Reviewed Risk Theory Notes

RISK THEORY FOR ACTUARIAL SCIENCES AND
FINANCIAL ENGINEERING STUDENTS
V. S. ANDIKA
January 25, 2015
RISK THEORY NOTES PREPARED BY V.S.ANDIKA
Course Objective
At the end of the course students will able apply statistics to risk measurement, perform sensitivity analysis and test risk models
Course Outline
- Introduction to risk theory
- Economics of insurance
- Individual risk models for a short term
- Collective risk models for single and extended periods
- Appraisal techniques
- Analysis of risk/uncertainty and situation measurement of risk in precise terms
- Sensitivity analysis of loss distribution
- Statistical inference for loss distributions
- Ruin theory and applications
- Risk matrix
Reference Books
1) Daykin, C & Pentikainen, Practical Risk Theory for Actuaries, Chapman and Hall, ISBN:
9780412428500, 1993.
2) N.L. Bowers, et al, Actuarial Mathematics, 2nd edition, Society of Actuaries, ISBN: 9780938959465,
1997.
3) IB Hossack, JH Pollard, & B Zehnwirth, Introductory Statistics with Applications in General Insurance, Cambridge University Press, ISBN: 9780521655347, 1999.
4) Kluggman S A, and Panjer, H H, et al, Loss Models: From Data to Decisions, 3rd edition,
John-Wiley and Sons, ISBN: 9780470391334, 2012.
5) Lam, J., Enterprise Risk Management from Incentives to Controls, Wiley Finance, ISBN:
9780471430001, 2003.
1
6) Bessis, J., Risk Management in Banking, 3rd edition, John-Wiley, ISBN: 9780470689851,
2011 .
7) Dowd, K., Beyond Value at Risks: The New Science of Risk Management,. Wiley, ISBN:
9780471976226, 2008.
8) Rob Kaas, Marc Goovaerts, Jan Dhaene, Michel Denuit ; Modern Actuarial Risk Theory,
Kluwer Academic publishers, 2001
Reference Journals
1) Journal of Risk and Uncertainty, ISSN: 0895-5646, ESSN: 1573-0476.
2) The Journal of Risk Analysis and Crisis Response (JRACR), ISSN: 2210-8491, ESSN: 22108505.
3) Journal of Risk and Insurance, ISSN: 0022-4367, ESSN: 1539-6975.
4) Risk and Decision Analysis, ISSN: 1569-7371, ESSN: 1875-9173.
5) The Geneva Risk and Insurance, ISSN: 1554-964X, ESSN: 1554-9658.
6) International Journal of Theoretical and Applied Finance, ISSN: 0219-0249, ESSN: 17936322.
7) The Mathematical Scientist, ISSN: 0312-3685.
8) Stochastic Analysis and Applications, ISSN: 0736-2994.
9) Journal of Modern Applied Statistical Methods, ISSN: 1538-9472.
10) The Annals of Statistics (Ann. Stat.), ISSN: 0090-5364.
Pre-Requisites:
1) STA 2300 Theory of Estimation
2) STA 2200 Probability and Statistics II
3) STA 2105 Calculus for Statistics II
Co-Requisites:
1) STA 2395 Decision Theory and Bayesian Inference I
2) STA 2301 Tests of Hypotheses
CHAPTER ONE
RISK THEORY INTRODUCTION
Definition
Risk theory is essentially a branch of probability theory, devoted to decision-making under probabilistic uncertainty. Basic concepts of the theory are: risk, risk measure, risk price, and individual attitude to risk.
Risk theory also connotes the study usually by actuaries and insurers of the financial impact
on a carrier of a portfolio of insurance policies. For example, if the carrier has 100 policies that
insures against a total loss of $1000, and if each policys chance of loss is independent and has
a probability of loss of p then the loss can be described by a binomial variable. With a large
enough portfolio however, we can use the Poisson function for the frequency of loss variable
where l is used as the mean equal to the number of policies multiplied by p.
Risk theory is a theory of decision-making under probabilistic uncertainty. From mathematical point of view it is a branch of probability theory, while its applications cover all aspects of
life. Financial applications are most advanced, including banking, insurance, managing market
and credit risks, investments and business risks. To name just a few, there are also applications
to managing risks of health hazard, environment pollution, engineering and ecological risks.
Terms used in risk theory

1. Risk management:- can be defined as the culture, processes, and structures that are
directed towards the effective management of potential opportunities and adverse effects
This is a broad definition that can quite rightly apply in nearly all fields of management
from financial and human resources management through to environmental management.
However in the context of contaminated sites, risk management can be taken to mean the
process of gathering information to make informed decisions to minimize the risk of adverse
effects to people and the environment.
Risk management is very important for insurance industry. Insurance means that insurance companies take over risks from customers. Insurers consider every available quantifiable factors to develop profiles of high and low insurance risk. Level of risk determines
insurance premiums. Generally, insurance policies involving factors with greater risk of
claims are charged at a higher rate. With much information at hand, insurers can evaluate
risk of insurance policies at much higher accuracy. To this end, insurers collect a vast
amount of information about policyholders and insured objects. Statistical methods and
4
tools based on data mining techniques can be used to analyze or to determine insurance
policy risk levels.
2. Risk assessment:- involves estimating the level of risk estimating the probability of an
event occurring and the magnitude of effects if the event does occur. Essentially risk assessment lies at the heart of risk management, because it assists in providing the information
required to respond to a potential risk.
3. Acceptable risk:- The term "acceptable risk" describes the likelihood of an event whose
probability of occurrence is small, whose consequences are so slight, or whose benefits
(perceived or real) are so great, that individuals or groups in society are willing to take
or be subjected to the risk that the event might occur. The concept of acceptable risk
evolved partly from the realization that absolute safety is generally an unachievable goal,
and that even very low exposures to certain toxic substances may confer some level of
risk. The notion of virtual safety corresponding to an acceptable level of risk emerged as
a risk management objective in cases where such exposures could not be completely or
cost-effectively eliminated.
Two proxy measures have been used to determine acceptable risk levels. The revealedpreference approach assumes that society, through trial and error, has achieved a nearly
optimal, and thus acceptable, balance of risks and benefits. The expressed-preference
approach uses opinion surveys and public consultations to obtain information about risk
levels warranting mitigation action.
Although regulatory authorities are reluctant to define a precise level of acceptable risk,
lifetime risks in the order of one in a million have been discussed in regulatory applications
of the acceptable risk concept. This level of risk is considered to be de minimis, an abbreviation of the legal concept de minimus non curatlex (the law does not concern itself with
trifles). Attempts have also been made to establish benchmarks, such as the risk of being
hit by lightning, to help interpret such small risks. Higher levels of risk might be tolerated
in the presence of offsetting health or economic benefits, when the risk is voluntary rather
than involuntary, or when the population at risk is small.
Although conceptually attractive, application of the concept of acceptable risk is fraught
with difficulty, ultimately involving consideration of social values. Inequities in the distribution of risks and benefits across society further complicate the determination of an
acceptable level of risk.
4. Risk determination:- involves the related processes of risk identification and risk estimation. Risk identification is the process of observation and recognition of new risk parameters
or new relationships among existing risk parameters, or perception of a change in the magnitudes of existing risk parameters. Risk, at the general level, involves two major elements:
the occurrence probability of an adverse event and the consequences of the event. Risk es5
timation, consequently, is an estimation process, starting from the occurrence probability

and ending at the consequence values.
5. Risk evaluation:- is a complex process of developing acceptable levels of risk to individuals,
groups, or the society as a whole. It involves the related processes of risk acceptance and
risk aversion.
6. Risk acceptance:- implies that a risk taker is willing to accept some risks to obtain a gain
or benefit, if the risk cannot possibly be avoided or controlled. The acceptance level is a
reference level against which a risk is determined and then compared. If the determined
risk level is below the acceptance level, the risk is deemed acceptable. If it is deemed
unacceptable and avoidable, steps may be taken to control the risk or the activity should
be ceased. The perception and the acceptance of risks vary with the nature of the risks and
depend upon many underlying factors. The risk may involve a "dread" hazard or a common
hazard, be encountered occupationally or non-occupationally, have immediate or delayed
effects and may effect average or especially sensitive people or systems.
7. Risk aversion:- is the control action, taken to avoid or eliminate the risk, regulate or
modify the activities to reduce the magnitude and/or frequency of adverse affects, reduce
the vulnerability of exposed persons, property or in this case urban systems, develop and
implement mitigation and recovery procedures, and institute loss-reimbursement and lossdistribution schemes.
8. False accept risk:- is the probability that out-of-tolerance product or other parameters are
perceived to be in-tolerance.
= False accept risk constitutes a measure of the quality of a measurement process as
viewed by individuals external to the measuring organization.
= The highier the false accept risk, the greater the chances for returned goods, loss of
reputation, litigation, and other undesirable outcomes.
= In a commercial context, individuals external to a measuring organization are labeled
consumers. For this reason, false accept risk has traditionally been called consumers
risk.
9. False reject risk:- is the probability that in-tolerance product or other parameters are
perceived to be out-of-tolerance.
= False reject risk is a measure of the quality of a measurement process as viewed by
individuals within to the measuring organization.
= The highier the false reject risk, the greater the chances for unnecessary re-work and
re-test.
= In a commercial context, individuals within to a measuring organization are labeled
producers. For this reason, false reject risk has traditionally been called producers risk.
6
Types of risks includes:

1. Systematic Risks (Systematic errors):- are classified as those whose sign and magnitude
remain fixed over a specified period of time or whose values change in a predictable way
under specified conditions. Example of this risk is market risk.
2. Unsystematic Risks (Random errors): - are those whose sign and/or magnitude may
change randomly over a specified period of time or whose values are unpredictable, given
randomly changing conditions. Examples of this risks includes; Stock and company specific risk
3. Credit or Default Risk :- can they pay the interest on the load or the dividend on that
stock
4. Country Risk :- Measure of political and economic stability
5. Foreign Exchange Risk: - will your money depreciate when you buy an asset in another
country?
6. Interest Rate Risk :- will the central bank raise interest rates
7. Political Risk :- Political stability of a country
8. Execution risk: - the time between when you see your price and when the trade actually
goes to the market.
CHAPTER TWO
ECONOMICS OF INSURANCE
Introduction
The insurance industry exists because people are willing to pay for being insured which is highier
than their expected claims. As a result, an insurer collects a premium that is larger than the
expected claim size.
Let X be a loss random variable then empirical or pragmatic rules of premium are
(i) P remium = p = E[X] = pure premium

(ii) P remium = p = (1 + )E[X], is the pure premium with safety (security) loading , where 0.
NB: = relative safety loading and E[X] =total safety loading
(iii) P remium = E[X] + aV ar(X) is the premium with variance loading principle.
p
(iv) P remium = E[X] + a V ar(X) is the premium with standard deviation loading principle.
Risk theory refers to a body of techniques to model and measure the risk associated with a
portfolio in insurance contracts.
A first approach consists modeling the distribution of total claims over a fixed period of time
using the classical collective model of risk theory. A second input of interest to the actuary is
the evolution of the surplus of the insurance company over many periods of time. In ruin theory,
the main quantity of interest is the probability that the surplus becomes negative, in which case
technical ruin of the insurance company occurs.
Modern life is characterized by risks of different kind: some threatening all persons and
some restricted to the owners of property, motor cars, etc, while still others are typical for some
individuals or for special occupations.
QUESTION
Define risk theory and discuss any two areas of interest in risk theory to an actuary.
Utility theory and Insurance

Under economics of insurance we examine the policyholders utility with and without insurance
and relate their preference to take out insurance or bear the risk themselves to the nature of
their utility function. We show that if an agent prefers more to less wealth and is risk a verse
then the agent will take out insurance.
The insurance industry exists because people are willing to pay for being insured which is
higher than their expected claims. As a result, an insurer collects a premium that is larger than
the expected claim size.
Generally without being a ware a decision maker, attaches a value () to his wealth instead
of just , where (.) is called his utility function. If a decision maker has to choose between
random losses X and Y , then he compares E[( X)] with E[( Y )] and chooses the loss
with the highest expected utility. With this model, the insured with wealth is able to determine
the maximum premium P + he is prepared to pay for a random loss X. This is done by solving
the equilibrium equation E[( X)] = ( P + ). At the equilibrium he doesnt care, in terms
of utility, whether he is insured or not.
The insurer, with his own utility function and perhaps supplementary expenses will determine a minimum premium P . If the insureds maximum premium P + is larger than the insurers minimum P , both parties involved increase their utility if the premium is between P
and P + .
Determination of utility function

The utility function of a decision maker can be obtained using the utility model: ( p+ ) =
p() + (1 p)( X), as illustrated in the example below.
Example
Describe how you will determine five points on the utility function of an individual whose wealth
is K Sh. 40,000. Assuming that probability of a risk occurring is 0.4 and the probability of
retaining the entire wealth is 0.6. Hence using the sketched utility function how would you
classify this type of risk individual and why?
Solution
Using the utility model
9
( G) = p() + (1 p)( X)
and by asking the question(s);
How much are you willing to pay as maximum premium G for complete cover of loss X likely
to occur at probability 1 p and retain your wealth at probability p.
We let () = 0 and (0) = 1 be the starting values yielding the points (40000, 0) and (0, 1)
when X = 40, 000 and say G = 28, 000
= (40, 000 28, 000) = 0.4(40, 000) + 0.6(0) = 0.6
i.e. (12, 000) = 0.6 = (12000, 0.6) is a third point on the utility function
when X = 28, 000 and say G = 20, 000
= (40, 000 20, 000) = 0.4(40, 000) + 0.6(40000 28000)
= (20, 000) = 0.4(40, 000) + 0.6(12000) = 0.4 0 + (0.6) 0.6 = 0.36
i.e. (20, 000) = 0.36 = (20000, 0.36) is a fourth point on the utility function
when X = 20, 000 and say G = 12, 000
= (40, 000 12, 000) = 0.4(40, 000) + 0.6(40000 20000)
= (28, 000) = 0.4(40, 000) + 0.6(20000) = 0.4 0 + (0.36) 0.6 = 0.216
i.e. (28, 000) = 0.216 = (28000, 0.216) is a fifth point on the utility function
Since this function is a concave function then the individual is a risk averse individual.
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Properties of ()
1. Should be a non-decreasing function, since more wealth generally implies a large utility
level.
2. Should accommodate the risk averse decision makers. Since they prefer a fixed loss over a
random loss that has the same expected value.
The expected utility model

Imagine that an individual runs the risk of losing an amount B with probability 0.01. He can
insure himself against this loss, and is willing to pay a premium p for this insurance policy. How
are B and P related? If B is very small, then P will be hardly larger than 0.01B. However, if B is
somewhat larger, say 500, then P will be a little larger than 5. If B is very large, P will be a lot
larger than 0.01B, since this loss could result in bankruptcy. So clearly, the premium for a risk
is not homogeneous, i.e. not proportional to the risk.
In economics, the model developed by Von Neumann & Morgenstern (1947) describes how
decision makers choose between uncertain prospects. If a decision maker is able to choose consistently between potential random losses X, then their exists a utility function (.) to appraise
the decisions he makes are exactly the same as those resulting from comparing the losses X
based on the expectation E[( X)].
For comparison of X with Y , the utility function (x) and its linear transform a(x) + b for
some a > 0 are equivalent, since they result in the same decision: E[( X)] E[( Y )] if
and only if E[a( X) + b] E[a( Y ) + b] so from each class of equivalent utility function,
0
we can select one, for instance by requiring that (0) = 0 and (1) = 1. Assuming that (0) > 0,
we could also use the utility function V (.) with V (0) = 0 and V 0 (0) = 0 such that
V (x) =
(x) (0)
0 (x)
Theorem (Jensens inequality)

If V (x) is a convex function and Y is a random variable then E[V (Y ) V (E[Y ])] with equality if
and only if V (.) is linear on the support of Y or V ar(Y ) = 0.
From this inequality it follows that for a concave utility function E[( X)] [E[( X)] =
( E(x)) So this particular decision maker is rightly called risk a verse: he prefers to pay a
risky amount X.
Now, suppose that a risk averse insured with capital used the utility function (.). Assum11
ing he is insured against a loss X for a premium P , his expected utility will increase if
E[( X)] E[( X)] = ( E[X]) = ( P )
(1)
Since (.) is a non-decreasing continuous function, this is equivalent to P P + . It is the

solution to the following utility equilibrium equation.
E[( X)] = ( P + )
(2)
Note:
Jensens inequalities states that for a random variable X and function ().
00
(i) if () < 0, then E[(X)] (E[X])

00
(ii) if () > 0, then E[(X)] (E[X])
Proof for case (i)

() in case (i) is a concave function with a maximum stationary point as shown below
The equation of a tangent function to the function () at the point (, ()),

0
where = E[X] = is given as () = () + ()( ).

0
For all values of > 0, () ()+ ()( ) and replacing with X and taking expectation
12
both sides we get; E[(X)] (E[X]).

This first Jensens inequality describes the attitute of a risk averse individual, who prefers
fixed loss over random losses.
Proof for case (ii)

() in case (ii) is a convex function with a minimum stationary point as shown below
The equation of a tangent function to the function () at the point (, ()),

0
where = E[X] = is given as () = () + ()( ).

