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RANDOM VARIABLES

SOURCES:
1. Klugman, S. A., Panjer, H. H., and Willmot, G E. (2004), Loss Models: From Data to
Decisions, 2
nd
edition, o!n Wile" and Son#, $e% &or', (!a)ter 2.
2. Hogg, *. +., ,-Kean, . W., and (raig, A. .. (200/), Introduction to Mathematical
Statistics, 0
t!
edition, Pear#on Prenti-e Hall.
W!at i# an a-tuarial model1 2a#i-all", it is an attempt to represent an uncertain stream
of future payments.
.!ere i# an un-ertaint" in t!e:
1. o--urren-e (or num3er) o4 )a"ment#, and5or
2. #e6erit" o4 )a"ment#, and5or
7. timing o4 )a"ment#.
Pro3a3ilit" model# ma" 3e u#ed to re)re#ent t!e un-ertaint". 8t i# a##umed t!at t!e
rele6ant )ro3a3ilit" di#tri3ution# are 'no%n. 9etermining %!i-! )ro3a3ilit" model# are
a))ro)riate 4or data at !and i# not )art o4 t!i# -our#e: it %ill 3e gi6en in t!e #e-ond )art o4
t!e *i#' .!eor" -our#e. A#)e-t# o4 a-tuarial )ro3a3ilit" model# %!i-! %ill 3e -o6ered in
*i#' .!eor" 1 -our#e are:
1. 9e4inition o4 random 6aria3le, im)ortant 4un-tion#, and #ome e;am)le#.
2. 2a#i- -al-ulation# 4rom )ro3a3ilit" model#.
7. S)e-i4i- )ro3a3ilit" di#tri3ution# and t!eir )ro)ertie#.
4. ,ore ad6an-ed -al-ulation# u#ing #e6erit" model#.
/. ,odel# in-or)orating t!e )o##i3ilit" o4 a random num3er o4 )a"ment# ea-! o4
random amount.
0. ,odel# t!at tra-' a -om)an"<# #ur)lu# t!roug! time.
8m)ortant model# %!i-! are not -o6ered in t!i# -our#e are:
1. ,odel# 4or in6e#tment earning# in 4uture "ear#:
2. ,odel# %!i-! -om3ine t!e earning o4 intere#t (%!et!er random or not) %it! t!e
timing o4 t!e )a"ment. .!e u#e o4 #u-! model# in li4e in#uran-e and annuitie# are
-o6ered in t!e -our#e =A-tuarial ,at!emati-#>.
Consider the following definitions from the latest working draft of oint !rinciples of
"ctuarial Science#
1
1
Klugman, S. A., Panjer, H. H., and Willmot, G E. (2004), Loss Models: From Data to Decisions, 2
nd

