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Week 1 1

Principles of Actuarial Science;

Games of Chance (1)
Outline:
1. Traditional Actuarial Application: Insurance
2. Principles of Actuarial Science
3. Probability Basics (Revision?)
4. Poisson and Binomial Distributions

Reading
(Req) Sherris, 1.3-1.4, 2.1-2.3
(Recc) Sherris 1.1-1.2

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Version: 15 July 2010. Copyright UNSW Actuarial Studies
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Traditional Application of Actuarial Science - Insurance

What is insurance?
Examples:
– Life (Death)
– Life (Survival)
– Health
– Disability
– Motor
– House
– Home Contents
– Workers Compensation
Fundamental Idea: Payment(s) that are incurred when a (random) event occurs
Other actuarial applications: Superannuation, Risk Management
(Will discuss in much more detail later in the course)
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Discussion
Consider a life insurance policy that:
– pays $100 at the end of the year if the policyholder ("Harry P") dies during the year
– assume that Harry has a 50% chance of dying
Q: Suppose that you are the actuary of the insurance company. Suggest how you
would determine the premium of this policy (making any additional assumptions if
required)
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Basic Principles of Actuarial Science

Probability and Statistics
– quantify future uncertainty
– probability models - Binomial, Poisson, Normal, Log-Normal
– Survival models
Risk Pooling
– Independent Risks
– Risk Factors (age, sex, smoker status etc)
Law of Large Numbers
– Expected values
– Variability of averages less for pools of independent risks
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Interest Rates
– Time Value of money
– economics of interest rates
– present values
Risk
– Utility Theory and Ranking of risky outcomes
– expected utility principle, certainty equivalents
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Discussion (ctd)
Suppose the premium for the policy has been set at $55, and that interest rates are
0.
What are some of the practical issues the company must now consider? Consider:
– (i) What to do with the $55 received as a premium?
(ii) How should this policy be reflected in the company’s financial reports?
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Basic Principles of Actuarial Science (ctd)

Financial Principles
– Accounting and Market values
– Fair Value of Liabilities
Actuarial Modelling
– Contingent Cash flows
– Death, survival, illness, financial asset returns
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Risk Management
– What is risk?
– Pooling and Diversification of Risk
– Experience Rating
– Profit Sharing
– Solvency
Risk Classification
– Moral Hazard
Careless or deliberate actions of insured affect payments
– Adverse Selection
Worse than average risks have incentives to purchase insurance
– Information Asymmetry
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Probability and Games of Chance

Probability
Permutation and Combinations
Useful Result: Binomial Theorem:
Xn
n n r r
(x + y)n = x y
r=0
r
Simple method of determining probabilities (where/if possible!):
– Evaluate all possible equally likely cases
– Count the Frequency or proportion of times that the event occurs
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Example
What is the probability of rolling a total of 12 with three dice?
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Sum F requency
3 1
4 3
5 6
6 10
7 15
8 21
9 25
10 27
11 27
12 25
13 21
14 15
15 10
16 6
17 3
18 1
T otal 216
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Random Variables
A random variable X is a function that assigns values to possible outcomes.
Discrete random variables - fixed number of finite values or countably infinite possible
values.
Continuous random variables - values on a continuous scale
Examples in Actuarial Science:
– Number of motor vehicle accidents occurring during a particular month
– Number of lives who die from cancer who are aged 40 last birthday during a par-
ticular time period.
– Time until the first accident for a particular car insurance policy
– Claim payment for a fire insurance policy
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Probability Density and Distribution Functions

Probability a discrete random variable X takes a particular value x is denoted
f (x) = P (X = x)
Probability density has the properties
X
f (x) 0 and f (x) = 1
all x

Distribution function, (= "cumulative distribution function") of X; is the probability that

the random variable takes a value less than or equal to a specified value x
F (x) = Pr (X x)
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For continuous random variables the probability density function (p.d.f.) f (x) is de-
fined such that
Z b
Pr (a X b) = f (x)dx
a
with

Z f (x) 0 for 1<x<1

1
f (t)dt = 1
1

CDF:
F (x) = Pr
Z x(X x)
= f (t)dt
1
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Expectation
Discrete random variable - expectation of a function of a random variable g(X) is
defined as
X
E [g (X)] = g (x) f (x)
all x

Continuous random variable

Z 1
E [g (X)] = g (x) f (x)dx
1
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Moments
Moments (about the origin) of a random variable are defined as
E [X r ] r = 1; 2; : : :
First moment (r = 1) is the mean of the distribution of the random variable - usually
denoted by .
Discrete random variable
X
E [X] = = xf (x)
all x

Continuous random variable

Z 1
E [X] = = xf (x)dx
1
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Moments - Variance
The mean is a measure of central tendency for a distribution.
The second moment about the mean is referred to as the variance of the distribution.
2
Variance usually denoted by
h i
2 2
V ar [X] = = E (X )
The standard deviation is the square root of the variance, .
The variance is a measure of dispersion or spread of the distribution.
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Example
Consider a random variable X which takes the value 1 if Harry P dies and 0 if he
survives the year.. Find the mean, variance and standard deviation of X:
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Common Distributions in Actuarial Science

Poisson
Binomial
Geometric
Exponential
Normal
Log-Normal
Weibull
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Poisson Distribution
The Poisson distribution
- often used to model the probability of occurrence of rare events such as insurance
claims
- also as an approximation for the chance of dying for a small enough parameter .
P oisson ( )
x
e
Pr (X = x) = x = 0; 1; 2 : : :
x!
E [X] =

V ar [X] =
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Exercise
Assume that the probability of an insurance claim on a particular insurance policy
1
during a year has a Poisson distribution with = 10 :
Calculate the probability that there will be
(a) no claims during the year on the policy?
(b) exactly 2 claims?
(c) at least one claim?
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Binomial Distribution
Number of successes (x) in a series of n independent trials where each success has
probability p.
In actuarial science
– probability that a number of lives in a group of lives with the same chance of dying
will die assuming independence between the lives.
Binomial (n; p)
n x
Pr (X = x) = p (1 p)n x
x = 0; 1; 2 : : :
x

E [X] = np

V ar [X] = np (1 p)
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Example
Suppose we have 100 policyholders, each with a probability of 0.2 of dying within the
next year. What is the probability that we observe a total of 10 or less deaths by the
end of the year?