Model Efficiency and Uncertainty in Quantile Estimation of Loss Severity Distributions

Vytaras Brazauskas and Sahadeb Upretee
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Vytaras Brazauskas: Department of Mathematical Sciences, University of Wisconsin-Milwaukee, P.O. Box 413, Milwaukee, WI 53201, USA
Sahadeb Upretee: Department of Mathematical Sciences, University of Wisconsin-Milwaukee, P.O. Box 413, Milwaukee, WI 53201, USA

Risks, 2019, vol. 7, issue 2, 1-16

Abstract: Quantiles of probability distributions play a central role in the definition of risk measures (e.g., value-at-risk, conditional tail expectation) which in turn are used to capture the riskiness of the distribution tail. Estimates of risk measures are needed in many practical situations such as in pricing of extreme events, developing reserve estimates, designing risk transfer strategies, and allocating capital. In this paper, we present the empirical nonparametric and two types of parametric estimators of quantiles at various levels. For parametric estimation, we employ the maximum likelihood and percentile-matching approaches. Asymptotic distributions of all the estimators under consideration are derived when data are left-truncated and right-censored, which is a typical loss variable modification in insurance. Then, we construct relative efficiency curves (REC) for all the parametric estimators. Specific examples of such curves are provided for exponential and single-parameter Pareto distributions for a few data truncation and censoring cases. Additionally, using simulated data we examine how wrong quantile estimates can be when one makes incorrect modeling assumptions. The numerical analysis is also supplemented with standard model diagnostics and validation (e.g., quantile-quantile plots, goodness-of-fit tests, information criteria) and presents an example of when those methods can mislead the decision maker. These findings pave the way for further work on RECs with potential for them being developed into an effective diagnostic tool in this context.

Keywords: data truncation and censoring; empirical estimator; maximum likelihood; model uncertainty; percentile matching; quantile estimation (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2019
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