edition, o!n Wile" and Son#, $e% &or', )age 12.
1
Phenomena are occurrences that can $e o$ser%ed. "n experiment is an
o$ser%ation of a gi%en phenomenon under specified conditions. &he result of an
e'periment is called an outcome( an event is a set of one or more possi$le
outcomes. " stochastic phenomenon is a phenomenon for which an associated
e'periment has more than one possi$le outcome. "n e%ent associated with a
stochastic phenomenon is said to $e contingent. Probability is a measure of the
likelihood of the occurrence of an e%ent. It is measured on a scale of increasing
likelihood from )ero to one. " random variable is a function that assigns a
numerical %alue to e%ery possi$le outcome.
Some random 6aria3le# en-ountered in a-tuarial )ra-ti-e:
1. .!e age at deat! o4 a randoml" #ele-ted 3irt! (Model 1)
2. .!e time to deat! 4rom %!en in#uran-e %a# )ur-!a#ed 4or a randoml" #ele-ted
in#ured li4e.
7. .!e time 4rom o--urren-e o4 a di#a3ling e6ent to re-o6er" or deat! 4or a randoml"
#ele-ted %or'er# -om)en#ation -laimant.
4. .!e time 4rom t!e in-iden-e o4 a randoml" #ele-ted -laim to it# 3eing re)orted to t!e
in#urer.
/. .!e time 4rom t!e re)orting o4 a randoml" #ele-ted -laim to it# #ettlement.
0. .!e num3er o4 rupiah )aid on a randoml" #ele-ted li4e in#uran-e -laim.
?. .!e num3er o4 rupiah )aid on a randoml" #ele-ted automo3ile 3odil" injur" -laim
(Model 2).
@. .!e num3er o4 automo3ile 3odil" injur" -laim# in one "ear 4rom a randoml" #ele-ted
in#ured automo3ile (Model 3).
A. .!e total dollar# in medi-al mal)ra-ti-e -laim# )aid in one "ear o%ing t!e e6ent# at a
randoml" #ele-ted !o#)ital (Model 4).
10. .!e time to de4ault or )re)a"ment on a randoml" #ele-ted in#ured !ome loan t!at
terminate# earl".
11. .!e amount o4 mone" )aid at maturit" on a randoml" #ele-ted !ig!B"ield 3ond.
All o4 t!e )!enomena a3o6e -an 3e e;)re##ed a# random 6aria3le# and pro$a$ility and
mathematical statistics are u#ed to -reate and anal"Ce model# 4or t!e#e random 6aria3le#.
FIVE KEY FUNCTIONS USED IN DESCRIBING A RANDOM VARIABLE:
1. ((umulati6e) di#tri3ution 4un-tion.
2. Sur6i6al 4un-tion.
7. (Pro3a3ilit") den#it" 4un-tion.
4. Pro3a3ilit" (ma##) 4un-tion.
/. HaCard rate or 4or-e o4 mortalit" or 4ailure rate.
Fir! "#$%!io$:
.!e &%#'#l(!i)e* di!ri+#!io$ "#$%!io$, a33re6iated a# cdf, 4or a random 6aria3le * i#
( ) ( ) Pr
*
F ' * '
or ( ) ( ) Pr F ' * '
.
2
(!ara-teri#ti-# o4 di#tri3ution 4un-tion:
1. ( ) 0 1 F '
4or all
'
2. ( ) F '
i# nonBde-rea#ing
7. ( ) F '
i# rig!tB-ontinuou#
4.
( ) lim 0
'
F '

and
( ) lim 1
'
F '

,oi+le di!ri+#!io$ "#$%!io$ "or Model 1 !o Model 4


Model 1
Det * 3e a random 6aria3le %!i-! denote t!e age at deat! o4 a randoml" #ele-ted 3irt!.
8t i# rea#ona3le to )ut a limit on t!e age o4 deat!. 2" t!i#, it i# a##umed t!at t!e
)ro3a3ilit" t!at a )er#on %ill die 3e"ond t!i# age limit i# #o #mall t!at it i# negligi3le.
A possi$le di#tri3ution 4un-tion o4 * i# o4 t!e 4orm
( )
1
0 , 0
0.01 , 0 100
1 , 100
'
F ' ' '
'
<

<
'

Model 2
Det * 3e a random 6aria3le %!i-! denote t!e num3er o4 ru)ia! )aid on an automo3ile
in#uran-e -laim. A possi$le di#tri3ution 4un-tion o4 * i# o4 t!e 4orm
( )
7
2
0 , 0
2000
1 , 0
2000
'
F '
'
'
<

'
_


+
,
Model 3
Det * 3e a random 6aria3le %!i-! denote t!e num3er o4 -laim# on one )oli-" in one
"ear. 8t i# rea#ona3le to limit t!e num3er o4 -laim# %!i-! -an 3e made 3" one )oli-" in
one "ear: alt!oug! ot!er model# %!i-! allo% no limit in t!e num3er o4 -laim# i# )o##i3le,
#u-! a# t!e Poi##on di#tri3ution.
A possi$le di#tri3ution 4un-tion o4 * i# o4 t!e 4orm
7
( )
7
0 , 0
0./ , 0 1
0.?/ , 1 2
0.@? , 2 7
0.A/ , 7 4
1 , 4
'
'
'
F '
'
'
'
<

<

<

'
<

<

8n t!i# model, a ma;imum num3er o4 -laim# on one )oli-" in one "ear i# 4. Pro3a3ilit" at
a )arti-ular num3er o4 -laim# i# eEual to t!e #iCe o4 t!e jum) in t!e di#tri3ution 4un-tion.
Model 4
Det * 3e t!e random 6aria3le %!i-! denote t!e total ru)ia! )aid on a mal)ra-ti-e )oli-"
in one "ear. 8t i# rea#ona3le to a##ume t!at in mo#t "ear#, no -laim %ill 3e made: !en-e,
t!e in#uran-e -om)an" %ill )a" not!ing. For t!i# rea#on, mo#t )ro3a3ilit" i# at Cero.
A possi$le di#tri3ution 4un-tion o4 * i# o4 t!e 4orm
( )
4 0.00001
0 , 0
1 0.7 , 0
'
'
F '
e '

