A Bivariate Shot Noise Self-Exciting Process for Insurance
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1 A Bivariate Shot Noise Self-Exciting Process for Insurance Jiwook Jang Department of Applied Finance & Actuarial Studies Faculty of Business and Economics Macquarie University, Sydney Australia Angelos Dassios Department of Statistics London School of Economics United Kingdom Macquarie University Financial Risk Day, 3 th March 212
2 Overview A catastrophic event such as flood, storm, hail, bushfire, earthquake and terrorism brings about huge losses in properties, motor vehicles and from the interruption of businesses. Particular examples concern losses due to 211 Great Eastern Japan Earthquake and Tsunami, Queensland floods, 29 Victorian Bushfires (Report of 29 Victorian Bushfires Royal Commission, 21), 25 Hurricane Katrina (Burton and Hicks 25) and 21 September 11 attack (Makinen 22). Theseareextremerisks whichposeanewchallengetothefinancial viability of insurers.
3 Overview (continued) Due to global warming and climate changes, it is inevitable that more extreme losses will occur from catastrophic events. To accommodate the clustering of losses due to increases in frequency and intensity of natural/man-made disasters, improved models are required to predict losses arising from catastrophic events. For that purpose, a bivariate shot noise Hawkes process is introduced in which both externally excited joint jumps following a homogeneous Poisson process and two separate self-excited jumps which themselves follow Poisson cluster processes, areused.
4 Self-exciting (or Hawkes) processes Self-exciting or Hawkes processes (Hawkes 1971, Hawkes and Oakes 1974 and Daley and Vere-Jones 23) are versatile point processes, interesting both from a theoretical as well as a practical point view. The theoretical foundation of Hawkes processes can be traced from a series of paper written by Brémaud and Massoulié (1996, 21 and 22) and Liniger (29). Relevant publications in seismology and the modelling of the occurrence of earthquakes are Vere-Jones (1975), Adamopoulos (1976), Vere-Jones (1978), Ozaki (1979), Vere-Jones and Ozaki (1982), Ogata (1988).
5 Self-exciting (or Hawkes) processes (continued) The applications and modelling of Hawkes processes in finance can be found in Chavez-Demoulin et al. (25), McNeil et al. (25), Bauwens and Hautsch (29), Bowsher (27), Aït-Sahalia et al. (21) and Embrechts et al. (211). Credit default modelling using these processes can be noticed in Errais et al. (21), Giesecke and Kim (211) and Dassios and Zhao (211). Stabile and Torrisi (21) apply Hawkes process in an insurance risk context to study the asymptotic behavior of infinite and finite horizon ruin probabilities.
6 A Self-exciting process = + X I ( )+ X I ³ 1 1 where is the initial value of a self-excited process, I is the indicator function, { } =12 is a sequence of independent identical distributed positive externally excited jumps with distribution function (), at the corresponding random times { } =12 following a homogeneous Poisson process with constant intensity and n is a sequence of independent identically distributed positive self-excited jumps with distribution o=12 function (),, at the corresponding random times n o=12.
7 An univariate shot noise self-exciting process = + X ( ) I ( )+ X ( ³ ) I 1 1 where is a constant as the initial value of an univariate shot noise selfexciting process, is a constant rate of exponential decay and all symbols have been previously defined.
8 Definition From = + X ( ) I ( )+ X ( ³ ) I 1 1 let us firstly look at + X 1 ( ) I ( )
9 Definition (continued): Immigrants + X 1 ( ) I ( ) where externally excited jumps { } =12 with distribution function (), at the corresponding random times { } =12 following a homogeneous Poisson process with points ( ) and constant intensity. Eachjump/point/birthiscalledanimmigrant and this is non-self exciting jump. These immigrants (i.e. jumps/births) form the points of generation.
10 I./... r<o
11 Definition (continued): Offsprings Each immigrants generates acluster = which the random set formed by the points of generations 1 2 with the following branching structure: The immigrant is said to be of generation. Given generations 1 2 in,eachpoint of generation generates a Poisson process on ³ of offspring of generation +1 with intensity function ( ), where a positive self-excited jump at time has distribution function (),, independent of the points of generation 1 2. Hence we have = + P 1 ( ) I ( )+ P 1 ( ) I ³.
