following
classification :
a) Discrete case: Only countably many (e.g. only integer valued)
time points in the planning interval are of interest to us.
b) Continuous case: All points of time in the planning interval are
of interest to us.
On the basis of these two classifications we have the four possibilities:
1a) finite planning horizon -discrete case,
1b) finite planning horizon -continuous case,
2 a) infinite planning horizon -discrete case,
2 b) infinite planning horizon -continuous case.
For example in the sketch below showing a realization of the random
walk Z, ruin occurs in cases 1b), 2a) and 2 b), but not in case la).
o discrete time
points of interest
For each of the four cases listed there is thus a set of unaccep-
table realizations of the random walk. We shall designate these Sets as
follows:
case 1a) : A T , , -planning horizon 7:
-time points of interest are multiples of h ;
case 1 b): AT,, -planning horizon 7:
-all time points are of interest;
case 2a): A,, , -planning horizon co,
-time points of interest are multiples of h ;
case 2 b): Am,, -planning horizon co,
-all time points are of interest.
It is easy to verify that
and
where "C" stands for "is a subset of".

The probability of ruin is now defined as the probability that-for the
particular case under consideration-a random path from the corre-
sponding Set A defined above is realized. It is obvious that on the basis
of the foregoing inclusion relations the following inequalities hold for
the probabilities of ruin:
Thus for every random walk of free reserves case l a ) produces the
smallest and case 2b) the largest probability of ruin of the four possible
cases.
It is also easy to see on intuitive grounds that
lim P [AT,,I = P [ A m ,,I

T + rn
for all h (also for h = 0)
and
lim P [ A T ,,I = P [AT,,I
h+ m
for all T (also for T= CO).
These relations express nothing other than the continuity of the probabi-
lity measure.
For the exact proof (especially for the second relation) the reader is
referred to [23].
6.2. The probability of ruin as stability criterion 135
6.2.2. Admissible stability policies

We shall now assume that we have chosen one of the four possible
cases indicated in the preceding section. We shall denote the related
set of unacceptable random paths simply by A. On the other hand if we
consider a stability policy [U,, C,, Q,] it is evident that the set A depends
on the latter, since 2,= Q +P,* - Si(cf. 5.3.2).
a) A positive change in a, increases P,* and therewith 2,.
b) A positive change in C , raises the value of &* (more premium
retained), but also that of S, (more claims for own account).
C) A positive change in Q, raises all the values of Z by the Same
amount.
Thus the set A of unacceptable random paths is decisively influenced
by the stability policy [U,, C,, Q,]; the probability of ruin P [ A ] can
only be determined with respect to a given stability policy.
If this probability lies below (or is equal to) some given admissible
level P, then we say that [ao, C,, Qo] is an admissible stability policy:
otherwise it is inadmissible. It follows from the nature of these definitions
that there are many admissible stability policies. The probability of ruin
criterion tells us nothing about how to choose among the various admis-
sible policies. In practice the borderline case P [AI =P, Comes into the
picture as just barely admissible in terms of the ruin probability criterion.
We are left now with the mathematical problem of calculaling the
probability of ruin P [ A l . In this connection we shall lay particular
emphasis on the extreme cases
and
For the remaining cases see e.g. [23].
6.2.3. Hypotheses about the model variables

in calculating the probability of ruin
In 5.3.2 we represented the random walk of free reserves as follows:
Since the rationale of calculating the probability of ruin depends upon

the explicit form of C* (accumulated premium income up to point of
time t ) and the stochastic behavior of the accumulated claim process
of the entire risk mass S we shall state here the properties which will
be assumed with respect to these two quantities in the sequel.
Chapter 6. The Insurance Carrier's Stability Criteria
U ) Accumulated claim process of the entire risk muss: Sr

Following the theorem proved in 5.3.2 Sr will be assumed to be a
weighted compound Poisson process, thus (in characteristic function
terminology)
= j e"*'9) " [x*'"/S) 'I
'
d U($)
-
and (in distribution function terminology)
where 9 is a general parameter (e.g. 9 = [9 ... ,9,] in 5.3.2). It follows

in particular from this assumption that for known risk parameter 9 the
process S, has independent and identically distributed increments. We
define (cf. 3.2.5)
Gk:) (X)= G:' (X)= P'' [S, 2 X] = P'' CS, - S, 5 X]
and
G~:'(X)= G'"(x) = P'" [SI 5 X] = P"' [S - S, 5 X]
for given risk parameter 9, and similarly

Gst (X) = G, (X)=J G!' (X) d U(9)
and
G,, (X) = G (X)= j G'@(x)d U (9)
for the case in which the total risk mass consists of risks drawn from one
or more collectives.
b ) Accumulated premium income &*
In the case of an infinite planning horizon we shall adopt the usual
assumption found in the literature, viz. that
&* is proportional to t .
This amounts to assuming the expected value principle for the premium
calculation, because proportionality to the expected value follows from
and vice versa. We can write then
It should be noted that this proportionality relation can also be

derived in the case of the vuriance principle, provided only that the risk
parameter is known. In this case, by using the result of exercise 4) in 2.3
(cf. also 5.2.2 and [13]) we have
On the other hand, in the case of a finite planning horizon, we shall

only use the proportionality assumption in the derivation of the im-
portant inequality
$kg)(U)se - R ( s ' . u ,
6.2.4. Calculating the probability of ruin in the discrete case

with finite planning horizon
U ) When the risk Parameter is given
What we are seeking here is P @ ) [ A ,I. , Without loss of generality
in our reasoning, we can Set h= 1 and T= n (an integer). In this section
we shall also write An for A n , , for the sake of simplicity. The event Ai in
which no ordinate becomes negative (ruin does not occur) can be de-
scribed best by the following conditions:
-,
Since the increments Sk - Sk are independent for a given risk para-
mater and since
G('' (tk)= P"' [Sk- Sk 1 5t k ] ,
P
we therefore have
This expression can be simplified somewhat by substitution for the var-

iables of integration. By setting
This formula cannot be further simplified analytically, even by using

special forms for G@)(x).It is, however, suitable for numerical work to
the extent that it represents an incomplete convolution ("incomplete"
because of the upper limits of integration, which are + co in the case of a
true convolution).
Let us see how the incomplete convolution can be carried through
by iteration. To this end we define [X; Afi-,I as the event that ruin does
not occur in the first n - 1 years and that in the next year Snremains 5 X.
From the relation above we then have the recursion formula
t= -a>
with
P'" [Afi] = P") [W ; Afi] = P(') [Q + E* ; A i _
b ) For risk parameter 9, distributed according to a structure

function U(9)
The first steps in the procedure are similar to those under a). The final
integration is then performed over all parameter values 9, thus
Although-in theory-we can determine the probability of ruin for the

discrete case with finite planning horizon as an iterative integral, we
quickly find that the calculation is only feasible by use of an electronic
Computer. For this reason it is understandable that simple approxima-
tions to the probability of ruin are often sought.
C ) An inequality for P")[A,]
According to the hypothesis about Si described in 6.2.3, we have for
,
the differences S - Si
where the characteristic function is
and the moment generating function is identical in form (cf. 1.1.4) except
that here we must set
+ a>
X*( 4 3 )= J euxd F (XIS).
- a>
~ * ( u / 3is) hereafter to be understood as a moment generating function.

Let us assume that there is an r>O such that

1) X* (r/9) exists and is finite (cf. 1.1.4 regarding the meaning of this
assumption) and
2) 1 +--- C r - X* (r/$) 2 0.
(The condition is discussed under
P* (9) in this section.)
3) Finally, let the premium income be linear (cf. the discussion
Now let B, denote the event in which ruin occurs precisely at time n,
that is
B n = [ S l s Q + c ; S 2 S Q + 2 c ; ... ; S n - l i Q + ( n - l ) c , S n > Q + n c ] .
Let
P'") [Bn/Q= U] = <P!,") (U)
and n
P'") [ AJQ = U] = $2)(U)= q$)(u).
k= 1
(N.B. In this context <P?) is used with a new meaning as a probability and
not as a characteristic function.)
These functions are meaningful only for non-negative arguments U.
We have, with similar recursion formulae as under U),
(P\s) (U) = 1- G") (U + C) for u 2 0
and
By summation of the latter relation we obtain
and thus
From (R,) we can See that

0
e-'"-$?(u)=H+ 1 [er"-$!,911(-u)] dG(')(v+u+c), (*)
V=-W
where o
~=e-'"-l+G")(u+c)- 1 er"dG"'(v+u+c).
V= -m
But it follows from hypotheses 1) and 2) that
because of 2) and thus
We therefore have from condition (*)
But we know also that
since HZO. And since it follows from (R,) that iC/~s)(u)5e-ruif

$;'I1( u ) s e r uit therefore holds quite generally that
$?(U) j e r u . (R3)
Finally, we note:
i) The right side of the inequality is independent of n.
ii) (R,) holds independently of the time unit chosen. While P*($)
and c are multiplied by a factor if the time unit is altered, the quotient
clp* (9) remains unchanged.
We thus huve for ull T und h
where R"'= smullest upper bound for r which sutisfies corlditions 1) und 2).
It is important to point out at this juncture that R'"' (as suggested by
the notation) varies with the risk Parameter 9.
d) Further remarks on the constunts R($'

We assumed in C) that
+m
-
I
1) X* (Y/$)= er" dF(xl9) exists and is finite for some r>0, and that
m
In addition let us now assume

+m
3) 0 < J 1x1 dF(x/$) < co (claim amount has finite first moment).
-m
From hypotheses 1) and 3) it follows that the right-hand derivative
of X*(r/9) exists at Zero and is equal to the first moment
It can further be shown that x*(r1/9)exists and is finite for all rfe[O, r]
and that the function
-provided that it exists-is strictly concave from below (because of

the convexity of er" in X).Note especially that W(O)=O. There are two
possible cases for the function W(t):
W(t)< 0 for all t >0 for which the function exists. Therefore R") = 0.
W(t)>0 for all t E [0, R@)]

where either
W(R"') =0
or
w(R@)) does not exist.
It is easy to See that R'') must be finite in the case F(0/9)< 1 (positive
probability of a positive claim amount). The Same holds for F(O/$)= 1
(only negative claims) and C <O (negative premium income). Thus in
cases which are relevant in practice
6.2.5. Calculating the probability of ruin with an infinite planning

horizon using the Wiener-Hopf method (Cramer [22])
In this and the following sections we shall calculate the probability
of ruin P'" [Am,,I for a known risk Parameter only. The transition to the
probability of ruin P[A,, ,I for risk Parameters drawn from one or more
collectiues will be carried through-as under 6.2.4b)-by integration

with the structure function U($), i.e. P[A,, ,I =J P'3'[Am,,] du($). We
shall also assume that the hypotheses of 6.2.4~)still hold.
U)7he inequality
The inequality (R,) derived in 6.2.4~)
is valid for all T and h. Thus we have from the limit relations mentioned
in 6.2.1 also
$~)<U)=P'"[A,,,/Q = U] - ~ e - ~ ' " ' "
for infinite planning horizon and discrete points of interest, and
for infinite planning horizon and continuous points of interest.

It may be mentioned in passing that we have equality if
$?)(U) = $@)(U)
=1 for aii u if R")=O ("certain" ruin)
This can be justified for example by taking the limit in the solutions of
the integral equation below.
The method described here yields an exact calculation of the proba-
bilities of ruin and more particularly the asymptotic formulae for large u
and
as solutions to the integral equations which we shall now derive.

b) 7he integral equations
In 6.2.4 we derived the relation (R,):
0
$ ~ ) ( ~ ) = l - G ( ~ ) ( u + c )f + $ ~ ( - u ) d C ' 3 ) ( v + u + c ) .
V= -m
By changing the time unit from 1 to h we obtain (T= n h)

0
$ ~ ' h ( ~ ) = l - ~ f ) ( ~ + ~J h $) :+9 ' _ h , h ( - ~ ) d ~ f ' ) ( ~ + ~ + ~ h ) .
V= -m
If we now let T+ GO we have the integral equation

from which the equations for the continuous case may be obtained by
taking the further limit h + 0. The latter limiting process is rather labo-
rious, however, and since we shall discuss another method for deriving
the same integral equation, we shall not reprodnce the proof here. (The
latter can be found for example in slightly different terminology in C221
or [23].) The resulting equation is
It follows in particular from (R,) that $("(M) is differentiable for

positive U and thus we obtain by differentiation (substituting W = u + U in
the last integral and then carrying through an integration by parts) the
integro-differential equation
C d$("(u) U
=-l+F(u/9)+$'"(u)- f $@)(U-w)dF("(w). (R,)
P*@) du -m
The integral equations (R,) and (R,) have been solved by Cramkr C221
and Tcklind C631 according to the Wiener-Hopf method (i.e. using
Fourier transforms and function-theoretical means in the complex plane).
We shall only summarize here the most important results in this con-
nection.
i) F(x/9) has measure only the positive half-axis
(only positive claims).
For large U we have
in the continuous case
and
in the discrete case (and where the claim distribution is absolutely
continuous)
(This holds only for large values of h.)

ii) F(x/9) has measure only on the negative half-axis
(only negative claims).
In the continuous case we haue

$(') ( U ) = e - R'S' for all U.
iii) F(x/9) has positive muss on both half-axes

(positive and negative claims).
Cramkr has developed an explicit formula for $("(U) and its asymp-
totic behavior and the reader is referred to his work [22].
6.2.6. Calculating the probability of r u h in the continuous case

with infinite planning horizon using renewal theory methods
(cf. Feller [33])
This method does not give us any new results for the case of the
infinite planning horizon beyond those that could be obtained by follow-
ing the Cramir approach. It is appealing, however, because of its elegance
and clarity.
We set ourselves the task of calculating
i.e. the probability of ruin in the continuous case with infinite planning
horizon, and where the initial reserves are equal to U .In order to simplify
the notation, we shall omit the characterizing risk parameter 9 from our
symbols in what follows, although the arguments used are only valid for
a given, known risk parameter 9. According to our hypothesis about the
accumulated claim process St (in 6.2.3) the latter is then (for a given risk
parameter) compound Poisson with distribution function
where N(1) is a homogeneous Poisson process with parameter p and

the Y,(i= 0, 1, . ..) are independent and identically distributed. Let us
assume once again that the premium income is linear, i.e. that e*
=C t .
a ) Interpretation of the ruin problem (continuous case, infinite plan-

ning horizon)
+
Ruin occurs if there is a point of time t such that u C t - Si<0. Thus
we can write as the definition of the set A m , , of unacceptable sampling
functions (random paths)

A,,,=[S,>u+ct for at least one t201.
It can be Seen with the aid of the drawing that ruin can only occur
at the random time points W i.e. when a claim occurs. Thus the set
A m . , can be characterized as follows:
A,,,=[Swn>u+cWn for at least one n z l ] .
Reverting to 2.2.2 we define
T,= W, - W, as the claim interoccurrence time.
Theorems 1 and 2 of 2.2.2 then give us at once (because of the time-

independent claim intensities p for all claims):
The T, are independent and identically, exponentially distributed
with density functions
,fT,(x)=pe-'" (x>O).
The Y, are independent (also from the T,), identically distributed claim
amounts (with distribution function F(x)).
The event A m , , can then also be defined as follows:
A,,,=[$l,:-c7;>u for at least one n - 1

I
or, setting F' = -c
~ , , , = [ $ ~ > ; ~ > uforatleastone n Z 1 .

