Gerrard, R. J. G. & Tsanakas, A. (2010). Failure Probability Under Parameter Uncertainty. Risk Analysis, 31(5), pp. 727744. doi: 10.1111/j.15396924.2010.01549.x
Abstract
In many problems of risk analysis, failure is equivalent to the event of a random risk factor exceeding a given threshold. Failure probabilities can be controlled if a decisionmaker is able to set the threshold at an appropriate level. This abstract situation applies, for example, to environmental risks with infrastructure controls; to supply chain risks with inventory controls; and to insurance solvency risks with capital controls. However, uncertainty around the distribution of the risk factor implies that parameter error will be present and the measures taken to control failure probabilities may not be effective. We show that parameter uncertainty increases the probability (understood as expected frequency) of failures. For a large class of loss distributions, arising from increasing transformations of locationscale families (including the lognormal, Weibull, and Pareto distributions), the article shows that failure probabilities can be exactly calculated, as they are independent of the true (but unknown) parameters. Hence it is possible to obtain an explicit measure of the effect of parameter uncertainty on failure probability. Failure probability can be controlled in two different ways: (1) by reducing the nominal required failure probability, depending on the size of the available data set, and (2) by modifying of the distribution itself that is used to calculate the risk control. Approach (1) corresponds to a frequentist/regulatory view of probability, while approach (2) is consistent with a Bayesian/personalistic view. We furthermore show that the two approaches are consistent in achieving the required failure probability. Finally, we briefly discuss the effects of data pooling and its systemic risk implications.
Publication Type:  Article 

Additional Information:  This is the accepted version of the following article: Gerrard, R. and Tsanakas, A. (2011), Failure Probability Under Parameter Uncertainty. Risk Analysis, 31: 727–744. which has been published in final form at http://dx.doi.org/10.1111/j.15396924.2010.01549.x 
Publisher Keywords:  insurance; locationscale families; parameter uncertainty; solvency; value at risk 
Subjects:  H Social Sciences > HF Commerce 
Departments:  Bayes Business School > Actuarial Science & Insurance 
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