Insurance Risk

Insurance Risk Theory
Leda D.Minkova
Lecture Notes
2010
Contents
1 Basic Risk Model 1
2 Random Variables 3
2.1 Hazard rate function . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 Moments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
2.3 Transforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.3.1 Probability Generating Functions . . . . . . . . . . . . 7
2.3.2 Moment Generating Functions . . . . . . . . . . . . . . 7
2.3.3 Characteristic Functions . . . . . . . . . . . . . . . . . 8
2.3.4 Laplace Transform . . . . . . . . . . . . . . . . . . . . 8
2.4 Counting Random Variables . . . . . . . . . . . . . . . . . . . 9
2.5 Continuous random variables . . . . . . . . . . . . . . . . . . 11
2.5.1 Exponential distribution and lack of memory property 11
2.5.2 Gamma distribution . . . . . . . . . . . . . . . . . . . 13
2.5.3 Beta distribution . . . . . . . . . . . . . . . . . . . . . 14
2.5.4 Weibull distribution . . . . . . . . . . . . . . . . . . . 14
2.5.5 Pareto distribution . . . . . . . . . . . . . . . . . . . . 15
2.5.6 The normal distribution . . . . . . . . . . . . . . . . . 16
2.5.7 Log-normal distribution . . . . . . . . . . . . . . . . . 17
2.5.8 Inverse Gaussian distribution . . . . . . . . . . . . . . 17
2.6 Functions of random variables . . . . . . . . . . . . . . . . . . 18
2.7 Joint density and distribution function . . . . . . . . . . . . . 19
2.8 Conditional distributions . . . . . . . . . . . . . . . . . . . . . 20
2.9 Sum of random variables . . . . . . . . . . . . . . . . . . . . . 21
i
ii CONTENTS
2.9.1 Negative binomial distribution . . . . . . . . . . . . . . 23

2.9.2 Erlang distribution . . . . . . . . . . . . . . . . . . . . 23
2.10 Mixed distributions . . . . . . . . . . . . . . . . . . . . . . . . 24
2.11 Compound distributions . . . . . . . . . . . . . . . . . . . . . 27
2.11.1 Hiperexponential distribution . . . . . . . . . . . . . . 30
3 Counting processes 31
3.1 Poisson process . . . . . . . . . . . . . . . . . . . . . . . . . . 31
3.1.1 Order statistics property . . . . . . . . . . . . . . . . . 36
3.2 Renewal process . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.2.1 Renewal function . . . . . . . . . . . . . . . . . . . . . 41
3.2.2 Recurrence times of a renewal process . . . . . . . . . . 43
3.2.3 Delayed Renewal process . . . . . . . . . . . . . . . . . 45
3.3 Mixed Poisson process . . . . . . . . . . . . . . . . . . . . . . 46
3.4 Compound Poisson process . . . . . . . . . . . . . . . . . . . . 47
3.4.1 Polya - Aeppli process . . . . . . . . . . . . . . . . . . 48
4 Claim Size Models 49

4.1 Heavy tailed distributions . . . . . . . . . . . . . . . . . . . . 51
4.2 Regularly varying functions . . . . . . . . . . . . . . . . . . . 51
4.2.1 Properties . . . . . . . . . . . . . . . . . . . . . . . . . 52
4.2.2 Regularly varying random variables . . . . . . . . . . . 54
4.3 Subexponential distributions . . . . . . . . . . . . . . . . . . . 55
4.3.1 Properties . . . . . . . . . . . . . . . . . . . . . . . . . 56
5 Cram
er - Lundberg model 61
5.1 Ruin probability . . . . . . . . . . . . . . . . . . . . . . . . . . 61
5.2 Integral equation of ruin probability . . . . . . . . . . . . . . . 62
5.3 Cramer - Lundberg approximation . . . . . . . . . . . . . . . 64
5.4 Martingale approximation . . . . . . . . . . . . . . . . . . . . 67
CONTENTS iii
6 Renewal Risk Model 71