I
It is noteworthy that the X' are not only identically distributed and
independent; they also have a (common) density function:
this being obtained from the convolution of f_cTi(x)with F(x).

b) Discrete random walks
Following the general theory (see Feller [33]) we shall call the
sequence of random variables S S S ... , Sn, .. . , where
n
So= 0, Sn= 2 X'
i= 1
(Note that Sn does not here denote the accumu-
lated claims to time n.)
(Y;, Y,', ..., Y,',.. . independent and identically distributed) a discrete
random walk. A realization of such a random walk is given in the following
diagram :
Sn t
The point (n, Sn)is called a record point (ladder point) if Si<Sn for
all i < n. In this case we refer to Sn as a record height (ladder height) and
designate it by M, if k further record points lie to the left of the point in
question. (We always Count (0, So) as a record point.) The differences
M , - M , - , = X are known as record jumps (ladder j ~ m p s ) .The ~
(k = 1,2,3, . ..) are identically distributed random variables with
distribution function
P[.gSx]=H(x).
The record jumps are dependent on each other to the extent that for
a non-existent 2,all later record jumps are also non-existent. Otherwise
they are independent of each other. It is obvious that H(O)=O; on the
other hand it is possible that H(co)< 1. (1- H(m) is the probability that
no further record point will be found. In this case we say that the distribu-
tion function H(x) has the defect 1 - H(co). Defective distribution func-
tions are also acceptable within the framework of the method of interest
to us here.)
The terminology chosen here differs slightly from that usually employed in renewal
theory; See Feller 1331 for example.
The events A m , , can then be described as follows:

k
Am,, = [ M > U ] , where M,= ,ril (in so far as M , is defined, i.e. in
i= I so far as a k-th record point
exists)
and M = sup M , (k = 0, 1,2, ... for which Mk is
defined).
The random variables M M M ... now form a renewal process
(=discrete random walk with strictly increasing ordinates). We say that
the latter breaks down (terminates) if the M , exist only for a finite number
of indices k. The most important tool for the treatment of a renewal
process is the
Renewal measure : W
U(x)= E
H*k(~).
k= 0
Intuitively, the renewal measure represents the expected number of

record points with record heights 5 X ;this is easily Seen from the relation
We have then the

Renewal theorem (see Feller [33]).
a) U(x)<co for all X ;
b) for bounded z(x) the renewal equation
has exactly one bounded solution, numely
By integrating the members of the sum which represents the renewal

measure one at a time, we can verify that the renewal measure itself
satisfies the renewal equation (with z(x)- 1):
Now it is the probability 6 (X)= P [ M 5 X] which interests us in con-

nection with the probability of ruin; it represents the probability that
for initial free reserves X no ruin occurs. The following connection with
the renewal measure then holds:
Theorem: If H ( m ) < 1 ( i . e . if the distribution of record jumps is
defectiue) then
a) every random path (realization of random walk) has only a finite
number of record heights (set of exceptions has probability measure 0)
und
b) 6(x)=[1 -H(Go)] U(x).
Proof of a): U(m) represents intuitively the expected number of
record points. If H(m) < 1, however,
But then the number of record points is a fortiori finite on almost all
random paths (i.e. the Set consisting of all random paths with infinitely
many record points has probability measure zero). In other terms the
associated renewal process breaks down (terminates).
Proof of b):
= P [last record point has record amount 5 X]

m
= E P [M, 5 x and the n-th record point is the last one]
n= 0
Remark: The case H(co)= 1 corresponds to the situation in which yet

another record point can always be found with probability 1. In this
case the renewal process increases beyond any given bound, as can be
proved on the basis of the independence and identical distribution of the
record jumps.
We thus obtain for the function 6 ( X ) = P [M 5 X ] the integral equation
(from the renewal equation for U(x))
(using the last theorem above).

The solution of this renewal equation does not give rise to any special
difficulties. In particular we find the following approximation for large u
(provided that the quantities IC and p # exist):
where IC is such that
For the details of the derivation of this formula the reader is referred
to pages 363 and 364 of Feller's book [33].
The main problem arising from this elegant method consists in
determining H(x) (distribution of record jumps) from the distribution
F(x) (distribution of claim amounts). In the following we shall again
solve this problem for non-negative claim amounts.
A comparison with the definition of the probability of ruin *(U)
given at the beginning of 6.2.5 shows us immediately the interconnection
with the above function. We have simply
C) Asymptotic .formda for the probability of ruin in the case of non-

negative claim amounts only
We shall assume here that the distribution function of the claim
amounts carries its probability mass only on the positive real half-axis,
i.e. that F(O)=O. Having assumed this, we wish to find an asymptotic
formula for t,b (U) = 1 - 6(u).
The following consideration leads us directly to an integral equation
for 6(u): The first jump of our compound Poisson process takes place
at time z and has amount X. Ruin does not occur if
i) x s u + c z and
ii) S , - x s u - x + c t for all l > z .
The probability that the jump takes place at time z and is of amount X,
both conditions i) and ii) being fulfilled, is
By integrating over all possibilities for the first jump, we obtain
Setting s = u + C z gives us
6(u) is thus differentiable and therefore
It is easy to see that (R,) corresponds exactly to the integro-differen-

tial equation (R,) derived earlier. (Set $(U)=1-d(u).) By integrating
(R,) over (0, t ) and applying the rule for integration by parts to
j 6(u-X) dF(x) we obtain
P
d ( t ) - d ( O ) = j d(t-x)[l-F(x)] dx. (R)
C o
But this is precisely our integral equation (R,) with
6(0)=1-H(m) and H ( x ) = -PJ ["1 - ~ ( t ) ] d t .

C 0
For the cases in which we are interested we have

P
H(m)=- p, < 1 (the case pl 2 C leading as it does to certain ruin),
C
where W W
We thus have as an approximation for large u
where K is chosen such that
-Pj e K Y [ l - F ( y ) ] d y = l and
C 0
This formula is identical with that found in 6.2.5, for we have (through
integration by parts)
P
1=-J eKY[l-F(y)] dy= ---+PSP P m
eKY
dF(y),
C o C.K C.K 0
from which - W
and thus K= R@)in the terminology used in 6.2.5.

On the other hand (again using integration by parts)
and thus
Introducing this in (Rn) we obtain
which agrees exactly with the expression developed in 6.2.5.

For the case in which the claim amounts may also take on negative
values, Gerber [36] has used the method of random walks employed
here to produce upper and lower bounds for the constant C in the
formula
*(U)- C . ecKU.
These bounds are
and @I')
where is defined as under (RlI). It is evident that formula (R) is

contained in this formula as a special case.
Exercises
1) If F(x) = 1 - e-"" (exponential distribution), develop the asymp-
totic formula for the probability of ruin $(U) for the continuous case
with infinite planning horizon gjven the risk Parameter 9, where
for the accumulated claim process and
for the accumulated premium income.

2) In the case of a variable risk Parameter with
and
e*=c. t
3) Use the estimate $ ( u ) S j e-R'"'u dU(9) for the assumptions of

exercise 1, P* (9)= 9 and structure function U(9) with density function
97-1
a) U($)=- e-' (gamma density),
{~e-'' for 0 $ 9 < c a

b) U($)= (truncated exponential density).
otherwise
6.3. The absolute retention when the probability of ruin is chosen

a s the stability criterion
6.3.1. Restatement of the problem and assumptions

Although we defined the absolute retention problem precisely in 5.3
we did not solve it at that point since-as we said-"this could only
be done given a formulation of business goals". If we now choose the
probability of ruin as our stability criterion, we thereby define a business
goal in point of fact. Intuitively, this choice can be best explained by
saying that security is taken to be the highest goal of the enterprise.
Thus the problem discussed in 5.3.1 can now be posed as follows:
Giuen: a gradation of retentions
a) V(aj, S(j')= K . y j for proportional reinsurance,
b) W(Mj, S"') = K . a j for non-proportional reinsurance.
Required: A constant K such that for the accumulated claim process
of the entire risk muss remaining within the retention the probability
6.3. The absolute retention
of ruin satisfies
$(U)5 Po
for given u (usually large) and P, (usually small, e.g. 1/).
Note: We have denoted the constant to be determined by K here,
whereas in 5.3.1 this constant was called C. We make this change of
notation on purpose since the letter C already has a specific meaning
in the asymptotic expression for the probability of ruin.
It is intuitively obvious (and will also be demonstrated) that-pro-
vided the loadings in the retained portion are unchanged-the smaller K
is, the smaller is the probability of ruin $(U). Since there is a secondary
interest to retain as much risk (and therewith expected profit) as possible,
the case $ (U)=P, is of particular significance in practice.
First of all we shall retain the assumptions of 5.3.2 with regard to
the accumulated claim process S, of the total risk mass. In addition let
us assume that the claim amounts of the individual risks may have
different distributions, but that the latter do not depend on the Parameters
to be drawn from the collectives; this assumption will simplify our work
considerably, but it is not essential in principle to the procedure which
we shall follow.
In terms of the characteristic function, therefore, we have then
for the accumulated claim process, where 9 appears as a general Parameter

(e.g. as the vector (9 !J,, ... ,SN)in 5.3.2). On the basis of (A) in 5.3.2
we have N
P* (9)= 1Pi (9)

i= 1
and
(N.B.: ~ * ( udepends
) upon 9, although the xi(u) do not.) For the accu-
mulated retained claim process gK(Si)we then have (The index K is
intended to recall the constant used in the gradation of retentions.):
where
154 Chapter 6 . The Insurance Carrier's Stability Criteria
in the case of proportional reinsurance and
in the case of non-proportional (excess of loss) reinsurance, ai being the

proportional retention resulting from the constant K in the retention
gradation and Mi the first risk for the i-th risk resulting from the same
constant K.
The processes Si and g,(S,) are subject to the Same law of probability
up to the substitution of x*(u/K) for ~ " ( u )Finally,
. we shall adhere to
the assumption of a linear premium income as under 6.3.1, i.e.
Note that c * in the absolute retention problem under discussion

here should be interpreted as the "premium remaining after deduction
of the reinsurance premium ".
6.3.2. The optimal gradation of retentions

In the following we shall always work with the optimal rather than
with the general rules V(aj, S")) and W(Mj, P ) . Thus in accordance
with 5.3.1 (and 5.2.1 resp. 5.2.2),
Var [aj S'j']
a) V*(aj, S(j))= = K . y j and
E [ U Si)]
Further, let us recall the relation
Var CAj] - E CAj]

&.T
E [Ajl
where Aj denotes counting variable of the number of claims in the

calculation period [0, 11.
By use of the counting variables Aj and the fact that the claim amounts
of the individual risk are independent (which follows from the hypotheses
about the accumulated claim process-also for the risk in the collective)
we can employ the formulae (cf. 5.2.2)
where X'j' is the i-th claim amount of the risk j, and

Var [aj S'j'] = E CAj] .Var [aj Y")] + Var CAj] . E2 [aj Y(i)]
=U;. E[Aj] {Var[Y'j'] +(1 + E ~ )E2
. [Y(j)]}
=U,? . E CAj] - E [(Y"))2] + a; . ej . E CAj] . E2[Y'j)].
From these we have the following relation, which we shall work with
subsequently (instead of a) above):
The case of the risk with known risk Parameter is characterized by

=0 (Poisson counting variable),
whereas for the risk drawn from the collective we have
(cf. the formulae in 5.2.3).
6.3.3. The stability condition

We are now faced with the problem of estimating the probability of
ruin t,b(u/K) (infinite planning horizon, continuous case) for the accu-
- .. . of the total risk mass. A constant K
mulated retained claim process g,(S,)
is admissible if
$ ( u m 5 P,.
In what follows we shall work with the inequality
$(') (u/K)5 e - R ~ " ) " (4
and consider K as admissible if the more stringent condition
Je RK(9)u d U (9)5 P, is fulfilled . (0)
It is clear in virtue of (A) that a value of K which is admissible in
terms of (B) guarantees a probability of ruin 5 P,. The inverse does not
hold, however, so that in the boundary case
e~~~"'dU(9)=P,
we shall in general obtain a constant K for which $(u/K) < P,. From
the standpoint of security, however, we are on the safe side; we must
accept the fact that we can obtain a clear and workable formula only
at the price of having values of K which are somewhat too low.
6.3.4. Determining the absolute retention when the risk Parameter

is known
U) General
The accumulated retained claim process g,(S,) of the entire risk mass
has the form
* ( W l x * ( u / K )- 11.
' P ~ ( S ,( ) 4 = e"
In accordance with the discussion of 6.2 the constant R"' is then deter-
mined from the equation
(We write R instead of R'" for the sake of simplicity.)

