An Introductory Guide in the Construction of Actuarial Models: A preparation for the Actuarial Exam C/4

(1)

Actuarial Models:

A Preparation for the Actuarial Exam C/4

Marcel B. Finan Arkansas Tech University

c

Last Updated April 14, 2013

(2)

(3)

This is the fifth of a series of lecture notes intended to help individuals to pass actuarial exams. The topics in this manuscript parallel the topics tested on Exam C of the Society of Actuaries exam sequence. As with the previous manuscripts, the main objective of the present manuscript is to increase users’ understanding of the topics covered on the exam.

The flow of topics follows very closely that of Klugman et al. Loss Models: From Data to Decisions. The lectures cover designated sections from this book as suggested by the 2012 SOA Syllabus.

The recommended approach for using this manuscript is to read each section, work on the embedded examples, and then try the problems. An answer key is provided at the end of the manuscript so that you check your numerical answers against the given ones.

Problems taken from previous SOA/CAS exams will be indicated by the symbol ‡.

This manuscript can be used for personal use or class use, but not for com-mercial purposes. If you find any errors, I would appreciate hearing from you: mfinan@atu.edu

Marcel B. Finan Russellville, Arkansas February 15, 2013.

(4)

(5)

Preface iii

Actuarial Modeling 1

1 Understanding Actuarial Models . . . 2

A Review of Probability Related Results 5 2 A Brief Review of Probability . . . 6

3 A Review of Random Variables . . . 17

4 Raw and Central Moments . . . 32

5 Empirical Models, Excess and Limited Loss variables. . . 43

6 Median, Mode, Percentiles, and Quantiles . . . 53

7 Sum of Random Variables and the Central Limit Theorem. . . . 59

8 Moment Generating Functions and Probability Generating Func-tions . . . 65

Tail Weight of a Distribution 75 9 Tail Weight Measures: Moments and the Speed of Decay of S(x) 76 10 Tail Weight Measures: Hazard Rate Function and Mean Excess Loss Function . . . 81

11 Equilibrium Distribtions and tail Weight . . . 88

Risk Measures 95 12 Coherent Risk Measurement . . . 96

13 Value-at-Risk . . . 100

14 Tail-Value-at-Risk . . . 104

Characteristics of Actuarial Models 109 15 Parametric and Scale Distributions . . . 110

16 Discrete Mixture Distributions. . . 115

17 Data-dependent Distributions . . . 120

(6)

19 Powers and Exponentiation of Random Variables . . . 129

20 Continuous Mixing of Distributions . . . 133

21 Frailty (Mixing) Models . . . 139

22 Spliced Distributions . . . 144

23 Limiting Distributions . . . 147

24 The Linear Exponential Family of Distributions . . . 151

Discrete Distributions 155 25 The Poisson Distribution . . . 156

26 The Negative Binomial Distribution. . . 161

27 The Bernoulli and Binomial Distributions . . . 165

28 The (a, b, 0) Class of Discrete Distributions. . . 171

29 The Class C(a, b, 1) of Discrete Distributions. . . 176

30 The Extended Truncated Negative Binomial Model . . . 181

Modifications of the Loss Random Variable 185 31 Ordinary Policy Deductibles . . . 186

32 Franchise Policy Deductibles . . . 192

33 The Loss Elimination Ratio and Inflation Effects for Ordinary Deductibles . . . 197

34 Policy Limits . . . 203

35 Combinations of Coinsurance, Deductibles, Limits, and Inflations207 36 The Impact of Deductibles on the Number of Payments . . . . 213

Aggregate Loss Models 219 37 Individual Risk and Collective Risk Models . . . 220

38 Aggregate Loss Distributions via Convolutions. . . 223

39 Stop Loss Insurance. . . 230

40 Closed Form of Aggregate Distributions . . . 234

41 Distribution of S via the Recursive Method . . . 240

42 Discretization of Continuous Severities . . . 245

43 Individual Policy Modifications Impact on Aggregate Losses . . 251

44 Aggregate Losses for the Individual Risk Model . . . 257

45 Approximating Probabilities in the Individual Risk Model . . . 261

Review of Mathematical Statistics 265 46 Properties of Point Estimators . . . 266

47 Interval Estimation . . . 273

(7)

The Empirical Distribution for Complete Data 285 49 The Empirical Distribution for Individual Data . . . 286 50 Empirical Distribution of Grouped Data . . . 291

Estimation of Incomplete Data 297

51 The Risk Set of Incomplete Data . . . 298 52 The Kaplan-Meier and Nelson-˚Aalen Estimators. . . 303 53 Mean and Variance of Empirical Estimators with Complete Data309 54 Greenwood Estimate for the Variance of the Kaplan-Meier

Es-timator . . . 315 55 Variance Estimate of the Nelson-˚Aalen Estimator and

Confi-dence Intervals . . . 321 56 Kernel Density Estimation . . . 325 57 The Kaplan-Meier Approximation for Large Data Sets . . . 330

BIBLIOGRAPHY 338

Index 340

(8)

This books is concerend with the construction and evaluation of actuarial models. The purpose of this chapter is to define models in the actuarial setting and suggest a process of building them.

(9)

1 Understanding Actuarial Models

Modeling is very common in actuarial applications. For example, life in-surance actuaries use models to arrive at the likely mortality rates of their customers; car insurance actuaries use models to work out claim probabil-ities by rating factors; pension fund actuaries use models to estimate the contributions and investments they will need to meet their future liabilities. A “model” in actuarial applications is a simplified mathematical descrip-tion of a certain actuarial task. Actuarial models are used by actuaries to form an opinion and recommend a course of action on contingencies relating to uncertain future events.

Commonly used actuarial models are classified into two categories:

(I) Deterministic Models. These are models that produce a unique set of outputs for a given set of inputs such as the future value of a deposit in a savings account. In these models, the inputs and outputs don’t have associated probability weightings.

(II) Stochastic or Probabilistic Models. In contrast to deterministic models, these are models where the outputs or/and some of the inputs are random variables. Examples of stochastic models that we will discuss in this book are the asset model, the claims model, and the frequency-severity model.

The book in [4] explains in enormous detail the advantages and disadvan-tages of stochastic (versus deterministic) modeling.

Example 1.1

Determine whether each of the model below is deterministic or stochastic. (a) The monthly payment P on a home or a car loan.

(b) A modification of the model in (a) is P + ξ, where ξ is a random variable introduced to account for the possibility of failure of making a payment.

Solution.

(a) In this model, the element of randomness is absent. This model is a deterministic one.

(b) Because of the presence of the random variable ξ, the given model is stochastic

(10)

In [1], the following process for building an actuarial model is presented. Phases of a Good Modeling Process

A good modeling requires a thorough understanding of the problem mod-elled. The following is a helpful checklist of a modeling process which is by no means complete:

Choice of Models. Appropriate models are selected based on the actuary’s prior knowledge and experience and the nature of the available data.

Model Calibration. Available data and existing techniques are used to cali-brate a model.

Model Validation. Diagnostic tests are used to ensure the model meets its objectives and adequately conforms to the data.

Adequacy of Models. There is a possibility that the models in the previ-ous stage are inadequate in which case one considers other possible models. Also, there is a possibility of having more than one adequate models.

Selection of Models. Based on some preset criteria, the best model will be selected among all valid models.

Modification of Models. The model selected in the previous stage needs to be constantly updated in the light of new future data and other changes.

(11)

Practice Problems

Problem 1.1

After an actuary being hired, his or her annual salary progression is modeled according to the formula S(t) = $45, 000e0.06t_{, where t is the number of years}

of employment. Determine whether this model is deterministic or stochastic.

Problem 1.2

In the previous model, a random variable ξ is introduced: S(t) = $45, 000e0.06t₊

ξ. Determine whether this model is deterministic or stochastic.

Problem 1.3

Consider a model that depends on the movement of a stock market such as the pricing of an option with an underlying stock. Does this model considered a deterministic or stochastic model?

Problem 1.4

Consider a model that involves the life expectancy of a policy holder. Is this model categorized as stochastic or deterministic?

Problem 1.5

Insurance companies use models to estimate their assets and liabilities. Are these models considered deterministic or stochastic?

