Local bias adjustment, duration-weighted probabilities, and automatic construction of tariff cells

Abstract

We study non-life insurance pricing and present a general procedure for constructing a distribution-free locally unbiased predictor of the risk premium based on any initially suggested predictor. The resulting predictor is piecewise constant, corresponding to a partition of the covariate space, and by construction auto-calibrated. Two key issues are the appropriate partitioning of the covariate space and the handling of randomly varying durations, acknowledging possible early termination of contracts. A basic idea in the present paper is to partition the predictions from the initial predictor, which as a by-product defines a partition of the covariate space. Two different approaches to create partitions are discussed in detail using (i) duration-weighted equal-probability binning, and (ii) binning by duration-weighted regression trees. Given a partitioning procedure, the size of the partition to be used is obtained using cross-validation. In this way we obtain an automatic data-driven tariffication procedure, where the number of tariff cells corresponds to the size of the partition. We illustrate the procedure based on both simulated and real insurance data, using both simple GLMs and GBMs as initial predictors. The resulting tariffs are shown to have a rather small number of tariff cells while maintaining or improving the predictive performance compared to the initial predictors.