12 / /\ cf / v --<
13 J I
14 Insurance application of univariate shot noise self-exciting process = + X ( ) I ( )+ X ( ³ ) I (*) 1 1 Replace with in (*) denoting by,whichistheaccumulated value of aggregate losses, then it is given by = + X ( ) I ( )+ X ( ³ ) I (**) 1 1 where is now the force of interest rate.
15 Insurance application of univariate shot noise self-exciting process (continued) Multiply by in (**) (i.e. = ), then the discounted value of the aggregate losses with initial loss amount $ is given by = + P 1 I ( )+ P 1 I ³ We can interpret the process as follows: the standard losses, { } =12 that occur according to a homogeneous Poisson process with constant intensity trigger after-losses (after-shock losses), n according to the o=12 branching structure described previously, which are unknown at the arrival times of standard losses from a catastrophic event in practice. The force of interest rate is used to discount all losses.
16 Insurance premium Based on the piecewise deterministic Markov process theory developed by Davis (1984), and the martingale methodology used by Dassios and Jang (23), the expectation of the discounted value of the aggregate losses is given by ³ = + 1 ³ = + 1 at +1 1, which can be considered as the net insurance premium at time =including the effect of the interest rate, where 1 = R () and 1 = R ().
17 Numerical Example 1 We assume that a Property Insurance Company s (or a State Government s) standard loss frequency rate is 5 per unit time period (say, per year) with the average of losses 1. The mean of after-losses (after-shock losses), which are unknown at the arrival times of standard losses from a catastrophic event, (e.g. anearthquake)isassumedtobe2. Weassumethattheforceof interest rate is 5 and that an initial loss amount that has been carried over is 1. Using an exponential distribution for () and (), respectively, i.e. () =1 and () =1 with,, then the parameter values to calculate the expectation of the discounted value of the aggregate losses are =1=5 =5=1=5 =1.
18 Numerical Example 1 (continued) Ã + 1 at (1)+1! 1 Table at (1) $16441 $49771 $51 $73891 Table 1 shows that the expected discounted premium value calculated based on shot noise self-exciting process is more than three-times higher than its counterpart calculated based on compound Poisson process. It is because the expected discounted premium of grows exponentially. 1 is the expected discounted premium after eliminating the frequency rate for standard losses, which also grows exponentially.
19 Numerical Example 1 (continued) Ã + 1 at (1)+1! 1 Table at (1) $16441 $49771 $51 $73891 Given time, 1 (or equivalently 1 ) which is the mean of after-losses (after-shock losses), is the main driver to raise the expected discounted premium higher than its counterpart. Hence the significance of loss clustering impacts from a catastrophic event depends on after-loss (after-shock loss) size measure (). It will be of interest to examine the expected discounted premium value using other after-loss (after-shock loss) size measures.
20 Numerical Example 1 (continued) Ã + 1 at (1)+1! 1 Table at (1) $16441 $49771 $51 $73891 The expected discounted premium value calculated based on shot noise selfexciting process clearly justifies that it can be used modelling discounted aggregate losses from catastrophic events to accommodate loss clustering due to increases in frequency and intensity of natural and man-made disasters in practice.
21 A bivariate shot noise self-exciting process (1) = (1) (1) + P 1 (2) = (2) (2) + P 1 (1) (1) ( 1 ) ³ 1 + P 1 (2) (2) ( 1 ) ³ 1 + P 1 ³ (1) ( 2 ) 2 (2) ( 2 ) ³ 2
22
23 Insurance application of bivariate shot noise self-exciting process (1) = (1) + P 1 (2) = (2) + P 1 (1) ( )+ P ³ 1 (2) ( )+ P ( ) 1 An economic interpretation from the perspective of the cluster process representation for bivariate shot noise self-exciting process is the following: As a result of a catastrophic event, such as flood, storm, hail, bushfire and earthquake, joint losses of properties and motors (or businesses interruption) (1) (2) =12 occur simultaneously/collaterally according to a homogeneous Poisson process
24 with constant intensity. In the aftermath of each joint losses to this company, n o they could further trigger a series of after-losses (after-shock losses), =12 and { } =12 according to the branching structure described previously, which are unknown at the arrival times of each joint losses. The force of interest rate is used to discount all losses. We have (1) (1) (2) (2) = = (1) + 11 at +1 1, (2) + 12 at +1 1.