(12)

Related Results

One aspect of insurance is that money is paid to policy holders upon the occurrence of a random event. For example, a claim in an automobile in-surance policy will be filed whenever the insured auto is involved in a car wreck. In this chapter a brief outline of the essential material from the the-ory of probability is given. Almost all of the material presented here should be familiar to the reader. A more thorough discussion can be found in [2] and a listing of important results can be found in [3]. Probability concepts that are not usually covered in an introductory probability course will be introduced and discussed in futher details whenever needed.

(13)

2 A Brief Review of Probability

In probability, we consider experiments whose results cannot be predicted with certainty. Examples of such experiments include rolling a die, flipping a coin, and choosing a card from a deck of playing cards.

By an outcome or simple event we mean any result of the experiment. For example, the experiment of rolling a die yields six outcomes, namely, the outcomes 1,2,3,4,5, and 6.

The sample space Ω of an experiment is the set of all possible outcomes for the experiment. For example, if you roll a die one time then the experiment is the roll of the die. A sample space for this experiment could be Ω = {1, 2, 3, 4, 5, 6} where each digit represents a face of the die.

An event is a subset of the sample space. For example, the event of rolling an odd number with a die consists of three simple events {1, 3, 5}.

Example 2.1

Consider the random experiment of tossing a coin three times. (a) Find the sample space of this experiment.

(b) Find the outcomes of the event of obtaining more than one head.

Solution.

We will use T for tail and H for head.

(a) The sample space is composed of eight simple events:

Ω = {T T T, T T H, T HT, T HH, HT T, HT H, HHT, HHH}.

(b) The event of obtaining more than one head is the set

{T HH, HT H, HHT, HHH}

The complement of an event E, denoted by Ec, is the set of all possible outcomes not in E. The union of two events A and B is the event A ∪ B whose outcomes are either in A or in B. The intersection of two events A and B is the event A ∩ B whose outcomes are outcomes of both events A and B. Two events A and B are said to be mutually exclusive if they have no outcomes in common. Clearly, for any event E, the events E and Ecare mutually exclusive.

Remark 2.1

The above definitions of intersection, union, and mutually exclusive can be extended to any number of events.

(14)

Probability Axioms

Probability is the measure of occurrence of an event. It is a function Pr(·) defined on the collection of all (subsets) events of a sample space Ω and which satisfies Kolmogorov axioms:

Axiom 1: For any event E ⊆ Ω, 0 ≤ Pr(E) ≤ 1. Axiom 2: Pr(Ω) = 1.

Axiom 3: For any sequence of mutually exclusive events {En}n≥1, that is

Ei∩ Ej = ∅ for i 6= j, we have

Pr (∪∞_n=1En) =P∞n=1Pr(En). (Countable Additivity)

If we let E1 = Ω, En = ∅ for n > 1 then by Axioms 2 and 3 we have

1 = Pr(Ω) = Pr (∪∞_n=1En) = P∞n=1Pr(En) = Pr(Ω) +P∞n=2Pr(∅). This

implies that Pr(∅) = 0. Also, if {E1, E2, · · · , En} is a finite set of mutually

exclusive events, then by defining Ek= ∅ for k > n and Axioms 3 we find

Pr (∪n_k=1Ek) = n

X

k=1

Pr(Ek).

Any function Pr that satisfies Axioms 1-3 will be called a probability mea-sure.

Example 2.2

Consider the sample space Ω = {1, 2, 3}. Suppose that Pr({1, 3}) = 0.3 and Pr({2, 3}) = 0.8. Find Pr(1), Pr(2), and Pr(3). Is Pr a valid probability measure?

Solution.

For Pr to be a probability measure we must have Pr(1) + Pr(2) + Pr(3) = 1. But Pr({1, 3}) = Pr(1) + Pr(3) = 0.3. This implies that 0.3 + Pr(2) = 1 or Pr(2) = 0.7. Similarly, 1 = Pr({2, 3}) + Pr(1) = 0.8 + Pr(1) and so Pr(1) = 0.2. It follows that Pr(3) = 1 − Pr(1) − Pr(2) = 1 − 0.2 − 0.7 = 0.1. It can be easily seen that Pr satisfies Axioms 1-3 and so Pr is a probability measure

Probability Trees

For all multistage experiments, the probability of the outcome along any path of a tree diagram is equal to the product of all the probabilities along the path.

Example 2.3

(15)

male. 70% of the male favor raising city sales tax, while only 40% of the female favor the increase. If a member of the council is selected at random, what is the probability that he or she favors raising sales tax?

Solution.

Figure 2.1 shows a tree diagram for this problem.

Figure 2.1

The first and third branches correspond to favoring the tax. We add their probabilities.

Pr(tax) = 0.455 + 0.14 = 0.595 Conditional Probability and Bayes Formula

Consider the question of finding the probability of an event A given that another event B has occurred. Knowing that the event B has occurred causes us to update the probabilities of other events in the sample space. To illustrate, suppose you roll two dice of different colors; one red, and one green. You roll each die one at time. Our sample space has 36 outcomes. The probability of getting two ones is ₃₆1. Now, suppose you were told that the green die shows a one but know nothing about the red die. What would be the probability of getting two ones? In this case, the answer is 1₆. This shows that the probability of getting two ones changes if you have partial information, and we refer to this (altered) probability as a conditional probability.

If the occurrence of the event A depends on the occurrence of B then the conditional probability will be denoted by P (A|B), read as the probability of A given B. It is given by

Pr(A|B) = number of outcomes corresponding to event A and B number of outcomes of B .

(16)

Thus, Pr(A|B) = n(A ∩ B) n(B) = n(A∩B) n(S) n(B) n(S) = Pr(A ∩ B) Pr(B) provided that Pr(B) > 0. Example 2.4

Let A denote the event “an immigrant is male” and let B denote the event “an immigrant is Brazilian”. In a group of 100 immigrants, suppose 60 are Brazilians, and suppose that 10 of the Brazilians are males. Find the probability that if I pick a Brazilian immigrant, it will be a male, that is, find Pr(A|B).

Solution.

Since 10 out of 100 in the group are both Brazilians and male, Pr(A ∩ B) =

10

100 = 0.1. Also, 60 out of the 100 are Brazilians, so Pr(B) = 60

100 = 0.6.

Hence, Pr(A|B) = 0.1_0.6 = 1₆

It is often the case that we know the probabilities of certain events con-ditional on other events, but what we would like to know is the “reverse”. That is, given Pr(A|B) we would like to find Pr(B|A).

Bayes’ formula is a simple mathematical formula used for calculating Pr(B|A) given Pr(A|B). We derive this formula as follows. Let A and B be two events. Then

A = A ∩ (B ∪ Bc) = (A ∩ B) ∪ (A ∩ Bc).

Since the events A ∩ B and A ∩ Bcare mutually exclusive, we can write

Pr(A) = Pr(A ∩ B) + Pr(A ∩ Bc)

= Pr(A|B)Pr(B) + Pr(A|Bc)Pr(Bc) (2.1)

Example 2.5

A soccer match may be delayed because of bad weather. The probabilities are 0.60 that there will be bad weather, 0.85 that the game will take place if there is no bad weather, and 0.35 that the game will be played if there is bad weather. What is the probability that the match will occur?

Solution.

(17)

there will be a bad weather. We are given Pr(B) = 0.60, Pr(A|Bc) = 0.85, and Pr(A|B) = 0.35. From Equation (2.1) we find

Pr(A) = Pr(B)Pr(A|B)+Pr(Bc)Pr(A|Bc) = (0.60)(0.35)+(0.4)(0.85) = 0.55

From Equation (2.1) we can get Bayes’ formula:

Pr(B|A) = Pr(A ∩ B) Pr(A) =

Pr(A|B)Pr(B)

Pr(A|B)Pr(B) + Pr(A|Bc_)Pr(Bc₎. (2.2)

Example 2.6

A factory uses two machines A and B for making socks. Machine A produces 10% of the total production of socks while machine B produces the remaining 90%. Now, 1% of all the socks produced by A are defective while 5% of all the socks produced by B are defective. Find the probability that a sock taken at random from a day’s production was made by the machine A, given that it is defective?

Solution.

