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1
Regression Models and Loss Reserving
Regression Models and Loss Reserving
Leigh J. Halliwell, FCAS, MAAA
EPIC Consulting, LLC
lhalliwell@ask-epic.com
Casualty Loss Reserve Seminar
Las Vegas, NV
September 14, 2004
Leigh J. Halliwell, FCAS, MAAA
EPIC Consulting, LLC
lhalliwell@ask-epic.com
Casualty Loss Reserve Seminar
Las Vegas, NV
September 14, 2004
2
OutlineOutline
Introductory Example
Linear (or Regression) Models
The Problem of Stochastic Regressors
Reserving Methods as Linear Models
Covariance
Introductory Example
Linear (or Regression) Models
The Problem of Stochastic Regressors
Reserving Methods as Linear Models
Covariance
3
Introductory ExampleIntroductory Example
A pilot is flying straight from X to Y. Halfway along he
realizes that he’s ten miles off course. What does he do?
X
Y?
4
Linear (Regression) ModelsLinear (Regression) Models
“Regression toward the mean” coined by Sir Francis
Galton (1822-1911).
The real problem: Finding the Best Linear Unbiased
Estimator (BLUE) of vector y2, vector y1 observed.
y = X + e. X is the design (regressor) matrix.
unknown; e unobserved, but (the shape of) its variance
is known.
For the proof of what follows see Halliwell [1997] 325-
336.
“Regression toward the mean” coined by Sir Francis
Galton (1822-1911).
The real problem: Finding the Best Linear Unbiased
Estimator (BLUE) of vector y2, vector y1 observed.
y = X + e. X is the design (regressor) matrix.
unknown; e unobserved, but (the shape of) its variance
is known.
For the proof of what follows see Halliwell [1997] 325-
336.
5
The FormulationThe Formulation
2212
2111
2212
2111
2
1
2
1
2
1
2221
12112
2221
1211
2
1
12
11
12
1
12
11,
X
X
tttt
tttt
tttt
tttt
t
t
kkt
kt
t
t
Var
e
e
e
e
y
y
7
The BLUE SolutionThe BLUE Solution
1
11
1112
varianceparameter 1
1112121
111212
varianceprocess12
1112122
222
11
111
1
11
111
111
112122
XXˆ
XXˆXX
ˆ
XXXˆ
ˆXˆXˆ
Var
Var
Var yy
y
yy
8
Special Case: = ItSpecial Case: = It
1
112
222
22
111
11
22
XXˆ
XˆXIˆ
XXXˆ
ˆXˆ
2
Var
VarVar tyy
y
y
10
Remarks on the Linear ModelRemarks on the Linear Model
Actuaries need to learn the matrix algebra.
Excel OK; but statistical software is desirable.
X1 of is full column rank, 11 non-singular.
Linearity Theorem:
Model is versatile. My four papers (see References)
describe complicated versions.
Actuaries need to learn the matrix algebra.
Excel OK; but statistical software is desirable.
X1 of is full column rank, 11 non-singular.
Linearity Theorem:
Model is versatile. My four papers (see References)
describe complicated versions.
22 ˆAA
yy
11
The Problem of Stochastic RegressorsThe Problem of Stochastic Regressors
See Judge [1988] 571ff; Pindyck and Rubinfeld [1998] 178ff.
If X is stochastic, the BLUE of may be biased:
See Judge [1988] 571ff; Pindyck and Rubinfeld [1998] 178ff.
If X is stochastic, the BLUE of may be biased:
e
e
e
e
y
EE
EE
XXX
XXXˆ
XXX
XXXX
XXXˆ
1
1
1
1
1
12
The Clue: Regression toward the MeanThe Clue: Regression toward the MeanTo intercept or not to intercept?To intercept or not to intercept?
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
0 1,000 2,000 3,000 4,000 5,000 6,000
Loss @12
Loss
@24
13
What to do?What to do?
Ignore it.
Add an intercept.
Barnett and Zehnwirth [1998] 10-13, notice that the
significance of the slope suffers. The lagged loss may
not be a good predictor.
Intercept should be proportional to exposure.
Explain the torsion. Leads to a better model?
Ignore it.
Add an intercept.
Barnett and Zehnwirth [1998] 10-13, notice that the
significance of the slope suffers. The lagged loss may
not be a good predictor.
Intercept should be proportional to exposure.
Explain the torsion. Leads to a better model?
14
Galton’s ExplanationGalton’s Explanation
Children's heights regress toward the mean. Tall fathers tend to have sons shorter than themselves. Short fathers tend to have sons taller than themselves.