X* (u/K)is to be understood here as the moment generating function,
the existence of which in the interval [0, R] we shall take for granted.
We could of Course work with this exact equation for R, but for the
sake of clarity we prefer an approximation approach. We know that
From the expansion
e R x = l+Rx+--- (Rx)2 +(terms in third and higher powers)

2
we iind-if we neglect the terms in the last pair of parentheses-
and by setting this approximation into the equation above we obtain
and thus
We set R = 0 here if formula (C) produces a negative value. In this case

our estimate yields the value 1 for the probability of ruin, independently
of the initial free reserves U.
6.3. The absolute retention 157
b) For proportional reinsurance

Since we are dealing here with given risk Parameters, we have E ~ = O
for all j and thus
a j . E [(Y'j))'] - E [(Y(j))'/K]
- =K.yj
E [Y(')] E Y(~)/K]
(cf. a) in 6.3.2). Therefore
and setting this into (C) produces
R can be calculated from this formula. The relation becomes clearer if

we represent by di the proportional loading added to the expected value
in the retained insurance premium (after deduction of the reinsurance
premium) and by yi as heretofore the loading added to the expected value
in the reinsurance premium.
We have then
~*=~t=x(l+d~).p~.E[Y(~)/K].t
and substituting this in the last formula we obtain
It should be noted that 2 / K is multiplied by a factor which represents

the ratio of the expected retained profits to the expected reinsurance
profits (what the reinsurer would achieve by taking over the retention).
If we set yi = p . 6 , (fixed ratio of proportional loading in the retained
portion in relation to that in reinsurance) we have at once
This formula holds even without the last special assumption if we

define
expected reinsurance profits if the retention
C . Yi . E Y(~)/KI - were taken over
P=
C pi . 6 , .E [Y)/K] expected retained profits
We find then that

je- ' " I ~ K
= P, we obtain
and from the relation eP2"lpK
where u = initial free reserves Q,

p=ratio of loadings added to expected value in reinsurance
premium and retained premium resp.,
P, = admissible probability of ruin.
C) For non-proportional reinsurance (excess of loss)
Since the risk Parameter is given for each risk, we have
M J. = K . aj. (aj denotes here the loading on the expected value in the
reinsurance premium.)
If further we use the conservative estimate
in formula (C) and the Same definition for hi as in the preceding section
for the percentage loading on the expected value in the retention, we
find that
If we now assume that

ai= T . hi, (Otherwise T can be defined in a similar fashion to p in the
proportional case.)
then the relation
follows automatically from the last formula.

Choosing-conservatively-R=~/T.K and making use of the
equality e-2ubK= P we have at once
where u = initial free reserves Q,

T = ratio of loadings added to expected value in reinsurance
premium and retained premium resp.,
P, = admissible probability of ruin.
d ) For mixed reinsurance
Suppose that a portion of the risk mass-say the risks 1 to Np-is
reinsured on a proportional basis and that another part-risks Ne,
to N-is reinsured on a non-proportional basis.
We can now split up the risks into the two parts described and
proceed as in the preceding sections. Let
E,=insurer's expected profit in the retention from risks which are
reinsured proportionally and
E,=insurer's expected profit in the retention from risks which are
reinsured non-proportionally.
Using the same notation as before, we have then
e ) Estimating the error of'our approximation

In U ) we Set
eRx-1 + ~ x + ( R ' / 2 ) x ~ .
The error involved here ( = remainder term of the Taylor series) is at most
(116)elRxlR3 IxI3.
Assuming I$(O/K)= 0 for all i and any value of K (no negative claims !),
the error in X* ( R I K )amounts at most to
From the equation
we find a new approximation for R which we shall call R , . If the equation

without the error term E ( R )produces the estimated value R , used thus
C
far, then we know that for the "correct" root R of 1 + - R -z*(R/K)=O
P*
The bound R , should also be calculated when working through a

concrete example. In the general case the formulae become too compli-
cated to be easily handled.
6.3.5. Determining the absolute retention when the risk parameters

are drawn from one or more collectives
a ) General
According to the hypotheses discussed in 6.3.1 the accumulated claim
process S, of the entire retained risk mass is subject in this case to the
following law of probability (expressed in terms of characteristic resp.

moment generating functions):
and
We now determine for each 9 a constant R'" such that
and we then obtain $(U) by integration:

$(U)- 1e - R ( s ' u d ~ ( 9 ) J+ du($),
@I 8 2
where 0,= (9; R@'$O), Set of 9 with positive R"' and

0,= (9; R"'=0), Set of 9 with R"'=O.
For R"' we use approximation (C) in section a) of 6.3.4
where our notation expresses clearly the fact that the values P,($) are
dependent upon the risk Parameters.
b) For the case of proportional reinsurance
For the optimal gradation derived from formula a) in 6.3.2 we have
where y, = percentage loading on the expected value in the reinsurance

premium P"', i. e.
PG'=(l+yi)-E[SG'] (cf.5.3.1)
and C.= VarC,4(s)1 (cf. 5.23).

' ECPi(9)l
In what follows we shall use the compact notation
Ei(K)=E [Y'i'/K] (expected claim amounts in the retention) and
6,(9) = percentage loading on the conditional expected value for given 9
in the retention.
Using these symbols in the relation for R@)found at the end of the
last sub-section, we have
The following relation holds here for the quantities 6,(9), where the
values on the right refer to the collective:
[1 +&($)I pi(9)=(l + 4 ) . pi for any 9 .
This simply expresses the fact that the premium income for any 9 is
always the same. The relation actually represents the definitin of the
Si (9).
Further, R'" must be set equal to Zero ($'")(M)=1 for all M) as soon
as the relation
1pi(9) di(9) Ei(K)>0
1
(sum of all loadings positive) (I)
is not satisfied. This follows from our considerations about the proba-
bility of ruin in 6.2.4d) (case I) and in 6.2.5a). Let us simplify further as
(Note that -
7, y, in practice.)
We set
1 - C ~i (9)6i (9)Ei ( K ) - expectedexpected retained profits s
p (9) C pi(9) Yi Ei(K) reinsurance profits if retention
is taken over by reinsurer
and we thus have
R'" = 2/[K .p ($)I
and
$(')(U)jexp { - 2u/[K. p(9)I).
Finally,
where (I) refers to the above-mentioned requirement that the sum of all
loadings be positive. The probability of ruin can be approximated
Interpretation holds if we assume ii- yi and that the true Parameter is known to the
reinsurer.
from (G)provided that the structure function U(9) is known. In particular,

the relation gives us a basis for determining K so that $(u)sP, (the
given probability of ruin). It should be noted, however, that
represents a lower bound beneath which $(U) can never lie regardless of
how large u is chosen (except in the trivial case in which the entire risk
muss is ceded to the reinsurer)!
c) For the case of non-proportional reinsurance (excess of loss)

Here the optimal gradation (cf. 6.3.2) produces
where Mi= first risk corresponding to K and

ai=percentage loading to expected value contained in the
reinsurance premium.
As in the case of proportional reinsurance we shall use the abbreviated
notation
Mi
Ei(K)= j [I -&(X)] dx (expected claim amount in the retention) and
bi(9)=percentage loading on the conditional expected value in the
retained premium as defined under b).
We then have (with reference to 5.2.2, Y"' may only take on non-
negative values !)
and by inserting the optimal gradation Mi = K a i - q Ei(K)
where
as in section b). The interpretation of the quantity
is likewise analogous to that in section b). We thus find that

~ " ' 2/[K
2 . T (9)]
and
$("(U) jexp{-2u/[K. ~(9)]]
Again, this approximation holds only if condition (I) is fulfilled, i.e.
1 ) . E,(K)>O). Thus
if the sum of the loadings is positive (i.e. ~ ~ ( 9hi(9)
$(4S J
(I) holds
exp(-2uICK.~(9)1)dU(9)+ 1
(1)does not hold
dU(9) (H)
from which once again K can be determined.

d) The mixed case
As in 6.3.4d) the case of a risk mass reinsured on a mixed basis can
be handled by splitting up the risks according to types of reinsurance.
We shall not present an exposition of this case here.
e) Estimating the error in the approximation

In the case of risks drawn from collectives the basis for determining
the error involved is also that given in 6.3.4e). The development is
extremely laborious, however, and we shall therefore not reproduce
it here.
6.3.6. Practical remark on the probability of ruin as stability criterion

Using the probability of ruin as stability criterion when fixing the
absolute retention limit makes a good deal of sense in practice. It must
be borne in mind, however, that-especially in the case of an infinite
planning horizon-the insurance carrier's free reserves will not be
immediately available when needed, since they are of Course tied up in
investments.
Thus we are faced with the further question of the insurer's liquid
free reserves. The need for the latter can be estimated for example by
using the annual, semi-annual or quarterly probability of ruin in the
discrete case. It must not be forgotten when performing this estimation,
however, that premiums are often due in full at the beginning of the year
of coverage. Thus the liquid free reserves are sometimes set up in practice
on the basis of the potential very large claims (jumbo claims) which
may occur.
6.4. Dividend policy as criterion of stability
6.4.1. General description of the criterion

Let us recall once again the description of the random walk Z, of
free reserves in 5.3.2 and the definition of the stability problem in 6.1.2:
Z,=Q+e*-S
where Q = initial free reserves,
e*= the premium which the risk carrier receives for the entire risk
mass in the interval [0, t ] , and
S, = accumulated claim process from the entire risk mass.
This random walk is influenced by the determination of the premium
loading level a, the retention C and the initial free reserves Q (stability
policy according to 6.1.2). The basic problem is to choose among the
various possible random walks of free reserves. This choice, however,
presupposes an evaluation of the individual random walks.
In 6.2 we undertook the evaluation of these random walks by the
ruin probability criterion. De Finetti C261 has criticized this evaluation
as being extremely conservative. His objection is above all that under
the usual assumptions with an initial reserve Q, and a probability of ruin
(continuous case, infinite planning horizon) P,-which is small in
practice-, the set of sampling functions of the accumulated claim
process for which Z , tends toward co with increasing t has the probability
1 - P , . (For small P, this probability is thus close to 1 !) To try to escape
this dilemma by reducing the free reserves at some later point of time
again to Q, (on the grounds that the probability of ruin is then simply
calculated anew), and to do this consistently in the case where Z, reaches
Q, > Q , , amounts however to raising the probability of ruin to 1. So
much for de Finetti's criticism. It is not the place here to follow the
controversy which arose as a result of this criticism; we are merely
concerned to describe and discuss the dividend policy criterion suggested
by de Finetti as an alternate to the ruin probability criterion.
Speaking somewhat vaguely, the random walk of free reserves Z,
should be diminished from time to time in accordance with a fixed rule.
These decreases (skimmings) will be called dividends in what follows,
although we can of Course imagine any sort of irreversible transactions
which reduce the free reserves. The evaluation is then made on the basis
of the sum of the discounted dividends up to the point of time at which
ruin occurs (which is the case with probability 1). The rule iP which
associates the dividends to be paid out with each random walk is called
the dividend policy; if it produces the largest possible expected sum of'
discounled dividends it is said to be the optimum dividend policy. A
6.4. Dividend policy as criterion of stability 165
stability policy [X,, Co, Qo] will be preferred to another [X Cl, QJ if

the former generates a higher discounted sum of dividends for the
optimum dividend policy. We are then faced with the problem of finding
optimum dividend policies and determining the related discounted
dividend Sums. At this point we would refer the reader also to the work
of Borch [ll], which deals primarily with the comparison of different
stability criteria.
6.4.2. Hypotheses about the model variables when the dividend policy
is used as stability criterion
The hypotheses adopted in 6.2.3 (including e*

= C t ) should also be
used for the case of the dividend policy. We shall use an even more
specialized approach and investigate this case for known risk parameters
only. (The case of risk parameters drawn from different collectives is
not omitted here as being devoid of interest, but rather because research
work on this case is still lacking.)
Let the accumulated claim process Si of the entire risk mass thus
have independent increments and be compound Poisson. In terms of
characteristic functions
= ,y*(9)"Ix*'"/~)-
'I
Since 9 is assumed to be fixed and known in what follows, we can omit

the parameter from our notation, thus
(U)= e ~ [ *X * @ ) - 1 I.
In addition we make a rather special assumption in the case of the

continuous time parameter: The distribution function F(x)-corre-
sponding to the characteristic function ~*(u)-is allowed to assign a
probability only to positive numbers; thus F(O)=O.
6.4.3. Dividend policy in the discrete case