6.1 Ordinary renewal risk model . . . . . . . . . . . . . . . . . . . 71
6.1.1 Lundberg exponent . . . . . . . . . . . . . . . . . . . . 73
6.1.2 Pollaczeck - Khinchine formula (Ruin probability as a
compound geometric probability) . . . . . . . . . . . . 74
6.2 Stationary case . . . . . . . . . . . . . . . . . . . . . . . . . . 76
6.3 Ruin probability for heavy tailed distributions . . . . . . . . . 77
7 Premium Calculation Principles 81

7.1 Premium calculation principles . . . . . . . . . . . . . . . . . 81
7.1.1 Pure premium principle . . . . . . . . . . . . . . . . . 81
7.1.2 Expected value principle . . . . . . . . . . . . . . . . . 82
7.1.3 The variance principle . . . . . . . . . . . . . . . . . . 82
7.1.4 Standard deviation principle . . . . . . . . . . . . . . . 82
7.1.5 Modified Variance Principle . . . . . . . . . . . . . . . 82
7.1.6 The Principle of Zero Utility . . . . . . . . . . . . . . . 83
7.1.7 The Esscher Principle . . . . . . . . . . . . . . . . . . 85
7.1.8 Risk adjusted premium principle . . . . . . . . . . . . 86
8 Diffusion Approximation 89
8.1 Ruin Probability for diffusion process . . . . . . . . . . . . . . 91
9 Reinsurance 95
9.1 Proportional Reinsurance . . . . . . . . . . . . . . . . . . . . . 95
9.2 Excess - of - Loss Reinsurance(XL) . . . . . . . . . . . . . . . 98
9.3 Stop - Loss Reinsurance . . . . . . . . . . . . . . . . . . . . . 98
Bibliography 100
Chapter 1
Basic Risk Model
The foundation of the modern risk theory goes back to the works of Filip
Lundberg and Harald Cramer. The Poisson process was proposed by Filip
Lundberg in 1903 as a simple process in solving the problem of the first
passage time. In 1930 Harald Cramer extended the Lundbergs work for
modeling the ruin of an insurance company as a first passage time problem.
The basic model is called a Cramer - Lundberg model or classical risk model.
Insurance Risk Theory is a synonym of non-life insurance mathematics.
The basic process of the general risk model is given by
X(t) = (t) S(t) (1.1)
and is called a risk process. Here (t) is the total amount of the premiums
to the insurance company up to time t. S(t) is the accumulated sum of claims
up to time t. The risk reserve of the insurance company with initial capital
u is given by
U (t) = u + (t) S(t), t 0. (1.2)
The stochastic process in (1.2) is S(t) and it can be described by the following
elements:
(i) The times 0 1 2 . . . , of claim arrivals. Suppose that 0 = 0.
The random variables Tn = n n1 , n = 1, 2, . . . , called inter - occurrence
or inter - arrival times are nonnegative.
1
2 CHAPTER 1. BASIC RISK MODEL
(ii) N (t) = sup{n : n t}, t 0 is the number of claims up to time

t. The relations between the times {0 , 1 , . . .} and the counting process
{N (t), t 0} are given by
{N (t) = n} = {n t < n+1 }, n = 0, 1, . . . .
(iii) The sequence {Zn , n = 1, 2, . . .} of independent identically dis-

tributed random variables represents the amounts of the successful claims
to the insurance company. Suppose that the sequence {Zn } is independent
of the counting process N (t).
The accumulated sum of claims up to time t is given by

N (t)
X
S(t) = Zi , t 0.
i=1
The process S = (S(t))t0 is defined by the sum Sn = Z1 + . . . + Zn , where

n is a realization of the random variable N (t) :
S(t) = Z1 + . . . + ZN (t) = SN (t) , t 0,
or a random sum of random variables. Suppose that S(t) = 0, if N (t) = 0.