25 Insurance premium Let us assume that an insurance company charges collateral loss insurance premium as follows: = + (1) (1) s + (2) (1) (1) + (1) (1) where 1 and can be considered as a security loading. s (2) + (2) (2) + s (2) (2) (1) + (2) (1) (2) +2 (1) + (2) (1) (2) (1) (2) (1) (2)
26 Covariance: (1) (2) (1) (2) (1) (1) (2) (1) (2) (2) (1) (2) (1) (1) = (2) (2) To calculate the covariance easier, we use the Farlie-Gumbel-Morgenstern (FGM) copulas given by ( 1 2 )= (1 1 )(1 2 ) where 1 [ 1], 2 [ 1] and [ 1 1], with ³ (1) =1 (1) () and ³ (2) =1 (2) (), from which we have (1) (2) = R R (1) (2) ³ (1) (2) = 1 ³ 1+ 4 We also use an exponential distribution for (), i.e.() =1 with.
27 Numerical Example 2 We assume that a Property and Motor (or Businesses Interruption) insurance company s (or a State Government s) standard loss frequency rate is 5 per unit time period (say, per year) with two average of losses 1 and 2, respectively. The mean of after-losses (after-shock losses) from Motor (or Businesses Interruption) insurance side, which are unknown at the arrival times of joint standard losses from a catastrophic event (e.g. an earthquake), is assumed to be 4. We assume that an initial loss amount that has been carried over from Motor (or Businesses Interruption) insurance side is 1.
28 As the security loading factor, this insurance company uses 5 i.e. = 5 and the force of interest rate, = (1) = (2) =5. Hence the parameter values used for Motor (or Businesses Interruption) insurancesideare (2) =1=5 =25. Using the parameter values in Example 1 for Property insurance side, i.e. (1) =1=5=1=5 =1, collateral loss insurance premium calculations are shown in Table 2.
29 Table 2 Collateral loss insurance premium Bivariate shot noise Bivariate shot noise self-exciting (discounted) Poisson (discounted) 1 $18588 $ $18582 $15949 $18575 $ $18569 $ $18562 $15866 Table 2 shows that collateral loss insurance premium values calculated using bivariate shot noise self-exciting process (discounted) are significantly higher than their counterparts calculated using bivariate shot noise Poisson process (discounted) at different value of. It is because two "exponential growths", i.e. 1 and 1.
30 Linear correlation coefficient Table 3 (1) (2) (1) (2) Bivariate shot noise Bivariate shot noise self-exciting (discounted) Poisson (discounted) Table 3 shows that the linearities between (1) and (2) calculated using bivariate shot noise self-exciting process (discounted) are significantly lower
31 than their counterparts calculated using bivariate shot noise Poisson process (discounted) at different value of. It is because two separate loss clustering impacts (i.e. two separate after-shock losses impacts) weaken the linearity between (1) and (2). Therefore it will be also of interest to compare bivariate distribution for shot noise self-exciting (discounted) case with its counterpart, in particular seeing their two tail corners inverting bivariate Fast Fourier transforms using bivariate Laplace transforms.
32 The generator of the process ³ (1) (2) ³ (1) (2) + " R R = + (1) (1) (1) + (2) (2) (2) ³ (1) + (1) (2) + (2) ³ (1) (2) ³ (1) # (2) + (1) " R + (2) " R ³ (1) + (2) () ³ (1) # (2) ³ (1) (2) + () ³ (1) # (2)
33 The significance of two separate loss clustering impacts (i.e. two separate aftershock losses impacts) from a catastrophic event depends on two after-shock loss size distributions () and () as well as standard joint loss size distribution ³ (1) (2) and its frequency rate. It will be of interest to examine collateral loss insurance premium values using other after-shock loss size distributions and other standard joint loss size distributions.
34 Future research Spillover effects and modelling systemic risk. Modelling security market events. Modelling operational risk with the extension of dimension. Adding diffusion components to price financial derivatives. Replacing a Poisson process with a Cox process.
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