Ruin theory

In actuarial science and applied probability, ruin theory (sometimes risk theory[1] or collective risk theory) uses mathematical models to describe an insurer's vulnerability to insolvency/ruin.

In such models key quantities of interest are the probability of ruin, distribution of surplus immediately prior to ruin and deficit at time of ruin.

The theoretical foundation of ruin theory, known as the Cramér–Lundberg model (or classical compound-Poisson risk model, classical risk process[2] or Poisson risk process) was introduced in 1903 by the Swedish actuary Filip Lundberg.

[3] Lundberg's work was republished in the 1930s by Harald Cramér.

[4] The model describes an insurance company who experiences two opposing cash flows: incoming cash premiums and outgoing claims.

Premiums arrive a constant rate

from customers and claims arrive according to a Poisson process

and are independent and identically distributed non-negative random variables

(they form a compound Poisson process).

So for an insurer who starts with initial surplus

are given by:[5] The central object of the model is to investigate the probability that the insurer's surplus level eventually falls below zero (making the firm bankrupt).

This quantity, called the probability of ultimate ruin, is defined as where the time of ruin is

This can be computed exactly using the Pollaczek–Khinchine formula as[6] (the ruin function here is equivalent to the tail function of the stationary distribution of waiting time in an M/G/1 queue[7]) where

In the case where the claim sizes are exponentially distributed, this simplifies to[7] E. Sparre Andersen extended the classical model in 1957[8] by allowing claim inter-arrival times to have arbitrary distribution functions.

are independent and identically distributed random variables.

Michael R. Powers[10] and Gerber and Shiu[11] analyzed the behavior of the insurer's surplus through the expected discounted penalty function, which is commonly referred to as Gerber-Shiu function in the ruin literature and named after actuarial scientists Elias S.W.

It is arguable whether the function should have been called Powers-Gerber-Shiu function due to the contribution of Powers.

is a general penalty function reflecting the economic costs to the insurer at the time of ruin, and the expectation

corresponds to the probability measure

The function is called expected discounted cost of insolvency by Powers.

is a penalty function capturing the economic costs to the insurer at the time of ruin (assumed to depend on the surplus prior to ruin

emphasizes that the penalty is exercised only when ruin occurs.

It is quite intuitive to interpret the expected discounted penalty function.

Since the function measures the actuarial present value of the penalty that occurs at

, the penalty function is multiplied by the discounting factor

, and then averaged over the probability distribution of the waiting time to

While Gerber and Shiu[11] applied this function to the classical compound-Poisson model, Powers[10] argued that an insurer's surplus is better modeled by a family of diffusion processes.

There are a great variety of ruin-related quantities that fall into the category of the expected discounted penalty function.

Other finance-related quantities belonging to the class of the expected discounted penalty function include the perpetual American put option,[12] the contingent claim at optimal exercise time, and more.