<

'

.!e #--or! o4 a random 6aria3le i# t!e #et o4 num3er# %!i-! are )o##i3le 6alue# o4 t!e
random 6aria3le.
A random 6aria3le i# -alled di%re!e i4 t!e #u))ort -ontain# at mo#t a -ounta3le num3er
o4 6alue#. .!e di#tri3ution 4un-tion 4or a di#-rete 6aria3le %ill 3e -on#tant e;-e)t 4or
jum)# at t!e 6alue# %it! )o#iti6e )ro3a3ilit". A random 6aria3le i# -alled %o$!i$#o# i4
t!e di#tri3ution 4un-tion i# -ontinuou# and i# di44erentia3le e6er"%!ere e;-e)t 4or a
-ounta3le num3er o4 6alue#. 8t i# -alled 'i.ed i4 it i# not di#-rete and i# -ontinuou#
e6er"%!ere e;-e)t 4or at lea#t one 6alue and at mo#t a -ounta3le num3er o4 6alue#. A
mi;ed di#tri3ution %ill !a6e at lea#t one jum). $oti-e t!at 4or ,odel 4, t!e di#tri3ution
4un-tion i# -ontinuou# e;-e)t at 0, %!ere it jum)#. Hen-e, ,odel 4 i# a mi;ed
di#tri3ution %it! #u))ort on nonnegati6e num3er#.
Se%o$d "#$%!io$:
.!e #r)i)(l "#$%!io$, u#uall" denoted ( )
*
S '
or ( ) S '
, 4or a random 6aria3le * i#
( ) ( ) ( ) Pr 1
* '
S ' * ' F ' >
.
&he sur%i%al function+ also known as a sur%i%or function or relia$ility function+ is a
property of any random %aria$le that maps a set of e%ents+ usually associated with
mortality or failure of some system+ onto time. It captures the pro$a$ility that the system
4
will sur%i%e $eyond a specified time. &he term relia$ility function is common in
engineering while the term sur%i%al function is used in a $roader range of applications+
including human mortality.
,
Hi#tori-all", %!en t!e random 6aria3le i# mea#uring time, t!e #ur6i6al 4un-tion i#
)re#ented: %!en it i# mea#uring rupiah, t!e di#tri3ution 4un-tion i# )re#ented.
(!ara-teri#ti-# o4 t!e #ur6i6al 4un-tion:
1. ( ) 0 1 S '
4or all
'
2. ( ) S '
i# nonBin-rea#ing
7. ( ) S '
i# rig!tB-ontinuou#
4.
lim 1
'

and
lim 0
'

$ote t!at:
( ) ( ) ( ) ( ) ( ) Pr a * $ F $ F a S a S $ <
( ) ( ) ( ) ( ) ( ) Pr * $ F $ F $ S $ S $


%!ere ( ) ( ) lim
' $
F $ F '

and
( ) ( ) lim
' $
S $ S '

.
84 t!e di#tri3ution 4un-tion i# -ontinuou# at
'
t!en ( ) Pr 0 * '
: ot!er%i#e, t!e
)ro3a3ilit" i# t!e #iCe o4 t!e jum).
T/ird "#$%!io$:
.!e (-ro+(+ili!0* de$i!0 "#$%!io$, denoted ( )
*
f '
or ( ) f '
, and a33re6iated pdf, i#
t!e deri6ati6e o4 t!e )ro3a3ilit" 4un-tion. .!at i#, ( ) ( ) ( ) G G f ' F ' S '
Fo#r!/ "#$%!io$:
.!e -ro+(+ili!0 &'(* "#$%!io$, denoted ( )
*
p '
or ( ) p '
, i# ( ) ( ) Pr p ' * '
.
Fi"!/ "#$%!io$:
84 t!e den#it" 4un-tion i# de4ined t!en t!e /(1(rd r(!e, al#o 'no%n a# t!e "or%e o"
'or!(li!0 and t!e "(il#re r(!e, denoted ( )
*
h '
or ( ) h '
, i# t!e ratio o4 t!e den#it" and
#ur6i6al 4un-tion#. .!at i# ( )
( )
( )
*
*
*
f '
h '
S '