We shall consider the random walk of free reserves 2, only at the
integral time points t = O , 1 , 2 , ..., which we may think of as the dates
on which the annual accounts are balanced, for example. In addition we
shall assume that all the quantities having a bearing on this random walk
take on integral values only; this refers to the quantities
Q , = Z(O),the initial free reserves;
S, (t = O,1, ...), the accumulated claim process; and
C, the premium income in one time unit.
-, ,
L, = Z , - Z , = C + Si- -Si represents then the annual increase in
the free reserves Z, .
Under the assumption made the L, are likewise integer valued,
independent and identically distributed (except for L,=Q,). Let the
(common) probability distribution be described by the numbers
g,: P[L,=j] = g j (j=O, f 1, +2, ...) for all positive integers 2.
Let the dividend to be paid out at the end of the year be denoted
by D,; as a result of this payment the original random walk of free
reserves
Z,=Qo+L1+...+L,
is replaced by a random walk modified by the dividend payments (last
dividend payment not yet counted)
At every point of time t a dividend policy Y assigns a dividend D, to the

past, described by the data [Q L Q ... , L Q,]. It is always assumed
here that 0 5 D, 5Q,. (We are not allowed to go into ruin by declaring
a dividend exceding the available free reserves.)
Let z be the time point of ruin, i.e. suppose that Q,<O for the first
time for t = T ; then we define appropriately
Using the discount factor 0 < V < 1 we then evaluate the policy Y (for
initial free reserves Q,) as follows:
where E [ - ] represents the expected value operation and the first

moment is tacitly assumed to be finite; intuitively, this is the expected
discounted sum of dividends.
The given random walk Z, is then evaluated by Y(Q,)= sup Y(QY),
Y
thus, intuitively, by the largest possible expected discounted sum of
dividends.
We require also the notion of a stationary dividend policy: Such a
policy depends only upon the inslanlaneous slalus of the free reserves Q,;
thus D, =f (Q,), where t = 0,1,2, .. . .
6.4.4. Results in the discrete case

The most important question is that of the existence and the nature
such that
Y ( Q o 9 % ) = ~ F Pv ( Q o , Y ) = v ( Q o ) .
Takeuchi C641 has proved the following result:

neorem: An optimum strategy always exists und it can be charac-
terized as a band strategy.
A band strategy is a special case of a stationary strategy described
by the non-negative integers a,, b, such that
O ~ a o < h , < a , < h Z < . . . < b n < a n (n finite)
and by the rule

D,=f (QA
where
x-a, for a k < x g b k + , (b,=m and k=O, 1, ..., n)
for b k < x g a k (bo=O and k=0, 1, ..., n).
Graphically this has the following appearance:
The small circles are to suggest that f (X)is of interest only at the integral
lattice points. The intuitive interpretation is quite clear: No dividend is
payable for free reserves Q in the interval (b,, a,]; otherwise Q is reduced
by dividend payment to the next lower a-value.
Of particular simplicity are the barrier strategies, which are a special
case of band strategies with n=O; in this case
In his original work de Finetti took only such strategies into account
(and made very special assumptions about the probabilities gj). Miya-
sawa C493 has shown that an optimum barrier strategy exists for the
case g, =g, = ... =O. This optimum property does not hold, however, in
the general case. (See examples in Morill [50].)We shall nevertheless
pursue our study of the barrier strategy in the next section because of
its practical significance. The chief disadvantage of the general band
strategy is the fact that the dividend payment does not depend mono-
tonically upon the available capital.
6.4.5. Barrier strategies in the discrete case

The sum of the expected dividends can be determined in the case of
a barrier strategy by solving a system of difference equations as follows:
Let V(Q ao) be the sum of the expected dividends for initial free
reserves Qo and a barrier at ao.
We have then the system
if Qo<O
ifOIQoIao PI)
Qo-ao + v ( u o , ao) if Qo
The middle equation is obtained by considering the situation after the
+
expiration of one time unit (year). If L, =j, then Q, = Qo j (since D, = 0
according to the strategy); the sum of the discounted dividends from the
second year is thus V(Qo+j,U,). This is then discounted for an addi-
tional year and the expected value is taken over all possible values j.
The other two equations are self-evident. In his original work C261
de Finetti considers the case where
gl =P, g-, = 1 -p=q and all other gj=O.
The middle equation then reads
We seek a solution to this of the form
and we find by using the boundary conditions for Qo= O and Qo=ao
that .Y-(Qo,U,)= C,. rpO+ C, . r)o with suitable constants C C,, where
r, and r2 (r, > r,) represent the solutions of the characteristic equation
r=upr2+uq.
The reader is referred to the work of de Finetti for the details. (See
also exercise 2 in this section.) Additional material on the general barrier
strategy in the discrete case can be found in Morill [50].
6.4.6. Dividend policy in the continuous case

Let the hypotheses of 6.4.2 continue to hold. We are now interested,
however, in all points of time t 2 0 of the random walk of free reserves
Z , and we can also pay a (discrete or continuous) dividend at each point
of time. In this case a dividend policy Y is a rule which assigns a non-
decreasing function Y(t) to every realization of the original random

walk Z r .By Y(t) we understand the summed dividend (t exclusive) taken
from the original random walk 2, of free reserves. (The claims which
enter into 2, are calculated with t inclusive.) Y(t,) - Y(t,) tells us therefore
how much dividend is paid out in the time interval [ t t,).
Q,=Qo+ct-Sr- Y(t)=Z,- Y(t)
thus represents the free reserves modified by the dividend payments at
time t-before a possible dividend payment Y(t+O) - Y(t) (jump of Y)
at time point t.
Here again we assume that (cf. the discrete case 6.4.3)
Y(t +O)- Y ( z )Q,
~ and Y(1)= Y(r) for all L 2 T ,
where r is the point of time at which ruin occurs.
Finally, we must assume that the dividend payments are allowed to
depend upon the past only up to time t; thus Y,(t)= Y, (t) if Z, (s)= 2, (s)
for all s < t, where Y,(t) and Y, (t) are the functions assigned by Y to the
realizations Z,(t) and Z,(t) respectively. The connection between Z(t),
Y(t) and Q, is illustrated by the following figure, which corresponds to a
barrier strategy with barrier U, .
It should further be mentioned that the rule Y can always be chosen

-without loss of generality in our model-so that the integrals and
expected values to be treated in the sequel are meaningful.
Using the force (intensity) of interest > O we evaluate the strategy Y
then as follows for initial free reserves Q,:
where E [-I denotes the expected value operation.

The right side in this defining equation represents the expected dis-
counted sum of dividends.
Chapter 6. The Insurance Carrier's Stability Critcria
As in the discrete case we have then
and Y . is said to be an optimum strategy if V(Q,, Y,)= V(Q,). The exist-

ence theorem for the continuous case has been proved by Gerber [35].
We shall not go into this general theorem here; we give rather the follow-
ing result of Gerber which is more relevant for practical work:
Theorem: There exists a number a , such that for any initial free reserves
Q, with 0 5 Q , 2 ao the following dividend policy is optimal:
I f Q, = U , the incoming premiums are paid out directly as dividends.
l f Q, < U , no dividend is paid.
For a given Pattern of claims, Y ( t )thus has the following appearance
when this strategy is applied:
Q, has fallen below U, because of claims. 0 Q, has reached the value U,.
In the drawing it is assumed that Q , = U,.

By analogy to the discrete case we also define here a barrier strategy
with barrier a as follows:
-1f Q, > U : Pay out Q, - a immediately (discrete dividend).
-1f Q,=a: Pay out the incoming premiums directly as dividends
(continuous dividend).
-1f Q, < U : Pay no dividend.
If we denote by V(Q U ) the expected discounted sum of dividends of
this barrier strategy, the preceding theorem tells us that a number U ,
exists such that
V U ) = V ) for O S Q , g a , (restricted optimality of the bar-

rier strategy with barrier a,).
This theorem is all the more useful in practice if U , is large; the calcula-
tion ofthe quantity a, is therefore of the utmost importance. This problem
is identical to that of determining the optimum barrier strategy, because
for Q O s a o the barrier strategy with barrier ao is optimal in respect of

all dividend strategies and thus in particular in respect of the barrier
strategies.
6.4.7. The integrodifferential equation of the barrier strategy

in the continuous case
Let us consider the barrier strategy with barrier a and expected sum
of dividends V ( Q ,U ) for given initial free reserves Q. We note first of all
that V ( Q ,U ) is continuous in Q for O s Q _ l a (albeit only from the right
in Q = 0). This follows from the relation
( e ~ " is* the

~ probability of no claim in the time interval (0, h] and e h
is the discount factor in the Same interval) and the fact that V ( Q ,a) is
monotonic in Q.
(Let h-0.) In a first (short) time interval of length h, moreover, claims
occur in the case of the compound Poisson process as follows:
No claim: with probability 1 -P* h + 0 ( h 2 ) ;
one claim: with probability P* h +O(h2);
more than one claim: with probability O(h2).
We thus have for sufficiently small h with y as claim amount variable
and O s Q < a :
Q+0
~ ( Q , a ) = ( l - ~ * h )Ve( ~~ ~+ ~c h , a ) + ~ * h 1
e -V~( ~ - y , a ) d ~ ( y ) + O ( h ~ ) .
0
Since e - h = 1- h + O ( h 2 )we find that

Q+O
V(Q,a)=(l-p*h-h) V(Q+ch,a)+p* h . 1 V(Q-y,a)dF(y)+O(h2).
Solving for h7
ch
because of the continuity of V ( Q ,a ) in Q
0
and taking the limit h - 0 , we obtain
which is valid for 0 5 Q < U .(Note the similarity to (R,) in 6.2.6.)For Q = a

we find the following boundary condition:
This condition is obtained as follows from the two summands:

Expected discounted diuidend payment up to the first claim: The
density function of the claim interoccurrence time is p* ecP*",for s>O.
S
Using this we form the expected value of J C ec' dt, which leads to
0
m
p* J ( { c e - t d t ) ecN*'ds=- P* J (1 - e-') e-p*s ds
0 0 0
Expected discounted diuidend payment after the first claim:
6.4.8. Solving the integro-differential equation for V ( Q , a)

By transformation into the renewal equation (cf. 6.2.6 and, for the
transformation, 6.4.9a)) it can be shown that the integro-differential
equation
has exactly one solution up to a multiplicative constant. We can therefore

conclude from (D,) that V(Q,U ) must have the following form:
Setting this expression into (D,) allows us to determine C ( a ) :
and thus
C 1
C(U)= a+O -
h'(4
( ~ * + ) h ( a ) - P *J h(a-y).dF(y)
0
because of (D,).
We therefore have
V(Q,a )=--h(Q) fiir O s Q s a .

h'(4
The determination of the optimal a , is therewith reduced to the

following analytic problem:
1) Determining a positive h ( x ) as the solution of (D,);
2) determining a , such that hl(aO)is a minimum.
We shall carry this through in detail for the case of the exponential
claim amount distribution F ( x )= 1- e- According to (D,) the integro-
differential equation then reads as follows:
X
ch'(~)=(p*+)h(x)-p*.~Jh(x-~)e-~~dy.
0
By differentiation we obtain
X
and by integrating the last term by Parts,

X
~ h " ( x ) = ( ~ * +hl () x ) - p * y h ( x ) + p * J~ dy.

( X - ~ ) ~ - Y Y
0
If we replace the last member by the relation from the original integro-
differential relation, it follows that
This linear differential equation can be solved by the usual methods. If

we denote by r, and r, the roots of the characteristic equation
then the general solution reads
It can be seen from the explicit solution of the characteristic equation

that the roots must satisfy the relation
Determining then the ratio of C, to C, from (D,) we have
As can easily be verified, the relation r, + y >0 always holds and thus C,
and C, have different signs. (For h ( x )to be positive we must have C, >0,
C, < O and C, + C, >O.) The function h'(x) then takes on its minimum
value at the point a, within [0, CO) and we find from hV(a,)=O that
The optimal bounds are tabulated in the following table for =0.05 and
several values of P*, y and C.
Expected Expected Margin 10 % Margin 20 %

claim number
amount of claims C 7' 0 C ao
premium optimal premium optimal
I/Y P* income bound income bound
1,000 1,000 1.1 millions 117,000 1.2 millions 79,600

5,000 200 1.1 millions 419,000 1.2 millions 304,000
10,000 100 1.1 millions 706,000 1.2 millions 530,000
1,000 5,000 5.5 millions 151,000 6 millions 98,700
5,000 1,ooo 5.5 millions 583,000 6 millions 398,000
10,000 500 5.5 millions 1,020,000 6 millions 714,000
Intuitively C stands for the annual premium income, P* for the annual
total number of claims, and l l y as the expected amount of a single claim.
=0.05 corresponds then approximately to an annual rate of interest
of 5 %. There is a certain satisfaction in noting that the optimal free
reserves ao (in respect of other criteria also) vary within quite reasonable
orders of magnitude.
6.4.9. Asymptotic formula for a ,

a) As we have Seen in 6.4.8 V(Q,a) can be determined from h(x), the
solution of (D,). Let us now break down h(x) into the product
where s denotes the positive root of the equation
By setting expression (A) into (D,) we obtain for the new function 6(x)
the integro-differential equation
where
W
1
A= J e-"dF(y) and dF(y)=- epSyd ~ ( y ) .
0 A.
But this is precisely equation (R,) from 6.2.6~)and thus 6(x) can be
represented as the solution to the renewal equation (cf. (R))
Therefore G(x)-and thus h(x)-is uniquely determined up to the choice

of a multiplicative constant. The determination of h(x) is reduced to the
determination of 6 (X).
b) As was mentioned at the end of 6.4.6, those cases for which the
optimal barrier ao is large are of special interest. The following theorem
tells us that the barrier is large for sufficiently small force of interest :
02
Theorem 1U: If C> p* J X dF(x) then a, +co as + 0.