0
For all values of > 0, () ()+ ()( ) and replacing with X and taking expectation
both sides we get; E[(X)] (E[X]).
This second Jensens inequality describes the attitute of a risk lover individual, who prefers
random loss over fixed losses. If the decision maker is neither risk averse or risk lover then he
is referred to as risk neutral individual. i.e. he is indifferent towards random and fixed losses.
Risk averse coefficient

Given the utility function (x), how can we approximate the maximum premium P + for a risk X?
13
Solution
Let u and 2 denote the mean and variance of X. Using the first terms in the series expansion of
(.) in we obtain
( P + ) ( u) + (u P + ) ( u);
1
0
00
( X) +( u) + (u X) ( u) + (u X)2 ( u)
2
(3)
Taking expectations on both sides of the latter approximation yields
1
00
E[( X)] ( u) + 2 ( u)
2
(4)
substituting 2 into 4, it follows from 3 that

1 00
0
( u) (u P + ) ( u)
2
Therefore, the maximum premium P + for a risk x is approximately
00
1 ( u)
P + u 2 0
2 ( u)
This suggest the following definition: (absolute) risk aversion coefficient r() of the utility function (.) of a wealth is given by
00
r() =
()
0 ()
Then the maximum premium P + to be paid for a risk X is approximately

1
P + u + r( ) 2
2
Exponential Premium
The insurer with utility function U (.) and capital W, will insure the loss X for a premium P if
E[(W + P X) U (W )], hence P P where P is the minimum premium to be asked. This
premium follows from solving the utility equilibrium equation reflecting the insurers position:
U (W ) = E[U (W + P X)]
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Question
Suppose that an insurer has an exponential utility function with parameter . What is the
minimum premium P to be asked for a risk X?
Solution
Solving the equilibrium equation U (W ) = E[U (W + P X)] with U (x) = ex yields
P =
1
log(mx ())
(5)
Where mx () = E[ex ] is the mgf of X at argument . We observe that this exponential premium
is independent of the insurers current wealth W, in line with risk aversion coefficient being a
constant.
The expression for the maximum premium P + is the same as 5, but now of course represents the risk aversion of the insured. Assume that the loss X is exponentially distributed
with parameter . Taking = 0.01 yields E[X] =
= 100. If the insureds utility function is
exponential with parameter = 0.005, then

1
log(mx ())

= 200log
= 200log(2)
P+ =
138.6
so the insured is willing to accept a sizable loading on the net premium E[X].
Quadratic utility
Suppose that for < 5, the insureds utility function is () = 10 2 . What is the maximum
premium P + as a function of , [0, 5] for an insurance policy against a loss 1 with probability
1
2?
What happens to this premium is increases. Let E[X] =
1
2
and var(x) =
1
4
Solution
We solve the equilibrium equation
E[( X)] = ( P + )
15
(6)
The expected utility after a loss X equals

E[( X)] = 11
11
2
2
(7)
and the utility after paying a premium P equals

( P ) = 10( P ) ( P )2
(8)
By the equilibrium equation 6, the right hand side of 7 and 8 should be equal, and after calculations
r
P = P () =
11
1
)2 + (5 ), [0, 5)
2
4
Exercise
A decision maker with an exponential utility function with risk aversion > 0 wants to insure a
gamma(n,1) distributed risk. Determine P + and prove that P + > n. When is P + = and what
does that mean?
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CHAPTER THREE
THE INDIVIDUAL RISK MODEL FOR SHORT TERMS
Introduction
We focus on the total claim amount S for the portfolio of an insurer.
- The individual risk model is defined as S = X1 + X2 + ... + Xn where Xi is the loss on insured
unit i.
- n is the number of risk units insured and S is the random variable which denotes the sum
of random loss on a segment of insuring organization risks.
- Under individual risks model one does not recognize the time value of money. Thus the
title individual risk model for short terms.
- Also in this case we discuss only closed models; that is the number of insured units n in
S = X1 + X2 + ... + Xn is known and fixed at the beginning of the period.
Note:
If we postulate about migration in and out of the insurance system, we have an open model.
In the Insurance practice, risks usually cant be modeled by purely discrete random variables,
nor by purely continuous random variables. Thus assuming that the risks in a portfolio are
independent random variables, the distribution of their sum can be calculated by making use
of convolution, moment generating functions, characteristic functions, probability generating
functions (pgf) and cumulant generating functions (cgf). Sometimes it is possible to recognize
the mgf of a convolution and consequently identify the distribution.
Mixed distributions and risks

Many distributions functions that are employed to model insurance payments have continuously
increasing parts, but also some positive steps.
Let Z represent the payment on three contract. Then, as a rule, there are three possibilities.
1. The contract is claim-free, hence S = 0.

17
2. The contract generates a claim which is larger than the maximum sum insured, say M .
Then, S = M .
3. The contract generates a normal claim, hence 0 < S < M .
Apparently, the cdf of S has steps in 0 and M . For the part in between we could use a discrete
distribution, since the payment will be some entire multiple of the monetary unit. This would
be a very large set of possible values, each of them with a very small probability, so using a
continuous cdf seems more convenient.
Note:
The following two-staged model allows us to construct a random variable with a distribution that
is a mixture of a discrete and a continuous distribution.
Let I be an indicator random variable, with values I = 1 or I = 0. Where I = 1 indicates that
some event has occurred. Suppose that the probability of the event is q = P r[I = 1], 0 q 1. If
I = 1, the claim Z is drawn from the distribution of X, if I = 0, then from Y . This means that
S = IX + (1 I)Y
(9)
If I = 1, then S can be replaced by X, if I = 0 can be replaced with Y . Note that we can consider
X and Y to be stochastically independent of I, since given I = 0 the value of X is irrelevant, so
we can take P r[X x|I = 0] = P r[X x|I = 1] just as well. Hence, the cdf of Z can be written as.
F (s) = P r[S s]
= P r[S s&I = 1] + P r[S s&I = 0]
= P r[X s&I = 1] + P r[Y s&I = 0]
= qP r[X s] + (1 q)P r[Y s]
(10)
Now, let X be a discrete random variable and Y a continuous random variable. From (10), we
0
d
get F (s) f (s 0) = qP r[X = s] and F (s) = (1 q) ds
P r[Y s] This construction yields a cdf F (s)
0
With steps where P r[X = s] > 0, but it is not a step function, since F > 0 on the range of Y .
Remark:
A mixed continuous/discrete cdfS (s) = P r[S s] arises when a mixture of random variables
S = IX + (1 I)Y is used, where X is a discrete random variable, Y is a continuous random
variable and I is a Bernoulli(q) random variable independent of X and Y .
18
Types of individual risk models

CASE I
The aggregate loss S = X could be a claim by an individual against a single policy where the
insurer agrees to pay amount X = b if the event insured against occurs at probability q and
X = 0 if the event does not occur at probability 1 q.
In this case; S = X = Ib.
where b is the constant amount payable in the event of death and I is the random variable
that is 1 for the event of death and 0 otherwise. Thus P r(I = 0) = 1 q and P r(I = 1) = q, the
mean and variance of I are q and q(1 q), respectively, and the mean and variance of X are bq
and b2 q(1 q) .
i.e.
The p.f is
1q
fX (x) = P r(X = x) =
q
f or x = 0
f or x = b
elsewhere
and the d.f is
FX (x) = P r(X x) =
1q
f or x < 0
f or 0 x < b
From the p.f and definitions of moments

E[X] = bq
E[X 2 ] = b2 q
V ar(X) = b2 q(1 q)
19
f or x b
CASE II
The aggregate loss S = X, could also be several claims by an individual from a single policy.
Example
Accident cover due to
constant Amount paid
F ire
b1
V ehicle
b2
T errorism
b3
N atural
b4
Riot
b5
&
B = Random variable
%
In this case: S = X = IB
where, B gives the total claim amount incurred during the period, and I is the indicator for
the event that at least one claim has occurred.
and we have
E[S] = E[E[S|I]] = E[E[IB|I]]

= E[IE[B|I]]
= E[I]E[B|I]
= E[I]E[B]
NOTE: The expected claim total equals expected value of indicator variable times expected
claim size.
V ar(S) = E[V ar(S|I)] + V ar(E[S|I]) = E[V ar(IB|I)] + V ar(E[IB|I])
= E[IV ar(B|I)] + V ar(IE[B|I])
= E[I]V ar(B|I) + (E[B|I])2 V ar(I)
cdf of S is
Letting FS (s) be the d.f of S = X we have
20
FX (x) = P r(X x) = P r(IB x)

= P r(IB x|I = 0)P r(I = 0)
+ P r(IB x|I = 1)P r(I = 1)
Assignment
Illustrate plots for pdfs and cdfs of S.
Application of Mixed distributions in modeling individual random variables

In a one-year term life insurance the insurer agrees to pay an amount b if the insured dies within
a year of policy issue and to pay nothing if the insured survives the year. The probability of a
claim during the year is denoted by q. The claim random variable, X, has a distribution that can
be described by either its probability function(p.f) or distribution function(d.f)
The p.f is
1q
fX (x) = P r(X = x) =
q
f or x = 0
f or x = b
elsewhere
and the d.f is
FX (x) = P r(X x) =
1q
f or x < 0
f or 0 x < b
From the p.f and definitions of moments

E[X] = bq
E[X 2 ] = b2 q
V ar(X) = b2 q(1 q)
21
f or x b
These formulas can also be obtained by writing

X = Ib
where b is the constant amount payable in the event of death and I is the random variable that
is 1 for the event of death and 0 otherwise. Thus P r(I = 0) = 1 q and P r(I = 1) = q, the mean
and variance of I are q and q(1 q), respectively, and the mean and variance of X are bq and
b2 q(1 q) as above.
Extending X = Ib, we postulate that where X is the claim random variable for the period, B
gives the total claim amount incurred during the period, and I is the indicator for the event that
at least one claim has occurred.
Example
Assume that for a particular individual the probability of one claim in a period is 0.15 and the
chance of more than one claim is 0. Then
P r(I = 0) = 0.85
P r(I = 1) = 0.15
Now consider an automobile insurance providing collision coverage above a 250 deductible up
to a maximum claim of 2000.
Since B is the claim incurred by the insurer, rather than the amount of damage to the car,
we can infer two characteristics of I and B. First, the event I = 0 includes those collisions in
which the damage is less than 250 deductible. The other inference is that B 0 s distribution has
a probability mass at the maximum claim size of 2000. Assume this probability mass is 0.1.
Furthermore assume that
P r(B x|I = 1) =
x0
0
h
0.9 1 1
Note:
The distribution Function for B, given I = 1 is
22
x
2000
2 i
0 < x < 2000

x 2000
Now, First we derive the distribution of X and use it to calculate E[X] and V ar(X). Letting
FX (x) be the d.f of X we have
FX (x) = P r(X x) = P r(IB x)

= P r(IB x|I = 0)P r(I = 0)
+ P r(IB x|I = 1)P r(I = 1)
For x < 0, FX (x) = 0(0.85) + 0(0.15) = 0

h
For 0 x < 2000, FX (x) = 1(0.85) + 0.9 1 1
2
x
2000
(0.15)
For x 2000, FX (x) = 1(0.85) + 1(0.15) = 1

This is a mixed distribution. It has both probability masses and a continuous part as can be
seen in the graph below
Corresponding to this d.f is a combination p.f and p.d.f given by
P r(X = 0) = 0.85
P r(X = 2000) = 0.015

with p.d.f
23
fX (x) = FX (x) =
0.000135 1
x
2000
0 < x < 2000

elsewhere
Moments of X can be calculated by
2000
xk fX (x)dx
E[X ] = 0 P r(X = 0) + (2000) P r(X = 2000) +

0
specifically,
E[X] = 120
E[X 2 ] = 150, 000

Thus V ar(X) = 135, 600
CASE III
The aggregate loss S = X could be also claim amount from n insuring units of an insuring
organization, or a single portfolio.
In this case:
S = X1 + X2 + ... + Xn
where;
24
Xi ; i = 1, 2, ....n, denotes the payment on policy i.

The risk Xi are assumed to be independent random variables and denotes the total claim
amount on ith insuring unit .
We have;
Let, = E[X] and 2 = V ar(X). Where, X is the claim severity.
Then
E[S] = E[X1 + X2 + ... + Xn ] = E[X1 ] + E[X2 ] + ... + E[Xn ] = nE[X] = n

NOTE: Expected value of aggregate claims=Number of insuring units times expected value of
claim severity.
V ar (X) = V ar[X1 + X2 + ... + Xn ] = V ar[X1 ] + V ar[X2 ] + ... + V ar[Xn ] = nV ar[X] = n 2
NOTE: Variance of aggregate claims=Number of insuring units times variance of claim severity.
St
M gf of S = MS (t) = E e
t[X1 +X2 +...+Xn ]
=E e
n
Y
tX n
n
= E e
= {MX (t)} =
MXi (t)
i=1
Determination of probability distribution for S = X1 + X2 + ... + Xn using Central

Limit Theorem
Given that Xi0 s are independent random variables and n 30, then using normal approximation
S = X1 + X2 + ... + Xn =
n
X
Xi N (E[S], V ar (S)) = N n, n 2
i=1
and
S n
S E[S]
p
=
N (0, 1)
n
V ar(S)
also
25
1
X1 + X2 + ... + Xn
1X
S=
=
Xi = S N
n
n
n
i=1

V ar(S)
n n2 2
2
E[S],
=N
= N ,
,
n
n
n
n
and
S E[S]
S
q
= N (0, 1)
n
V ar(S)
Question
Give an illustration that requires application of this theorem.
Determination of probability distribution for S = X1 + X2 + ... + Xn using Moment

generating functions
Since,
n
i n
h
Y

= {MX (t)}n =
MXi (t)
M gf of S = MS (t) = E eSt = E et[X1 +X2 +...+Xn ] = E etX
i=1
Due to uniqueness theorem of moment generating functions. Which says that, mgfs uniquely
determines distributions. i.e. variables with similar distributions have the same mgf function.
This means that one can deduce the pdf of S by examining the product
Qn
i=1 MXi (t)
examination one tries to find out if the product is mgf of a known distribution.
Recall:
Suppose that X is a random variable with pdf f (x) and mgf MX (t).
Then;
t 1
(a) If X poison() then, MX (t) = e(e
) , E[X] = , and V ar(X) =

n
(b) If X binomial(n, p) then, MX (t) = pet + (1 p) , E[X] = np, and V ar(X) = npq.
Where q = 1 p.
With a special case:
26
. During
When n = 1, then X Bernoulli(p).

(c) If X gamma(, ) then, MX (t) = t

= 1 t
, E[X] = , and V ar(X) =
.
2
With special cases:

(i) When = 1, then X exponential().
V
2
and = 12 , then X 2V .
r

p
then, E[X] =
(d) If X N B(r, p) then, MX (t) = 1(1p)e
t
(ii) When =
rq
p,
and V ar(X) =
rq
.
p2
Where q = 1 p.
With a special case:
When r = 1, then X geometric(p)

1 2 2
(e) If X N , 2 then, MX (t) = E[etX ] = et+ 2 t , E[X] = , V ar(X) = 2 .
(f) If X U nif orm(a, b) then, MX (t) =
etb eta
tbta ,
E[X] =
a+b
2 ,
and
(ba)2
12
Determination of probability distribution for S = X1 + X2 + ... + Xn using convolution

In the risk model we are interested in the distribution of the total S of the claims on a number
of policies, with S = X1 + X2 + ... + Xn , where Xi ; i = 1, 2, ....n, denotes the payment on policy i.
The risk Xi are assumed to be independent random variables.
Let us consider the sum of two random variables S = X + Y , with the sample space shown
below (Representing the event {X + Y s})
The line X + Y = s and the region below the line represent the event [X + Y s]
27
Hence the d.f of S is FS (s) = P r(S s) = P r(X + Y s)

The operation Convolution calculates the distribution function of X + Y from those of two
independent random variables X and Y , as follows.
FX+Y (s) = P r[X + Y s]

=
P r[X + Y s|X x]dFX (x)

=
P r[Y s x|X = x]dFX (x)

=
P r[Y s x]dFX (x)

FY (s x)dFX (x)
=
= FX FY (s)
(11)
The cdf FX FY (.) is called the convolution of the cdfs FX (.) and FY (.). For the density function
we use the same notation. If X and Y are discrete random variables, we find
X
FX FY (s) =
FY (s x)fX (x)
and
X
fX fY (s) =
fY (s x)fX (x)
Where the sum is taken over all x with fX (x) > 0. If X and Y are continuous random variables,
then
FY (s x)fX (x)dx
FX FY (s) =
and taking the derivatives under the integral sign, yields
fX fY (s) =
fY (s x)fX (x)dx
Note:
1. For three cdfs i.e. for cdf of X + Y + Z
(FX FY ) FZ FX (FZ FZ ) FX FZ FZ
i.e it does not matter in which order we do the convolutions. \item For the sum of n
independent and identically distributed random variables with marginal cdf, the cdf is the
n-fold convolution power of F , written as
F F ... F = F n
28
Example: (convolution of discrete distributions)

Let f1 (x) = 14 , 21 , 14 f or x = 0, 1, 2; f2 (x) = 12 , 21 f or x = 0, 2 and f3 (x) = 14 , 12 , 14 f or x = 0, 2, 4.
Let f1+2 denote the convolution of f1 and f2 and f1+2+3 denote the convolution of f1 , f2 and
f3 . To calculate F1+2+3 , we need to compute the values as shown in the table below.
f1 (x)*
f2 (x)
1
2
1
4
1
2
1
4
f1+2 (x)*
f3 (x)
1
4
1
8
2
8
2
8
2
8
1
8
1
2
f1+2+3 (x)
0
1
2
0
1
4
1
32
2
32
4
32
6
32
6
32
6
32
4
32
2
32
1
32
F1+2+3 (x)
1
32
3
32
7
32
13
32
19
32
25
32
29
32
31
32
32
32
Example: (Convolution of two uniform distributions)

Suppose that X U nif orm(0, 1) and Y U nif orm(0, 2) are independent. What is the cdf of
X +Y?
Solution
We introduce the concept indicator function". The indicator function of a set A is defined as
follows
IA (x) =
if x A
if x
/A
Indicator functions provide us with a concise notation for functions that are defined differently on some intervals. For all x, the cdf of X can be written as
FX (x) = xI[0,1) (x) + I[1,) (x)
0
While for FY (y) = 12 I[0,2) (y) for all y, which leads to the differential
1
dFY (y) = I[0,2) (y)dy
2
29
The convolution formula (11), applied to Y + X rather than X + Y , then yields
FX (s y)dFY (y) =
FY +X (s) =
1
FX (s y) dy, s 0
2
The interval of interest is 0 s < 3. Substituting it into [0,1), [1,2) and [2,3) yields

FX+Y (s) =
0

s1

s
1
1
1
(s y) dy I[0,1) (s) +
dy +
(s y) dy I[1,2) (s)
2
2
2
0
s1

s1
+
0
1
dy +
2

1
(s y) dy I[2,3) (s)
2
s1
1
1
1
= S 2 I[0,1) (s) + (2s 1)I[1,2) (s) + [1 (3 s)2 ]I[2,3) (s)
4
4
4
Notice that X + Y is symmetrical around s = 1.5
Models for individual claim amount (claim severity)