.
2
!tt):55en.%i'i)edia.org5%i'i5Sur6i6alH4un-tion
/
.!e !aCard rate i# denoted 3" ( ) '
i4 it i# -alled t!e 4or-e o4 mortalit": and i# denoted
3" ( ) '
i4 it i# -alled 4ailure rate.
.!e !aCard rate54or-e o4 mortalit"54ailure rate ma" 3e inter)reted a# the pro$a$ility
density at
'
gi%en that the argument will $e at least
'
: t!at i#
( )
0
lim Pr
'
' * ' ' * '

< + >
. 8n mortalit" term#, t!at i#, i4 * i# a random 6aria3le 4or
age at deat!, t!e 4or-e o4 mortalit" ma" 3e inter)reted a# the annuali)ed pro$a$ility#
that a person age
'
will die in the ne't instant+ e'pressed as a death rate per year.
-otice that the force of mortality is not a pro$a$ility .in particular+ it can $e greater than
/0 although it does no harm to %isuali)e it as a pro$a$ility.
From t!e de4inition o4 t!e !aCard rate a3o6e, it -an 3e #een t!at
( )
( )
( )
( )
G
ln
*
S ' d
h ' S '
S ' d'

. Hen-e, t!e #ur6i6al 4un-tion -an 3e o3tained 4rom t!e
eEuation
( )
( )
0
t
h ' d'
S t e

.
Model 2
An alternati6e to t!e #im)le li4etime di#tri3ution in ,odel 1 i# %!en t!e #ur6i6al 4un-tion
i# o4 t!e 4orm
( )
/
1 0.01 , 0 /0
1./ 0.02 , /0 ?/
' '
S '
' '
<

'
<

Some note# on ,odel /:


1. .!e model i# )ie-e%i#e linear.
2. .!e deri6ati6e at /0 i# not de4ined.
7. From (2), t!e den#it" 4un-tion and t!e !aCard rate 4un-tion are not de4ined at /0.
4. From (7), t!ere i# no di#-rete )ro3a3ilit" ma## at /0.
1. &he density or ha)ard rate at 12 could $e ar$itrarily defined with no effect on
su$se3uent calculations.
For the purpose of this course+ such %alues will $e ar$itrarily defined such that the
sur%i%al function is right continuous.
.!e 'ode o4 a random 6aria3le i# the most likely %alue. For a di#-rete 6aria3le it i# t!e
6alue %it! t!e large#t )ro3a3ilit". For a -ontinuou# 6aria3le it i# t!e 6alue 4or %!i-! t!e
den#it" 4un-tion i# large#t. 84 t!ere are lo-al ma;ima, t!e#e )oint# are al#o -on#idered to
3e mode#.
E3ERCISES &Kl#4'($5 -(4e 23*:
0
1. (on#tru-t gra)!# o4 t!e di#tri3ution 4un-tion 4or ,odel# 1B/. Al#o, gra)! t!e den#it"
or )ro3a3ilit" 4un-tion a# a))ro)riate and t!e !aCard rate 4un-tion, %!ere it e;i#t#.
2. A random 6aria3le * !a# den#it" 4un-tion ( )
2 7
4 (1 ) , 0 f ' ' ' '

+ >
. 9etermine
t!e mode o4 * .
7. A nonnegati6e random 6aria3le !a# a !aCard rate 4un-tion o4 ( )
2
, 0
'
h ' " e ' +
.
&ou are al#o gi6en ( ) 0.4 0./ S
. 9etermine t!e 6alue o4 ".
4. * !a# a Pareto di#tri3ution %it! )arameter# 2 and
10, 000
. 4 !a# a 2urr
di#tri3ution %it! )arameter# 2 ,
2
, and 20, 000 . Det
r
3e t!e ratio o4
( ) Pr * d >
to ( ) Pr 4 d >
. 9etermine
lim
d
r

.
$ote:

( )
( )
1 *
f '
'

( ) 1
*
F '
'

_


+
,

( )
( )
( )
1
1
4
y
f y
y y

1
+
]

( )
( )
1
1 %!ere
1
4
F y u u
y


+
?

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