Two maxentropic approaches to determine the probability density of compound risk losses Articles uri icon

publication date

  • May 2015

start page

  • 42

end page

  • 53

volume

  • 62

International Standard Serial Number (ISSN)

  • 0167-6687

Electronic International Standard Serial Number (EISSN)

  • 1873-5959

abstract

  • Here we present an application of two maxentropic procedures to determine the probability density distribution of a compound random variable describing aggregate risk, using only a finite number of empirically determined fractional moments. The two methods that we use are the Standard method of Maximum Entropy (SME) and the method of Maximum Entropy in the Mean (MEM). We analyze the performance and robustness of these two procedures in several numerical examples, in which the frequency of losses is Poisson and the individual losses are lognormal random variables. We shall verify that the reconstructions obtained pass a variety of statistical quality criteria, and provide good estimations of VaR and TVaR, which are important measures for risk management purposes. As side product of the work, we obtain a rather accurate numerical description of the density of such compound random variable. These approaches are also used to develop a procedure to determine the distribution of the individual losses from the knowledge of the total loss. Thus, if the only information available is the total loss, and the nature of the frequency of losses is known, the method of maximum entropy provides an efficient method to determine the individual losses as well. (C) 2015 Elsevier B.V. All rights reserved.