Chapter 2
Random Variables
All the random variables are defined on a complete probability space (, F, P ).
Definition 2.1 The function
FX (x) = P (X x) = P (X (, x]). (2.1)
is called a distribution function of the random variable X.
The distribution function FX (x) satisfies the following conditions.

a) FX () = limx FX (x) = 0.
b) FX () = limx FX (x) = 1.
c) FX (x) is nondecreasing, i. e., if x < y, then
FX (x) FX (y).
d) FX (x) is a right continuous, i. e. for any x,
FX (x + 0) = FX (x).
The function F X = 1 FX (x) = P (X > x) is called a survival function

for X and represents the tail distribution.
The random variables are characterized by the properties of the distribu-
tion function in three different types.
The random variable X is called discrete, if the distribution function is a
stepwise and has countable many jumps.
3
4 CHAPTER 2. RANDOM VARIABLES
For the discrete random variable there exists a countable subset E =

{x0 , x1 , . . .} of R such that P (X E) = 1. In this case the probability
function is given by
pk = P (X = xk ), k = 0, 1, . . .
and the distribution function

X
FX (x) = P (X = xk ),
xk x
where the sum is over all jump points of FX (x).

A discrete r. v. X is called arithmetic with a step h, if the values of X
belong to the set {x = ih : i = 0, 1, 2, . . . , }. We use arithmetic distribu-
tion in the case of h = 1. An arithmetic distribution over the nonnegative
values is called a counting distribution. So the counting random variables are
discrete with integer nonnegative values, i. e.
pk = P (X = k), k = 0, 1, . . . .
The r. v. X is called continuous, if the distribution function FX (x) is

continuous. The continuous r. v. X is called absolutely continuous, if FX (x)
is differentiable over all R.
For the continuous r. v., the function
d
fX (x) = FX (x),
dx
if it exists, is called a probability density function of X. The function fX (x)
is nonnegative. It is easy to see that
Z Z x
fX (x)dx = 1 and FX (x) = fX (t)dt.

In a more general case for any event A,

Z
P (A) = f (t)dt.
A
Intuitively, we could write that P (X = x) = f (x)dx and consider P (X = x)

like the probability P (x < X x + dx) over an infinitesimal interval.
2.1. HAZARD RATE FUNCTION 5
The r. v. X is of a mixed type, if it is neither discrete nor continuous. If

x is a jump point of F (x), then we say that X has a mass P (X = x) at the
point x. In the points where F (x) is absolutely continuous we consider the
r. v. like continuous.
2.1 Hazard rate function

Let X be a continuous r. v. with distribution function F and density function
f.
f (t)
(t) =
F (t)
is called hazard rate function for the r. v. X.
Depending of the applications, the hazard rate function is called also failure
rate function, force of default, intensity rate function. Let X be the life
distribution. Then the hazard rate function is equal to the probability that
the individual, survived the time t dies in the additional time dt, i. e.
P (X (t, t + dt), X > t) P (X (t, t + dt))

P (X (t, t + dt)|X > t) = =
P (X > t) P (X > t)
f (t)dt
= (t)dt.
F (t)
The function (t) is interpreted like the intensity of deathes in the set
of individuals at age t and characterizes the distribution of the r. v. Let
d
Rt dt F (t)
(t) = 0 Ff (s)
(s)
ds. Since (t) = F (t)
it follows that (t) = log F (t).
Consequently
Z t
F (t) = exp (s)ds = exp((t)). (2.2)
0
The function Z t
(t) = (s)ds
0
is called a hazard function.