In this section we consider continuous distributions to model individual claim amount. This is
justified on the grounds that the monetary amounts are continuous rather than discrete. The
following are the most commonly used continuous distributions.
Normal distribution
A continuous random variable X is said to follow a normal distribution if its pdf is given by
f (x) =
1
1 e 2 (
2
x 2
< x < , < < , 2 > 0
MX (t) = E[etX ] = et+ 2
elsewhere
2 t2
E[X] = mX (t)|t=0 =
V ar(X) = 2
Gamma distribution
A random variable X possesses a gamma distribution with and =
30
if its distribution is:
f (x) =
x1 e

MX (t) = (1 t) or
1
1t
0 < x < , > 0, > 0

otherwise
E[X] =
V ar(X) = 2
OR
f (x) =
x1 ex

0 < x < , > 0, > 0

otherwise
With
E[X] =
V ar(X) =
Beta distribution
f (x) =
x1 (1x)1
B(,)
0 < x < 1, > 0, > 0
otherwise
With
E[X] =
V ar(X) =
(+)2 (++1)
Exponential distribution
It is a special case for poison distribution with = 1 and =
= f (x) =
ex
With
MX (t) =
31
0<x<
otherwise
E[X] =
V ar(X) =
1
2
Chi-Square distribution
It is a special case for gamma distribution where =
f (x) =
r 1
and = 2, r > 0
x2 e2
r
( r2 )2 2
r
2
0<x<
otherwise
With
r
MX (t) = (1 2t) 2 ,
t<
1
2
E[X] = r
V ar(X) = 2r
Log-normal distribution
A random variable X is said to be log-normally distributed with parameters and 2 if Y = ln(x)
and Y is normal with mean and variance 2
i.e. Y N (, 2 ) We can get the density of X by change of variable technique i.e
h(y)dy = f (x)dx but dy =
1
1 e 2
2
1
1 e 2
2
(y)2
2
(y)2
2
dy = f (x)dx
dx
x
2
1 (lnx)
2
e 2
2
dx
x
= f (x)dx
dx
If X is log-normally distributed the mgf exists but its not useful.
E[X] =
xf (x)dx
=
=
2
1 x 12 (lnx)
2
e
dx
2 x

2
1 (lnx)
1
e 2 2 dx
2
32
but Y = lnx, dy =
dx
x
dx = xdy = ey dy
E[X] =
2
+
= e
1
2 2
2 2 2 y]
e 22 [(y)
dy
e 22 [(y(+
2 )]2
dy
= e+ 22
With V ar(X) = e(2 + 2 )[e( 2 1)]
Pareto distribution
f (x) =
x
(x+)+1
x > 0, > 0, > 0
otherwise
Where
MX (t) = does not exist
E[X] =
=
=
=
=
=
=
=
x
dx
(x + )+1
0

x
dx
(x + )+1
0

x + ( )
dx
(x + )+1
0

x+
dx
(x + )+1 (x + )+1
0

1
1
1
.
+
dx
1 (x + )+1 (x + )+1 0

1
1
.
+
dx
1 ()+1 ()

1
1 1
and
V ar(X) =
2
(1)2 (2)
33
Example
In a Bayesian investigation in the insurance industry, a particular claim rate is to be estimated.
To obtain a suitable prior distribution, an expert is consulted and he suggest that will have
a mean of 0.15 and a standard deviation of 0.05. It is required to consult a prior gamma
distribution to fit the experts information. Find the parameters for the appropriate gamma
distribution.
Solution
For a gamma distribution with parameters and , E[X] = and V ar(X) = 2
= 0.15 2 = (0.05)2
=
0.15
, (0.15)
= (0.05)2 = 0.0166666 and = 9
Question
Let X P oisson() and Y P oisson() be independent random variables. If S = 0, 1, 2, ..., find
the distribution of X + Y = S using the convolution method.
Question
Independent random variables Xk for four lives have the discrete probability functions given
below.
P r(X1 = x)
P r(X2 = x)
P r(X3 = x)
P r(X4 = x)
0.6
0.7
0.6
0.9
0.0
0.2
0.0
0.0
0.3
0.1
0.0
0.0
0.0
0.0
0.4
0.0
0.1
0.0
0.0
0.1
Use a convolution process on the non-negative values of x to obtain FS (x) for X = 0, 1, 2, ...
where S = X1 + X2 + X3 + X4 , hence calculate the mean, variance, skewness and kurtosis of
the distribution of S.
34
CHAPTER FOUR
COLLECTIVE RISK MODELS (or Compound risk models)
Introduction
Under collective risk models we calculate the distribution of the total claim amount in a certain
time period, but now we regard the portfolio as a collective that produces a claim at random
points in time. We write
S = X1 + X2 + ... + XN
(12)
Where N denotes the number of claims and Xi is the ith claim, and by convention, we take S = 0
if N = 0. So the terms of S in (12) correspond to actual claims. But for individual risk model
there are many terms equal to zero, corresponding to the policies which do not produce a claim.
The number of claims N is a random variable, and we assume that the individual claims Xi are
independent and identically distributed. In the special case that N is poison distributed. S has
a compound poison distribution. If N is (negative) binomial distributed, then S has a compound
(negative) binomial distribution.
Note:
- In collective risk models we require the claim number N and the claim amounts Xi to be
independent.
- Collective risk model is a computationally efficient model, which is also rather close to
reality.
- In collective models, some policy information is ignored.
Compound distribution
Assume that S = X1 +X2 +...+XN is a compound distribution, Xi are distributed as X, k = E[X k ],
P r(x) = P r[X x] and F (s) = P r[S s]. We can then calculate the expected value of S by using
the conditional distribution of S, given N.
i.e.
35
E[S] = E[E[S|N ]] =
E[X1 + ... + XN |N = n]P r(N = n)
n=0
=
=
=
X
n=0
X
n=0
E[X1 + ... + Xn |N = n]P r(N = n)

E[X1 + ... + Xn ]P r(N = n)
n1 P r(N = n) = 1 E[N ]
n=0
NOTE: The expected claim total equals expected claim frequency times expected claim size.
V ar(S) = E[V ar(S|N )] + V ar(E[S|N ])
= E[N V ar(X)] + V ar(N 1 )
= E[N ]V ar(X) + 21 V ar(N )
mgf of S is

MS (t) = E E[etS |N ]
h
i
X
=
E et(X1 +...+XN ) |N = n P r(N = n)
=
=
n=0
X
n=0
i
h
E et(X1 +...+Xn ) P r(N = n)
{MX (t)}n P r(N = n) = E
h
i
N
elogMX (t)
n=0
(13)
= MN (logMX (t))
Example (on compound distribution with closed form)

Let N geometric(p),
for 0 < p < 1 and X exponential(1). What is the mgf of S?
Solution
Write q = 1 p. First, we compute the mgf of S, and then we try to identify it. For qet < 1, which
means t < logq, we have
MX (t) =
ent pq n =
n=0
36
p
1 qet
Since X exponential(1), i.e. MX (t) = (1 t)1 equation (13) yields

MS (t) = MN (logMX (t)) =
p
p
=1+q
1 qMX (t)
pt
So the mgf of S is a mixture of the mgfs of the constant 0 and of the exponential(p) distribution.
Because of one-to-one correspondence of cdfs and mgfs we may conclude that the cdf of S is
the mixture
F (x) = p + q(1 epx ) = 1 qepx f or x 0
This is a distribution function which has a jump of size p in 0 and is exponential otherwise.
Distribution for the Number of claims

To describe rare events the poison distribution which has only one parameter is always the first
choice. If the model for the number of claims exhibits a larger spread around the mean value,
one may use the negative binomial distribution instead.
Example (on compound distribution with closed form)

Let N geometric(p), 0 < p < 1 and X exponential(1). What is the mgf of S?
Solution
Write q = 1 p. First, we compute the mgf of S, and then we try to identify it. For qet < 1, which
means t < logq, we have
MX (t) =
ent pq n =
n=0
p
1 qet
Since X exponential(1), i.e. MX (t) = (1 t)1 equation (13) yields

MS (t) = MN (logMX (t)) =
p
p
=1+q
1 qMX (t)
pt
So the mgf of S is a mixture of the mgfs of the constant 0 and of the exponential(p) distribution.
Because of one-to-one correspondence of cdfs and mgfs we may conclude that the cdf of S is
the mixture
F (x) = p + q(1 epx ) = 1 qepx f or x 0
This is a distribution function which has a jump of size p in 0 and is exponential otherwise.
37
Distribution for the Number of claims

To describe rare events the poison distribution which has only one parameter is always the first
choice. If the model for the number of claims exhibits a larger spread around the mean value,
one may use the negative binomial distribution instead.
Question
Assume that some car driver causes a poison() distributed number of accidents in one year. The
parameter is unknown and different for every driver. We assume that is the outcome of a
random variable . The conditional distribution of N, the number of accidents in one year, given
= , is poison().
(a) What is the marginal distribution of N?

(b) What is the mean and variance of N?
(c) What is the distribution of N if gamma(, )
Solution
Let U () = P r( ) denote the distribution function of . Then we can write the marginal
distribution of N as
P r(N = n) =
P r(N = n| = )dU ()
n
dU ()
n!
while for mean and variance of N we have
E[N ] = E[E[N |]] = E[]
V ar(N ) = E[V ar(N |)] + V ar[E[N |]]

= E[] + V ar[] E[N ]
Now assume additionally that gamma(, ), then
38
MN (t) = E[E[e
where p =
+1 ,
tN
(et 1)
|]] = E e
= M (e 1) =
(et 1)

=
p
1 (1 p) et
so N has a negative binomial(, (+1)

) distribution.
Models for the timing and occurrence of events

These models use discrete variables since they count the number of events occurring within a
specified time interval. The following are the most commonly used distributions used to model
such events.
Binomial distribution

n
P r(X = x) = px (1 p)nx ,
x
x = 0, 1, 2, ...
The mgf
MX (t) = E[ext ]

n
=
ext px (1 p)nx
x
all x

X n
(pet )x (1 p)nx
=
all x x
X
Recall

n
ax bnx = (a + b)n
x x
X
all
MX (t) = (pet + q)n

and
E[X] = MX |t=0
= npet (pet + q)n1 |t=0

= npe0 (pe0 + q)n1
= np(p + q)n1 but p + q = 1
= np
39
V ar = E[X 2 ] (E[X])2
0
= MX (t)|t=0 (MX (t))2 |t=0

= npq
Negative binomial distribution

A random variable X is said to have a negative binomial distribution if pdf is given by

P r(X = x) = v+x1
pv (1 p)x1 , v > 0, 0 < p < 1
x1
(where v= the number of occurrences for the event)

v
p
MX (t) = 1qe
t
dt
p
1 qet
v
= pv
d
(1 qet )v
dt
= pv (v)(qet )(1 qet )v1

pv vqet
pv vq
=
|
=
(1 qet )v+1 t=0
(1 q)v+1
pv vq
=
pv+1
vq
=
p
E[X] = MX (t)|t=0 =
vq
p
and
V ar(X) =
vq
p2
Suppose v = 1 then P r(X = x) = p(1 p)x1 , x = 1, 2, 3, ... which is geometric distribution with
mgf,
MX (t) =
p
1qet ,
E[X] =
q
p
and V ar(X) =
q
p2
Example
A portfolio consists of a total of 120 independent risks. On each risk, no more than 1 event can
occur each year, and the probability of an event occurring is 0.02. When such an event occurs,
the number of claims N has the following distribution. P (N = x) = 0.4(0.6)x1 ,
X = 1, 2, 3, ...
Determine the mean and variance of the distribution of the number of claims which arise
from this portfolio in one year.
40
Solution
Recall that if X and Y are independent random variables then E[Y ] = E[E[Y |X]]. By convention,
let the random variable Z = X1 + X2 + ... + Xn denote the aggregate claim amount where Xi , i =
1, 2, 3, ..., n are iid, random variables, independent of N, the number of claims on a risk in 1 year.
Then
E[Z] = E[[E(Z|N )]]

= E[N E(X)]
= E[N ]E[X]
and
V ar(X) = E[V ar(Z|N )] + V arE[Z|N ]
= E[N V ar(X)] + V ar(N E[X])
= E[N ]V ar(X) + V ar(N )(E[X])2
Now let M be the total number of claims, also let K be the number of risks for which the events
occurs.
M = N1 + N2 + ... + NK , where N geometric, k B(n, p) = B(120, 0.02)
Then mean is
E[M ] = E[E[M |K]]

= E[K]E[N ]
q
= np.
p
= (120 0.02)
= 3.6
and
41
0.6
0.4
V ar(M ) = E[V ar(M |K)] + V ar(E[M |K])

= E[K]V ar(N ) + V ar(K)(E[N ])2
2
q
q
= np. 2 + npq
p
p
0.6
(0.6)2
= 120(0.02)
+
120(0.02)(0.98)
(0.4)2
(0.4)2
= 14.292
Theorem: Panjers recursion

Consider a compound distribution with inter-valued non-negative claims with pdf P (x), x =
0, 1, 2, ... for which the probability qn of having n claims satisfies the following recursion relation

qn =
b
a+
n

qn1 ,
(14)
n = 1, 2, ...
for some real a and b. Then the following relations for probability of a total claim equal to s hold:
f (0) =
P r(N = 0)
if p(0) = 0
MN (logP (0))
f (s) =
p(0) > 0

s
X
bh
1
a+
p(h)f (s h),
1 ap(0)
s
s = 1, 2, 3, ...
(15)
h=1
Proof:
P r(S = 0) =
P r(N = n)P n (0)
n=0
gives us starting value f (0). Write Tk = X1 + ... + Xk . First, note that because of symmetry.
h
i
1
E a + bX
|T
= a + kb . This expectation can be determined in the following way.
k
S

bX1
E a+
|Tk
S

=
=
s
X
h=0
s
X
h=0
bh
a+
s
bh
a+
s
P r(X1 = h|Tk = s)
42
P r(X1 = h)P r(Tk X1 h|s h)

P r(Tk = s)
Because (14) and the previous two equalities, we have for s = 1, 2, ...
f (s) =
=
=
=
=
P r(Tk = s) =
k=1

qk1
k=1
b
a+
k

P r(Tk = s)

s
X
b
qk1
a+
P r(X1 = h)P r(Tk X1 = s h)
k
0
k=1

s
X
X
b
a+
P r(X1 = h)
qk1 P r(Tk X1 = s h)
k
h=0
k=1

s
X
bh
p(h)f (s h)
a+
s
h=0

s
X
bh
aP (0)f (s) +
a+
p(h)f (s h)
s
h=1
From which the second relation of (15) follows immediately
Distributions suitable for panjers recursion

Only the following distributions satisfy

b
qn = a +
q ,
n n1
n = 1, 2, ...
1. Poison() with a = 0 and b = 0, in this case (14) simplifies to
f (0) = e(1P (0))

s
1X
f (s) =
hP (h)f (s h)
s
(16)
h=1
2. Negative binomial(r,p) with a = 1 p and b = (1 p)(r 1), so 0 < a < 1 and a + b > 0. In this
case (14) simplifies to
f (0) = pr
f (s) = (1 p)
s
X
h=1

h
(r 1) + 1 P (h)f (s h)
s
(17)
NOTE: The constants a and b for Negative binomial distribution are obtained using the
distribution that models the number of failures before rth success. I.e. if Y is the number
of failures before rth success then;
43
Y N B(r, p) and f (y) =
r+y1
y
pr q y , where y=0,1,2...
Also note that;

If X denotes the bernoulli trial at which the rth success occurs, where r is fixed. Then;
x1
pr q xr ., where x=0,1,2,...
X N B(r, p) and f (x) =
r1
p
and b =
3. Binomial(m,p) with a = 1p
(m+1)p
(1p)
. so a < 0, b = a(m + 1) . In this case (14)
simplifies to
f (0) = (1 p)m

s
X
h
p
(m + 1) 1 P (h)f (s h)
f (s) =
(1 p)
s
(18)
h=1
Example:
A compound poison distribution with = 4 and P r(X = 1, 2, 3) = 14 , 12 , 41 . What is the distribution
of S = X1 + X2 + X3
Solution
Equation (16) yields, with = 4, P (2) =
1
2
and P (1) = P (3) =
1
4
1
f (s) = [f (s 1) + 4f (s 2) + 3f (s 3)],
s
s = 1, 2, 3, ...
and the starting value is f (0) = e4 0.0183. We have

f (1) = f (0) = e4
f (2) = 12 [f (1)4f (0)] = 52 e4
f (3) = 31 [f (2) + 4f (1) + 3f (0)] =
19 4
6 e
and so on.
Question
A compound Negative binomial distribution with r = 14, p = 0.7 and P r(X = 1, 2, 3) = 14 , 12 , 14 . What
is the distribution of S = X1 + X2 + X3
44
Question
A compound Binomial distribution with m = 15, p = 0.3 and P r(X = 1, 2, 3) = 14 , 12 , 14 . What is the
distribution of S = X1 + X2 + X3
Question
Prove that in deed the values of the constants a and b in Panjers recursion theorem

b
qn = a +
q ,
n n1
n = 1, 2, ...
for Poisson, Negative binomial and Binomial distribution are as given in the discussion above.
45
CHAPTER FIVE
RUIN THEORY
Under ruin theory we focus again on collective risk models, but now in the long term. We
consider the development in time of the capital U(t) of an insurer. This is a stochastic process
which increases continuously because of the earned premiums, and decreases stepwise because
of the payment of claims. When the capital becomes negative, we say that ruin has occurred.
The risk process

A stochastic process consists of related random variables, indexed by the time t. We define the
surplus process or risk process as follows:
U (t) = u + ct S(t),
t0
where
U (t) = the insurer0 s capital at time t

u = U (0) = the initial capital
c = the (constant)premium income per unit of time
S(t) = X1 + X2 + ... + XN (t) ,
with
N (t) = the number of claims up to time t and

Xi = the size of the ith claim, assumed to be non negative.
The figure below shows a typical realization of risk process

The random variables T1 , T2 , ...denote the time points at which a claim occurs. The slope of
the process is c if there are no claims; if however, t = Tj for some j, then the capital drops by Xj ,
which is the size of the j th claim. Since in the figure above, at time T4 the total of the incurred
claims X1 + X2 + X3 + X4 is larger than the initial capital u plus the earned premium CT4 , the
remaining surplus U (T4 ) is less than 0. This state of the process is called ruin and the point in
time at which this occurs for the first time is denoted by T. So
46
= min{t|t 0 &U (t) < 0}