Height = “genetic height” + environmental error A son inherits his father’s genetic height:
Son’s height = father’s genetic height + error.
A father’s height proxies for his genetic height. A tall father probably is less tall genetically. A short father probably is less short genetically.
Excellent discussion in Bulmer [1979] 218-221.
Children's heights regress toward the mean. Tall fathers tend to have sons shorter than themselves. Short fathers tend to have sons taller than themselves.
Height = “genetic height” + environmental error A son inherits his father’s genetic height:
Son’s height = father’s genetic height + error.
A father’s height proxies for his genetic height. A tall father probably is less tall genetically. A short father probably is less short genetically.
Excellent discussion in Bulmer [1979] 218-221.
15
The Lesson for ActuariesThe Lesson for Actuaries Loss is a function of exposure. Losses in the design matrix, i.e., stochastic
regressors (SR), are probably just proxies for exposures. Zero loss proxies zero exposure.
The more a loss varies, the poorer it proxies. The torsion of the regression line is the clue. Reserving actuaries tend to ignore exposures –
some even glad not to have to “bother” with them! SR may not even be significant. Covariance is an alternative to SR (see later). Stochastic regressors are nothing but trouble!!
Loss is a function of exposure. Losses in the design matrix, i.e., stochastic
regressors (SR), are probably just proxies for exposures. Zero loss proxies zero exposure.
The more a loss varies, the poorer it proxies. The torsion of the regression line is the clue. Reserving actuaries tend to ignore exposures –
some even glad not to have to “bother” with them! SR may not even be significant. Covariance is an alternative to SR (see later). Stochastic regressors are nothing but trouble!!
16
Reserving Methods as Linear ModelsReserving Methods as Linear Models
The loss rectangle: AYi at age j Often the upper left triangle is known; estimate
lower right triangle.
The earlier AYs lead the way for the later AYs. The time of each ij-cell is known – we can
discount paid losses. Incremental or cumulative, no problem. (But
variance structure of incrementals is simpler.)
The loss rectangle: AYi at age j Often the upper left triangle is known; estimate
lower right triangle.
The earlier AYs lead the way for the later AYs. The time of each ij-cell is known – we can
discount paid losses. Incremental or cumulative, no problem. (But
variance structure of incrementals is simpler.)
17
The Basic Linear ModelThe Basic Linear Model
yij incremental loss of ij-cell
aij adjustments (if needed, otherwise = 1)
xi exposure (relativity) of AYi
fj incremental factor for age j (sum constrained)
r pure premium
eij error term of ij-cell
yij incremental loss of ij-cell
aij adjustments (if needed, otherwise = 1)
xi exposure (relativity) of AYi
fj incremental factor for age j (sum constrained)
r pure premium
eij error term of ij-cell
1 j
jijjiijij frfxa ey
18
Familiar Reserving MethodsFamiliar Reserving Methods
Additive
Bühlmann-StanardFerguson-rBornhuette1
LadderChain X
ijjiij
ijjiij
ijjiij
ijijij
rfxrfx
rfxrxf
eyeyeyey
eY
BF estimates zero parameters. BF, SB, and Additive constitute a progression. The four other permutations are less interesting. No stochastic regressors
BF estimates zero parameters. BF, SB, and Additive constitute a progression. The four other permutations are less interesting. No stochastic regressors
19
Why not Log-Transform?Why not Log-Transform?
Barnett and Zehnwirth [1998] favor it. Advantages:
Allows for skewed distribution of ln yij. Perhaps easier to see trends
Disadvantages: Linearity compromised, i.e., ln(Ay) A ln(y). ln(x 0) undefined.
Barnett and Zehnwirth [1998] favor it. Advantages:
Allows for skewed distribution of ln yij. Perhaps easier to see trends
Disadvantages: Linearity compromised, i.e., ln(Ay) A ln(y). ln(x 0) undefined.
ijjiij rfx ey lnlnlnln
20
The Ultimate QuestionThe Ultimate Question
Last column of rectangle is ultimate increment. May be no observation in last column:
Exogenous information for late parameters fj or fj. Forces the actuary to reveal hidden assumptions. See Halliwell [1996b] 10-13 and [1998] 79.
Risky to extrapolate a pattern. It is the hiding, not the making, of assumptions that ruins the actuary’s credibility. Be aware and explicit.
Last column of rectangle is ultimate increment. May be no observation in last column:
Exogenous information for late parameters fj or fj. Forces the actuary to reveal hidden assumptions. See Halliwell [1996b] 10-13 and [1998] 79.
Risky to extrapolate a pattern. It is the hiding, not the making, of assumptions that ruins the actuary’s credibility. Be aware and explicit.
