Question

8.8: How are loss distributions created?

Answer 1

The term loss distributions could represent a per claimant loss distribution, a per occurrence loss distribution, a per risk annual loss ratio distribution, etc. For financial institutions, risk has several components: credit risk, market risk, other types of risk such as operational risk.

LDA is a statistical approach which is very popular in actuarial sciences for computing aggregate loss distributions.

There are three basic approaches to deriving the loss distribution in an insurance risk model: empirical, analytical, and moment based. The empirical method is based on a sufficiently smooth and accurate estimate of the cumulative distribution function (cdf) and can be used only when large data sets are available. The analytical approach is probably the most often used in practice and certainly the most frequently adopted in the actuarial literature. It reduces to finding a suitable analytical expression which fits the observed data well and which is easy to handle. In some applications the exact shape of the loss distribution is not required. We may then use the moment based approach, which consists of estimating only the lowest characteristics (moments) of the distribution, like the mean and variance.