= if U (t) 0 f or all t
The probability that ruin ever occurs, i.e, the probability that T is finite, is called the ruin
probability. It is written as follows
(u) = P r[T < ]
NOTE:
Ruin is said to occur when U (t) is negative
Ruin is not equivalent to insolvency of an insurer
Infinite time probability of ruin is () = P r (U (t) < 0 f or some t 0). In this case () is
the probability of ruin over an infinite horizon. () is an upper bound for (, t). () is
more trackable mathematically.
(, t) = P r(T < t) is the probability of ruin before time t.
Let Tj denote the time when claim j occurs, such that T1 < T2 < T3 < ....... Then the random
variable of the interarrival (or wait) time between claim j 1 and j is defined as W1 = T1 and
Wj = Tj Tj1 , j 2. With the following assumptions:
(i) Premiums are collected at a constant rate c hence c(t) = ct
(ii) The sequence {Tj }j1 forms an ordinary renewal process, provided Wj0 s are iid
47
Poisson Process
Before we turn to the claim process S(t), i.e. the total claims up to time t, we first look at the
process N(t) of the number of claims up to t. We assume that N(t) is a Poisson process.
The process N(t) is a poison process if for some intensity > 0, the increments of the process
have the following property
N (t + h) N (t) P oisson(h)
for all t > 0, h > 0 and each history N(s), s t
As a result, a Poisson process has the following properties:
The increments are independent: If the intervals (ti , ti + h), i=1,2,... are disjoint, then the
increments i.e. N (ti + hi ) N (ti ) are independent
The increments are stationary: N (t + h) N (t) is Poisson(h) distributed for every value of
t.
Next to this global definition of the claim number process, we can also consider infinitesimal
increments N (t + dt) N (t), where the infinitesimal number" dt again is positive, but smaller
than any real number larger than 0. For the Poisson process we have
P r[N (t + dt) N (t) = 1|N (s); 0 s t] = edt dt = dt
P r[N (t + dt) N (t) = 0|N (s); 0 s t] = edt dt = 1 dt
P r[N (t + dt) N (t) 2|N (s); 0 s t] = edt dt = 0
these equalities are only valid if we ignore terms of order (dt)2
Lumdbergs exponential bound theorem for the ruin probability

For a compound Poisson risk process with an initial capital u, a premium per unit of time c,
claims with cdf P(.) and mgf Mx (t), and an adjustment coefficient R, we have the following
inequality for the ruin probability (u) eRu 0.
Assignment
Proof the above theorem
48
How to determine adjustment coefficient (R)

CASE I: Given Claim amount and Interarrival time random variables
The adjustment coefficient is defined as the smallest strictly positive solution (if it exists) of
the Lundberg equation

h(t) = E etXtcW = 1
Where X is the claim random variable, W is the interarrival time random variable, c is the
constant premium rate that satisfies the condition E[x cW ] < 0. If X and W are independent,
as in the most common models, then the equation can be re-written as;
h(t) = MX (t)MW (tc) = 1
Question
If W and X are independent and W exp(2), X exp(1) and premium rate is c = 2.4. Find
adjustment coefficient.
CASE II: A Discrete time model
For a discrete time model the surplus process is given as
Un = u + nc Sn
where;
Un denotes the insurers surplus at time n, where n = 0, 1, 2, 3, ....
denotes initial surplus
c denotes the constant premium received per unit time/period
Sn denotes the aggregate claims of the n periods
N ote :
Un is viewed by examining amount of surplus on a periodic basis. Since insurance managers
submit financial report on a yearly, semi annual, quarterly or monthly basis.
Assume, Sn = X1 + X2 + ... + Xn . Where Xi is the sum of the claims in period i. X1 , X2 , ... are
49
independent, identically distributed random variables with = E[Xi ] < c.

Un can also be written as; Un = + (c X1 ) + (c X2 ) + ... + (C Xn ) and we define adjustment
coefficient as the positive solution of the equation
h
i
MXc (r) = E er(Xc) = erc MX (r) = 1 or logMX (r) = rc
Where X denotes a random variable with the distribution of the annual claims.
Example
Derive an expression for R in the special case where the Xi0 s have a common distribution N (, 2 ).
Solution
log [MX (r)] = r +
= R =
2(c)
2
2 r2
2
but logMX (r) = rc
where < c.
Generally
Since for a random variable X
d
dt logMX (t)|t=0
= E[X] and
d2
logMX (t)|t=0
dt2
= V ar[X]
and using Maclaurin series expression

logMX (r) = r + 12 2 r2 + ...
where, 2 = V ar(X)
=Then R '
2(c)
2
Note:
If X has a compound distribution and the relative security loading is given by c = (1 + ) then
R=
2{[+]}
2
2
2
Let, pk = E[X]k = E[Loss]k

then
50
R
=
2p1 E[N ]
(p2 p21 )E[N ]+p21 V ar(N )
Where N is a random variable distributed as the number of claims in a period.
Example
Approximate R if;
a) N has a poison distributed with parameter .
b) N has a negative binomial distributed with parameters r and p.
Solution
a) E[N ] = V ar(N ) =
Therefore, R
=
b) E[N ] =
rq
p,
2p1
p2
V ar(N ) =
Therefore, R
=
rq
p2
2p1
h
p2 +p21
Note; as p 1, R
=
1
p
i
1
2p1
p2
CASE III: A Continuous time model

For a continuous time series, the surplus process is defined as;
U (t) = U + c(t) S(t)

and,
considering a period of length t > 0 where the a mount of premiums collected is ct and the
claim distribution is compound poison with expected number of claims t Then R is the smallest
positive root of
h
i
MS(t)ct (r) = E er(S(t)ct) = erct MS(t) (r) = erct et[MX (r)1] = 1
Thus
[MX (r) 1] = rc
51
Substituting, c = (1 + )p1
We get, 1 + (1 + )p1 r = MX (r). Which is a linear of r.
Note: 1 + (1 + )p1 r = MX (r) has two solutions, A side from the trivial solution r = 0, there is
a positive solution r = R which is defined as adjustment coefficient.
Example
Determine the adjustment coefficient is the claim distribution is exponential with parameter
> 0.
Solution
The adjustment coefficient is obtained from 1 + (1 + )p1 r = MX (r)
as 1 +
(1+)r
= (1 + )r2 r = 0
as r = 0 is a solution and R is smallest positive root
= R =
1+
Question
Calculate the adjustment coefficient if all claims are of size 1.
Approximation of Ruin probability in the case of compound Poisson aggregate

claims process
Here we give an expression for the ruin probability which involves the mgf of U(T) i.e the capital
at the moment of ruin, conditionally given the event that ruin occurs in a finite time period.
This expression enables us to give an exact expression for the ruin probability in case of an
exponential distribution. i.e the ruin probability for u 0 satisfies
(u) =
eRu
f or 0
E[eRU (T ) |T < ]
where R is the smallest positive of 1 + (1 + )p1 r = MX (r).
52
Proof:
Let R > 0 and t > 0. Then
E[eRU (t) ] = E[eRU (t) |T t]P r[T t] + E[eRU (t) |T > t]P r[T > t]
(19)
The adjustment coefficient R has the property that E[eRU (t) ] is constant in t. i.e. eRU (t) is a
martingale: and since U (t) = u + ct S(t) and S(t) Compound Poisson with parameter t, we
have,
E[eRU (t) ] = E[eR{u+ctS(t)} ]
= eRu [eRc exp{(Mx (R) 1)}]t
= eRu
(20)
From equation 17 the left-hand side equals eRu . For the first conditional expectation in eqn 17
we take v [0, t] and write, using U (t) = U (v) + c(t v) [S(t) S(v)] see also equation 18
E[eRU (t) |T = v] = E[eR{U (v)+c(tv)[S(t)S(v)]} |T = v]
= eRU (v)|T =v eRc E[eR{S(t)S(v)} |T = v]

tv
= eRU (v)|T =v eRc exp[(Mx (R) 1)]
h
i
= E eRU (T ) |T = v
(21)
The total claims S(t) S(v) between v and t has again a compound Poisson distribution. What
happens after v is independent of what happened before v, so U(v) and S(t)S(v) are independent.

The term in curly brackets equals 1. Equality in eqn 19 holds for all v t, so E eRU (t) |T v =

E eRU (T ) |T v also holds.
Since P r[T t] P r[T < ] for t , it suffices to show that the last term in eqn 17 vanishes
for t . For that purpose, we split the event T > t according to the size of U(t). More precisely,
we consider the cases U (t) uo (t) and U (t) > uo (t) for some function uo . Notice that T > t implies
that we are not in ruin at time t, i.e. U (t) 0 so eRU (t) 1. We have
E[eRU (t) |T > t]P r[T > t] = E[eRU (t) |T > t & 0 U (t) uo (t)]P r[T > t & 0 U (t) uo (t)]
+ E[eRU (t) |T > t & U (t) > uo (t)]P r[T > t & 0 U (t) > uo (t)]
P r[U (t) uo (t)] + E[exp(Ruo (t))]
= 0
53
The second term vanishes if uo . For the first term in eqn 17, note that U(t) has an expected
value U (t) = u + ct tu1 and a variance 2 (t) = tu2 .
Question
Calculate the probability of ruin in the case that the claim amount distribution is exponential
with parameter > 0.
Theorem: Distribution of the capital at time of ruin

If the initial capital u equals 0, then for all capital y > 0 we have
P r[U (T ) (y dy, y) & T < ] =
[1 p(y)]dy
c
(22)
Proof:
In a compound Poisson process, the probability of having a claim in the interval (t, t + dt) equals
dt. Which is independent of t and of the history of the process up to that time. So, between
0 and dt there is either no claim (with probability 1 dt), and the capital increases from u to
u + cdt, or one claim with size X. In the latter case, there are two possibilities. If the claim size is
less than u, then the process continues with capital u + cdt X. Otherwise ruin occurs, but the
capital at ruin is only larger than y if X > u + y. Defining
G(u, y) = P r[U (T ) (, y) T < |U (0) = u]
we can write

G(u, y) = (1 dt)G(u + cdt, y) + dt
G(u x, y)dP (x) +

0

dP (x) .....................................................()
u+y
If $G^{}$ denotes the partial derivative of G with respect to u, then

0
G(u + cdt, y) = G(u, y) + cdtG (u, y)......................................................................................................................()

Substitute (**) into (*), subtract G(u,y) from both sides and divide by cdt. Then we get
G (u, y) =
c
0

G(u, y)
G(u x, y)dP (x)

0
u+y
54

dP (x)
integrating this over u [0, z] yields
G(z, y) G(0, y) =
c
G(u x, y)dP (x)du
G(u, y)du
0

dP (x)du .................................( )
u+y
The double integrals in (***) can be reduced to single integrals as follows. For the first double integral, exchange the order of integration, substitute v = u x and again exchange the integration
order. This leads to
zv
G(u x, y)dP (x)du =

0
G(v, y)P (z v)dv
G(v, y)dP (x)dv =

0
In the second double integral in (***) we substitute v = u + y. Then
z+y
[1 P (v)]
dP (x)dv =
0
v+y
Hence
G(z, y) G(0, y) =
c
z+y
[1 P (v)]dv
0
z+y

[1 P (u)]du .............................................................( )
for z , the first term on both sides of (****) vanishes, leaving
G(0, y) =
c
[1 P (u)]du
y
which completes the proof.
Approximation of ruin probability when initial capital is zero

The ruin probability at 0 depends on the safety loading only. Integrating eqn 20 for y (0, )
yields P r[T < ], so regardless of P(.) we have
(0) =
c
[1 p(y)]dy =
0
1
u1 =
c
1+
where, is the relative security loading factor.
Reinsurance, individual claims

Assume that the reinsurer pays an amount h(x) if the claims amount is x. In other words, the
retained loss equals x h(x). we consider two special cases
h(x) = x 0 1 for proportional reinsurance
h(x) = (x )+ 0 for excess of loss reinsurance
55
Obviously, proportional reinsurance can be considered as a reinsurance on the usual adjustment coefficient Rh , which is the root of
er[xh(x)] dP (x)
+ (c ch )r =
(23)
where ch denotes the re-insurance premium. The reinsurer uses a loading factor on the net
premium.
Assume that = 1, and p(x) = 0.5 for x = 1 and x = 2. Furthermore, let c = 2, so that = 31 ,
and consider two values =
1
3
and = 25 . \par In case of proportional reinsurance h(x) = x, the
premium equals
3
ch = (1 + )E[h(x)] = (1 + )
2
so, because of x h(x) = (1 )x eqn 21 leads to the equation

3
1
1
1 + 2 (1 + ) r = er(1) + e2r(1)
2
2
2
For = 13 , we have ch = 2 and Rh =
0.325
1 ,
for = 52 , we have ch = 2.1.
Next, we consider the excess of loss reinsurance h(x) = (x )+ with 0 2. The reinsurance premium equals

1
1
1
ch = (1 + ) h(1) + h(2) = (1 + ) [(1 )+ + (2 )+ ]
2
2
2

while x h(x) = min{x, }, and therefore Rh is the root of

i
1
1 h min{,1}r
1 + 2 (1 + ) [(1 )+ + (2 )+ ] r =
e
+ emin{,2}r
2
2
NOTE:
Assuming that other factors remain constant, the following reduces the probability of ruin.
1. Increase of C
2. Increase of initial surplus
3. Increase of re-insurance
The following increases the probability of ruin
1. Increase of variance of the individual claim size
56
2. Increase of skewness of the individual claim size
57
CHAPTER SIX
RISK AND MODELLING
The uncertainty regarding future cash flows is of three types ie Amount, occurrence and timing.
The uncertainty regarding the amount of cash flow is witnessed when for instance, a businessman buys shares and plans to sell them within the year. The amount realized from selling the
shares would be determined by the market price of the shares within the year which is not
known at the moment. Similarly, when a general insurance company provides comprehensive
motor insurance to a motorist, they dont know how much the claims arising from the policy over
the following year will be. In fact they dont know whether there will be any claims arising from
the policy which brings us to the notion of uncertainty arising from the occurrence of events.
The final dimension of uncertainty regards the timing of cash flows. In a whole life policy, policy
holders pay regular premiums until death, and on death, a nominated beneficiary is paid a fixed
sum assured. Though the amount is known in advance, the timing of crucial event (death) is
not known and this is a source of uncertainty.
Financial Engineers solve financial problems by modeling cash flows, projecting these cash
flows and then using the cash flows to obtain a solution. In finance, financial economists use the
standard deviation of a cash flow as an indicator of its riskiness. However, standard deviation
does not take into account the special circumstances of the investor. Investors have different
attitudes towards risk and different objectives.
Financial risk takes into account these different objectives being defined as the risk that the
investors objectives may be met. It is actually expressed as a probability.
Statistical models
From the fact that cash flows have three dimensions ie time, occurrence and the amount, we
describe some of the models used to represent these three dimensions with particular emphasis
on applications in general insurance. We will first consider models used to represent timing and
occurrence of events associated with cash flows, proceed to models representing the amount of
cash flows and then aggregate the amount arising from several events. Aggregation will be the
total claim amount paid out under a single policy or a portfolio of policies over a specified period
of time eg 1 year. Modeling the aggregate claims will guide us on the correct premium to charge.
It will also enable us to decide what reinsurance arrangements will be best for our needs.
58
ESTIMATION OF MODEL PARAMETERS

We have various methods of estimating model parameters. They include:
1. Maximum Likelihood
2. Least square method
3. Method of moments
4. Bayes estimation
Maximum likelihood method

The likelihood of a sample is the product of the probabilities of drawing the individual observations from the population. In this method, we look for the value of the population parameter that
maximizes the likelihood function by differentiating the function with respect to the population
parameter of interest and equating it to 0 and then solving the equation.
Example
An insurance company has an excess of loss reinsurance contract with retention of 50,000 US
dollars. Over the last year, the insurer paid the following claims in dollars 12372, 2621,389 and
43299. In addition, the insurer paid the amount of 50,000 dollars on 6 claims with the excess
being paid by the re-insurer. The insurer believes that distribution of gross claim amounts is
exponential with mean . Calculate the maximum likelihood estimate of based on the above
information.
Solution
Let X be the random variable for the gross claim amounts. The likelihood function is
L=
n
Y
f (xi , )
i=1
but
f (x, ) =
1 x
e
,x > 0
n
Y
1 xi
e =L
i=1
59
The chance that the 6 claims exceed the retention amount is
P (X > 50000) =
m
m
1 x
e dx = e
where m is the retention amount of 50000

L=
4
Y
1 x m 6
e e
i=1
1
e
4
xi
6
A general rule is to take logarithms and then maximize log L

P
logL = 4log
xi 6m
P
dL
4
xi 6m
=
+ 2 + 2 =0
d
P
4
xi 6m
=
+ 2
X
4 =
xi + 6m
xi + 6m
58681 + 300000
=
= 89670.25
4
4
Assignment Question
Consider a group of n males, each aged 30 years living in a particular society. Their lives may
be assumed to be independent. Suppose that x of the n men die by the end of a subsequent
period of duration to years and that n-x survive the period. Suppose that the lifetime of these
men from age 30 is to be modeled as a random variable with an exponential distribution with
mean
years.
i) State the distribution of the random variable X whose value is x, the number of men who
the M.L.E of .
die within to years has been observed. Hence determine ,
and show that the value
ii) Consider the case n = 1000, to = 20 years and x = 320. Evaluate
of its standard error is approximately 0.00108.
iii) Calculate an approximate 95% confidence interval for the mean life time for age 30 of such
men
60
Bayesian Estimation
Loss function
Let d be an estimate of a parameter, say . The loss function, defined by l(, d) is defined to be
a real valued function (non-negative) which measures the loss in taking d as the decision on the
value of . The risk function of d is given by R(, d) = E[l(, d)]. The best estimator is the one with
minimum risk. We have various types of loss functions.
(i) Squared error loss function (Quadratic loss function):It is given by l(, d) = (d )2
Note that this loss function is minimized when d is the mean of f (|x) the posterior distribution
(ii) All or nothing loss function (0/1 loss function):Here the loss function takes the values 1 when d < < < d + and 0 otherwise. is a
small number that may be allowed to tend to 0. The loss function is minimized when d is
the mode of f (|x) the posterior distribution
(iii) Absolute error loss function:It is given by l(, d) = |d |
The loss function is minimized when d is the median of f (|x) the posterior distribution
Example
A risk consists of 5 policies. On each policy in 1 month, theres exactly 1 claim with probability
and theres a negligible probability of more than 1 claim in 1 month. The prior distribution of
is uniform on 0 and 1. There are a total of 10 claims on this risk over a 12 month period.
i) Derive the posterior distribution

ii) Determine the Bayesian estimate of under quadratic loss and all or nothing loss functions.
Solution
Let Xi be the number of claims in month i, so that xi has a binomial distribution with parameters
5 and , i=1,2,3,...,12. The posterior density is given by
f (|x) f (x|)h()
61
P12
i=1
xi
(1 )60
P12
i=1
xi
= 10 (1 )50
The posterior distribution is a beta distribution with parameter = 11 and = 51.