0
The limit is taken here by holding all other quantities constant while
we let the force of interest approach Zero. The hypothesis of the theorem
tells us that we must be in the realistic situation in which the premium
income exceeds the expected claim amount.
m
Proof: Let d be any number such that 0 < d <c - p* J X dF(x).

0
We define then a dividend policy Y which consists in paying a

continuous dividend of density d up to the time at which ruin occurs
(if it occurs). From the considerations in 6.2.6 (cf. (RN)and consequences)
it follows that in this case the probability of survival 1 -$(Q) must be
positive for arbitrary initial free reserves QZO. In particular, it must
hold for initial reserves Q = 0 that
> d
V(0) V(0, Y)2 [I - $(0)] -

(-d = present value of perpetual dividend
of intensity d)
Thus V(0) cc as 0. It follows from this, however, that U, + co as

-+ -+
-+ 0; since if ao were bounded for -+0 so would be the expectation

of life when using the a, barrier strategy (and thus V(O)= V(0, U,) would
also need to be bounded)!
C) As can be Seen by changing the time scale (cf. (D,)), a variation
of the force of interest in our model is equivalent to a variation of p*
and c while keeping the ratio p*/c fixed. For example halving is the
same as doubling p* and C;this, however, simply amounts to doubled

claim frequency together with doubled premium income. In particular,
the case "-. 0" corresponds to the case "p*, C + W , p*/c and con-
stant", which gives us a new interpretation of theorem 1 a:
m
Theorem 1b: I f C > p* j X dF(x) lhen a, -+m as p*, c +CO (p*/c und
conslanf ). 0
Remark: Intuitively speaking, the theorem states that for large risk
masses the optimal barrier a, also becomes large.
d) Let us now determine the asymptotic behavior of 6(x) and thus
of h(x) also. It is practical to norm 6(x) in such a way that 6(00)= 1. It
then follows from (D,) that 6(x) is identical with the probability of
survival which appeared in 6.2.6. If
p*A.
--- 1[ l - p(x)] dx < 1 (and this always holds in the case which is of
C o interest to us: C > p* J X dF(x)),
we can take over directly formula (Ru)from 6.2.6c), i.e.
d(x)-l-Ce-"" (forlargex),
with K such that
and
where
By using all of these abbreviating symbols we have thus
e) As was said in 6.4.5 the optimal barrier a0 is characterized as

that point x=a, at which hl(x) is a minimum. It seems natural then to
determine the point X = a, at which the function g'(x) (where g(x)=
e ~ C~~ ( S --K ) X ) is a minimum, and to expect a, to produce a good asymp-
totic (i.e. for -,0) approximation for U,. (The investigation into the
exactness of this approximation is omitted here.)
We find then that
and from the relation

gl'(al)= 0
we have
f) The quantities s, rc and C in (D,) are still dependent upon ; we

shall replace them by the first non-vanishing terms of the related series
expansion about Zero :
C - Co, where C, =
"0 Pt
and , ~ ~ P*
= ~ ~ y e ~ ~ ~ [ l - F ( y ) ] d ~ .
0
We thus obtain finally the asymptotic formula
which can be simplified by dropping terms of minor order to
U, ---1 In [ ;P, P*) ]'

"0
6.4.10. Optimum dividend policy for Q > a, and other evaluations

The theorem of Gerber cited in 6.4.6 proves that the barrier strategy
with barrier U, is optimal for initial free reserves Q 5 U,. For Q > ao the
Same author C351 has also given the optimal dividend policy; the latter
has a rather complicated structure. It is, however, interesting that for the
exponential claim amount distribution the barrier strategy with barrier a0
is also optimal for Q > U,. In this case, if free reserves Q > ao are available
initially, the best Course of action is to pay a dividend of Q-ao imme-
diately.
If an evaluation for the random walk of free reserves is desired which
puts more emphasis on the security aspect than the discounted sum of
dividends, the expected duration of life T (up to the time point of ruin T)
or the discounted expected duration of life E

[U1 I
e-B' dt may be used,
for example. These are determined using similar methods as for the
expected discounted sum of dividends.
Exercises
1) Show that the integro-differential equation (D,) is reduced to a
linear differential equation of order (n + 2) with constant coefficients if
dF(x)= f(x)dx, f(x)=P(x)e-" and xzO,
where P(x) denotes a polynomial of the n-th degree.
1
Example: f ( x ) = X" ~ e-", the integral gamma distribution.
n.
2) Solve the system of difference equations (D,) for deFinettils
special case: g, = p, g, = q.
( ~ i n:tSet Y (Q U,) = rQO

and use the boundary conditions
vp+vqV"(a,- La,)
V(0, a,)=vpV(l,a,) and V(,,, U,)=--
1-vp
3) Verify the asymptotic formula of 6.4.9 for the optimal barrier U,
(resp. U,)in the case of the exponential claim amount distribution.
6.5. Utility as criterion of stability
6.5.1. Evaluating the random walk of free reserves

In what follows we shall consider once again-as we did in the
preceding Part of chapter 6-a risk mass of N risks. This generates a
random walk of free reserves (cf. 5.3.2), which we understand as a
random process (2,; t 2 0 ) with
where we recall once again the intuitive meaning of the symbols, viz.,
Q = initial free reserves,
E* = accumulated premium income in the time interval [0, t],and
S, = accumulated claim process variable (accumulated claim amounts)
in the interval CO, t].
2, thus represents the remaining amount of free reserves at time t. As
we have explained already in 5.3.2, the stability problems of the insurance
enterprise cannot be handled in a meaningful fashion without formula-
6.5. Utility as criterion of stability 179
tion of a business goal. This formulation is introduced as an evaluation

of the possible random processes { Z , ; t z O ) . The probability of ruin
criterion (cf. 6.2) and the dividend policy criterion (cf. 6.3) represent two
possible evaluations.
Denoting the evaluation of the random walk of free reserves { Z , ;t 2 0 )
by @[Z,; t>=O],we can express the two evaluations discussed in the
preceding sections as follows:
I ) Evaluation by the probability of ruin

@ [ Z t ;t 2 01 = P [ Z ,2 0 for all t 2 01 = the probability for those real-
izations of the random walk which do not lead to ruin.
11) Evaluation by the discounted sum of dividends
Two cases must be distinguished here:
IIa) Evaluation when the dividend policy Y, is fixed in advance: Y,
assigns a non-decreasing function I; (accumulated dividends) to each
realization of {Z,; t r O ) . We then have
= V(Q, Y,)= the expected discounted sum of dividend pay-

ments with initial free reserves Q and dividend
policy Y,.
I1b) Evaluation under the optimum dividend policy, i. e.
B [ Z t ;t 2 01 = sup V(Q, Y ) = V(Q) (cf. 6.4.6).

9
6.5.2. Equivalent evaluations; definition of utility

The usefulness of an evaluation @ lies in the possibility that it gives
us of choosing between two different random walks. We will prefer the
first of the two random walks of free reserves { Z i ;t 2 0 ) and { Z ; ' ;t 2 0 }
The choice between the two is a matter of indifference to us if
q z ; ;t r o ] = @ [ z ; ' ;t 2 0 ]
and we will choose the second in preference to the first if
180 Chapter 6. The lnsurance Carrier's Stability Criteria
We also say that the evaluation % of the random walks (2,;t r O )

defines an order of preference. Two evaluations are then regarded as
equivalent if they define the same order of preference. This is stated
formally in the following
Definition: @ and 9 are called equivalent if for any two random
walks (2:;t 2 0 ) and ( 2 : ' ;t 2 0 )
For example, if @ stands for an evaluation which assumes only non-

negative values, then 9 = (4!!)2is an equivalent evaluation. (Carry through
the evaluation % and then Square the number so obtained.) More
generally, an equivalent evaluation h(@)=9 can be obtained from the
evaluation @ by every strictly monotonic real function h.
Now von Neumann and Morgenstern C531 have shown that under
quite general assumptions an equivalent 9 which is linear in respect
of mixtures can be found for every evaluation %. By the mixture
we mean the random walk which arises by carrying out the random
walk (2;; t z O } with probability a and the random walk {Z:';t r O }
with probability 1-U. (The probability laws of 2; and 2;' are assumed
here to be independent.) Obviously a must be a number between Zero
and one. Then the following linearity condition (in respect of the mixture
operation) must hold for the evaluation 9 in order that 9 be called
linear:
9 [ Z , ; t r o ] = a 9 [ Z : ;t 2 0 ] + ( 1 - a ) 9 [ z ; ' ; t 2 0 1 .
In the examples of evaluations given in the last section-by the prob-

ability of ruin and by the discounted sum of dividends-the original
evaluation 42 is already linear in cases I) and I1a). In case I1b), however,
the linearity relation no longer holds. We have then
%?[Z,;tzO]=sup
Y { r: I r: 11
a E jep'dY,' + ( l - @ ) E J e - ' d ~ " ,
where Y,' and Y," are assigned by the dividend policy 9'to the random
walks 2; and ZJ' respectively. By carrying out the supremum operation
separately for each member, it follows that
The evaluation 4Y is thus only sub-linear relative to the mixture but no

longer linear. That there is also generally no equivalent linear evaluation
2' in this case is shown by the following example. Before we go into it
we give the
Definition: A linear evaluation 2
' is called a utility.
Example (This can be omitted at a first reading.): Let us compare the
two random walks of free reserves
t fort<l.
i) (2;;t 101, where Z;= 1s defined deterministically,
t-1 for trl
and
0 with probability e c V r
ii) {Z;'; t 2 0 } , where Z;' = t - Sr and Sr =
1 with probability 1- e-"'
(every realization of Sr having only one jump of amount 1).
i) represents a random walk for which the premium income is equal
to the time elapsed and a claim of amount 1 occurs with certainty at
time 1.
ii) represents a similar random walk with the differencethat the unique
possible claim of amount 1 occurs at a random point of time.
For the sake of simplicity we shall consider only two different dividend
policies as permissible.
Yo:The incoming premiums are paid out as dividends until ruin
occurs (which in this case is identical with the occurrence of a claim).
q :The incoming premiums are saved until the required claim
payment of 1 is available, after which the incoming premiums are paid
out as dividends.
The following table indicates the discounted Sums of dividends for
the two random walks Z; and Z;' as well as for the two dividend strategies
Y. and q.We work with a force of interest equal to P.
i"o 8 Discounted sum of

dividends for optimum
strategy
1
-e-# (Y;)

182 Chapter 6. The lnsurance Carrier's Stability Criteria
For the comparison of the magnitudes in this table we have assumed

that
or using our abbreviations, that A > B > C > D (which is correct for
example if V = B = In (714)).
Because of the linearity of the evaluation we have then for the mixture
{Z,; t20}={aZ;,(l-a)Z;'; t Z 0 )
discounted sum of dividends under ,Y, : a C + (1 - a) B,
discounted sum of dividends under : a A + (1 - E ) D.
evaluation with %
The heavy broken line is the graphic representation of the evaluation

with the optimum dividend strategy and variable U.
According to the discounted sum of dividends obtained with the
optimum dividend strategy, {Zf;t 2 0 1 is to be preferred to {Z:'; t 2 0 )
1 1
since - e P >- . In spite of this, the evaluation according to the
v+
optimum dividend strategy decreases for small a ( Z u , ) if the a in the
mixture (2,; t 2 0) = {a Zf, (1 - a)2:'; t 2 0} increases. For a linear (in
respect of mixtures) evaluation 2,however, (cf. auxiliary theorem 2
under 6.5.4) 2 [ { a Z j , (1 - a)Z;'; t 2 O}] would always have to increase
with increasing a. There is therefore no linear evaluation equivalent to
the evaluation by the optimal dividend strategy.
6.5.3. Axioms about utility
We shall follow here the reasoning of von Neumann and Morgen-

stern [53], which establishes the existence of a utility equivalent to any
given evaluation under quite plausible assumptions. The preceding
example is nonetheless a warning signal not to ascribe grounds for
existence to these assumptions in every application.
Let the stipulated evaluation 4Y from which we shall proceed assign