We are given Pr(A) = 0.1, Pr(B) = 0.9, Pr(D|A) = 0.01, and Pr(D|B) = 0.05. We want to find Pr(A|D). Using Bayes’ formula we find

Pr(A|D) =Pr(A ∩ D) Pr(D) = Pr(D|A)Pr(A) Pr(D|A)Pr(A) + Pr(D|B)Pr(B) = (0.01)(0.1) (0.01)(0.1) + (0.05)(0.9) ≈ 0.0217

Formula2.2is a special case of the more general result:

Theorem 2.1 (Bayes’ Theorem)

Suppose that the sample space S is the union of mutually exclusive events H1, H2, · · · , Hn with P (Hi) > 0 for each i. Then for any event A and 1 ≤

i ≤ n we have

Pr(Hi|A) =

Pr(A|Hi)Pr(Hi)

Pr(A) where

Pr(A) = Pr(H1)Pr(A|H1) + Pr(H2)Pr(A|H2) + · · · + Pr(Hn)Pr(A|Hn).

Example 2.7

A survey is taken in Oklahoma, Kansas, and Arkansas. In Oklahoma, 50% of surveyed support raising tax, in Kansas, 60% support a tax increase, and

(18)

in Arkansas only 35% favor the increase. Of the total population of the three states, 40% live in Oklahoma, 25% live in Kansas, and 35% live in Arkansas. Given that a surveyed person is in favor of raising taxes, what is the probability that he/she lives in Kansas?

Solution.

Let LI denote the event that a surveyed person lives in state I, where I

= OK, KS, AR. Let S denote the event that a surveyed person favors tax increase. We want to find Pr(LKS|S). By Bayes’ formula we have

Pr(LKS|S) =

Pr(S|LKS)Pr(LKS)

Pr(S|LOK)Pr(LOK) + Pr(S|LKS)Pr(LKS) + Pr(S|LAR)Pr(LAR)

= (0.6)(0.25)

(19)

Practice Problems

Problem 2.1

Consider the sample space of rolling a die. Let A be the event of rolling an even number, B the event of rolling an odd number, and C the event of rolling a 2. Find

(a) Ac, Bc and Cc.

(b) A ∪ B, A ∪ C, and B ∪ C. (c) A ∩ B, A ∩ C, and B ∩ C.

(d) Which events are mutually exclusive?

Problem 2.2

If, for a given experiment, O1, O2, O3, · · · is an infinite sequence of outcomes,

verify that Pr(Oi) = 1 2 i , i = 1, 2, 3, · · · is a probability measure. Problem 2.3 ‡

An insurer offers a health plan to the employees of a large company. As part of this plan, the individual employees may choose exactly two of the supplementary coverages A, B, and C, or they may choose no supplementary coverage. The proportions of the company’s employees that choose coverages A, B, and C are 1₄,1₃, and ,₁₂5 respectively.

Determine the probability that a randomly chosen employee will choose no supplementary coverage.

Problem 2.4

A toll has two crossing lanes. Let A be the event that the first lane is busy, and let B be the event the second lane is busy. Assume that Pr(A) = 0.2, Pr(B) = 0.3 and Pr(A∩B) = 0.06. Find the probability that both lanes are not busy. Hint: Recall the identity

Pr(A ∪ B) = Pr(A) + Pr(B) − Pr(A ∩ B).

Problem 2.5

If a person visits a car service center, suppose that the probability that he will have his oil changed is 0.44, the probability that he will have a tire replacement is 0.24, the probability that he will have airfilter replacement is 0.21, the probability that he will have oil changed and a tire replaced is

(20)

0.08, the probability that he will have oil changed and air filter changed is 0.11, the probability that he will have a tire and air filter replaced is 0.07, and the probability that he will have oil changed, a tire replacement, and an air filter changed is 0.03. What is the probability that at least one of these things done to the car? Recall that

Pr(A∪B∪C) = Pr(A)+Pr(B)+Pr(C)−Pr(A∩B)−Pr(A∩C)−Pr(B∩C)+Pr(A∩B∩C)

Problem 2.6 ‡

A survey of a group’s viewing habits over the last year revealed the following information

(i) 28% watched gymnastics (ii) 29% watched baseball (iii) 19% watched soccer

(iv) 14% watched gymnastics and baseball (v) 12% watched baseball and soccer (vi) 10% watched gymnastics and soccer (vii) 8% watched all three sports.

Find the probability of a viewer that watched none of the three sports during the last year.

Problem 2.7 ‡

The probability that a visit to a primary care physician’s (PCP) office results in neither lab work nor referral to a specialist is 35% . Of those coming to a PCP’s office, 30% are referred to specialists and 40% require lab work. Determine the probability that a visit to a PCP’s office results in both lab work and referral to a specialist.

Problem 2.8 ‡

You are given Pr(A ∪ B) = 0.7 and Pr(A ∪ Bc) = 0.9. Determine Pr(A).

Problem 2.9 ‡

Among a large group of patients recovering from shoulder injuries, it is found that 22% visit both a physical therapist and a chiropractor, whereas 12% visit neither of these. The probability that a patient visits a chiropractor exceeds by 14% the probability that a patient visits a physical therapist. Determine the probability that a randomly chosen member of this group visits a physical therapist.

(21)

Problem 2.10 ‡

In modeling the number of claims filed by an individual under an auto-mobile policy during a three-year period, an actuary makes the simplifying assumption that for all integers n ≥ 0, pn+1= 1₅pn, where pn represents the

probability that the policyholder files n claims during the period.

Under this assumption, what is the probability that a policyholder files more than one claim during the period?

Problem 2.11

An urn contains three red balls and two blue balls. You draw two balls without replacement. Construct a probability tree diagram that represents the various outcomes that can occur. What is the probability that the first ball is red and the second ball is blue?

Problem 2.12

Repeat the previous exercise but this time replace the first ball before draw-ing the second.

Problem 2.13 ‡

A public health researcher examines the medical records of a group of 937 men who died in 1999 and discovers that 210 of the men died from causes related to heart disease. Moreover, 312 of the 937 men had at least one parent who suffered from heart disease, and, of these 312 men, 102 died from causes related to heart disease.

Determine the probability that a man randomly selected from this group died of causes related to heart disease, given that neither of his parents suffered from heart disease.

Problem 2.14 ‡

An actuary is studying the prevalence of three health risk factors, denoted by A, B, and C, within a population of women. For each of the three factors, the probability is 0.1 that a woman in the population has only this risk factor (and no others). For any two of the three factors, the probability is 0.12 that she has exactly these two risk factors (but not the other). The probability that a woman has all three risk factors, given that she has A and B, is 1₃. What is the probability that a woman has none of the three risk factors, given that she does not have risk factor A?

Problem 2.15 ‡

An auto insurance company insures drivers of all ages. An actuary compiled the following statistics on the company’s insured drivers:

(22)

Age of Probability Portion of Company’s Driver of Accident Insured Drivers 16 - 20 0.06 0.08

21 - 30 0.03 0.15 31 - 65 0.02 0.49 66 - 99 0.04 0.28

A randomly selected driver that the company insures has an accident. Cal-culate the probability that the driver was age 16-20.

Problem 2.16 ‡

An insurance company issues life insurance policies in three separate cate-gories: standard, preferred, and ultra-preferred. Of the company’s policy-holders, 50% are standard, 40% are preferred, and 10% are ultra-preferred. Each standard policyholder has probability 0.010 of dying in the next year, each preferred policyholder has probability 0.005 of dying in the next year, and each ultra-preferred policyholder has probability 0.001 of dying in the next year.

A policyholder dies in the next year. What is the probability that the de-ceased policyholder was ultra-preferred?

Problem 2.17 ‡

Upon arrival at a hospital’s emergency room, patients are categorized ac-cording to their condition as critical, serious, or stable. In the past year:

(i) 10% of the emergency room patients were critical; (ii) 30% of the emergency room patients were serious; (iii) the rest of the emergency room patients were stable; (iv) 40% of the critical patients died;

(vi) 10% of the serious patients died; and (vii) 1% of the stable patients died.

Given that a patient survived, what is the probability that the patient was categorized as serious upon arrival?

Problem 2.18 ‡

A health study tracked a group of persons for five years. At the beginning of the study, 20% were classified as heavy smokers, 30% as light smokers, and 50% as nonsmokers.

Results of the study showed that light smokers were twice as likely as non-smokers to die during the five-year study, but only half as likely as heavy smokers.

(23)

A randomly selected participant from the study died over the five-year pe-riod. Calculate the probability that the participant was a heavy smoker.