Therefore under quadratic loss function,
E[X] =
11
=
= 0.1774
+
11 + 51
Under all or nothing loss function, the Bayesian estimate is the posterior mode. To get the mode,
we differentiate the posterior density with respect to the parameter of interest, in this case,
equate the results to 0 and solve for for ie
109 (1 )50 5010 (1 )49 = 0
109 (1 )50 = 5010 (1 )49

1
109 (1 ) = 5010 = = 0.167
6
62
CHAPTER SEVEN
NATURE OF INVESTMENT DECISION
Introduction
The fundamental problem in economics is to choose what to produce and how to produce it.
This translates for financial engineers into choosing between the set of cash flows. An important
aspect of this regards the criteria to be applied in making such choices. There are two basic
types of commercial and economic values. \par The first is investment in the economic sense of
the term and involves the actual creation or the significant modification of assets. The result is
a capital project and techniques have been developed for appraising such projects.
The second type involves purchasing already existing assets and thereafter being entitled to
the proceeds from the assets. The objective in the latter case will be defined as maximizing
returns subject to an acceptable degree of risk. The former could include the financial management of companies eg the general insurance firms etc.
NOTE:
An efficient allocation of capital is a crucial finance function in modern times. It involves decisions to commit firms funds to the long-terms assets. These decisions are important since they
determine the firms value size by influencing its growth, profitability and risks.
The investment decisions of a firm can also be known as capital budgeting or capital expenditure decisions. A capital budgeting decision of a firm can also be defined as the firms decision
to invest its current funds most efficiently in the long term assets in anticipation of an expected
flow of benefits over a series of years.
The firms investment decisions may include expansion, acquisition, modernization and replacement of long-term assets and also sale of a division or business (divestment). Other activities include change in the methods of sales distribution advertisement campaigns, research and
development programs.
Features of investment decisions:

1. Exchange of current funds for future benefits
2. The funds are invested in long-term assets
3. The future benefits will occur in the firm over a series of years.
63
It is emphasized that the expenditures and benefits of an investment should be measured

in cash. In investment analysis, it is cash flow which is important and not the accounting
profits. Investment decisions also affect the firms value. Firms value increases if investments
are profitable and add to the shareholders wealth. This means that investments should be
evaluated on the basis of a criterion with the objective of shareholders wealth maximization.
An investment will add to the shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of the capital. In this topic we make the following
assumptions.
1. The investments project opportunity cost of capital is known

2. The expenditure and benefits of the investment are known with certainty
Importance of investment decisions:

Investment decisions require special attention because of the following reasons:-
1. They influence the firms growth in the long-run: Investment decision effects extend into
the future and have to be endured for longer periods than the consequences of current
operating expenditures. Unwanted or unprofitable expansion of assets results in heavy operating costs. Inadequate investment of assets will make it difficult for the firm to compete
successfully and maintain its market shares.
2. They affect the risk of the firm: A long term commitment of funds may change the risk
complexity of the firm. If the adoption of an investment increases average gain but causes
frequent changes in its earnings, the firm will become more risky.
3. They involve commitment of large amounts of funds: Investment decisions involve large
amounts of funds which makes it essential for the firm to plan its investment programs very
carefully and make an advance arrangement for procuring/obtaining finances internally
and externally.
4. They are irreversible or reversible at substantial loss: Most investment decisions are irreversible. Once such capital items have been acquired, its difficult to find a market for
them. The firm incurers heavy losses if such assets are scrapped.
5. They are among the most difficult decisions to make: Investment decisions are an assessment of future events which are difficult to predict. It is very complex to correctly
estimate the future cash flows of an investment. The uncertainty in cash flows is caused
by economic, social, political and technological forces.
64
Investment evaluation criteria (Appraisal techniques)

The following are steps involved in evaluation/appraised of an investment:
1. Estimation of cash flows
2. Estimation of required rate of return
3. Application of decision rule for making the choice.
In this topic we assume the the first two and concentrate on the third step. In specific
we focus on merits and demerits of various decision rules. Investment decision rules may be
referred to as capital budgeting techniques or investment criteria. A good appraised technique
should be used to measure the economic worth of an investment project. A good investment
evaluation criteria should possess the following characteristics:1. It should maximize the shareholders wealth
2. It should consider all cash flows to determine the true profitability of the project.
3. It should be in a position to separate good projects from bad projects.
4. It should be in a position to rank projects according to their true profitability.
5. It should recognize the fact that bigger cash flows are preferred to smaller cash flows, and
early cash flows are preferred to later cash flows.
6. It should help to choose more mutually exclusive projects, the projects which maximize the
shareholders wealth.
7. It should be applicable to any conceivable investment project independent of others.
We have various investment criteria for appraising the worth of an investment project. We
group them into two categories:1. Discounted Cash Flow (DCF) criteria
- Net Present Value (NPV)
-Internal Rate of Return (IRR)
-Profitability Index (PI)
-Discounted Payback Period
2. Non-discounted cash flow criteria
-Payback Period
-Accounting Rate of Return (ARR)
65
Discounted cash flow criterion (DCF)

Net Present Value (NPV) method
It is the most valid technique of evaluating an investment project. It is generally consistent with
the objective of maximizing the shareholders wealth. It also recognizes the time value of money.
Steps involved in calculating of NPV

1. Forecast the cash flows of the investment project on realistic assumptions.
2. Identify an appropriate discount rate to discount the forecasted cash flows.
3. Calculate the present value of cash flows using the opportunity cost of the capital as the
discount rate
4. Net present value is computed by subtracting present value of cash out flows from the
present value of cash in flows.
The Net Present value is accepted if the N P V > 0

Consider a project that has the following cash inflows over its useful economic life. The
projects initial investment is I i.e.
Period
...
Cash flows
R1
R2
R3
...
Rn
Then
NPV =
n
X
t=1
Rt
I
(1 + i)t
Where i is the appropriate discount rate; n is the expected life of the investment; (1 + i)t is
the present value factor (PVF)
Example:
Assume that project X costs $2500 now and expected to generate the year-end cash inflows
of $900, $800, $700, $600 and $500 for 5 consecutive years. The opportunity cost of the capital
(discount rate) may be assumed to be 10%. Compute the NPV for project X.
66
Solution
NPV
n
X
t=1
Rt
I
(1 + i)t
900
800
700
600
500
=
+
+
+
+
1
2
3
4
(1.1)
(1.1)
(1.1)
(1.1)
(1.1)5
= $2725.53 $2500

2500
= $225.53 > 0
This shows that the net present value of project X (2725.53) is greater than the cash outflow
(2500). Thus project X adds to the wealth of the owners and therefore should be accepted.
NB:
The difficult part in calculation of present value of an investment project is the precise measurement of the discount rate.
Acceptance Rule:
The acceptance rule using NPV method is to:-accept the investment project if N P V > 0
-reject the investment project if N P V < 0
-may accept the project if N P V = 0
NPV method can be used to select between mutually exclusive projects. The one with a higher
NPV is selected.
Advantages of NPV method

1. It recognizes the time value of money ie a dollar received today is worth more than a dollar
received tomorrow.
2. It uses all the cash flows occurring over the entire life of the project in calculating its worth.
3. It satisfies the value-additivity principle (eg NPV(A+B)=NPV A+NPV B) ie NPVs of two or
more projects can be added. This is an important criterion because it means that each
project can be evaluated independently of the others on its own merit.
4. It is always consistent with the objective of maximizing the shareholders wealth.
67
Disadvantages of NPV method

1. It requires estimates of cash flows which is a tedious task due to uncertainty prevailing
2. It is sensible to discount rates. Ranking of investment projects as per NPV rule is not
independent of discount rates.
Illustration:
Consider two projects, A and B, each consisting of $50. Project A returns $100 after 1 year
and $25 after 2 years. Project B returns $30 after 1 year and $100 after 2 years. The NPV of
the projects and their ranking at 5% and 10% discount rates are as follows
NPV at 5%
Rank
NPV at 10%
Rank
Project A
67.92
II
61.57
Project B
69.27
59.91
II
The reason of change in ranking lies in the cash flows patterns. The impact of discounting
becomes more severe for cash flows occurring later in the life the project.
3. It requires computation of opportunity cost of the capital especially when alternative projects
with unequal lives or fund constraints are evaluated, which poses practical difficulties.
Internal Rate of Return (IRR) method

It takes account of the magnitude of timing and cash flows. Assume that you deposit $10, 000
with a bank and you get back $10, 800 after 1 year. The true rate of return on this investment is
Rate of return =
10, 800 10, 000

= 0.08 or 8%
10, 000
We observe that the rate of return of your investment (8%) makes the discounted value of your
cashinflow (10,800) equal to 1 year investment (10,000). The rate of return (r) on an investment
(co ) that generates a single cash flow after one period (c1 ) is given by
=
=
c1 co
co
c1
1
c0
r+1=
c1
c0
(24)
From equation 1, we can define internal rate of return as the rate which equates investment
68
outlay or outflow with the present value of inflow received after 1 period. In short, we can define
IRR as the discount at which the projects N P V = 0. Note that theres no satisfactory way of
defining the true rate of return of a long-term asset. The rate of return can be determined by
solving the following equation for r.
c0 =
c3
cn
c1
c2
+
+ ... +
+
2
3
1 + r (1 + r)
(1 + r)
(1 + r)n
n
X
ct
c0 =
(1 + r)t
(25)
t=1
Calculating IRR
Case A: uneven cash flows
Under uneven cash flows, we use trial and error method. The value of r in equation 2 can be
found by trial and error method. The approach starts by selecting any discount rate to compute
the present value of cash flows. If the calculated present value of the expected cash inflows is
lower than the present value of cash outflows, a lower rate is tried. A higher rate is tried if the
present value of cash inflows is higher than the present value of cash outflows. The process is
repeated until N P V = 0.
Example
A project costs $16000 and is expected to generate cash flows of $8000, $7000, and $6000 at the end
of each year for the next 3 years. Compute the IRR.
Solution
The IRR is the rate at which the NPV of the project is zero (0). We start by trying 20%.
NPV
3
X
t=1
ct
I
(1 + r)t
8000
7000
6000
=
+
+
2
1.2
(1.2)
(1.2)3
= $1000
69

16000
The negative present value at 20% indicates that the projects true IRR is lower than 20%. Next
try 16%
NPV
3
X
t=1
ct
I
(1 + r)t
6000
8000
7000
+
=
+
2
1.16
(1.16)
(1.16)3
= $57

16000
Next, try 15%
NPV
3
X
t=1
ct
I
(1 + r)t
8000
7000
6000
=
+
+
2
1.15
(1.15)
(1.15)3
= $200

16000
The true rate of return lies between 15% and 16%. We approximate IRR by method of linear
interpolation, as follows
PV required $16000
Difference
PV at 15%$16200
$200
PV at 16%$15943
$257
r=15%+(16%-15%) 200
257 =15.8%
Case B: Level/Equal cash flows

It is easy to compute IRR for a project with level or equal cash flows each period.
Illustration
Assume an investment which costs $20000 and provides annual cash inflow of $5430 for 6 years.
We want to compute the IRR, assuming opportunity cost of capital to be 10%.
In this case, we start by computing the NPV. Note that $5430 is an annuity.
NPV =
n
X
t=1
ct
I
(1 + r)t
(1 + r)t is the present value of annuity factor (PVAF)

70
NPV
5430(1 rn )
20000
i

1 6
5430 1 1.1
20000
=
0.1
= $3649
=
We compute IRR as follows, i.e.

NPV
P V AF
= $20000 + $5430 P V AF = 0
20000
=
5430
= 3.683
IRR is the rate which gives PVAF of 3.683 for 6years. From tables, IRR=16%. This implies
that 16% is the IRR which equates the present value of the initial cash outlay with the constant
annual cash inflows for 6 years.
Acceptance Rule
-We accept the project if IRR is higher than the opportunity cost of capital ie r > k.
-We reject the project if r < k
-We may accept the project if r = k
NB:
In case of independent projects, the IRR and the NPV rules will give the same results so long as
the firm has no shortage of funds.
Advantages of IRR
1. It recognizes the time value of money \item It considers all the cash flows occurring over
the entire life of the project
2. It is consistent with the shareholders wealth maximization objective
3. It is a true measure of profitability
Disadvantages of IRR
1. Does not hold the value-additivity principle
71
2. It fails to indicate a correct choice between mutually exclusive projects under certain situations.
3. Requires estimates of cash flows which is a tedious task
4. Gives misleading and inconsistent results when the NPV of a project does not decline with
discount rate.
Profitability Index (PI)

It is a time-adjusted method of evaluating investment proposals. It is also called benefit cost
ratio. It can be defined as the ratio of the present value of cash inflows at the required rate of
return at the initial cash outflows of the investment. Ie
PI =
P V of cash inf lows

Initial cash outlay (cash outf low)
P V (ct )
co
Pn
ct
t=1 (1+r)t
co
Illustration
The initial cash outlay of a project is $100000 and it can generate cash inflow of $40000, $30000,
$50000, and $20000. Assume a 10% rate of discount and compute the profitability index.
Solution
Pn
PI =
ct
t=1 (1.1)t
co
40000 P V F1,0.1 + 30000 P V F2,0.1 + 50000 P V F3,0.1 + 20000 P V F4,0.1
=
100000
112350
=
100000
= 1.1235 > 1
Acceptance Rule
-We accept the project if P I > 1
72
-We reject the project if P I < 1

We note that when P I > 1, the project will have a positive NPV
Advantages of Profitability Index

1. Recognizes the time value of money.
2. It considers all the cash flows occurring over the entire life of the project in calculation of
its its worth.
3. It is consistent with the wealth maximization principle.
4. It is a relative measure of projects profitability since the present value of the cash inflow is
divided by the initial cash outflow.
Disadvantages of Profitability Index

1. It requires time estimates of cash flows which is a tedious task.
2. At times, it fails to indicate the correct choice between mutually exclusive projects.
Payback Method (PB)

It is one of the most popular and widely recognized traditional method of evaluating investment
projects. We can define payback as the number of years required to recover the original cash
outlay invested in a project. If the project generates a constant annual cash inflow, then the
payback should be equal to the initial investment divided by annual cash inflow.
PB =
co
Initial Investment
=
Annual cash inf low
c
Illustration
A project requires an outlay of $50000 and yields an annual cash inflow of $12500 for 7 years.
Then PB is
50000
= 4 years
12500
In a case of unequal cash flows, the payback period is computed by adding the cash inflows
until the total is the initial cash outlay
73
Illustration
A project requires a cash outlay of $20000 and generates cash inflows of $8000, $7000, $4000,
and $3000 in 4 years. Adding the cash inflows for the first 3 years. we have $19000 of the
original cash outlay. In the fourth year, we need only $1000. Time required to recover $1000 is
1000
3000
12 = 4 months.
The payback period is 3 years 4 months.
Acceptance Rule
We accept the project if PB period is less than the standard PB period set by the management
otherwise, we reject the project.
Payback period can also be used as a method of ranking projects. The project with the
shortest payback period is given the highest ranking while the one with the longest payback
period is given the lowest rank. Thus, to choose among mutually exclusive projects, we select
the one with the shortest payback period.
Advantages of PB
1. It is simple to understand and easy to calculate \item It costs less than the most sophisticated techniques which require a lot of the analysts time and use of computer.
2. Payback emphasizes on the early recovery of the investment, thus giving an insight into the
liquidity of the project.
3. It is an easy and crude way to cope with risk. The riskiness of the project can be tackled
by setting a shorter payback period as it may ensure a guarantee against loss.
Disadvantages of PB
1. It fails to take account of the cash inflows after the payback period
2. Not an appropriate method of measuring profitability of an investment project since it does
not consider all cash flows yield by the project.
3. It ignores the time value of money
4. No objective way to determine the standard payback ie it is a subjective decision which may
create administrative difficulties in setting it.
5. It is not consistent with the objective of maximizing the shareholders wealth.
74
Accounting Rate of Return (ARR) method