a real (finite) number to every random walk of free reserves {Z,; t 2 0 ) .
Our order of preference among the possible random walks is to be
thought of as following the increasing order of this real-valued evalua-
tion. In order to keep the terminology as clear as possible, we shall
write in what follows Z for {Z,; tZO}, %[Z] for %[{Zr; tlO)],
%[aZr, (1 - U ) Z"] for %[{aZ;, (1 - U ) Z:'; t ZO)], etc.
We now postulate the following basic properties (axioms)with regard
to the evaluation:
Al) @[Z] is dependent upon Z only through the probability law of
the random process {Zr;t2OJ. (Two processes with the Same law of
probability have the Same evaluation.)
A,) If %[Zl] 2Uld[Wl] and
%[Z2] 2 %[W,], then
@ [ a Z ( 1 - a ) Z 2 ] 2 0 & [ a W l , ( 1 - a )W*] for any a (OSa51).
In addition the following stronger form must hold:
If Uld[Zl] > %[Wl], then the strictly greater than relation ( > ) applies
in the latter inequality for all a+O.
A3) If @[Wl] Z%[Z] 2@[W2], then there is always an a ( 0 5 ~ 1)
5
such that
%[.Wl, (1-U) W2]=%[Z].
In addition we assume also the stronger form to hold:
If %[W,] >%[W2], then the value of a which exists according to A,)
is unique.
Remark: The stronger form required under A,) need not be postu-
lated; it can be derived from axioms Al), A,) (with its stronger form)
and A , ) (without its stronger form). Auxiliary theorems 1 and 2 from
6.5.4 are used in this derivation, but in order not to complicate our
presentation, however, we shall not carry this derivation through here.
Axioms Al) to A,) are intuitively plausible. Al) needs no further
explanation. A,) postulates-intuitively speaking-that given two ran-
dom mixtures with the same mixing probability, the one formed from
the random walks having the higher evaluation is to be preferred.
A,) requires that it be possible to attain any intermediate level in the
evaluation by a suitable mixture of two random walks. As can easily
be seen, it follows from A,) that elements having an identical evaluation
can be replaced in a mixture without changing the evaluation of the
mixture. Given these three axioms Al) to A,), we shall now derive the
existence of an evaluation 9 which is equivalent to Uld and which is
linear (in respect of the mixture operation). It will also be shown that-
ignoring positive linear transformation (choice of origin and unit)-

there is exactly one such linear evaluation 9 equivalent t o the given @,
i.e. which generates the same order of preference.
In order to present the derivation of this important result as clearly
as possible, we shall break the reasoning down into different steps by
proving at the outset several auxiliary theorems.
6.5.4. Existence theorem for an equivalent utility
Assuming that the axioms Al) to A,) (including the strongcr forms)
hold, we have the
Auxiliary theorem 1 : Let
@[Z1] =@[U Wl, (1 -a) W,] und
@CZ"I = % [ P w (1 - P ) W,].
7hen
%[AZ',(l-A.)Z1']=%[y Wi,(l -y) W,], where y=A.a+(l-A).
Proof: It follows from A,) that
The "two stage" mixture [A. {a Wl, (1 - a) W,), (1 - A) { Wl, (1 - ) W,)]

can be written as follows as a "simple" mixture in accordance with the
rules of probability theory if we assume that consecutive mixtures are
stoachastically independent of each other, as we required in 6.5.2:
--
probability of
choosing mixture
I and therein W,
probability of
choosing mixture
2 and therein W,
which proves the auxiliary theorem.

Auxiliary theorem 2 : Let
Proof: It follows from auxiliary theorem 1 that

6.5. Utility as ciiterion of stability 185
and from axiom A,) that the right hand side must be greater than or
equal to the expression
The following two definitions will be of significance in our further con-

siderations :
Definition I : We speak of the (closed) interval [W W,] of random
walks (with respect to an evaluation @) when we wish to designate the
totality of random walks Z where
%[w,12@[zlr@[w2].
(Note the unusual form of the inequality in the definition of [W W,].)
Definition2 Let @[Wi]>42[Wz]and Z E [ W W,]. The number
y [ Z ]= I [Z/W W,] associated with every random walk Z in the interval
[W W,] which has the property that
' @ C ~ I = ~ [ Y W W21 ( ~ - Y for
) y=ym
is called the utility of Z with respect to the interval [Wl, W,].
Remark: The existence and the uniqueness of I [Z/Wl,W,] follow
from A,) together with its stronger form.
Auxiliary theorem 3 : I [ZjW W,] is linear with respect to mixtures
i.e. if Z = (AZ',( 1 - A) T),where Z', Z"E[WW,], then
i [ z / w l ,w 2 1 = n i [ z t / w l ,w , l + ( i - ~ ) i [ ~ ' ~ lW,].
w
Proof: Let
@[Z']=%[aWl,(l-cc)W2] and 42[Z"]=&[PW(l-)W,].
It follows then from auxiliary theorem 1 that
%[Z]=42[yWl,(1-y)W,], where y=Aa+(l-A)=I[ZIWW,].
But since cr = I [Z'l W W,] and
= I [Z"/W,, W,], it follows at once that
~ [ z i w ,w2]=n~[z1lw
, w,l+(i-n)~[z~~jw,,W,].
Auxiliary theorem 4 : IIZ/Wl, W,] generates the same order of pref-
erence on [Wi, W2]as 42 [ Z ] ,i. e.
1 [Z'l W,,W,] > I [Zr./W,, W,] ifgd
%! [Z1]2 0 [Zr.]
only if
Proof: a) Let IIZ'/Wl, W2]2I[ZUIW

W,] and let us write
cc for I [Z'I W W,] and
P for 1 [Zu/W W,] .
186 Chapter 6 . The Insurance Carrier's Stability Criteria
We have then in virtue of the definition of I [Z1/W W,] that

%[Zr] =%[C( Wi, (1 - U ) WJ, and similarly for Z",
@IZ1'l='WW (1 -) W,].
Since cc 2 , it follows from auxiliary theorem 2 that d?i [Z'] 2 4![Zu]. (The
same conclusion can also be reached with the strictly greater than sign.)
b)Let now%[Z']z%[Z"]. Ifin thiscaseIIZr/W,, W,] < IIZ"/Wl, W,]
it would follow from reasoning analogous t o that of a) that %[Z'] <
q[Z"], which is a contradiction. Therefore I [Z'IW,, W,] 2 I [Z"/Wl, W,].
Corollary to auxiliary theorems 3 und 4 : A . I [Z/W,, W,] +B, where
A und B are real constants (A>O) also has the properties which uuxiliury
theorems 3 und 4 established for I [Z/W W,] (analogous proof).
Auxiliary theorem 5 : Suppose that the two evaluations I [Z] und K [Z]
generate the same orders of preference (are equiualent) on a non-de-
generate interval [Z',Zu] und that they are linear with respect to mix-
ture, i. e.
i) I [Z'] > 1[Zu] und K [Z'] > K [Zu] ;
ii) I[Wf]21[W"] ifgd
KIW1]ZKIW"]
only if
for W', W"E[Z',Z"];
iii) IIAW1, (1-2) W"]=AI[W'] +(I-A)I[W"] und
KIAW1,(l -2) W"]=AK[W']+(l-A) K[W"]
jbr W', W"E [Z'. L"].
In this case
I[Z]=A.K[Z]+B for all ZE[Z',Z"]
with a suitable positive number A und u suitable real number B.
Proof: Let I [Z] = I [AZ', (1 - A) Z"]. (According to axiom A,) this
representation is possible and unique.)
Then we have because of ii) K [Z] = K [AZ', (1 - A) Zu] and because
of iii)
I [Z] = AI [Z'] + (1 - A) I [Z"] = A {I [Zr] - I [Z"]) + I [Zr'] and
K[Z] =AK [Z'] +(I-A) K [Zu] =A.{KIZ1] -K[ZU]) +KIZ1'].
Therefore
K [Z] K [ZU]
I [ZU]) + I [ZU],
-
I [Z] = {I[Z'] -
K [Z'] - K [ZU]
n
and by rearranging terms,

I [Z'] I [Z"] 1 [Z'] - I [Zr']
I [Z] =
K [Z'l
-
K [Zr']
K [Z] + I [Zu] - K [ Z ] - -- .
- K [Z'] - K [Z"]
A B
It follows in particular from i) that A>0.

Corollary: I f I [ Z ] und K [ Z ]fulfill the conditions of'auxiliury theo-

rem 5 on [Z',Z"] und in addition
= K C Z 1 l ) for two qecific random walks Z , , Z,E [ T ,Z r ]

IW 2 1 =K P 2 1
which haue different evaluation, then I [ Z ]= K [ Z ] for all Z E[Z',Zr'].

Proof: Since
I I Z l ] = A . K I Z l ] + B = K I Z l ] and
I[Z,]=A. K[Z,]+B=K[Z,],
it follows of necessity that A = 1 and B = 0.
Principal theorem 1 :
I f the evuluation 4?i satisfies axioms Al) to A,) (including its stronger
forms), then there exists an evaluation 9 f o r all Z which is equivalent to
Uli und lineur, i.e.
Proof: a) Let us consider two random walks Z , and Z , such that

4?i[Zl]> %[Z,]. For Z E [ Z ~ Z,]
, we define 9 [ Z ]= I [ Z / Z l ,Z,].
b) For any Z $ [ Z l ,Z,] we choose another interval [W,, W,] such
that Z E[Wl, W,] and [Z,, Z,] c [W,, W,] (which is always possible). Now
choose 9 [ Z ]= A . I [Z/Wl,W,] +B, where A and B are determined such
that 9 [ Z l ]= I [ Z l / Z l ,Z,] = 1 and 9 [ Z , ] =I [ Z 2 / Z l Z,]
, =O.
C) According to the corollary to auxiliary theorem 5, the definitions
for 9 Set forth under a) and b) are identical on the common interval
CZ12 z21.
d) 2'is linear, since the evaluation A . I [ZIW,, W,] + B is linear for
every interval [W W,] (auxiliary theorem 3).
e) 2
' generates the same order of preference as %!, since this holds
for every interval [Wl, W,] (auxiliary theorem 4).
We have also
Principal theorem 2
Let 9 ' he an evaluation which is likewise linear und equivalent to Uli.
Then 9 ' [ Z ]= A 9 [ Z ] + B ( A>0, B real).
Proof: From auxiliary theorem 5.
These two principal theorems complete the reasoning of von Neu-
mann and Morgenstern. In the following sections we shall treat some of
the consequences of the considerations made here.
6.5.5. Integral evaluation

Within the very large class of linear evaluations (utilities) of random
walks (2,; t2O) there is a particularly useful sub-class of evaluations
which we shall call integral evaluutions. The following definition lays
down precisely what we understand under this title.
Let
be the distribution function of the accumulated claims to time t (cf. 2.3

and 3.2.5), and
HZt(X)= H, (X) = P [Z, 5 X]
the distribution function of the random walk of free reserves at time t.

Since 2,= Q + e * - S we have
H,(x)=l-G,(-x+e*+Q) for any t.
An integral evaluation % of the random walk (2,; t 2 0 ) is then defined
by specifying
-an evaluation kernel K(t, X),which we shall call the utility kernel
(any integrable function), and
-a time evaluation V(t) (a monotonically increasing function with
V(0) = 0).
The evaluation % is then determined as
(K(t, X) and V(t) are assumed to be such that the defining integral yields
a finite value.)
This evaluation is obviously linear-and thus a utility-since the
distribution function A H: (X)+ (1 - A) H:'(x) corresponds to the mixture
{nz:,(i-n)z;; t z o } .
Intuitively, K(t, X) measures the evaluation of the free reserves of
amount X at time t , whereas V(t) (resp. its increments) assigns to each
time interval the weight corresponding to our estimation of its impor-
tance.
For example : K (t, X)= K (X)e - ' ( = force of interest), where K (X)
expressing the idea that all equally long time intervals in the planning
period [0, T] are judged to be of equal importance.
For reasons related to economic theory it is appropriate to postulate

the following properties for the utility kernel:
i) K(t, X) is monotonically increasing in X for fixed t;
aK
ii) -- (t, X) is monotonically decreasing in X for fixed t;
ax
iii) K(t, X) is monotonically decreasing in t for fixed X > 0
and monotonically increasing in t for fixed X < 0.
(The existence of the indicated partial derivative is tacitly assumed.)
The significance of these assumptions lies in the fact that they imply
an increasing utility for an increasing level of the random walk of free
reserves; on the other hand the speed of this increase in utility decreases
as the level of the random walk of free reserves increases (Law of dimin-
ishing marginal utility). The monotonic property in t can most suitably
be thought of as discounting.
The class of integral evaluations gives only one indication of the
great diversity of possible utility evaluations. In point of fact, the range
of our freedom in choosing the evaluation characteristics K(t, X) and V(t)
is enormous. From the practician's viewpoint this freedom is often
misunderstood as "arbitrariness" leading to no reliable procedures for
applied work. It can be replied that in utility theory precisely those
properties of an evaluation 42 are studied which are independent of the
special choice of the evaluation rule. Thus there are naturally fewer
direct consequences which can be derived for practical work, but these
few have all the more general validity.
In what follows we shall even consider a very special class of integral
evaluations; we shall call these instantaneous integral evaluations and
thus express explicitly the fact that only the random walk {Z,;t2O) at
a definite point of time t, (resp. its distribution function H,(x) for t = t,)
is to enter into the evaluation. In this way we give expression to the
intuitive fact that only one point of time t, in the entire period of time
is of interest to us. A natural generalization would be to state that only
a finite number of time points t t ... , t, (e.g. the periodic points of
time at which the insurance carrier closes its books) is of interest to us.
An instantaneous integral evaluation is achieved by the following special
choice of the function V(t):
0 for t < t,
V ( t )=
1 for t r t , .
Only the utility kernel at time t, plays a role then and, using the abbre-
viation K(x)= K(t,, X),we obtain
The evaluation 42 can therefore be interpreted simply as the expected

value of K ( Z t o )(expected value of the utility kerne1 at time t,).
6.5.6. The problem of risk exchange