Problem 2.19 ‡

An actuary studied the likelihood that different types of drivers would be involved in at least one collision during any one-year period. The results of the study are presented below.

Probability Type of Percentage of of at least one driver all drivers collision

Teen 8% 0.15

Young adult 16% 0.08 Midlife 45% 0.04 Senior 31% 0.05 Total 100%

Given that a driver has been involved in at least one collision in the past year, what is the probability that the driver is a young adult driver?

Problem 2.20 ‡

A blood test indicates the presence of a particular disease 95% of the time when the disease is actually present. The same test indicates the presence of the disease 0.5% of the time when the disease is not present. One percent of the population actually has the disease.

Calculate the probability that a person has the disease given that the test indicates the presence of the disease.

(24)

3 A Review of Random Variables

Let Ω be the sample space of an experiment. Any function X : Ω −→ R is called a random variable with support the range of X. The function notation X(s) = x means that the random variable X assigns the value x to the outcome s.

We consider three types of random variables: Discrete, continuous, and mixed random variables.

A random variable is called discrete if either its support is finite or a countably infinite. For example, in the experiment of rolling two dice, let X be the random variable that adds the two faces. The support of X is the finite set {2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12}. An example of an infinite discrete random variable is the random variable that counts the number of times you play a lottery until you win. For such a random variable, the support is the set N.

A random variable is called continuous if its support is uncountable. An example of a continuous random variable is the random variable X that gives a randomnly chosen number between 2 and 3 inclusively. For such a random variable the support is the interval [2, 3].

A mixed random variable is partly discrete and partly continuous. An example of a mixed random variable is the random variable X : (0, 1) −→ R defined by X(s) = 1 − s, 0 < s < 1₂ 1 2, 1 2 ≤ s < 1.

We use upper-case letters X, Y, Z, etc. to represent random variables. We use small letters x, y, z, etc to represent possible values that the correspond-ing random variables X, Y, Z, etc. can take. The statement X = x defines an event consisting of all outcomes with X−measurement equal to x which is the set {s ∈ Ω : X(s) = x}.

Example 3.1

State whether the random variables are discrete, continuous, or mixed. (a) A coin is tossed ten times. The random variable X is the number of heads that are noted.

(b) A coin is tossed repeatedly. The random variable X is the number of times needed to get the first head.

(c) X : (0, 1) −→ R defined by X(s) = 2s − 1.

(d) X : (0, 1) −→ R defined by X(s) = 2s − 1 for 0 < s < 12 and X(s) = 1

(25)

Solution.

(a) The support of X is {1, 2, 3, · · · , 10}. X is an example of a finite discrete random variable.

(b) The support of X is N. X is an example of a countably infinite discrete random variable.

(c) The support of X is the open interval (−1, 1). X is an example of a continuous random variable.

(d) X is continuous on (0,1₂) and discrete on [1₂, 1)

Because the value of a random variable is determined by the outcome of the experiment, we can find the probability that the random variable takes on each value. The notation Pr(X = x) stands for the probability of the event {s ∈ Ω : X(s) = x}.

There are five key functions used in describing a random variable:

Probability Mass Function (PMF)

For a discrete random variable X, the distribution of X is described by the probability distribution or the probability mass function given by the equation

p(x) = Pr(X = x).

That is, a probability mass function (pmf) gives the probability that a dis-crete random variable is exactly equal to some value. The pmf can be an equation, a table, or a graph that shows how probability is assigned to pos-sible values of the random variable.

Example 3.2

Suppose a variable X can take the values 1, 2, 3, or 4. The probabilities associated with each outcome are described by the following table:

x 1 2 3 4

p(x) 0.1 0.3 0.4 0.2

Draw the probability histogram.

Solution.

(26)

Figure 3.1

Example 3.3

A committee of m is to be selected from a group consisting of x men and y women. Let X be the random variable that represents the number of men in the committee. Find p(n) for 0 ≤ n ≤ m.

Solution. For 0 ≤ n ≤ m, we have p(n) = x n y m − n x + y m

Note that if the support of a random variable is Support = {x1, x2, · · · }

then p(x) ≥ 0, x ∈ Support p(x) = 0, x 6∈ Support Moreover, X x∈Support p(x) = 1.

Probability Density Function

(27)

f (not necessarily continuous) defined for all real numbers and having the property that for any set B of real numbers we have

Pr(X ∈ B) = Z

B

f (x)dx.

We call the function f the probability density function (abbreviated pdf) of the random variable X.

If we let B = (−∞, ∞) = R then Z ∞

−∞

f (x)dx = Pr[X ∈ (−∞, ∞)] = 1.

Now, if we let B = [a, b] then

Pr(a ≤ X ≤ b) = Z b

a

f (x)dx.

That is, areas under the probability density function represent probabilities as illustrated in Figure 3.2.

Figure 3.2

Now, if we let a = b in the previous formula we find

Pr(X = a) = Z a

a

f (x)dx = 0.

It follows from this result that

Pr(a ≤ X < b) = Pr(a < X ≤ b) = Pr(a < X < b) = Pr(a ≤ X ≤ b)

and

(28)

Example 3.4

Suppose that the function f (t) defined below is the density function of some random variable X. f (t) = e−t t ≥ 0, 0 t < 0. Compute P (−10 ≤ X ≤ 10). Solution. P (−10 ≤ X ≤ 10) = Z 10 −10 f (t)dt = Z 0 −10 f (t)dt + Z 10 0 f (t)dt = Z 10 0 e−tdt = −e−t 10 0 = 1 − e −10

Cumulative Distribution Function

The cumulative distribution function (abbreviated cdf) F (t) of a ran-dom variable X is defined as follows

F (t) = Pr(X ≤ t)

i.e., F (t) is equal to the probability that the variable X assumes values, which are less than or equal to t.

For a discrete random variable, the cumulative distribution function is found by summing up the probabilities. That is,

F (t) = Pr(X ≤ t) =X

x≤t

p(x).

Example 3.5

Given the following pmf

p(x) =

1, if x = a 0, otherwise.

Find a formula for F (x) and sketch its graph.

Solution.

A formula for F (x) is given by

F (x) =

0, if x < a 1, otherwise

(29)

Its graph is given in Figure 3.3

Figure 3.3

For discrete random variables the cumulative distribution function will al-ways be a step function with jumps at each value of x that has probability greater than 0. Note that the value of F (x) is assigned to the top of the jump.

For a continuous random variable, the cumulative distribution function is given by

F (t) = Z t

−∞

f (y)dy.

Geometrically, F (t) is the area under the graph of f to the left of t.

Example 3.6

Find the distribution functions corresponding to the following density func-tions: (a)f (x) = 1 π(1 + x2₎, −∞ < x < ∞. (b)f (x) = e −x (1 + e−x₎2, −∞ < x < ∞. Solution. (a) F (x) = Z x −∞ 1 π(1 + y2₎dy = 1 π arctan y x −∞ =1 πarctan x − 1 π · −π 2 = 1 πarctan x + 1 2.

(30)

(b) F (x) = Z x −∞ e−y (1 + e−y)2dy = 1 1 + e−y x −∞ = 1 1 + e−x

Next, we list the properties of the cumulative distribution function F (x) for any random variable X.

Theorem 3.1

The cumulative distribution function of a random variable X satisfies the following properties:

(a) 0 ≤ F (x) ≤ 1.

(b) F (x) is a non-decreasing function, i.e. if a < b then F (a) ≤ F (b). (c) F (x) → 0 as x → −∞ and F (x) → 1 as x → ∞.

(d) F is right-continuous.

In addition to the above properties, a continuous random variable satisfies these properties:

(e) F0(x) = f (x). (f) F (x) is continuous.

For a discrete random variable with support {x1, x2, · · · , } we have

p(xi) = F (xi) − F (xi−1). (3.1)

Example 3.7

If the distribution function of X is given by

F (x) =                0 x < 0 1 16 0 ≤ x < 1 5 16 1 ≤ x < 2 11 16 2 ≤ x < 3 15 16 3 ≤ x < 4 1 x ≥ 4 find the pmf of X. Solution.

(31)

0 otherwise

The Survival Distribution Function of X

The survival function (abbreviated SDF), also known as a reliability function is a property of any random variable that maps a set of events, usually associated with mortality or failure of some system, onto time. It captures the probability that the system will survive beyond a specified time. Thus, we define the survival distribution function by

S(x) = Pr(X > x) = 1 − F (x).

