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Variance and Covariance Due to Inflation David R. Clark Casualty Loss Reserve Seminar – September 2006 Agenda Statement of the Correlation Problem 3 Graphical Description of Inflation Applied to Loss Payout 5 The Mean-Reverting Random Walk Model 10 What Can Be Accomplished with this Model 15 Variance and Covariance Due to Inflation The Problem: We wish to estimate the covariance between two or more reserve segments. But… The development triangles themselves do not provide a sufficient basis for reliably estimating this covariance. Variance and Covariance Due to Inflation A Solution: From first principles, we begin by asking “why do we think that there should be covariance and not simple independence?” One reason for thinking this is that there are external forces, such as inflation, that will affect all of the reserve segments to greater or lesser degrees. Variance and Covariance Due to Inflation Variance and Covariance Due to Inflation Two observations as to how inflation should behave: There is more variability in the inflation index as the time horizon increases. There is an implicit correlation between payments. For example, if the ninth year is higher than average, then the tenth year should also be higher than average. Variance and Covariance Due to Inflation The actual inflation index could be higher or lower than expected, and each annual payment would move with the corresponding point on the index. Similarly, if there are two payout patterns, then the annual payment for each of the two patterns would move with the corresponding point on the index. Variance and Covariance Due to Inflation Variance and Covariance Due to Inflation We can start by thinking about this in a simulation context. We generate a set of simulated inflation projections and then adjust the payout patterns by each of those projections. So we must define a model from which to pull our simulated values. Variance and Covariance Due to Inflation For the inflation model, we will use