Assessing Risk Heterogeneity through Heavy-Tailed Frequency and Severity Mixtures

Abstract: In operational risk management and actuarial finance, the analysis of risk often begins by dividing a random damage-generation process into its separate frequency and severity components. In the present article, we construct canonical families of mixture distributions for each of these components, based on a Negative Binomial kernel for frequency and a Gamma kernel for severity. The mixtures are employed to assess the heterogeneity of risk factors underlying an empirical distribution through the shape of the implied mixing distribution. From the duality of the Negative Binomial and Gamma distributions, we first derive necessary and sufficient conditions for heavy-tailed (i.e., inverse power-law) canonical mixtures. We then formulate flexible 4-parameter families of mixing distributions for Geometric and Exponential kernels to generate heavy-tailed 4-parameter mixture models, and extend these mixtures to arbitrary Negative Binomial and Gamma kernels, respectively, yielding 5-parameter mixtures for detecting and measuring risk heterogeneity. To check the robustness of such heterogeneity inferences, we show how a fitted 5-parameter model may be re-expressed in terms of alternative Negative Binomial or Gamma kernels whose associated mixing distributions form a "calibrated" family.