It follows from Theorem 3.1, that any random variable satisfies the prop-erties: S(−∞) = 1, S(∞) = 0, S(x) is right-continuous, and that S(x) is nonincreasing.

For a discrete random variable, the survival function is given by

S(x) =X

t>x

p(t)

and for a continuous random variable, we have

S(x) = Z ∞ x f (t)dt. Note that S0(t) = −f (t). Remark 3.1

For a discrete random variable, the survival function need not be left-continuous, that is, it is possible for its graph to jump down. When it jumps, the value is assigned to the bottom of the jump.

Example 3.8

Consider an age-at-death random variable X with survival distribution de-fined by

S(x) =

_75−x

75 , 0 ≤ x ≤ 75

0, x > 75.

(a) Find the probability that the person dies before reaching the age of 18. (b) Find the probability that the person lives more than 55 years.

(c) Find the probability that the person dies between the ages of 25 and 70.

Solution. (a) We have

(32)

(b) We have

Pr(X > 55) = S(55) = 0.267. (c) We have

Pr(25 < X < 70) = F (70) − F (25) = S(25) − S(70) = 0.60

The Hazard Rate Function

The hazard rate function, also known as the force of mortality or the failue rate function, is defined to be the ratio of the density and the survival functions: h(x) = hX(x) = f (x) S(x) = f (x) 1 − F (x). Example 3.9 Show that h(x) = −S 0_(x) S(x) = − d dx[ln S(x)]. (3.2) Solution.

The equation follows from f (x) = −S0(x) and _dxd[ln S(x)] = S_S(x)0(x)

Example 3.10

Find the hazard rate function of a random variable with pdf given by f (x) = e−ax, a > 0. Solution. We have h(x) = f (x) S(x) = ae−ax e−ax = a Example 3.11

Let X be a random variable with support [0, ∞). Show that

S(x) = e−Λ(x) where Λ(x) = Z x 0 h(s)ds.

(33)

Solution.

Integrating equation (3.2) from 0 to x, we have

Z x 0 h(s)ds = − Z x 0 d ds[ln S(s)]ds = ln S(0)−ln S(x) = ln 1−ln S(x) = − ln S(x).

Now the result follows upon exponentiation

Some Additional Results

For a given event A, we define the indicator of A by

IA(x) =

1, x ∈ A 0, x 6∈ A.

Let X and Y be two random variables. It is proven in advanced probability theory that the conditional expectation E(X|Y ) is given by the formula

E(X|Y ) = E(XIY) Pr(Y ) .

Example 3.12

Let X and Y be two random variables. Find a formula of E[(X − d)k|X > d] in the

(a) discrete case (b) continuous case. Solution. (a) We have E[(X − d)k|X > d] = P xj>d(x − d) k_p(x j) Pr(X > d) . (b) We have E[(X − d)k|X > d] = 1 Pr(X > d) Z ∞ d (x − d)kfX(x)dx

If Ω = A ∪ B then for any random variable X on ω, we have by the double expectation property1

E(X) = E(X|A)Pr(A) + E(X|B)Pr(B).

(34)

Probabilities can be found by conditioning:

Pr(A) =X

y

Pr(A|Y = y)Pr(Y = y)

in the discrete case and

Pr(A) = Z ∞

−∞

Pr(A|Y = y)fY(y)dy

(35)

Practice Problems

Problem 3.1

State whether the random variables are discrete, continuous, or mixed. (a) In two tossing of a coin, let X be the number of heads in the two tosses. (b) An urn contains one red ball and one green ball. Let X be the number of picks necessary in getting the first red ball. (c) X is a random number in the interval [4, 7].

(d) X : R −→ R such that X(s) = s if s is irrational and X(s) = 1 if s is rational.

Problem 3.2

Toss a pair of fair dice. Let X denote the sum of the dots on the two faces. Find the probability mass function.

Problem 3.3

Consider the random variable X : {S, F } −→ R defined by X(S) = 1 and X(F ) = 0. Suppose that p = Pr(X = 1). Find the probability mass function of X.

Problem 3.4 ‡

The loss due to a fire in a commercial building is modeled by a random variable X with density function

f (x) =

0.005(20 − x) 0 < x < 20 0 otherwise.

Given that a fire loss exceeds 8, what is the probability that it exceeds 16 ?

Problem 3.5 ‡

The lifetime of a machine part has a continuous distribution on the interval (0, 40) with probability density function f, where f (x) is proportional to (10 + x)−2.

Calculate the probability that the lifetime of the machine part is less than 6.

Problem 3.6 ‡

A group insurance policy covers the medical claims of the employees of a small company. The value, V, of the claims made in one year is described by

(36)

where Y is a random variable with density function f (x) = k(1 − y)4 _{0 < y < 1} 0 otherwise where k is a constant.

What is the conditional probability that V exceeds 40,000, given that V exceeds 10,000?

Problem 3.7 ‡

An insurance policy pays for a random loss X subject to a deductible of C, where 0 < C < 1. The loss amount is modeled as a continuous random variable with density function

f (x) =

2x 0 < x < 1 0 otherwise.

Given a random loss X, the probability that the insurance payment is less than 0.5 is equal to 0.64 . Calculate C.

Problem 3.8

Let X be a continuous random variable with pdf

f (x) =

αxe−x, x > 0 0, x ≤ 0.

Determine the value of α.

Problem 3.9

Consider the following probability distribution

x 1 2 3 4

p(x) 0.25 0.5 0.125 0.125

Find a formula for F (x) and sketch its graph.

Problem 3.10

Find the distribution functions corresponding to the following density func-tions:

(a)f (x) = a − 1

(1 + x)a, 0 < x < ∞, 0 otherwise.

(37)

Problem 3.11

Let X be a random variable with pmf

p(n) = 1 3 2 3 n , n = 0, 1, 2, · · · .

Find a formula for F (n).

Problem 3.12

Given the pdf of a continuous random variable X.

f (x) = ₁ 5e −x₅ _{if x ≥ 0} 0 otherwise. (a) Find Pr(X > 10). (b) Find Pr(5 < X < 10). (c) Find F (x). Problem 3.13

A random variable X has the cumulative distribution function

F (x) = e

x

ex_{+ 1}.

Find the probability density function.

Problem 3.14

S(x) = 1

10(100 − x)

1

2, 0 ≤ x ≤ 100.

(a) Explain why this is a suitable survival function.

(b) Find the corresponding expression for the cumulative probability func-tion.

(c) Compute the probability that a newborn with survival function defined above will die between the ages of 65 and 75.

Problem 3.15

S(x) = e−0.34x, x ≥ 0. Compute Pr(5 < X < 10).

(38)

Problem 3.16

Consider an age-at-death random variable X with survival distribution S(x) = 1 −₁₀₀x2 for x ≥ 0. Find F (x).

Problem 3.17

Consider an age-at-death random variable X. The survival distribution is given by S(x) = 1 − ₁₀₀x for 0 ≤ x ≤ 100 and 0 for x > 100.

(a) Find the probability that a person dies before reaching the age of 30. (b) Find the probability that a person lives more than 70 years.

Problem 3.18

An age-at-death random variable has a survival function

S(x) = 1

10(100 − x)

1

2, 0 ≤ x ≤ 100.

Find the hazard rate function of this random variable.

Problem 3.19

Consider an age-at-death random variable X with force of mortality h(x) = µ > 0. Find S(x), f (x), and F (x). Problem 3.20 Let F (x) = 1 −1 − x 120 1₆ , 0 ≤ x ≤ 120. Find h(40).

(39)

4 Raw and Central Moments

Several quantities can be computed from the pdf that describe simple charac-teristics of the distribution. These are called moments. The most common is the mean, the first moment about the origin, and the variance, the second moment about the mean. The mean is a measure of the centrality of the distribution and the variance is a measure of the spread of the distribution about the mean.

The nth moment = µ0_n = E(Xn) of a random variable X is also known as the nth moment about the origin or the nth raw moment. For a continuous random variable X we have

µ0_n= Z ∞

−∞

xnf (x)dx

and for a discrete random variable we have

µ0_n=X

x

xnp(x).

