Improving risk classification and ratemaking using mixture‐of‐experts models with random effects

Abstract

AbstractIn the underwriting and pricing of nonlife insurance products, it is essential for the insurer to utilize both policyholder information and claim history to ensure profitability and proper risk management. In this paper, we apply a flexible regression model with random effects, called theMixed Logit‐weighted Reduced Mixture‐of‐Experts, which leverages both policyholder information and their claim history, to categorize policyholders into groups with similar risk profiles, and to determine a premium that accurately captures the unobserved risks. Estimates of model parameters and the posterior distribution of random effects can be obtained by a stochastic variational algorithm, which is numerically efficient and scalable to large insurance portfolios. Our proposed framework is shown to outperform the classical benchmark models (Logistic and Lognormal GL(M)M) in terms of goodness‐of‐fit to data, while offering intuitive and interpretable characterization of policyholders' risk profiles to adequately reflect their claim history.