Sometimes we call it investment on return or return on investment (ROI). ARR is computed by
dividing the average after tax profit by the average investment. The average investment will be
equal to
1
2
of the original investment if it is depreciated consistently or it can be found by diving
the total of investments book value after depreciation by life of the project.
Accounting Rate of Return is the Average Rate of Return
ARR =
=
Average Income
Average investment
Pn
t=1 [EBITt (1 T )]/n
(Io + In )/2
where
EBITt =Earning before interest and taxes
T=tax rate
Io =Book value of investment in the beginning
In =Book value of investment at the end of n years
Illustration
A project will cost $40000 . Its stream of earnings before depreciation, interest and taxes (EBDIT)
during the first year through 5 years is expected to be $10000, $12000, $14000,$16000 and
$20000. Assuming a 50% tax rate and a depreciation of $8000 on straight line basis, compute the
ARR.
Solution
Period
Average
EBDIT(A)
10000
12000
14000
16000
20000
14400
Depreciation (B)
8000
8000
8000
8000
8000
8000
EBIT (C=A-B)
2000
4000
6000
8000
12000
6400
Taxes at 50% (D = 50%of C)
1000
2000
3000
4000
6000
3200
EBIT(1-T) (E=C-D)
1000
2000
3000
4000
6000
3200
Book value of investment at beginning
40000
32000
24000
16000
8000
24000
Book value of investment at end
32000
24000
16000
8000
16000
Average
36000
28000
20000
12000
4000
20000
75
Where, EBIT (1 T ) = Earning bef ore interest and af ter taxes. And
Pn
ARR =
T )]/n
(Io + In )/2
t=1 [EBITt (1
3200
100
20000
= 16%
=
Acceptance Rule
The method accepts all those projects whose ARR is higher than the minimum rate established
by the management and rejects the projects with ARR less than the minimum rate. The method
gives the project the highest rank if it has the highest ARR and vice versa for projects with lowest
ARR.
Advantages of ARR
1. It is easy to understand and calculate
2. It uses the accounting data with which executives are familiar with
3. It incorporates the entire stream of income in calculating the projects profitability
Disadvantages of ARR
1. It uses accounting profits, not cash flows in appraising the projects. Accounting profits are
based on arbitrary assumptions and choices and also include non-cash items. Thus the
criterion is in appropriate to rely on in measuring acceptability of the investment projects.
2. It ignores the time value of money.
3. No objective way of determining the minimum acceptance rate of return.
76
CHAPTER EIGHT
RISK ANALYSIS IN CAPITAL BUDGETING
Introduction
Risk exists because of the inability of the decision maker to make a perfect forecast. Forecasts
cant be made with certainty because of uncertain future events they depend on. An investment
is not risky if we can specify a unique sequence of cash flows for it. The problem is that cash
flows cant be forecased accurately and alternative sequences of cash flows can occur depending
on the future events. Thus risk arises in investment evaluation because we cannot expect
the occurrence of possible future events with certainty, making it difficult to make any correct
prediction about the cash flow sequence. eg A firm is considering a proposal to commit its funds
in a machine which will help to produce a new product. The demand for this product may be
very sensitive to the general economic conditions. It may be very high under favorable economic
conditions and very low under unfavorable economic conditions. This means that the investment
is profitable in the former and unprofitable in the latter case. Uncertainty of economic conditions
result to uncertainty about the cash flows associated with the investment.
Definition
The risk associated with an investment may be defined as the variability that is likely to occur
in the future returns of an investment. eg an investor may purchase the shares of a company.
In this case it is not possible to estimate future returns accurately. In fact the returns may be
negative, zero or large figure. This investment may be considered risky because of high degree of
variability associated with the future returns. The greater the variability of the expected returns,
the riskier the project.
The most common measures of risk are standard deviation and coefficient of variation.
Techniques of handling/measuring risk in capital budgeting

They include:
Payback
Risk Adjusted Discount rate (RAD)
Certainty equivalent
77
Sensitivity analysis
Statistical techniques
Decision tree
Payback
It is a common method for explicitly recognizing risk associated with an investment project.
Business firms using this method prefer short payback to longer payback. Longer term projects
are viewed to be riskier. The payback period as a method of risk analysis is useful only in allowing
for a special type of risk ie the risk that a project will go exactly as planned for a certain period
and will then suddenly cease altogether and become worth nothing. It is suitable in assessment
of risks of time future. This method ignores the time value of cash flows eg 2 projects with, say
a 4 year payback period are at different risks if in one case the capital is recovered evenly over
the 4 years while in the other it is recovered in the last year. The second project is more risky
since anything can happen before the four years. If both cease after 3 years, the first project will
have recovered
3
4
of its capital and a total loss in the second project.
Risk Adjusted Rate

The more uncertain the returns in the future, the greater the risk and the greater the premium
required. Based on this argument, it is proposed that the risk premium be incorporated into
the capital budgeting analysis through the discount rate ie if the time prevalence for money is to
be recognized by discounting estimated future cash flows at some risk free rate to their present
value, then to allow for riskiness of those future cash flows, a risk premium rate may be added
to risk free discount rate. Such a composite discount rate is called the Risk Adjusted Discount
rate which allows for both time prevalence. We can define RAD rate as the sum of risk free rate
and the premium rate reflecting the investors attitude towards risk.
RAD is computed from the expression:Pn
NPV =
t=0 N CF
(1 + k)t
where k=Risk Adjusted Rate

The RAD rate accounts for risk by varying the discount rate depending on the degree of risk
of the investment projects. Higher rate will be used for riskier projects and a lower rate for less
risky projects.
The Net Present Value decreases with increase in k indicating that the riskier the project, the
78
less its likely to be accepted. If the Risk free rate is assumed to be 10%, some rate would be
added to it, say 5% as a compensation for the risk of the investment and the composite 15% rate
will be used to discount the cash flows.
Example
An investment project will cost $50000 initially and is expected to generate cash flows in 4 years
ie $25000, $20000, $10000 and $10000 respectively. What is the projects NPV if its expected to
generate certain cash flows? Assume 10% risk free rate.
Solution
NPV
n
X
t=1
Rt
I
(1 + k)t
25000 20000 10000 10000

+
+
+
50000
1.1
(1.1)2 (1.1)3 (1.1)4
= $3599
If the project is risky, higher rate should be used to allow for the perceived risk. Assuming
$15\%$ rate, it implies that
NPV
n
X
t=1
Rt
I
(1 + k)t
25000
20000
10000
10000
+
+
+
50000
2
3
1.15
(1.15)
(1.15)
(1.15)4
= $845
=
We observe that the project would be accepted when no allowance for risk is granted but it will
be rejected if risk premium is added to the discount rate.
Advantages of RAD
1. It is simple and can be easily understood.
2. It has a great deal of intuitive appeal for a risk averse businessman.
3. It incorporates an attitude towards uncertainty.
Disadvantages of RAD
1. Theres no easy way of deriving RAD rate.
79
2. It is based on the assumption that investors are risk averse.

3. It does not make nay risk adjustments in the numerator for the cash flows that are forecased for the future years.
Certainty equivalent
A common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash
flows to some conservative level. For instance, an investor according to his best estimate expects
a cash flow of $60000 next year. He will apply an intuitive correction factor and may work with
$40000 to be on the safe side. Certainty equivalent approach may be expressed as
NPV =
n
X
t N CFt
(1 + kf )t
t=0
where
N CFt =forecasts of net cash flow without risk adjustment.
t =risk adjusted factor or certainty equivalent co-efficient
kf =risk free rate assumed to be constant for all the periods
The value of certainty equivalent coefficient t , ranges between 0 and 1 and varies inversely
with risk. If greater risk is perceived, lower t is used and higher t is used if lower risk is
expected. The coefficients are subjective in nature and vary from one decision maker to another.
We multiply the estimated cash flows with t to get the certain cash flows.
t =
=
N CFt
N CFt
certain net cashf low
risky net cashf low
Illustration
A project costs $6000 and has cash flows of $4000, $3000, $2000 and $1000 for 4 years consecutively.
Assume that the associated t factors are estimated to be o = 1, 1 = 0.9, 2 = 0.7, 3 = 0.5, 4 =
0.3 and the risk free discount is 10%. We want to compute the NPV
80
Solution
NPV
n
X
t N CFt
=
(1 + kf )t
t=0
= (1 6000) +
0.9 4000 0.7 3000 0.5 2000 0.3 1000

+
+
+
1.1
(1.1)2
(1.1)3
(1.1)4
= $37
If IRR is used, we calculate the rate of discount which equates the present value of certainty
equivalent cash inflows with present value of certainty equivalent of cash outflows. The project
is accepted if the computed rate is greater than the minimum rate otherwise it is rejected.
Advantage
1. The approach recognizes risk explicitly
Disadvantages
1. The procedure for reducing forecased cash flows is implicit and may be inconsistent from
one investment to another.
2. It may give wrong estimates since the forecaster may inflate them.
3. Exaggeration of original forecasts if the forecasts pass through several stages of management.
4. Focusing explicit attention only on gloomy outcomes may increase the chances of passing
by some good investments.
RAD verses certainty equivalent

Certainty equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk free rate to discount cash flows. On the other hand RAD rate
adjusts for risk by adjusting the discount rate. The two approaches yield the same results if the
risk free rate is constant and RAD rate is the same for all future periods. Thus
n
X
t N CFt
N CFt
=
t
(1 + kf )
(1 + k)t
t=0
81
Solving for t , we have

t N CFt (1 + k)t = (1 + kf )t N CFt
t =
=
(1 + kf )t N CFt
N CFt (1 + k)t
(1 + kf )t
(1 + k)t
For a period of say, 1+t, the above equation becomes

t+1 =
(1 + kf )t+1
(1 + k)t+1
If kf and k are constants for all future periods, then k > kf since 0 < t < 1.
Example
Suppose k = 10% and kf = 5%
1 =
2 =
(1.05)1
= 0.955
(1.1)1
(1.05)2
= 0.911
(1.1)2
82
CHAPTER NINE
SENSITIVITY ANALYSIS
It is another technique used to handle risk in capital budgeting. In evaluation of an investment
project, we work with the forecasts of cash flows which depend on expected revenue and costs.
Further, the expected revenue is a function of sales volume and unit selling price. Again, the
sales volume depend on the market size and the firms market shares. Cost is a function of sales
volume and unit variable costs and fixed costs. The N.P.V and IRR of a project is determined by
analyzing after-tax cash flows arrived at by combining forecasts of various variables. Uncertainty
prevails in these variables.
Reliability of NPV or IRR of the project will depend on their reliability of the forecasts of
variables involved in estimating the net cash flows.
To determine the reliability of NPV or IRR of the project, we can work out how much difference
it makes if any of those forecasts goes wrong. Each forecast can be changed one at a time to at
least 3 values ie pessimistic, expected and optimistic values.
The NPV of the project is re-calculated under these different assumptions. These method of
analyzing change in the projects NPV or IRR for a given change in one of the variables is called
sensitivity analysis. The sensitivity analysis indicates how sensitive the projects NPV or IRR is
to changes in particular variables. The more sensitive the NPV, the critical is the variable.
Steps involved in sensitivity analysis

1. Identification of all variables which influence the projects NPV or IRR.
2. Define the underlying relationship between the variables.
3. Analyze the impact of the change in each of the variables on projects NPV
As the decision maker performs sensitivity analysis he computes the NPV for each forecast under 3 assumptions ie pessimistic, expected and optimistic assumptions. The approach
examines the sensitivity of the variables underlying the computation of NPV/IRR rather than
quantifying the risk. The shortcoming of sensitivity analysis is that it makes no statement about
the probability that a low, baseline, or high value of a parameter might be obtained.
83
Example
A financial manager of a food processing company is considering the installation of a plant
costing $10000 to increase its processing capacity. The expected values of the underlying variables are as follows: Investment ($10000), Sales volume(1000 units), Unit selling price($15), Unit
variable cost($6.75), Annual fixed costs($4000), Depreciation(25%), Corporate tax rate(35%) and
Discount rate(12%). Find the projects after-tax cash flows over its expected life of 7 years.
The following table provides the projects after-tax cash flows over its expected life of 7 years.
S/No.
Year
1.
Investment($)
-10,000
2.
Revenue
1500
1500
1500
1500
1500
1500
1500
3.
Variable cost
6750
6750
6750
6750
6750
6750
6750
4.
Fixed cost
4000
4000
4000
4000
4000
4000
4000
5.
Depreciation
2500
1875
1406
1055
791
593
445
6.
EBIT
1750
2375
2844
3195
3459
3659
3805
7.
Profit after tax
1137.5
1544
1849
2077
2248
2377
2473
8.
Net Cash flow
-10,000
3638
3419
3255
3132
3039
2970
2918
The NPV at 12% and IRR are 4829 and 26.8% respectively. Since N P V > 0, the project can
be undertaken. Before the financial manager takes a decision, he may like to know whether the
NPV changes if one forecasts goes wrong.
Sensitivity analysis can be conducted with regard to volume, price, costs, etc. This is done
by obtaining pessimistic and optimistic estimates of the underlying variables. Let us assume the
following pessimistic and optimistic values for volume, price and costs
S/No.
Variable
Pessimistic
Expected
Optimistic
1.
Volume(Units)
750
1000
1250
2.
Unit selling price($)
12.75
15.00
16.50
3.
Unit variable cost($)
7.425
6.75
6.075
4.
Annual fixed costs($)
4800
4000
3200
The following table shows their re-calculated NPV where other variables dont change.
Sensitivity analysis under different assumptions
84
S/No.
Variable
Pessimistic
Expected
Optimistic
1.
Volume(Units)
-1289
4829
10948
2.
-184.5
4829
9729
3.
2827
4829
6832
4.
2456
4829
7203
The above table shows the projects NPV when each variable is set to its pessimistic and
optimistic values. The most critical variable is sales volume followed by unit selling price. If the
volume decreases by 25% ie 750, the NPV becomes -1289 and NPV is -184.5 if the selling price
decreases by 15%
Discounted cash-flow break even analysis

Sensitivity analysis is a variation of break even analysis. The break even point is a point where
the project ceases to be profitable. ie when N P V < 0. Consider the expected values of the
variables in the previous example. We can measure after-tax cash flows as follows:N CF = (Revenue Expenses)(1 T ) + (T ax Depreciation)
(26)
The first part of the right hand expression is annuity ie

[1000(15 6.75) 4000](1 0.35) = 2763
and its present value at 12% discount rate is
2763 4.5638 = 12610
Next, we workout the present value of the series of depreciation tax shield as the discounted rate
of the products tax rate and depreciation charges. ie
T ax.Depreciation =
2500 0.35 1875 0.35 1406 0.35 1055 0.35 791 0.35 593 0.35 445 0.35
+
+
+
+
+
+
(1.12)
(1.12)2
(1.12)3
(1.12)4
(1.12)5
(1.12)6
(1.12)7
PV =
7
X
t=0
D
= 2222
(1.12)t
The following expression is used to determine the break even point ie

NPV
= P V of N CF Investment
= 0
= [((V (15 6.75) 4000)0.65 4.5638 + 2222] 10000 = 0
85
(27)
Where V is the sales volume

4.5638 is the PV factor of a 7 year annuity (at 12%)
2222 is the PV of the series of depreciation tax shield.
From equation 5, we solve for V, ie
24.473V 11866 + 2222 10000 = 0
V = 803.
The project will start loosing money if the sales volume goes below 803 units ie if the sales
decline by more than 19.7%. Similarly, we can work out the lowest selling price. Given other
assumptions. how low the units selling price can go before the projects NPV becomes negative?
We solve the following equation ie
N P V = [(1000(p 6.75) 4000)]0.65 4.5638 + 2222] 10000 = 0; P = 13.37
The selling price declined by more than 10.867%
The sales volume variable is more critical than the selling price variable.
Advantages of sensitivity analysis

1. It enables the decision maker to identify the variables affecting the cash flow forecasts
2. It indicates the critical variables for which additional information may be obtained.
3. It helps to expose inappropriate forecasts hence guiding the decision maker to concentrate
on relevant variables.
Disadvantages of sensitivity analysis

1. No clear cut results are provided since pessimistic and optimistic values are subjective thus
the range of values suggested may be inconsistent.
2. It fails to focus on the inter-relationship between variables.
Statistical techniques for handling risk

Statistical techniques can also be used to incorporate risk in capital budgeting These techniques
are analytical in nature and enable the decision maker to make decisions under uncertainty. The
86
probability concept is fundamental to the use of the risk analysis techniques. The most critical
information for capital budgeting decision is a forecast of future cash flows. So we make use of
probability distributions to get the best estimate of such forecasts
Expected Net present value

After getting the probability distribution of the future cash flows, we get the expected NPV ie
EN P V =
n
X
EN CFt
t=0
(1 + k)t
where EN CFt = N CFjt .Pjt
Example
The following are possible net cash flows for projects X and Y and their associated probabilities
over 1 year period. Both projects have a discount rate of 10%. Calculate the ENPV for each
project. Which project is preferred? Assume initial cost of $5000 for each project.
Solution
Project X
Project Y
Possible event
Cash flows($)
Probability
Cash flows($)
Probability
4000
0.1
12000
0.1
5000
0.2
10000
0.15
6000
0.4
8000
0.5
7000
0.2
6000
0.15
8000
0.1
4000
O.1
Project X:
EN P V =
n
X
EN CFt
t=0
(1 + k)t
but EN CFt = N CFjt .Pjt = 4000(0.1) + 5000(0.2) + 6000(0.4) + 7000(0.2) + 8000(0.1) = $6000
EN P V = $5000 +
$6000
1.1
= $454.5
Project Y:
EN P V =
n
X
EN CFt
t=0
(1 + k)t
but EN CFt = N CFjt .Pjt = 12000(0.1) + 10000(0.15) + 8000(0.5) + 6000(0.15) + 4000(0.1) = $8000
87
EN P V = $5000 +
$8000
1.1
= $2272.7
Project Y is preferred than project X. This can be extended to more than 1 year.
Standard deviation: An absolute measure of risk

We have established that computation of ENPV incorporates the risk explicitly but we still have
another better technique which will be obtained by measuring the variational dispersion of cash
flows. The dispersion of cash flows indicates the degree of risk. The standard deviation of Net
cash flow for each period can be expressed as;
v
uX
u n
t = t (N CFjt EN CFt )2 .Pjt
j=1
where t =standard deviation of net cash flow in period t

Pjt =Probability associated with each cash flow
Under the assumption of independence of cash flows over time, we use standard deviations
of various periods to develop a measure of risk for the project. ie
v
uX
u n
=t
j=1
t2
(1 + kf )2t
where =standard deviation of probability distribution of possible net cash flows, t2 =Variance
of each period.
When the cash flows are dependent over time, the standard deviation will be larger than
under the assumption of independent cash flows. The greater the degree of correlation between
the cash flows the larger will be the standard deviation. However, the expected Net Present Value
(ENPV) remains unchanged irrespective of dependence or independence of cash flows.
In case of perfect correlation, the formula for standard deviation is given by
v
uX
u n
=t
j=1
t
(1 + kf )t
In case of moderate correlation (ie the cash are neither independent nor perfectly correlated over
time) the above methods cant be applied to measure the risk. Such a problem can be handled
by making use of conditional probabilities and decision trees.
88
Example
Consider a project which costs $8, 000 at t = 0 and 3 years. The following table presents the
cash flows and probability information for the project. Assuming a risk free discount rate of
10%. Calculate the expected value and the standard deviation of the probability distribution of
possible NPVs under the assumption of perfect correlation. Assuming a normal distribution,
what is the probability of 0 or less, of 3500 or more. Compare the standard deviation with the
one under assumption of independent of cash flows over time.
Year 1
Year 2
Year 3
Cash flows($)
Probability
Cash flows($)
Probability
Cash flows($)
Probability
6000
0.1
3000
0.15
6000
0.25
5000
0.4
4000
0.5
5000
0.2
4000
0.3
5000
0.25
4000
0.35
3000
0.2
6000
0.1
3000
0.2
Solution
Work it out as an assignment
Coefficient of variation: A relative measure of risk