By contrast, the quantity µn = E[(X − E(X))n] is called the nth central

moment of X or the nth moment about the mean. For a continuous random variable X we have

µn=

Z ∞

−∞

(x − E(X))nf (x)dx

and for a discrete random variable we have

µn=

X

x

(x − E(X))np(x).

Note that Var(X) is the second central moment of X.

Example 4.1

Let X be a continuous random variable with pdf given by f (x) = 3₈x2 for 0 < x < 2 and 0 otherwise. Find the second central moment of X.

Solution.

We first find the mean of X. We have

E(X) = Z 2 0 xf (x)dx = Z 2 0 3 8x 3_{dx =} 3 32x 4 2 0 = 1.5.

(40)

The second central moment is µ2 = Z 2 0 (x − 1.5)2f (x)dx = Z 2 0 3 8x 2_{(x − 1.5)}2_dx =3 8 x5 5 − 0.75x 4_{+ 0.75x}3 2 0 = 0.15

The importance of moments is that they are used to define quantities that characterize the shape of a distribution. These quantities which will be dis-cussed below are: skewness, kurtosis and coefficient of variatoion.

Departure from Normality: Coefficient of Skewness

The third central moment, µ3, is called the skewness and is a measure of

the symmetry of the pdf. A distribution, or data set, is symmetric if it looks the same to the left and right of the mean.

A measure of skewness is given by the coefficient of skewness γ1:

γ1 =

µ3

σ3 =

E(X3_{) − 3E(X)E(X}2_{) + 2[E(X)]}3

[E(X2_{) − (E(X)}2_]32

.

That is, γ1 is the ratio of the third central moment to the cube of the

standard deviation. Equivalently, γ1 is the third central moment of the

standardized variable

X∗ = X − µ σ .

If γ1 is close to zero then the distribution is symmetric about its mean such

as the normal distribution. A positively skewed distribution has a “tail” which is pulled in the positive direction. A negatively skewed distribution has a “tail” which is pulled in the negative direction (See Figure 4.1).

Figure 4.1

Example 4.2

(41)

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃

Find the coefficient of skewness of X.

Solution.

We first find the mean of X :

µ = E(X) = 120×1 4+122× 1 12+124× 1 6+150× 1 12+167× 1 12+245× 1 3 = 2027 12 .

The second raw moment is

E(X2) = 1202×1 4+122 2_×1 12+124 2_×1 6+150 2_× 1 12+167 2_×1 12+245 2_×1 3 = 379325 12 .

Thus, the variance of X is

Var(X) = 379325 12 − 4108729 144 = 443171 144

and the standard deviation is

σ = r

443171

144 = 55.475908183.

The third central moment is

µ3 = 120 − 2027 12 3 ×1 4 + 122 − 2027 12 3 × 1 12 + 124 − 2027 12 3 ×1 6 + 150 − 2027 12 3 × 1 12 + 167 − 2027 12 3 × 1 12 + 245 − 2027 12 3 ×1 3 =93270.81134. Thus, γ1 = 93270.81134 55.475908183= 0.5463016252 Example 4.3

Let X be a random variable with density f (x) = e−x on (0, ∞) and 0 otherwise. Find the coefficient of skewness of X.

(42)

Solution. Since E(X) = Z ∞ 0 xe−xdx = −e−x(1 + x) ∞ 0 = 1 E(X2) = Z ∞ 0 x2e−xdx = −e−x(x2+ 2x + 2) ∞ 0 = 2 E(X3) = Z ∞ 0 x3e−xdx = −e−x(x3+ 3x2+ 6x + 6) ∞ 0 = 6 we find γ1 = 6 − 3(1)(2) + 2(1)3 (2 − 12₎32 = 2 Coefficient of Kurtosis

The fourth central moment, µ4, is called the kurtosis and is a measure of

peakedness/flatness of a distribution with respect to the normal distribution. A measure of kurtosis is given by the coefficient of kurtosis:

γ2=

E[(X − µ))4] σ4 =

E(X4) − 4E(X3)E(X) + 6E(X2)[E(X)]2− 3[E(X)]4

[E(X2_{) − (E(X))}2_]2 .

The coefficient of kurtosis of the normal distribution is 3. The condition γ2 < 3 indicates that the distribution is flatter compared to the normal

distribution, and the condition γ2 > 3 indicates a higher peak (relative to

the normal distribution) around the mean value.(See Figure 4.2)

(43)

Example 4.4

A random variable X has the following pmf:

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃

Find the coefficient of kurtosis of X.

Solution.

We first find the fourth central moment.

µ4 = 120 − 2027 12 4 ×1 4 + 122 − 2027 12 4 × 1 12 + 124 − 2027 12 4 ×1 6 + 150 − 2027 12 4 × 1 12 + 167 − 2027 12 4 × 1 12 + 245 − 2027 12 4 ×1 3 =13693826.62. Thus, γ2 = 13693826.62 55.475908183 = 1.44579641 Example 4.5

Find the coefficient of kurtosis of the random variable X with density func-tion f (x) = 1 on (0, 1) and 0 elsewhere.

Solution. Since E(Xk) = Z 1 0 xkdx = 1 k + 1. we obtain, γ2 = 1 5− 4 1 4 ₁ 2 + 6 1 3 ₁ 2 2 − 3 1 2 4 1 3− 1 4 2 = 9 5 Coefficient of Variation

Some combinations of the raw moments and central moments that are also commonly used. One such combination is the coefficient of variation, denoted by CV (X)), of a random variable X which is defined as the ratio of the standard deviation to the mean:

CV (X) = σ

µ, µ = µ

0

(44)

It is an indication of the size of the standard deviation relative to the mean, for the given random variable.

Often the coefficient of variation is expressed as a percentage. Thus, it expresses the standard deviation as a percentage of the sample mean and it is unitless. Statistically, the coefficient of variation is very useful when comparing two or more sets of data that are measured in different units of measurement.

Example 4.6

Let X be a random variable with mean of 4 meters and standard deviation of 0.7 millimeters. Find the coefficient of variation of X.

Solution.

The coefficient of variation is

CV (X) = 0.7

4000 = 0.0175% Example 4.7

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃ Find the coefficient of variation of X.

Solution.

We know that µ = 2027₁₂ = 168.9166667 and σ = 55.47590818. Thus, the coefficient of variation of X is

CV (X) = 55.47590818

168.9166667 = 0.3284217754 Example 4.8

Find the coefficient of variation of the random variable X with density func-tion f (x) = e−x on (0, ∞) and 0 otherwise.

Solution. We have µ = E(X) = Z ∞ 0 xe−xdx = −e−x(1 + x) ∞ 0 = 1 and σ = (E(X2) − (E(X))2)12 = (2 − 1) 1 2 = 1. Hence, CV (X) = 1

(45)

Practice Problems

Problem 4.1

Consider n independent trials. Let X denote the number of successes in n trials. We call X a binomial random variable. Its pmf is given by

p(r) = C(n, r)pr(1 − p)n−r

where p is the probability of a success.

(a) Show that E(X) = np and E[X(X − 1)] = n(n − 1)p2_{. Hint: (a + b)}n₌

Pn

k=0C(n, k)akbn−k.

(b) Find the variance of X.

Problem 4.2

A random variable X is said to be a Poisson random variable with param-eter λ > 0 if its probability mass function has the form

p(k) = e−λλ

k

k!, k = 0, 1, 2, · · ·

where λ indicates the average number of successes per unit time or space. (a) Show that E(X) = λ and E[X(X − 1)] = λ2.

(b) Find the variance of X.

Problem 4.3

A geometric random variable with parameter p, 0 < p < 1 has a probability mass function

p(n) = p(1 − p)n−1, n = 1, 2, · · · . (a) By differentiating the geometric seriesP∞

n=0xn= 1−x1 twice and using

x = 1 − p is each equation, show that P∞

n=1n(1 − p)n−1 = p−2 and

P∞

n=1n(n − 1)(1 − p)n−2= 2p−3.

(b) Show that E(X) = 1_p and E[X(X − 1)] = 2p−2(1 − p). (c) Find the variance of X.

Problem 4.4

A normal random variable with parameters µ and σ2 _{has a pdf}

f (x) = √1 2πσe

−(x−µ)2

2σ2 , − ∞ < x < ∞.

Show that E(X) = µ and Var(X) = σ2. Hint: E(Z) = E

X−µ σ

= 0 where Z is the standard normal distribution with parameters (0,1).