A very clear and elegant application of the instantaneous integral
evaluation is provided by the problem of risk exchange: N insurance
carriers must decide at time t , whether they can "improve" by mutual
exchange the random variables Z"), Z"), ... ,Z(,) corresponding to the
random walks {Zji);t z O J of their free reserves at time point t = t,.
Company no. Random variables Random variables

before the exchange after the exchange
. - -
1 Zu' with distribution H"'(x) Y"' with distribution L!"(x)

function function
2 ZIZ) HI2'(x) y~21 EZ'(x)
H"' (X) Y(J) L"'(x)
Note that we are using the symbol Y in a different sense here from
that of 2.1. Y'j) is a random variable which tells us what insurance
carrier j's free reserves are after the exchange. The exchange takes place
here as the result of ugreements (reinsurance treaties) among the insurance
carriers; we can describe these agreements by real junctions
with the intuitive meaning that they should produce the share of insurance
carrierj after the exchange in dependence upon the quantities X,, X,, . . .,X ,
which relate to the situation before the exchange.
From the nature of the agreements as exchange we must have the
following admissibility condition for the functions f j ( j = 1,2, ...,N):
N N
C f,(x
j= 1
X,, . . . , X,)= C xi
i= l
identically in X X ... ,X,.
The random variables Y") ( j = 1,2, . . . , N) representing the free reserves

after the exchange arise then by application of the functions j; to the
original random variables Z"' (i= 1,2, ... , N) relating to the free reserves
before the exchange, i. e.
y(j'= z ' ~ ' , .. , z ' N ' ) .
,
In what follows Y"', . .. , Y',' resp. Y"', ... , Y',)will always denote random
variables which arise from the Zu', ... , Z',) through exchange, i.e. by
applying udmissihle functions &(X,, . .. ,X,) ( j= 1,2, ... , N ) , as just defined.
Let us now suppose that insurance carrier j evaluates its random
walk at time t , with a given utility kerne1 K j ( x ) having the properties
postulated in 6.5.5. We then have the following evaluations of the
situation before and after the exchange:
Cornpany Kerne1 Evaluation Evaluation

no. before the exchange after the exchange
1 K1(x) "lil(Zcl')=E [ K , ( Z c l ' ) ] "Z1(Y"')= E I K l ( Y c l ' ) ]

= J K , ( x )d H U ' ( x ) = JK l ( x )dL"'(x)
j K,(x) "u,(Zc") = E [ K j(Z"')] %,(Yc")= E[K,(Y"')]

= j K j ( x )d H c j ' ( x ) =J K , ( x ) dL"'(.x)
The point of the exchange is to improve the evaluation of the random

walk through the exchange operation. We can argue that only those
situations which d o not permit all rundom walks t o be fur-ther improved
simultaneously fail to lead to further exchanges. In this sense we define
Y('),Yc2',..., Y ( N as
) Pareto-optimal if there are no
F('), F(2),..., Y(N)such that % , ( Y ' j ) ) > % ( ~ ( jfor
) ) all j= 1, 2, ...,N.
In the next section we shall characterize the totality of Pareto-
optimal exchange operations (reinsurance arrangements) among the
admissible exchange operations. We would merely remark here that in
practice we can reasonably expect a group of insurance carriers to agree
upon a Pareto-optimal exchange arrangement only if an essentially
cooperative attitude reigns within the group. Otherwise the Pareto-
optimal situation-to the disadvantage of oll concerned-is often not
attained.
6.5.7. The theorem of Borch [9]

Borch [9, 101 has discussed the previously mentioned risk exchange
problem in a series of Papers and has determined the set of all Pareto-
optimal exchange agreements.
Definition: The real functions
( J = ~
...? ~ ~ ~
are called admissible exchange agreements if they satisfy the condition
Theorem: Under ihe usual assumplions (cj: 6.5.5) aboui lhe utiliiy
kernels Kl(x),K,(x), ...,K N ( x ) i.e.
, where
i) K i ( x ) is strictly monotonically increasing und differentiuble every-
where for all i, und
ii) K:(x)is strictly monotonically decreasing for all i, the
f j ( ~ 1 > ~...>
2 ?xN), ( J = 2,
are Pareto-optimal among all admissible exchange agreements if' und only
if they satisfy the condition
K ; ( & ( x ~..., , x ~ ) ) = c , K \ ( f ~ (...,
x ~X,))
>
identicully in
x1,x2,..., X , (j=1,2,..., N). (z)
The c,, ... , C , (C, = 1) are here arbitrary positive constants.
Remark: Since the evaluation of random walks of free reserves is
made by using expected values, it suffices of Course to require condi-
tion (Z) for any X ...,X , in a Set M of N-tuples ( X ... , X,) with proba-
bility 1. What occurs outside M has no influence at all upon the expected
value.
Proof: Here we follow essentially Du Mouchel (cf. [29]).
U )( Z )is sufficient
We assume that (2) holds for the N-tuple of the functions
f1(x,, ..., X,), ..., fN(xl,... , X,) for constants C,, C,, ..., C , which are all
positive. Let el(x ..., X,), ... ,eN(xl,... , X,) be a further N-tuple of func-
tions with which we form the admissible functions fj=fj+ej. N
From the admissibility condition (N) it follows at once that ej
j= 1
must be equal to zero. By applying the- f;. to the Z"), . .. ,Z'N' we obtain
then the random variables F"),.. . , Y',), similarly as we obtained the

) applying the & to the Z"', .. . , Z',). Finally, we Set
Y('),... , Y ( Nby
) Y(j)= ej(2"),. . . , Z',').
e(j)= Y ( J- (Note the difference between e(j'
and ej.)
For these new random variables we have
We define the constant
and the random variable
It can easily be verified that
Since (Z) is assumed not to hold, E[V2] must be greater than 0. We

define then
s = + E [ v 2 1 /[~K ; ( Y ( ~ ) ) >
] 0,
e") = (6 - V) E (E yet to be determined),
e ( 2 ) = - e(1) (because of the condition (N) defining admissibility),
and
,W = 0 for j > 2 .
The following then holds
tends to Zero as E tends to zero; this can be

Seen as follows:
It follows from the existence of the derivative K;(x) that the expression
in brackets tends itself toward Zero as E approaches zero; the convergence
is monotonic since &(X) is monotonic and thus the expected value on
the right hand side also tends toward 0. It is therefore possible to find
a small positive C such that @ l ( Y ( l ) ) - % l ( ~ " ) ) > ~ .
6.5. Utility as criterion of stability
In a similar way we find that
By the same procedure as before we find that the second term is relatively
insignificant for small E . Considering the first term, we find that
In this transformation we have made use of the definitions of V and 6

as well as the fact that E [ V K ; ( Y ( ' ) )=O.
] It is certain therefore for suf-
ficiently small E that a2(I")) - a2 ( Y ' ~>
) )0 and thus we have found
the desired functions Y"', and Y")= Y(') for j>2. This concludes
our proof.
This theorem of Borch, which gives the condition for Pareto-optimal
exchange of risk, is very impressive in its generality. It does leave the
question Open, however, as to whether there do exist Pareto-optimal
solutions to the risk exchange problem in the first place. This question
has also been answered by Du Mouchel [29]. We give here only his result
without proof; the content of his existence theorem is intuitively plausible.
Existente theorem: If all rhe K:(x) are in addition continuous and the
1
ranges of the functions - Ki(x) haue a common, non-empty intersection
Cj
(for c j > 0), then there is a Pureto-optimal solution.
Remark: The conditions for the existence of a Pareto-optimal solu-
tion are very weak. In particular, in the case treated here-where the
utility kernels are strictly monotonic-we can always choose the c,>O
such that there is a Pareto-optimal solution.
6.5.8. A consequence of Borch's theorem

According to the theorem of Borch proved in the last section the
necessary and sufficient condition for a Pareto optimum for the risk
exchange problem reads as follows:
and under the additional condition of admissibility
If we further assume that the utility kernels can be differentiated twice

and that the exchange functions f i ( i = 1, ...,N) are differentiable once
then the conditions (Z) and (N) produce the relations
for any j, i, k and

Ci
It follows from the first of these relations that
and summing both sides over i we have
It can be seen from this latter relation that

af;.
-- 1s
. .
independent of k ;
axk
we therefore conclude thatfj(x X ... ,X , ) depends upon the arguments
X only through the sum z = x , + x , + . . . + x N , i.e. that for a Pareto-
optimal solution we have necessarily
f , ( x x 2 , ..., x N ) = h j ( z ) , where z = x 1 + x 2 + ~ ~ ~ + x , .
With regard to the practical interpretation this result tells us that Pareto-
optimal risk exchanges of random walks depend only on the sum of these
random walks. The insurance carriers will thus form a pool if they are to
realize a Pareto-optimal solution. The Pareto-optimal criterion says
nothing, however, about how they should divide up the results of this
pool. On the other hand, we would mention again at this point the basic
attitude of cooperation which remains the prerequisite for the insurance
carrier's attaining a Pareto optimum.
6.5.9. Price structures with quadratic utility kernels

In conclusion, we shall examine the influence of the instantaneous
integral evaluation on price determination in the commercial world of
insurance. Decisive in this connection is the market behavior with which
the individual participants approach this problem. This murket behavior
together with the utility kernels allows us to make an actual price evalua-
tion of risks.
As an illustration we use the following simple example (see also [16]):
Two insurance carriers A and B are prepared to insure a risk X (X = ran-
dom variable of the possible claim cost). The party seeking insurance
turns its risk over to the insurer which requires the smaller price (pre-
mium) for accepting it. The problem can be characterized by two utility
kernels :
Insurance carrier A : utility kernel
~,(x)=a+hx-cx2;
Insurance carrier B: utility kernel
For the utility kernels to satisfy the usual properties we must have
b
for insurance carrier A : X s--=
2C
H, and
e
for insurance carrier B : X 5--=
2f
(These conditions will always be tacitly assumed to hold in what follows.)
M and thus play the role of a level of saturation (capacity) for insurers
A and B respectively.
Moreover, h, C,e and f must be non-negative constants. We are, by
the way, working with very special quadratic utility kernels here simply
for computational reasons. These quadratic forms can in addition be
justified as approximations to more complicated utility kernels as long
as the values of the random variables X characterizing the risk are small
in comparison to the domains [0, a] and [0, ] of the two utility kernels.
We shall be concerned below with the question: "What is the (minimum)
price (=premium) for which the two insurance carriers are prepared to
take over the risk?"
a) Solution under individual market behavior
In this case each insurer determines the price for the risk X exclusively
on the basis of its own standards. We shall follow through the situation
of insurance carrier A. It is obviously worthwhile for A to assume the

risk as long as the price (=premium) 4 satisfies the inequality
If we let the equal sign hold in this solution we have the minimum
premium P, (cf. principle of Zero utility in 4.1.2). Because of the quadratic
form we find for this minimum premium
~=E[xI+~-/-,
where a = b/2c and E [X] and a2[X] are the expected value and variance
of X respectively.
Similarly, for insurance carrier B :
e
P,=E[x]+~-~/-, where P=-.
2f
In particular: The higher the level of saturation (capacity) the smaller
the minimum premium.
b ) Solution under cooperatiue market behavior
In this case the two insurance carriers are prepared to work together
and to divide up the risk proportionally, i.e.
insurance carrier A will take over y X and
insurance carrier B will take over (1 - y) X
of every possible claim charge X produced by the risk (Osy 5 1). For
this the minimum premium
4 (YX) + 5 ((1 - y) X) = P(X/y) is to be charged .
The effect of the cooperation is strongest if y is chosen such that P(X/y)
becomes minimal.
Since
~(~/y)=~[~]+a-1/a~-~~a~[~]+-fl-(l-~)~cr
we wish to find that y* which maximizes
We find easily that

a
y* =---
a+
and thus
~(~/y*)=~[~]+a-l/a~-y*~a~[~]+-1/~-(l-~*)~o~
=~[~]+a+-I/(a+)~-a~[X],
as may be verified by substitution in the above relation.
By cooperation the two companies can hold the minimum price at

the same level as a single company with level of saturation (capacity)
(cl +) would do. The minimum price is thus reduced.
Solution under rivalistic market behavior

C)
Here the two insurance carriers adopt the (very extreme) standpoint
that each seeks to make its utility as large as possible as compared to
that of the other company. More precisely, each wants to maximize the
difference between its own utility and that of its rival.
The following cases are possible for the premiums P, and P, to be
charged by A and B:
i) P, <P, (The risk is taken over by A.)
The utility of insurance carrier A is 4?Ll (P, -X) = E [K, (P, -X)] ;
the utility of insurance carrier B is a2(O)= K, (0);
the difference V(P P,)= E [K, (P,- X)] - K, (0).
ii) &=P, (The risk is taken over by A with probability p and
by B with probability 1 -P.)
+
The utility ofinsurancecarrier A is p E [ K , ( P ,- X)] (1 -p) K,(O);
the utility of insurance carrier B is (1 - p) E [K, (P,- X)] + p K,(O);
the difference V(P,, &)=P. E[K,(P,-X)- K2(0)]-(1 -p)
. ECK,(P,-X)-K,(O)I.
iii) &<P, (The risk is taken over by B.)
The utility of insurance carrier A is a1(O)= K,(O);
the utility of insurance carrier B is @, (P,- X) = E [K, (P,- X)] ;
the difference V(& P,) = K,(O)- E [K, (P,- X)].
In the rivalistic case A seeks through its choice of P, to make V(P P,)
as large as possible and B through an adroit choice of P, seeks to make
the same function as small as possible. This is exactly the situation of a
two-person zero-sum game. (See e.g. von Neumann-Morgenstern [53].)
Because K, (X) and K, (X) are continuous and monotonic, we find that
inf V(P,, P,)=min {E [K,(P,-X)] - K,(O), Kl(0)- E [K,(P,-X)])