The coefficient of variation is a relative measure of risk. We can define coefficient of variation as
the standard deviation of probability distribution divided by its expected value ie
CV =
standard deviation of distribution

Expected value
It is a useful measure of risk when comparing the projects under the following situations
1. Same standard deviations but different expected values
2. Different standard deviations but same expected values
3. Different standard deviations and different expected values
Illustration
Suppose project X has an expected value of $6000 and standard deviation of $1095.45 and Project
Y has an expected value of $8000 and a standard deviation of $2097.62
89
Project Y may be preferred because of larger expected NPV, but it is more risky as compared
to project X. ie
CV of project X =
1095.45
= 0.1826
6000
CV of project Y =
2097.62
= 0.2622
8000
The acceptance of project X and Y will depend on the investors attitude towards risk. He would
prefer project Y if he is ready to assume more risk in order to obtain the higher expected monetary
value. On the other hand, if he has a great aversion to risk, he would accept project X for it is
less risky.
Decision trees
Decision trees are useful tools for helping you to choose between several courses of action. They
provide a highly effective structure within which you can explore options, and investigate the
possible outcomes of choosing those options. They also help you to form a balanced picture of
the risks and rewards associated with each possible course of action. This makes them particularly useful for choosing between different strategies, projects or investment opportunities,
particulary when your resources are limited.
How to use Decision trees

You start a decision tree with a decision that you need to make. Draw a small square to represent
this on the left side of a large piece of paper, half way down the page. From this box draw out
lines towards the right for each possible solution, and write a short description of the solution
along the line. Keep the lines apart as far as possible so that you can expand your thoughts. At
the end of each line, consider the results. If the result of taking that decision is uncertain, draw
a small circle. If the rasult is another decision that you need to make, draw another square.
Squares represent decisions, and circles represent uncertain outcomes. Write the decision or
factor above the square or circle. If you have completed the solution at the end of the line, just
leave it blank. Starting from the decision squares on your diagram, drwa out lines representing
the options that you could select. From the circles draw lines representing possible outcomes.
Again make a brief note on the line saying what it means. Keep on doing this until you have
drawn out as many of the possible outcomes and decisions as you can see leading from the
original decisions.
90
Illustration
A company has the options now of building a full-size plant or a small plant that can be expanded later. The decision depends primarily on future demands for the product the plant will
manufacture. The construction of a full-size plant can be justfied economically if the level of
demand is high. Otherwise, it may be advisable to construct a small plant now and then decide
in two years whether it should be expanded.
The multistage decision problem arises here because if the company decides to build a small
plant now, a future decision must be made in two years regarding expansion. In other words,
the decision process involves two stages: a decision now regarding the size of the plant, and
a decision two years from now regarding expansion (assuming that it is decided to construct a
small plant now).
The diagram above summarises the problem as a decision tree. It is assumed that the demand can be either high or low. The decision tree has two types of nodes: a square represents
a decision point and a circle stands for a chance event. Thus, starting with node 1 (a decision
point), we must make a decision regarding the size of the plant. Node 2 is a chance event from
which two branches representing low and high demand emanate depending on the conditions of
the market. These conditions will be represented by associating probabilities with each branch.
Node 3 is also chance event from which two branches representing high and low demands emanate.
91
Logically, the company will consider possible future expansion of the small plant only if the
demand over the first two years turns out to be high. This is the reason node 4 represents a
decision point with its two emanating branches representing the expansion" and no expansion"
decisions. Again, nodes 5 and 6 are chance events, and the branches emanating fron each
represent high and low demands.
The data for the decision tree must include
1. The probabilities associated with the branches emanating from the chance events and
2. The revenues associated with different alternatives of the problem.
Suppose that the company is interested in studying the problem over a 10-year period. A
market survey indicates that the probabilities of having high and low demands over the next 10
years are 0.75 and 0.25, respectively. The immediate construction of a large plant will cost $5
million and a small plant will cost only $1 million. The expansion of the small plant 2 years from
now is estimated to cost $4.2 million. Estimates of annual income for each of the alternatives are
given as follows.
1. Full-size plant and high (low) demand will yield $1, 000, 000 ($300, 000) annually.
2. Small plant and low demand will yield $200, 000 annually.
3. Small plant and high demand will yield $250, 000 for each of the 10 years.
4. Expanded small plant with high (low) demand will yield $900, 000 $(200, 000) annually.
5. Small plant with no expansion and high demand in the first two years followed by low
demand will yield $200000 in each of the remaining 8 years. As a Financial Engineer assist
the company in making the right decision
These data are summarised in the decision tree above. We are now ready to evaluate the
alternatives. The final decision must tell us what to do at both of the decision nodes 1 and 4
E{net prof it|expansion} = (900000 0.75 + 200000 0.25) 8 4200000 = $1, 600, 000
E{net prof it|no expansion} = (250000 0.75 + 200000 0.25) 8 = $1,900,000
Thus, at node 4, the decision calls for no expansion, and the associated expected net profit is
$1, 900, 000.
We can now replace all the branches emanating from node 4 by a single branch with an
expected net profit of $1, 900, 000, representing the net profit for the last 8 years. We now make
92
stage 1 computations corresponding to node 1 as follows:

E{net prof it|large plant} = (1000000 0.75 + 300000 0.25) 10 5000000 = $3,250,000
E{net prof it|small plant} = (1900000 + 500000) 0.75 + 2000000 0.25 1000000 = $1, 300, 000
Thus the optimal decision at node 1 is to build a full-size plant now. Making this decision now
obviously eliminates the need for considering the alternatives at node 4.
Exercise
Suppose that demand during the last 8 years can be high, medium, or low, with probabilities
0.7, 0.2 and 0.1, respectively. The annual incomes are as follows.
1. Expanded small plant with high, medium, and low demands will yield annual income of
$900, 000, $600, 000 and $200, 000.
2. Non expanded small plant with high, medium, and low demand will yield annual income of
$400, 000, $280, 000 and $150, 000.
i) Determine the optional decision at node 4.
ii) Assist the company in making the right decision.
93
CHAPTER TEN
REVISION PAPERS
Paper One
DATE: PAPER 1
TIME: 2 HOURS
INSTRUCTIONS: Attempt question ONE and any other TWO questions .

QUESTION ONE (30 MARKS)
(a) Briefly explain what you understand about the following terms as used in Risk theory.
(i) Risk matrix
[1 mark]
(ii) Sensitivity analysis
[1 mark]
(iii) Probability of ruin
[1 mark]
(iv) Risk process
[1 mark]
(v) Hypothesis testing
[1 mark]
(vi) Risk adjusted interest rate
[1 mark]
(b) An insurer with net worth 100 has accepted (and collected the premiums for) a risk X with
the following probability distribution
P r(X = x) =
3 , f or x = 0
4
1 , f or x = 51
4
(i) What is the maximum a mount it should pay another insurer to accept 100% of this
loss? Assume the first insurers utility function of wealth is () = log.
(ii) An insurer with wealth 650 and the same utility function, () = log, is considering
accepting the above risk. What is the maximum a mount this insurer would accept as a
premium to cover 100% of the loss?
[5 marks]
(c) Given that Tj denotes the time when claim j occurs, such that T1 < T2 < T3 < .... Then the
interarrival time between claim j 1 and j defined as Wj = Tj Tj1 for j 2 is exponentially
distributed random variable with parameter = 3 and also claim amount is exponentially
distributed with parameter = 1. Using premium rate of 3.8, calculate the adjustment
coefficient.
[4 marks]
(d) Derive the probability density function for the number of claims, given that the occurrence
of a claim is a rare event that happens at the rate of T annually. Where T Gamma(, ).
94
[6 marks]
(e) Define and proof Jensens inequalities. Hence, explain why the inequalities are appropriate
for describing risk averse and risk lover preferences.
[8 marks]
QUESTION TWO (20 MARKS)
(a)
(i) Enumerate features of individual risk models for short term.
[2 marks]
(ii) Given that there are three fixed insured units in a portfolio and that each unit generates exponentially distributed claims with parameter i for i = 1, 2, 3. Using convolution and
mgf technique determine the pdf and cdf of the aggregate claim amount for this portfolio.
Assume that the claims are independent.
[11 marks]
(b) Discuss the relevancy of Panjers recursion theorem in risk theory. What does this theorem result to when the number of claims follows a negative binomial distribution with
parameters (r, p).
[6 marks]
QUESTION THREE (20 MARKS)
(a) The loss random variable X has a pdf given by f (x) =
1
100 ,
0,
0 < x < 100

elsewhere
(i) Calculate E[X] and var(X).
[3 marks]
(ii) Consider a proportional policy where l(x) = kx,
0 < k < 1 and a stop-loss policy
where
ld (x) =
0 , f or x < d
x d, f or x d
Determine k and d such that the pure premium in each case is p = 12.5.
[4 marks]
(b) Determine first non-central, second central moments and moment generating function of
the total claims if claims frequency is a random event. Hence workout the average and variation of the aggregate claims given that the random losses have Geometric(0.8) and number
of claims have P oisson() distribution respectively. Where Gamma(5, 0.5).
[13 marks]
QUESTION FOUR (20 MARKS)
(a) Given a Poisson claim number process with exponential(1) distributed interarrival times and
exponential(2) distributed claim amounts. What is the probability of ruin? When the initial
capital is 100 with fixed premium if 5.
[3 marks]
95
(b) Consider the insurance portfolio that will produce 0, 1, 2 or 3 claims in a fixed time period
with probability of 0.2, 0.2, 0.3 and 0.3 respectively. An individual claim will be of amount
1, 2 or 3 with probabilities 0.3, 0.6, 0.1 respectively. Find the variance of the aggregate claims
for this portfolio. Sketch the probability density function of the total amount claimed on a
Cartesian plane.
[17 marks]
Paper Two
DATE: PAPER 2
TIME: 2 HOURS

(a) Describe how you will determine five points on the utility function of an individual whose
wealth is K Sh. 40,000. Assuming that probability of a risk occurring is 0.4 and the
probability of retaining the entire wealth is 0.6. Hence using the sketched utility function
how would you classify this type of risk individual and why?
[6 marks]
(b) Define and state the uses of risk matrix in risk management?
[3 marks]
(c) Using moment generating function technique determine the distribution of Poisson claim
frequency, with a random parameter that follows Gamma(2,0.05) distribution.
[5 marks]
(d) The initial outlay of a product is K Sh. 100,000 and it can generate cash inflow of K Sh.
40,000 after first year, K Sh. 30,000 after second year, K Sh. 50,000 after third year and K
Sh. 20,000 after fourth year, before adjustments. Assuming that the rate of discount is 10%
and risk free rate is 8%. Determine whether this project is profitable using; (i) Profitability
index, (ii) IRR, and (iii) Certainty equivalent.
[8 marks]
(e) A loss random variable has an exponential distribution with mean . A random sample of
100 values is observed with the following results.
58 of the values lie between 0 and 100
32 of the the values lie between 100 and 200
10 of the values are in excess of 200
Find the maximum likelihood estimate for .
96
[4 marks]
(f) Losses from a portfolio of policies are believed to follow an exponential distribution with
parameter , which is unknown. A reinsurance arrangement is in place, under which the
reinsurer pays the amount of each loss in excess of K Sh. 800. The last four payments
made by the reinsurer in respect of these policies were: 760, 954, 1201, 1158. Assuming
that a suitable prior distribution for is an inverse gamma prior with parameters 2 and
2800 determine the Bayesian estimate of under 0/1 loss.
[4 marks]
(a) XYZ Ltd produces handmade childrens cots. Forecast sales for the next year are 10,000
cots at a selling price of K Sh. 60 per cot. Material costs are K Sh. 18 per cot and direct
labour costs of K Sh. 22 per cot. Forecast fixed costs for the year are K Sh. 80,000. You
are required to:
(i) Calculate the percent change in each of the following variables which result in
breakeven.
- Unit selling price
- Unit material costs
- Unit labour costs
- Volume i.e the margin of safety
- Fixed costs
[12 marks]
(ii) Calculate and discuss the effect on profit of a 10% chance in each variable in the
profit calculation.
[3 marks]
(b) Suppose that the initial capital of an insurer is 10 units, the claim interarrival time and
the claim losses are exponentially distributed with parameters 0.5 and 0.2 respectively.
Assuming that the relative safety loading factor is 0.5.
(i) What is the upper bound probability of ruin for this insurer?
(ii) What will be the probability of ruin in case the initial capital is zero?
[5 marks]
(a) Suppose a risk X has a compound Poisson(10) distributed with claim severity having a
Gamma(1, 0.01) distribution and a decision maker with an exponential utility function with
97
insured risk aversion of 0.005, has wealth of K Sh. 30,000. Approximate the maximum
premium this individual will be willing to pay for a complete insurance cover.
[6 marks]
(b) The net cash flows of two products X and Y, each with initial cost of K Sh. 110,000
and discount rate of 10% are distributed as follows. X = IB and Y = W1 + W2 + ... +
WN , where I Binomial(20, 0.5), B Gamma(10, 0.001), W Exponential(0.002) and N
N egative binomial(200, 0.5)
(i) Using EN P V criteria, which project is preferred?
(ii) With reasons, using coefficient of variation as a relative measure of risk which project
is preferred?
[14 marks]
(a) Discuss how the law of total probability can be used in determining the probability distributions of the open risk model and the closed risk model. Given that all claim severity are
independent continuous random variables.
[5 marks]
(b) Suppose the loss random variable S is such that S = X1 + X2 + ... + XN , where Xi0 s
are independent non negative integer valued random variables. With i = 1, 2, ..., N and
P r(N =n)
P r(N =n1)
= a + nb .
Determine the real values of the constants a and b given that N N egative binomial(20, 0.5).
Hence given that P r(X = 1, 2, 3) = 0.25, 0.5, 0.25, work out P r(S 2).
[15 marks]
Paper Three
DATE: PAPER 3
TIME: 2 HOURS

(a) Define and explain what you understand by the terms risk process and probability of ruin.
Hence state factors that may reduce or increase ruin probability
[6 marks]
(b) Given that for a property of 1 million shillings the insured and insurer utility function is
() = e3 , show that both insured maximum premium and insurer minimum premium
98
will not depend on wealth. Is this utility function favourable to a risk averse decision
maker?
[6 marks]
(c) Determine the pdf, mean and variance of the aggregate claims from three insurance units
with exponential(1000) distribution
[6 marks]
(d) Find mean, variance and mgf of the aggregate gamma(3,2000) distributed claims from N
poisson(10) distributed number of claims.
[7 marks]
(e) A compound poisson distribution has a parameter = 5 with P r(x1 ) = 15 , P r(x2 ) = 53 , P r(x3 ) =
1
5
. Find the copmound distribution of the sum of the claims X1 , X2 , X3
[5 marks]
(a) Suppose that the random claims X1 , X2 , X3 from three portfolios are distributed as X1
poisson(3), X2 geometric(0.6), and X3 binomial(10, 0.5). Using convolution technique, find
pdf of S = X1 + X2 + X3 for S = 0, 1, 2, 3, 4, 5, 6. Hence sketch the cdf of this aggregate claims.
[14 marks]
(b) X and Y are independent, normally distributed loss random variables. Given a random
sample of 100 observations of each random variable with X = 957, Y = 975, standard
deviation of X as 102.6 and standard deviation of Y as 67.5. Perform a suitable hypothesis
test to decide whether the loss random variables have equal means. Use a 5% level of
significance.
[6 marks]
(a) Consider the insurance portfolio that will produce geometric(0.7) distributed claims, with
individual claim amount of 1, 2, 3, or 4 with probabilities 0.3,0.4,0.1 and 0.2 respectively.
Find pdf and cdf of the aggregate claims. Determine also the variance of these aggregate
claims.
[14 marks]
(b) What will the Panjers recursion theorem reduce to in the case of the following three distributions. poison(), negative binomial(r,p) and binomial with parameters m and p. [6 marks]
(a) Suppose that data 5000, 16000, 24000, 13000, 26000, 40000, 50000, 43000, 75000,
82000, 60000, 32000, 18000, 20000 and 81000 in Kenyan shillings constitutes random
claims expected on a certain risk for claims expected on a certain risk for any financial year.
If the worth of the unit insured is K Sh. 95000, what maximum premium is the insured
99
likely to pay using an exponential utility function. Furthermore, if the initial capital of the
insurer is K Sh. 300000. Using Lundbergs exponential bound theorem, find the upper
bound ruin probability of the insurer.
[12 marks]
(b) Assume that a decision makers current wealth is = 10000 with utility function () such
that (0) = 1 and (w) = 0 . The decision maker would be willing to pay premium of up
to P + for complete insurance, if he/she faces the risk of losing amount X at probability of
0.4 and retain the current wealth with probability 0.6. Determine the four values on the
decision makers utility of wealth function (), given values of X are 10000, 6000, 3300
and 1700. Hence state whether the decision maker is risk averse, risk lover or risk neutral
individual.
[8 marks]
Paper Four
DATE: PAPER 4
TIME: 2 HOURS