(46)

Problem 4.5

An exponential random variable with parameter λ > 0 is a random variable with pdf

f (x) =

λe−λx if x ≥ 0 0 if x < 0

(a) Show that E(X) = 1_λ and E(X2_{) =} 2 λ2.

(b) Find Var(X).

Problem 4.6

A Gamma random variable with parameters α > 0 and θ > 0 has a pdf

f (x) = ( 1 θα_Γ(α)xα−1e −x θ if x ≥ 0 0 if x < 0 where Z ∞ 0 e−yyα−1dy = Γ(α) = αΓ(α − 1). Show: (a) E(X) = αθ (b) V ar(X) = αθ2. Problem 4.7

Let X be a continuous random variable with pdf given by f (x) = 3₈x2 for 0 ≤ x ≤ 2 and 0 otherwise. Find the third raw moment of X.

Problem 4.8

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃

Find the fourth raw moment.

Problem 4.9

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃

(47)

Problem 4.10

Compute the coefficient of skewness of a uniform random variable, X, on [0, 1].

Problem 4.11

Let X be a random variable with density f (x) = e−x and 0 otherwise. Find the coefficient of kurtosis.

Problem 4.12

x 120 122 124 150 167 245 p(x) 1₄ ₁₂1 1₆ ₁₂1 ₁₂1 1₃

Find the coefficient of variation.

Problem 4.13

Let X be a continuous random variable with density function f (x) = Axbe−Cx for x ≥ 0 and 0 otherwise. The parameters A, B, and C satisfy

A = R∞ 1 0 xBe−Cxdx , B ≥ −1 2, C > 0. Show that E(Xn) = B + r C E(X n−1_). Problem 4.14

A = R∞ 1

0 xBe−Cxdx

, B ≥ −1

2, C > 0.

Find the first and second raw moments.

Problem 4.15

A = R∞ 1

0 xBe−Cxdx

, B ≥ −1

2, C > 0.

(48)

Problem 4.16

A = R∞ 1

0 xBe−Cxdx

, B ≥ −1

2, C > 0. Find the coefficient of kurtosis.

Problem 4.17

You are given: E(X) = 2, CV (X) = 2, and µ0₃ = 136. Calculate γ1.

Problem 4.18

Let X be a random variable with pdf f (x) = 0.005x for 0 ≤ x ≤ 20 and 0 otherwise.

(a) Find the cdf of X.

(b) Find the mean and the variance of X. (c) Find the coefficient of variation.

Problem 4.19

Let X be the Gamma random variable with pdf f (x) = _θα_Γ(α)1 xα−1e− x θ for

x > 0 and 0 otherwise. Suppose E(X) = 8 and γ1 = 1. Find the variance of

X.

Problem 4.20

Let X be a Pareto random variable in one parameter and with a pdf f (x) =

a

xa+1, x ≥ 1 and 0 otherwise.

(a) Show that E(Xk) = _a−ka for 0 < k < a. (b) Find the coefficient of variation of X.

Problem 4.21

For the random variable X you are given: (i) E(X) = 4

(ii) Var(X) = 64 (iii) E(X3) = 15.

Calculate the skewness of X.

Problem 4.22

Let X be a Pareto random variable with two parameters α and θ, i.e., X has the pdf

f (x) = αθ

α

(x + θ)α+1, α > 1, θ > 0, x > 0

(49)

Problem 4.23

Let X be a Pareto random variable with two parameters α and θ, i.e., X has the pdf

f (x) = αθ

α

(x + θ)α+1, α > 1, θ > 0, x > 0

and 0 otherwise. Calculate the coefficient of variation.

Problem 4.24

Let X be the Gamma random variable with pdf f (x) = _θα_Γ(α)1 xα−1e− x θ for

(50)

5 Empirical Models, Excess and Limited Loss

vari-ables

Empirical models are those that are based entirely on data. Consider a statistical model that results in a sample Ω of size n. Data points in the sample are assigned equal probability of 1_n. Let X be a random variable defined on Ω. We refer to this model as an empirical model.

Example 5.1

In a fitness club monthly new memberships are recorded in the table below.

January February March April May June 100 102 84 84 100 100

July August September October November December

67 45 45 45 45 93

Use an empirical model to construct a discrete probability mass function for X, the number of new memberships per month.

Solution.

The sample under consideration has 12 data points which are the months of the year. For our empirical model, each data point is assigned a probability of ₁₂1. The pmf of the random variable X is given by:

x 45 67 84 93 100 102 p(x) 1₃ ₁₂1 1₆ ₁₂1 1₄ ₁₂1

Excess Loss Random Variable

Consider an insurance policy with a deductible. The insurer’s interest are usually in the losses that resulted in a payment, and the actual amount paid by the insurance. The insurer pays the insuree the amount of the loss that was in excess of the deductible2. Any amount of losses that are below the deductible are ignored by the insurance since they do not result in an insurance payment being made. Hence, the insurer would be considering the conditional distribution of amount paid, given that a payment was actually made. This is what is referred to as the excess loss random variable. Let X be a random variable. In insurance terms, X is known as the loss

2

The deductible is referred to as ordinary deductible. Another type of deductible is called franchise deductible and will be discussed in Section 32.

(51)

random variable. For a given threshold d such that Pr(X > d) > 0, the random variable YP = (X − d|X > d) = undefined, X ≤ d X − d, X > d

is called the excess loss variable, the cost per payment, or the left truncated and shifted variable.

We can find the kthmoment of the excess loss variable as follows. For a con-tinuous distribution with probability density function f (x) and cumulative distribution function F (x), we have3

ek_X(d) =E[(X − d)k|X > d] = 1 Pr(X > d) Z ∞ d (x − d)kf (x)dx = 1 1 − F (d) Z ∞ d (x − d)kf (x)dx

provided that the improper integral is convergent.

For a discrete distribution with probability density function p(x) and a cu-mulative distribution function F (x), we have

ek_X(d) = 1 1 − F (d)

X

xj>d

(xj− d)kp(xj)

provided that the sum is convergent. When k = 1, the expected value

eX(d) = E(YP) = E(X − d|X > d)

is called the mean excess loss function. Other names used have been mean residual life function and complete expectation of life. If X denotes payment, then eX(d) stands for the expected amount paid given

that there has been a payment in excess of the deductible d. If X denotes age at death, then eX(d) stands for the expected future lifetime given that

the person is alive at age d.

Example 5.2

Show that for a continuous random variable X, we have

eX(d) = 1 1 − F (d) Z ∞ d (1 − F (x))dx = 1 S(d) Z ∞ d S(x)dx. 3_{See P.32}

(52)

Solution.

Using integration by parts with u = x − d and v0 = f (x), we have

eX(d) = 1 1 − F (d) Z ∞ d (x − d)f (x)dx = −(x − d)(1 − F (x)) 1 − F (d) ∞ d + 1 1 − F (d) Z ∞ d (1 − F (x))dx = 1 1 − F (d) Z ∞ d (1 − F (x))dx = 1 S(d) Z ∞ d S(x)dx. Note that 0 ≤ xS(x) = x Z ∞ x f (t)dt ≤ Z ∞ x tf (t)dt =⇒ lim x→∞xS(x) = 0 Example 5.3

Let X be an excess loss random variable with pdf given by f (x) = 1₃(1 + 2x)e−x for x > 0 and 0 otherwise. Calculate the mean excess loss function with deductible amount x.

Solution. The cdf of X is given by F (x) = Z x 0 1 3(1 + 2t)e −t _{= −}1 3e −t_{(2t + 3)} x 0 = 1 −e −x_{(2x + 3)} 3 .

where we used integration by parts.

eX(x) = 1 e−x_(2x+3) 3 Z ∞ x 1 −e −x_{(2x + 3)} 3 dx = e−x(2x+5) 3 e−x_(2x+3) 3 = 2x + 5 2x + 3 Example 5.4 Show that F_YP(y) = FX(y + d) − FX(d) 1 − FX(d) . Solution. We have

F_YP(y) =Pr(YP ≤ y) = Pr(X − d ≤ y|X > d) =

Pr(d < X ≤ y + d) Pr(X > d)

=FX(y + d) − FX(d) 1 − FX(d)

(53)

Left-Censored and Shifted Random Variable

Note that in the excess loss situation, losses below or at the value d are not recorded in any way, that is, the excess loss random variable is left-truncated and it is shifted because of a number subtracted from X. However, when small losses below d are recorded as 0 then we are led to a new random variable which we call a left-censored and shifted random variable or the cost per loss random variable. It is defined as

YL= (X − d)+=

0, X ≤ d X − d, X > d.