21
Linear TransformationsLinear Transformations
Results: and Interesting quantities are normally linear: AY totals and grand totals Present values
Powerful theorems (Halliwell [1997] 303f):
The present-value matrix is diagonal in the discount factors.
Results: and Interesting quantities are normally linear: AY totals and grand totals Present values
Powerful theorems (Halliwell [1997] 303f):
The present-value matrix is diagonal in the discount factors.
2y 22 yy Var
AˆAˆAA
ˆAˆA
2222
22
yyyy
yy
VarVar
EE
22
Transformed ObservationsTransformed Observations
2221
1211
2
1
2
1
2
1
2
1
AAAAA
,A
XAXA
ee
ee
yy
Var
If A-1 exists, then the estimation is unaffected. Use the BLUE formulas on slide 7.If A-1 exists, then the estimation is unaffected. Use the BLUE formulas on slide 7.
24
CovarianceCovariance
An example like the introductory one: From Halliwell [1996a], 436f and 446f. Prior expected loss is $100; reaches ultimate at age 2.
Incremental losses have same mean and variance. The loss at age 1 has been observed as $60. Ultimate loss: $120 CL, $110 BF, $100 Prior Hypothesis.
Use covariance, not the loss at age 1, to do what the CL method purports to do.
An example like the introductory one: From Halliwell [1996a], 436f and 446f. Prior expected loss is $100; reaches ultimate at age 2.
Incremental losses have same mean and variance. The loss at age 1 has been observed as $60. Ultimate loss: $120 CL, $110 BF, $100 Prior Hypothesis.
Use covariance, not the loss at age 1, to do what the CL method purports to do.
25
Generalized Linear ModelGeneralized Linear Model
2222
1222
2
2
1ˆ
1050
11005.060111005.0ˆ
11
11005.01005.060
yy
y
y
Var
Off-diagonal element
Result: = 1 CL, = 0 BF, = 1 Prior HypothesisResult: = 1 CL, = 0 BF, = 1 Prior Hypothesis
26
ConclusionConclusion Typical loss reserving methods:
are primitive linear statistical models originated in a bygone deterministic era underutilize the data
Linear statistical models: are BLUE obviate stochastic regressors with covariance have desirable linear properties, especially for
present-valuing fully utilize the data are versatile, of limitless form force the actuary to clarify assumptions
Typical loss reserving methods: are primitive linear statistical models originated in a bygone deterministic era underutilize the data
Linear statistical models: are BLUE obviate stochastic regressors with covariance have desirable linear properties, especially for
present-valuing fully utilize the data are versatile, of limitless form force the actuary to clarify assumptions
27
ReferencesReferencesBarnett, Glen, and Ben Zehnwirth, “Best Estimates for Reserves,” Fall
1998 Forum, 1-54.
Bulmer, M.G., Principles of Statistics, Dover, 1979.
Halliwell, Leigh J., “Loss Prediction by Generalized Least Squares, PCAS LXXXIII (1996), 436-489.
“ , “Statistical and Financial Aspects of Self-Insurance Funding,” Alternative Markets / Self Insurance, 1996, 1-46.
“ , “Conjoint Prediction of Paid and Incurred Losses,” Summer 1997 Forum, 241-379.
“ , “Statistical Models and Credibility,” Winter 1998 Forum, 61-152.
Judge, George G., et al., Introduction to the Theory and Practice of Econometrics, Second Edition, Wiley, 1988.
Pindyck, Robert S., and Daniel L. Rubinfeld, Econometric Models and Economic Forecasts, Fourth Edition, Irwin/McGraw-Hill, 1998.
Barnett, Glen, and Ben Zehnwirth, “Best Estimates for Reserves,” Fall 1998 Forum, 1-54.
Bulmer, M.G., Principles of Statistics, Dover, 1979.
Halliwell, Leigh J., “Loss Prediction by Generalized Least Squares, PCAS LXXXIII (1996), 436-489.
“ , “Statistical and Financial Aspects of Self-Insurance Funding,” Alternative Markets / Self Insurance, 1996, 1-46.
“ , “Conjoint Prediction of Paid and Incurred Losses,” Summer 1997 Forum, 241-379.
“ , “Statistical Models and Credibility,” Winter 1998 Forum, 61-152.
Judge, George G., et al., Introduction to the Theory and Practice of Econometrics, Second Edition, Wiley, 1988.
Pindyck, Robert S., and Daniel L. Rubinfeld, Econometric Models and Economic Forecasts, Fourth Edition, Irwin/McGraw-Hill, 1998.
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