(a) A decision maker has utility function u(x) =
x for x 0. He is given the choice between
two random amounts X and Y, in exchange for his entire present capital w. The probability
distributions of X and Y are given by P r(X = 400) = P r(X = 900) = 0.5 and P r(Y = 100) =
1 P r(Y = 1600) = 0.6. Explain which random amount between X and Y he would prefer.
Can you think of utility functions with which he would prefer the rejected amount.
[4 marks]
(b) Suppose that the initial capital of an insurer is 10 units, the claim interarrival time and
the claim losses are exponentially distributed with parameters 0.5 and 0.2 respectively.
Assuming that the relative safety loading factor is 0.5.
(i) What is the upper bound probability of ruin for this insurer?
(ii) What will be the probability of ruin in case the initial capital is zero?
[5 marks]
(c) Briefly discuss what you understand about risk matrix in risk management.
[4 marks]
(d) A project will cost $50, 000. Its stream of earnings before depreciation, interest and taxes
during the first year through 6 years is expected to be $13, 000, $12, 000, $14, 000, $18, 000,
$20, 000 and $22, 000. Assuming a 30% tax rate annually and a depreciation of 10%, compute
the Accounting rate of return.
100
[9 marks]
(e) Determine probability for observing compound binomial distributed claims with parameters
10 and 0.5 greater or equal to 2. Given that claim severity are distributed as P r(X =
1, 2, 3) = 0.2, 0.5, 0.3
[8 marks]
(a) Ken India Insurance company has categorized its policies into five homogeneous groups.
During the year 2013, the groups produced claims distributed as follows.
Homogeneous
Group
1
2
3
4
5
Number of
Policies
10
5
6
9
4
Claims distribution
Normally distributed with parameters mean=100 and variance=20
Chi-Square distributed with 90 degrees of feedom
Negative Binomial distributed with parameters 50 and 0.2
Exponential distributed with parameter 0.01
Uniform distributed over the interval (0,200)
Determine the measures of central tentancy and spread for the aggregate claims realized
by Ken India insurance. Also find P r(Aggregate claims are atleast 3500)
[12 marks]
(b) A financial Engineer invested in a project that required initial capital worth KSh. 600. The
projects life is four years with expected cash in flows distributed as follows:
1
Exponential( 100
) for the 1st year; Chi-Square with 100 degrees of freedom for the second
year; Uniform with parameters 0 and 300 for the 3rd year and Gamma(2,0.005) for the 4th
year.
Using ENPV and payback method discuss whether the project was worth undertaking,
given that risk free discount rate is 10%.
[8 marks]
(a) Management accounting information for decision making is mainly composed of estimates
simply because it is based upon predictions concerning the future. One solution to the
consequent lack of precision is to use sensitivity analysis.
(i) Describe Sensitivity analysis and illustrate how it is applied to a specific management
accounting problem.
(ii) How can Sensitivity analysis aid managers and what drawback and limitations does
it have?
101
[7 marks]
(b) Determine coefficient of variation for aggregate claims with claim frequency probability
equal to 0.1, 0.2,0.4,0.2,0.1 for frequencies 0,1,2,3,4 respectively and claim severity probabilities given as 0.2,0.5,0.3 for claims observed equal to 0,1,2 respectively.
[13 marks]
(a) The data observed from three losses namely X,Y,Z by a financial Engineer for the last five
months are as shown below.
Monthly Observations
Loss
X
Y
Z
1
10
57
24
2
22
10
50
3
40
5
20
4
25
15
32
5
30
20
36
6
35
25
30
Test whether the losses have the same mean at 5% level of significance.
[10 marks]
(b) For a certain risk process, it is given that = 0.4 and p(x) = 21 (3e3x + 7e7x ). Which of the
numbers 0,1 and 6 are roots of the adjustment coefficient equation
1 + (1 + )1 R = MX (R)?
Which one is the real adjustment coefficient?
One of the four expressions below is the ruin probability for this process; determine which
expression is the correct one.
(i) () =
24
35 e
(ii) () =
24
35 e
1 6
35 e
11 6
35 e
(iii) () =
24 0.5
35 e
1 6.5
35 e
(iv) () =
24 0.5
35 e
1 6.5
35 e
[10 marks]
Paper Five
DATE: PAPER 5
TIME: 2 HOURS

102
(a) What is risk theory?
[1 mark]
(b) The decision maker has a utility function () = e for > 0, 0 < < 21 , and is faced with
a random loss that has a chi-square distribution with n degrees of freedom. Determine the
maximum insurance premium the decision maker will pay, and prove that this premium is
greater than n.
[8 marks]
(c) Let Xi for i = 1, 2 be independent and identically distributed with the pdf
P r(X = x) =
e0.25(x3) ,
2
0,
f or < x <
otherwise
(i) Using moment generating function, find probability density function of S = X1 + X2 .

[5 marks]
(ii) What is the expectation and variance of S?
(d)
[2 marks]
(i) Let S denote the number of people crossing a certain intersection by car in a given
hour. How would you model S as a random sum?
[2 marks]
(ii) Suppose that the number of passengers in each car has a binomial distribution with
parameters n and p. Find E[S], variance of S and mgf of S.
[5 marks]
(e) Suppose that Lundbergs exponential bound theorem for the ruin probability is given as
() eR . Where R is the adjustment coefficient and = 10 is the initial surplus.
Determine the upper bound probability of ruin when
(i) The claims have a compound poisson with parameter = 0.2. (assume the safety
loading factor is 4%).
[4 marks]
(ii) The claims have a compound negative binomial distribution with parameters r = 5
and p = 0.5. (assume the safety loading factor is 4%).
[3 marks]
(a) Given that S has a compound Poisson distribution with = 2 and p(x) = 0.1x for x=1,2,3,4.
Calculate probabilities that aggregate claims equal 0, 1, 2, ..., 16.
Hence determine E[S],
var(S).
[15 marks]
(b) The probability of a fire in a certain structure in a given period is 0.02. If a fire occurs,
the damage to structure is uniformly distributed over the interval (0, a) where a is its total
value. Calculate the mean and variance of fire damage to the structure within the time
period.
[5 marks]
103

(a)
(i) Determine the adjustment coefficient if the claim amount distribution is exponential
with parameter > 0.
[4 marks]
(ii) Calculate the probability of ruin in the case that the claim amount distribution is
exponential with parameter > 0.
(b)
[10 marks]
(i) An insurer with net worth 500 has accepted a risk X with the following probability
distribution.
P r(X = 0) = 0.4 and P r(X = 60) = 0.6 what is the maximum amount it should pay another
insurer to accept 100% of this loss? Assume the first insurers utility function of wealth is
() = log.
[3 marks]
(ii) An insurer, with wealth 1250 and the same utility function, () = log is considering accepting the above risk. What is the minimum amount this insurer would accept as a
premium to cover 100% of the loss?
[3 marks]
(a) Compute for x=0,1,2,3,4,5 and P r(S 2) for the following three compound distributions,
each with claim amount distribution given by
P r(X = x) =
0.2, f or x = 1
0.3, f or x = 2
0.5, f or x = 3
0, otherwise
(a) Poisson with parameter = 5

(b) Negative binomial with parameters r = 6 and p = 0.25
(c) Binomial with parameters m = 10 and p = 0.75
[15 marks]
(b) The distribution of X, the claim severity from a portfolio of non-life insurance policies has a
Pareto distribution with mean KSh. 350 and standard deviation of KSh. 452. If the insurer
arranges excess of loss reinsurance with retention of KSh. 1200. Calculate the probability
that a claim will involve the insurer.
[5 marks]
104
Paper Six
DATE: PAPER 6
TIME: 2 HOURS

(a) Briefly, what do you understand about the following terms as used in risk theory.
(i) Risk process
(ii) Utility function
(iii) Jensens inequalities
[3 marks]
(b) Suppose X unif orm(0, 3) and Y unif orm(0, 4). Assuming X and Y are independent
random variables. Find pdf of S = X + Y , using convolution technique.
[6 marks]
(c) The value a decision maker attaches to his/her wealth () is given by a quadratic utility
function with aversion coefficient () equal to 0.02 and < 50. Find the maximum insurance
premium that the decision maker will pay for complete insurance. If he/she is willing to
retain his/her wealth of amount = 20 units at a probability of 0.6 and suffer a loss of
amount c = 10 units at aprobability of 0.4. Assuming that c < 50.
[5 marks]
(d) X and Y are independent, normally distributed loss random variables. You collect a random
sample of 200 observations of each random variable and find that: X = 863, Y = 882, SX =
96.4 and SY = 58.5. Carry out a suitable hypothesis test to decide whether the loss random
variables have equal means at 1% level of significance.
[4 marks]
(e) Given that the number of claims, N are geometric distributed with parameter p, for 0 < p < 1
and claims, X are exponentially distributed with parameter = 2. What is the moment
generating function of total amount of claims.
[5 marks]
(f) A portfolio consists of a total of 400 independent risks. On each risk, no more than one event
can occur each year, and the probability of an event occurring is 0.035. When such an event
occurs, the number of claims N has the following distribution. P (N = x) = 0.55(0.45)x1 ,
x = 1, 2, ...
Determine the mean and variance of the distribution of the number of claims which arise
from this portfolio in one year.
[4 marks]
(g) An insurance company has an excess of loss reinsurance contract with retension of KSh. 40, 000.
Over the last year, the insurer paid the following claims in shillings, 12, 000, 2, 700, 398 and
105
43, 567. In addition, the insurer paid the amount of KSh. 40, 000 on 7 claims with the excess
being paid by the re-insurer. The insurer believes that distribution of gross claim amounts
is exponential with mean . Calculate the maximum likelihood estimate of based on the
above information.
[8 marks]
(a) A decision makers utility function is given by () =
. The decision maker has wealth
of = 12 and faces a random loss X with a uniform distribution on (0, 12). Show that
this utility function satisfies requirements of a risk averse individual. Hence, What is the
maximum amount this decision maker will pay for complete insurance against the loss?.
[8 marks]
(b) Consider an insurance portfolio that will produce zero, one, two, or three claims in a fixed
time period with probabilities 0.1, 0.3, 0.4, and 0.2, respectively. An individual claim will
be of amount 1,2, or, 3 with probabilities 0.5, 0.4, and 0.1, respectively. Calculate the
variance of aggregate claims and
P r(aggregate claims 6).
[12 marks]
Suppose in a 1-year term life insurance paying an extra benefit in case of accidental death.
If death occurs and is accidental, the benefit is 50, 000. For other causes of death, the benefit
amount is 25, 000. In addition given that for the age, health, and occupation of aspecific individual, the probability of an accidental death within the year is 0.0009, while the probability of a
non-accidental is 0.0025.
(a) Determine the conditional distribution of the total claim amount B, incurred during the
period. Given that atleast a claim occurs.
(b) Given that acertain automobile insurance provides collision coverage above a 250 deductable
up to a maximum claim of 2, 000. If for a particular individual the probability of one claim in
a period is 0.25 and the chance of more than one claim is 0. Assume that total claims (i.e.
B) distribution from (a) above, has a probability mass at the maximum claim size of 2, 000,
assume this probability mass is 0.2. Furthermore, assume that claim amounts between 0
and 2, 000 can be modeled by a continuous distribution with probability distribution funch
2 i
x
tion of total claims equal to 0 for x 0 and 0.8 1 1 2000
for 0 < x < 2, 000 and 1 for
x 2, 000. Where X is the aggregate random claims in one period.
(i) Sketch distribution function of the random amount claimed, X given a claim occurs.
106
(ii) Find the distribution of X.

(iii) Derive an expression for determining the mean and variance of X, hence find their
actual values. Without using the method of moments.
[20 marks]
(a) State and prove Panjers recursion theorem.

Hence find the distribution of S = X1 + X2 + X3 + X4 given that S is a compound poison with
parameter 10 and P r(X = 1, 2, 3, 4) = 0.2, 0.2, 0.5, 0.1.
[10 marks]
(b) Using Lundbergs exponential bound theorem for the ruin probability with initial surplus
as 10 units. Determine the upper bound probabilities of ruin when;
(i) The claims are compound Poisson distributed with parameter = 0.2 and safety
loading factor of 4%.
[5 marks]
(ii) The claims are compound negative binomial distributed with parameters r = 5, p =
0.5 and safety loading factor of 4%.
[5 marks]
Paper Seven
DATE: PAPER 7
TIME: 2 HOURS

(a) Explain what you understand by the following terms

(i) RAD
(ii) Risk Theory
[4 marks]
(b) Briefly discuss the application of certainty equivalent and risk adjusted discount rate as
techniques of handling risk in capital budgeting.
(c) Suppose project M has an expected value of $6000 and a standard deviation of $1205 and
project N has an expected value of $9800 and a standard deviation of $2297. Depending on
the investors attitude towards risk, with reasons which project is preferable?
107
[5 marks]
(d) An investment project will cost $62, 000 initially and is expected to generate cash flows in 5
years i.e. $22, 000, $19, 000, $13, 500, $11, 600 and $10, 400 respectively. What is the projects
internal rate of return for the five years.
[6 marks]
(e) In a bayesian investigation in the financial industry, a particular claim rate is to be
estimated. To obtain a suitable prior distribution, an expert is consulted and he suggest
that will have a mean of 0.24 and a standard deviation of 0.06. It is required to construct
a prior gamma distribution to fit the experts information. Find the parameters for the
appropriate gamma distribution.
[3 marks]
(f) What is the return on portfolio and risk of portfolio for a two-asset portfolio comprising the
following two assets if the correlation of their returns is 0.7?
Asset A
Asset B
Expected return
15%
30%
Standard deviation of expected returns
5%
30%
$40000
$60000
Amount Invested
[5 marks]

(a) A project will cost $40, 000. Its stream of earnings before depreciation, interest and taxes
(EBDIT) during the first year through 5 years is expected to be $13, 000, $14, 500, $15, 000,
$19, 000 and $24, 000. Assuming a 25% tax rate and a depreciation of $6, 000 on straight line
basis, compute the Accounting rate of return.
[8 marks]
(b) Consider a project which costs $15, 000 at t = 0 and 3 years. The following table presents the
cash flows and probability information for the project. Assuming a risk free discount rate of
18%. Calculate the expected value and the standard deviation of the probability distribution
of possible NPVs under the assumption of dependence. Assuming a normal distribution,
what is the probability of 0 or less, of 3000 or more. Compare the standard deviation with
the one under assumption of independent cash flows over time.
108
Year 1
Year 2
Year 3
Cash flows($)
Probability
Cash flows($)
Probability
Cash flows($)
Probability
8500
0.2
3050
0.25
5600
0.2
7500
0.3
6050
0.4
6600
0.25
5500
0.25
4050
0.15
3600
0.45
3500
0.25
7050
0.2
4600
0.1
[12 marks]

A financial manager of cloth processing company is considering the installation of a plant costing
$20, 000 to increase its processing capacity. The expected values of the underlying variables are
as follows.
1.
Investment($)
20,000
2.
Sales Volume(units)
1,500
3.
15
4.
5.
5,000
6.
Depreciation(%)
20
7.
Corporate tax rate(%)
30
8.
Discount rate(%)
15
(a) Compute the projects after-tax cash flows over its expected life of 7 years. Hence, based
on N.P.V criteria, should the financial manager undertake the project or not.
[6 marks]
(b) Before the financial manager takes a decision, he/she may like to know whether the N.P.V
changes if one of the forecast goes wrong. Perform sensitivity analysis with regard to
volume, price and costs. Hence determine the most critical variable. Use the following
pessimistic and optimistic values.
[7 marks]
109
S/No.
Variable
Pessimistic
Expected
Optimistic
1.
Volume(Units)
90% of 1,500
1,500
110% of 1,500
2.
90% of 15.00
15.00
110% of 15.00
3.
110% of 8.00
8.00
90% of 8.00
4.
110% of 5,000
5,000
90% of 5,000
(c) Using the most critical variable obtained above and the forecasts under the expected assumptions, determine the variables break even point if sales volume is assumed to be a
random variable.
[7 marks]

(a) A company has the options now of building a full-size plant or a small plant that can be
expanded later. The decision depends primarily on future demands for the product the
plant will manufacture. The construction of a full-size plant can be justified economically if
the level of demand is high. Otherwise, it may be advisable to construct a small plant now
and then decide in two years whether it should be expanded. Suppose that the company is
interested in studying the problem over a 12-year period. A market survey indicates that
the probabilities of having high and low demands over the next 12 years are 0.55 and 0.45,
respectively. The immediate construction of a large a large plant will cost $4.5 million and a
small plant will cost only $0.95 millions. The expansion of the small plant 2 years from now
is estimated to cost $4 million. Estimates of annual income for each of the alternatives are
given as follows.
(i) Full-size plant and high (low) demand will yield $1, 000, 500 ($300, 900) annually.
(ii) Small plant and low demand will yield $200, 000 annually.
(iii) Small plant and high demand will yield $255, 000 for each of the 12 years.
(iv) Expanded small plant with high (low) demand will yield $907, 000 $(199, 500) annually.
(v) Small plant with no expansion and high demand in the first two years followed by
low demand will yield $200000 in each of the remaining 10 years. As a Financial Engineer
assist the company in making the right decision.
[12 marks]
(b) Suppose that demand during the last 10 years can be high, medium, or low, with probabilities 0.5, 0.3 and 0.2, respectively. The annual incomes are as follows.
(i) Expanded small plant with high, medium, and low demands will yield annual income
of $900, 000, $600, 000 and $250, 000.
(ii) Non expanded small plant with high, medium, and low demand will yield annual
income of $400, 000, $290, 000 and $160, 000.
110
Determine the optional decision if the company decides to build small plant due to high
demand.
[8 marks]
111

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RISK THEORY FOR ACTUARIAL SCIENCES AND

FINANCIAL ENGINEERING STUDENTS

January 25, 2015

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Terms used in risk theory

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

timation, consequently, is an estimation process, starting from the occurrence probability

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Types of risks includes:

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

(i) P remium = p = E[X] = pure premium

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Utility theory and Insurance

Determination of utility function

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

The expected utility model

Theorem (Jensens inequality)

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Since (.) is a non-decreasing continuous function, this is equivalent to P P + . It is the

(i) if () < 0, then E[(X)] (E[X])

(ii) if () > 0, then E[(X)] (E[X])

Proof for case (i)

The equation of a tangent function to the function () at the point (, ()),

where = E[X] = is given as () = () + ()( ).

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

both sides we get; E[(X)] (E[X]).

Proof for case (ii)

The equation of a tangent function to the function () at the point (, ()),

where = E[X] = is given as () = () + ()( ).

Risk averse coefficient

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Taking expectations on both sides of the latter approximation yields

substituting 2 into 4, it follows from 3 that

Then the maximum premium P + to be paid for a risk X is approximately

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

= 100. If the insureds utility function is

exponential with parameter = 0.005, then

What happens to this premium is increases. Let E[X] =

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

The expected utility after a loss X equals

and the utility after paying a premium P equals

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Mixed distributions and risks

1. The contract is claim-free, hence S = 0.

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Types of individual risk models

and the d.f is

From the p.f and definitions of moments

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

Accident cover due to

constant Amount paid

E[S] = E[E[S|I]] = E[E[IB|I]]

RISK THEORY NOTES PREPARED BY V.S.ANDIKA

FX (x) = P r(X x) = P r(IB x)

Application of Mixed distributions in modeling individual random variables

and the d.f is

From the p.f and definitions of moments

RISK THEORY NOTES PREPARED BY V.S.ANDIKA