The kth-moment of this random variable is given by

E[(X − d)k₊] = Z ∞

d

(x − d)kf (x)dx

in the continuous case and

E[(X − d)k₊] = X

xj>d

(xj − d)kp(xj)

in the discrete case. Note the relationship between the moments of YP and YL _{given by}

E[(X − d)k₊] = ek_X(d)[1 − F (d)] = ek_X(d)S(d).

Setting k = 1 and using the formula for eX(d) we see that

E(YL) = Z ∞

d

S(x)dx.

This expected value is sometimes called the stop loss premium.

We can think of the excess loss random variable as of a random variable that exists only if a payment has been made. Alternatively, the left censored and shifted random variable is equal to zero every time a loss does not produce payment.

Example 5.5

For a house insurance policy, the loss amount (expressed in thousands), in the event of a fire, is being modeled by a distribution with density

f (x) = 3

56x(5 − x), 0 < x < 4.

For a policy with a deductible amount of $1,000, calculate the expected amount per loss.

(54)

Solution.

We first calculate the survival function:

S(x) = 1 − F (x) = 1 − Z x 0 3 56x(5 − x)dx = 1 − 3 56 5 2x 2₋1 3x 3 . Thus, E(YL) = Z 4 1 1 − 3 56 5 2x 2₋1 3x 3 dx = 1.325893 thousands

Limited Loss Variable

Many insurance policies are covered up to a certain limit. Let’s say the limit is u. That is, the insurer covers all losses up to u fully but pays u for loses greater than u. Thus, if X is a loss random variable then the amount paid by the insurer is X ∧ u. We call X ∧ u the limited loss variable and is defined by

X ∧ u = min(X, u) =

X, X ≤ u u, X > u.

Notice that the distribution of X is censored on the right and that why the limit loss variable is also known as the right-censored random variable. The expected value of the limited loss value is E(X ∧ u) and is called the limited expected value.

For a discrete distribution with probability density function p(xj) and a

cumulative distribution function F (xj) for all relevant index values j, the

kthmoment of the limited loss random variable is given by

E[(X ∧ u)k] = X

xj≤u

xk_jp(xj) + uk[1 − F (u)].

For a continuous distribution with probability density function f (x) and cumulative distribution function F (x), the kth moment is given by

E[(X ∧ u)k] = Z u

−∞

(55)

Using integration by parts, we can derive an alternative formula for the kthmoment: E[(X ∧ u)k] = Z u −∞ xkf (x)dx + uk[1 − F (u)] = Z 0 −∞ xkf (x)dx + Z u 0 xkf (x)dx + uk[1 − F (u)] = xkF (x) 0 −∞− Z 0 −∞ kxk−1F (x)dx − xkS(x) u 0 + Z u 0 kxk−1S(x)dx + ukS(u) = − Z 0 −∞ kxk−1F (x)dx + Z u 0 kxk−1S(x)dx.

Note that for x < 0 and k odd we have Z x −∞ tkf (t)dt ≤ xk Z x −∞ f (t)dt = xkF (x) ≤ 0 so that lim x→−∞x k_{F (x) = 0.}

A similar argument for x < 0 and k even. In particular, for k = 1, we obtain

E(X ∧ u) = − Z 0 −∞ F (x)dx + Z u 0 S(x)dx.

One can easily that

(X − d)++ X ∧ d = 0, X ≤ d X − d, X > d. + X, X ≤ u u, X > u. = X.

That is, buying one policy with a deductible d and another one with a limit d is equivalent to purchasing full cover.

Remark 5.1

Usually the random variable X is non-negative (for instance, when X rep-resents a loss or a time until death), and the lower integration limit −∞ is replaced by 0. Thus, for X ≥ 0, we whave

E(X ∧ u) = Z u

0

(56)

Example 5.6

A continuous random variable X has a pdf f (x) = 0.005x for 0 ≤ x ≤ 20 and 0 otherwise. Find the mean and the variance of X ∧ 10.

Solution. The cdf of X is F (x) = Z x −∞ 0.005tdt = Z x 0 0.005tdt =    0, x < 0 0.0025x2, 0 ≤ x ≤ 20 1, x > 20. Thus, E(X ∧ 10) = Z 10 0 [1 − F (x)]dx = Z 10 0 [1 − 0.0025x2]dx = 55 6 . Now, E[(X ∧ 10)2] = Z 10 0 x2(0.005x)dx + 102[1 − F (10)] = 87.5. Finally, Var(X ∧ 10) = 87.5 − 55 6 2 = 125 36

(57)

Practice Problems

Problem 5.1

Suppose that a policy has a deductible of $500. Complete the following table.

Amount of loss 750 500 1200 Insurance payment

Problem 5.2

Referring to Example 5.1, find the cumulative distribution function of X.

Problem 5.3

Referring to Example 5.1, find the first and second raw moments of X.

Problem 5.4

Suppose you observe 8 claims with amounts 5, 10, 15, 20, 25, 30, 35, 40. Calculate the empirical coefficient of variation.

Problem 5.5

Let X be uniform on the interval [0, 100]. Find eX(d) for d > 0.

Problem 5.6

Let X be uniform on [0, 100] and Y be uniform on [0, α]. Suppose that eY(30) = eX(30) + 4. Calculate the value of α.

Problem 5.7

Let X be the exponential random variable with mean λ. Its pdf is f (x) = λe−λx for x > 0 and 0 otherwise. Find the expected cost per payment (i.e., mean excess loss function).

Problem 5.8

For an automobile insurance policy, the loss amount (expressed in thou-sands), in the event of an accident, is being modeled by a distribution with density

f (x) = 3

56x(5 − x), 0 < x < 4.

For a policy with a deductible amount of $2,500, calculate the expected amount per loss.

Problem 5.9

The loss random variable X has an exponential distribution with mean _λ1 and an ordinary deductible is applied to all losses. Find the expected cost per loss.

(58)

Problem 5.10

The loss random variable X has an exponential distribution with mean _λ1 and an ordinary deductible is applied to all losses. Find the variance of the cost per loss random variable.

Problem 5.11

The loss random variable X has an exponential distribution with mean _λ1 and an ordinary deductible is applied to all losses. The variance of the cost per payment random variable (excess loss random variable) is 25,600. Find λ.

Problem 5.12

The loss random variable X has an exponential distribution with mean _λ1 and an ordinary deductible is applied to all losses. The variance of the cost per payment random variable (excess loss random variable) is 25,600. The variance of the cost per loss random variable is 20,480. Find the amount of the deductible d.

Problem 5.13

The loss random variable X has an exponential distribution with mean _λ1 and an ordinary deductible is applied to all losses. The variance of the cost per payment random variable (excess loss random variable) is 25,600. The variance of the cost per loss random variable is 20,480. Find expected cost of loss.

Problem 5.14

For the loss random variable with cdf F (x) = x_θφ, 0 < x < θ, and 0 otherwise, determine the mean residual lifetime eX(x).

Problem 5.15

Let X be a loss random variable with pdf f (x) = (1 + 2x2)e−2x for x > 0 and 0 otherwise.

(a) Find the survival function S(x). (b) Determine eX(x). Problem 5.16 Show that S_YP(y) = SX(y + d) SX(d) .

(59)

Problem 5.17

Let X be a loss random variable with cdf F (x) = 1 − e−0.005x− 0.004e−0.005x for x ≥ 0 and 0 otherwise.

(a) If an ordinary deductible of 100 is applied to each loss, find the pdf of the per payment random variable YP.

(b) Calculate the mean and the variance of the per payment random variable.

Problem 5.18

Show that, for X ≥ 0, we have

eX(d) =

E(X) − E(X ∧ d) S(d) .

Problem 5.19

A continuous random variable X has a pdf f (x) = 0.005x for 0 ≤ x ≤ 20 and 0 otherwise. Find the mean and the variance of (X − 10)+.

Problem 5.20 ‡

For a random loss X, you are given: Pr(X = 3) = Pr(X = 12) = 0.5 and E[(X − d)+] = 3. Calculate the value of d.