Pu
and
sup inf V(& P,)= V(P, P),
PA PB
where P must satisfy the equation

Since also
inf sup V(& P,)= V(P, P)
PB PA
produces the same value, the two-person zero-sum game described here
is determined (i.e. it has a pure value).
By setting the special forms of K,(x) and K, (X) into the determining
+
equation E[K,(P- X)] E[K,(P- X)] = K,(O)+ K,(O) we find that
Here too the resultant price is that which a company with level of satura-
tion (capacity)
would receive as minimum premium on an individual basis.
d ) Comparison
If we assume that a > , we have the following quantitative comparison
of the (minimum) premiums under the different market behaviors discus-
sed above:
Individual (Minimum) Level of saturation Comparison

premium (capacity)
Insurer A
Insurer B
Cooperative
(for optimal y*) P a+ _P<$<$
Rivalistic
e ) Discussion
The three different market behaviors represent extreme cases. In
concrete situations it must be assumed that all three behaviors are present
"in a certain mixture" for the individual insurer. An understanding of
the significance of market behavior can be gained, however, by a study
of the extreme cases. The relations between the magnitudes of the resulting
prices are particularly suggestive.
APPENDIX
The Generalized Riemann-Stieltjes Integral

We shall explain in this appendix the meaning of the symbol
jg(x)dF(x). The reader who is familiar with the theory of Lebesgue
integration may choose to consider this (for any Borel function g) as the
Lebesgue-Stieltjes integral. The reader who has not mastered measure
theory, however, may think of it simply as the generalized Riemann-
Stieltjes integral, as defined below.
A.1. Preliminary
Every distribution function F(x) can be broken down uniquely into
a weighted average of two distribution functions of which one is a pure
continuous and the other a pure step distribution function. This finding
can be stated formally as follows:
Lemma: a) F ( x ) = p . F , ( x ) + ( l - p ) F , ( x ) ,
where F(x) = any distribution function,
F, (X) = continuous distribution function,
<(X)= step distribution function und
05~51.
b) ?bis breakdown is unique.
The proof can be found in C441 or C551 for example.
A.2. Definition of the generalized Riemann-Stieltjes integral

in two special cases
a) Pure continuous distribution function F(x)
b
Let us first define { g(x) dF(x) (similarly as for the Riemann integral)
a
by taking the limit of Darboux sums.
i) The half-open interval [U,b) can be divided into subintervals

[X, _ X,) by choosing a sequence of points
Appendix. The Generalized Riemann-Stieltjes Integral
ii) The Darboux Sums then have the form
where X,-, 5 4, <X,
if the limit on the right-hand side exists and is the same for all sequences
of partitions of the interval for which the fineness tends to 0 and for any
intermediate points 5,.
iv) We say that g(x) dF(x) (the indefinite integral over the whole
real axis) exists if
b
J g(x) dF(x) exists for all a, b and
a
b
- lim Ig(x)l dF(x)< cc (absolute convergence of the indefinite
a-+ - m
b++m <I integral)
and we then define:
h
J ~ ( x ) ~ F ( x )lim
= jg(x)d~(x).
a-t-m
b++m
When the above conditions are not fulfilled we say that the (generalized)
Riemann-Stieltjes integral does not exist.
Special case: If F' (X)=f (X)exists, then
becomes the usual (indefinite) Riemann integral.

b) Pure step distribution function F(x)
We describe the step distribution function by its points of discontinuity
a, and its jumps pk:
A.4. Integrable functions
We then define:
provided that the defining sum converges absolutely. Otherwise we say

that the (generalized) Riemann-Stieltjes integral does not exist.
A.3. Definition in the general case
Suppose that F(x)= p . F, (X) + (1- p) . &(X).This breakdown is unique

by the lemma cited in A.1. We define:
where the integrals on the right correspond to the definitions given

in A.2. We thus say that the generalized Riemann-Stieltjes integral
exists if both integrals on the right-hand side of the defining equation
exist.
A.4. Integrable functions
The integral concept used here is very useful and intuitively easy
to grasp, but is nevertheless seldom encountered in the literature. (The
closest approach is the description in [55].) We shall therefore state
several existence theorems and properties relating to our concept. (For
proofs See for example [52].)
In what follows we shall proceed from the breakdown
which applies to any distribution function.

I . Existence theorem:
b
i) j g(x)dF,(x) exists if
a
-g(x) is bounded und

t h e points of discontinuity of g(x) form an set of measure Zero
with respect to F,.
A set of measure Zero with respect t o F, is a set that can be covered by half-open
intervals (a, b], so that the sum of the F, measures F,(b)-F,(n) of these intervals can be
made as small as we like.
204 Appendix. The Generalized Riemann-Stieltjes Integral
d
ii) If jdF,(x)>O for all subintervals (c,d] of (U,b], then the condi-
C
tions above are also necessary for the existence of the integral.
b
Important special case: j g(x) dF,(x) exists, if
a
--g(x) is bounded und
g ( x ) has at most a countable number of points ofdiscontinuity.
2. Existence theorem: g(x) dF(x) exists if and only if
b
i) j g(x) dF(x) exists for all a, b und
a
b
ii) lim j lg(x)l dF(x)< cc.
U+-a, ,
b
Remark: S g(x)dF,(x)= C g(ak)p,
a k
likewise exists only if the series
converges absolutely.
A.5. Properties of the generalized Riemann-Stieltjes integral
Ist property: (follows directly from the definition)
2nd property: (also follows from the definition)

I f O S g ( x ) s k , then o ~ j ~ ( x ) d ~ ( x ) g k .
Dominated convergence property :If
i) Jg,(x)lSh(x) for all n, where h(x) is integrable,
ii) g,(x)+g(x), pointwise convergent, where g,(x) and g(x) are
integrable,
then j g,(x) dF(x) also converges toward g(x) dF(x).
Remark: With reference to the continuous part, this result is known
as the Arzela-Osgood Theorem. For the step distribution function it
follows from the definition.
Integration hy parts:
Let g(x) be monotonic (increasing or decreasing) and continuous on
the left if F(x)is continuous on the right (and uice versa).Then the following
A.S. Properties of the generalized Riemann-Stieltjes integral 20 5
rule holds for the limits a, h which are continuity points of F ( x ) and g ( x ) :
Variable transformation rule: Provided the two integrals exist,

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Index
Absolute retention problem 113 DE FINETTI 113, 114, 115, 132, 164, 168
- - when the risk parameters are drawn De Finetti solution 116
from one or more collectives 159 Density function 5
- - when the risk Parameter is known Discrete random walks 145
156 Distribution function 3
Accumulated claim process 36 Dividend policy 164
Admissible stability policy 135 - in the continuous case 168
AMMETER68 - in the discrete case 165
P
Approximation part 99 DOOB 100

Asymptotic formula for a , 174 DU MOUCHEL 192,195
Equivalent evaluations 179

BAILEY 93
Excess of loss 113
Barrier strategy 168
Existence theorem for an equivalent
BEARD,PENTIKAEINEN and PESONENV11
utility 184
BERNOULLI32
Expected value 12
Beta distribution 7, 18 - part 100
BICHSEL 65,93, 106
Exponential distribution 6, 18
BinomiaI distribution 9, 18
BORCH 132,165, 191, 195
FELLER 15, 39,44,69,75, 144, 145, 146,
147, 149
Cauchy distribution 8, 18 Fluctuation part 99, 100
Central moment 16 FREEDMANN 100
Characteristic function 20
Chebyshev's inequality 21 Gamma distribution 6, 18
CHINTCHIN69 Generalized Riemann-Stieltjes integral
CHUNG 42 12,201
Claim amount 3 Geometric distribution 11, 18
- interoccurrence time 47 GERBER 151, 170, 177
Collective premium 88 Global reinsurance 112
Compound Poisson 39 GREENWOOD and YULE 68
Conditional distribution function 25
- expectation 25 HOFMANN39, 58
Contagion models 51 Homogeneous with respect to the claim
Continuous distribution function 4, 201 amounts 64
Contingency loading 87 - - P to the number of claims 64
Covariance 30 - - - to the number of claims and to
CRAMER 23, 132, 141, 143 the claim amounts 64
Credibility formula 101
- premium 93 Independence 28
Criterion, the dividend policy 132 Individual reinsurance 111
-, the probability of ruin 132 Integro-differential equation of the barrier
-, the utility 132 strategy 171
210 Index
Integrable function 203 Quantile 20

Integral evaluation 188
- -, instantaneous 189 Random variable 3
lntensity of frequency 43 - walk of the risk carrier's free reserves
I26
Record height 146
- jump 146
- point 146
KENDALL 15
Kolmogorov's (forward) differential Reinsurance arrangements 14
equation System 43 Relative retention problem 113
KUPPER 54 Renewal theory 144
- process 147
k-th central moment 16
k-th moment about the origin 16 Reserves 1 11, 129
Retentions I1 1
Law of large numbers 32 Risk exchange 190
- in the collective 63
LEVY 69
- premium 87
Logarithmic distribution 11, 18
- normal distribution 5, 18 - process 35
LUNDBERG, 0. 68,77,93 -, collective and credibility premium in
LUNDBERG. F. 132 automobile liability insurance 106
ROZANOV I5
Markov processes 39 SCHWARTZ 100
MAYERSON93 SEAL V11
MIYASAWA167 Skewness 16
Moment about the origin 16 Stabilizing in size 77
- generating function 20 - in time 77
MORILL 167, 168 Stability criteria 131, 132
Multi-dimensional distribution function - problem 13 1
22 Standard deviation 16
Step distribution function 5, 201
Negative binomial distribution 11, 18 Stochastic processes with independent
Non-proportional reinsurance 112 incrernents 37
Normal distribution 5, 18 Surplus reinsurance 1 12
Number of claims process 36
TAECKLIND143
TAKEUCHI 167
Operational time 49
THYRION 70, 75
Optimum dividend policy 164
Transition probabilities 40
Pareto distribution 8, 18 Utility as criterion of stability 178
Pareto-optimal 191 -, axioms about 182
PARZEN 15 -, definition of 179
PESONEN 75 - kerne1 188
PHILIPSON VII, 39, 58
VAJDA 114
Planning horizon 133
Variance 16
Poisson distribution 10, 18
- part 100
POLYA-EGGENBERGER 53
VONNEUMANN, MORGENSTERN
Portfolio 76
182, 187, 199
- function 76
Premium calculation 85 Waiting time 47
- function 36 Weighted laws of probability 65
Principles of premium calculation 86 Weights in the credibility formulae 103
Proportional reinsurace 112 Wiener-Hopf method 141

Mathematical Methods in Risk Theory

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Mathematical Methods in Risk Theory

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Actuarial mathematics originated toward the end of the 17th century,

when E. Halley's famous mortality table permitted the mathematical

Zrich, September 15, 1970

3.2.3. The nun~berof claims process in the collective . . . . . . . . . 68

Part TI . Consequences of the Theoretical Model

Chapter 6: The Insurance Carrier's Stability Criteria ............ 131

Appendix: The Generalized Riemann-Stieltjes Integral . . . . . . . . . . . . 201

The Theoretical Model

Probability Aspects of Risk

where the right-hand side of the definition is read as "the probability

clairn arnount in francs

claim amount in francs

It follows directly from the foregoing definition that the distribution

1.1.2. Classification and examples of distribution functions

Category a) can be further divided into

Graph of the density function:

The special case p = 0, a = 1 is called the standardized normal distribu-

Graph of the density function:

The log-normal distribution is very useful for depicting claim

The gamma distribution is also often used to represent the distribu-

The r-distribution can be obtained from the B-distribution by taking

The Cauchy distribution is similar to the normal curve but converges

The Pareto distribution likewise converges slowly to Zero for extreme

The usual terminology with regard to step distribution functions

We should mention that the following examples of step distribution

P,= (i) pk(l-pyPk for k = ~ 1,

Histogram : For n = 6, p =0.6.

The binomial distribution gives the probability of k successes in n

Histogram: For A = 1,5.

The Poisson distribution arises as a limiting case of the binomial

ix) 7he negative binomial distribution

Histogram : For cx = 2, p = 0.4.

The special case cr = 1 (where k is often replaced by k - 1 in the litera-

The negative binomial distribution plays an important role in

Histogram: For p = 0.6.

The logarithmic distribution can be obtained as a limiting case of

1.1.3. Expected values

ii) if F(x) is a step distribution function with positive amount jumps pk

b) The integration in the above definition is over the range - co

Probabilities can be interpreted as idealized relative frequencies, i.e.

prob [S = k] - nk/n, (The symbol

= average payment per claim.

Practical application in reinsurance arrangements

E [g(S)] =expected claims within the retention,

In words: i h e expected claims within the retention amount to a times the

In words: Expected claims within the retention total expected claims.

trivial. They do show, however, how well the concept of "theoretical

for any distribution function (for which F is continuous at M) and

To aid in the solution of these exercises the following works are

1.1.4. Characteristics of a probability distribution and auxiliary functions

also plays a useful role.

An analogous useful formula for the third central moment is the

The intuitive meaning of these characteristics is probably most easily

C can be thought of as representing the amount of insurance under a

Then the following characteristic measures of the distribution are pro-

Probability distribution Expected value Variance Skewness

Tuble of Moments und Auxiliury

Distribution Density function Domain of x Parameters Expected value

V) Cauchy distribution -cc<x<~ -ccipim does not exist

Distribution functions wich

Distribution Probability Domain of k Parameters Expected value

vii) Binomial 0 , 1 , 2,..., 11 n natural number np

" Not integrable in closed algebraic form.

Functions for the Examples in 1 .I .2