For a discrete random variable with distribution {pk }
k=0 , the hazard rate
function is given by
pk
(k) = P , k = 0, 1, . . . .
j=k pj
In this case (k) 1.
2.2 Moments
Mathematical expectation = EX of the r. v. X is defined by
X
EX = xk p(xk ),
k
if X is a discrete and Z
EX = xf (x)dx,

P R
if X is continuous, conditionally on k |xk |p(xk ) < and
|x|f (x)dx <
. The mathematical expectation is called also mean value or simply a mean.
In the more general case, for any measurable function g : R R,
the mathematical expectation Eg(X) is defined by the Lebesgue - Stieltjes
R R
integral Eg(X) = g(x)dF (x), providing that |g(x)|dF (x) < .
The mathematical expectation k = E(X k ), for any integer k, is called a
k th moment of the r. v. X. E(X )k is called a kth central moment.
The second central moment V ar(X) = 2 = E(X )2 is called a dispersion
or variance. The variance is often used as a measure of the risk, modeled
by the random variable. Another risk measure is the standard deviation
p
= V ar(X). Essentials in applications are the coefficient of variation
2
CV =
and the index of dispersion I =
, known also as a Fisher index.
E(X)3
The skewness coefficient is defined by the third moment: 1 = 3
.
E(X)4
The kurtosis coefficient is 2 = 4
. The kth factorial moment is (k) =
E[X(X 1) . . . (X k + 1)].
2.3. TRANSFORMS 7
2.3 Transforms
2.3.1 Probability Generating Functions
Let X be a nonnegative integer - valued random variable with PMF
pk = P (X = k), k = 0, 1, 2, . . . .
Definition 2.3 The Probability generating function (PGF) is defined

as
X
X
PX (s) = Es = sk pk , (2.3)
k=0
provided the expectation is finite.
It is easy to verify that
(k)
1 dk P (0)
pk = k
PX (s)|s=0 = X
k! dt k!
and the factorial moments
dk (k)
(k) = E[X(X 1) . . . (X k + 1)] = PX (s)|s=1 = PX (1).
dtk
2.3.2 Moment Generating Functions

Let X be a real - valued random variable.
Z
sX
MX (s) = Ee = esx dFX (x), (2.4)
is called a Moment generating function (MGF) of the random variable

X, whenever the expectation is finite.
Note that the MGF is finite if s = 0 and M (0) = 1. The power series of the
exponential function implies that

(sx)i s2 s3
Z X
MX (s) = dFX (x) = 1 + 1 s + 2 + 3 + . . . ,
i=0
i! 2! 3!
where
dk k
k = EX = k MX (s)|s=0 , k = 1, 2, . . .
dx
2.3.3 Characteristic Functions

Definition 2.5 Let X be an R valued random variable. Then
Z
isX
(s) = Ee = esx dFX (x), s R

is called a characteristic function of X.
Apart from a minus sign in the exponent and the factor 1 , the characteristic
2
functions coincide with Fourier transforms in the absolutely continuous case
and with Fourier series in the lattice case.
2.3.4 Laplace Transform

Suppose that the random variable X is nonnegative.

Z
sX
LTX (s) = Ee = esx dFX (x), (2.5)
0
if it exists is called Laplace transform (LT) of the random variable X or its

distribution.
The Laplace transform is defined for complex values of s with positive

real part. For our purposes it is sufficient to assume that s is a positive real
number.
The LT (2.5) of the random variable is called also Laplace - Stijeltes
transform (LST) of the distribution function FX (x) and actually is the LT
of the density function fX (x), if it exists.
Properties of the Laplace transform
Suppose that the random variable X is nonnegative with density function
f (x). Then Z
LTX (s) = LTf (s) = esx f (x)dx, (2.6)
0
where s is a positive real number. It is easy to show that if f (x) is continuous,
then the integral in (2.6) exists, and there exist numbers 1 , 2 and > 0,
such that, for all x > ,
|f (x)| 1 e2 x .
2.4. COUNTING RANDOM VARIABLES 9
Example 2.1 Let us find the Laplace transform of f (x) = ex , x > 0.

According to the definition
Z Z
sx x 1
LTf (s) = e e dx = e(s)x dx = , s > .
0 0 s
Suppose that the LTf (s) in (2.6) exists. Then

R
1. LTf (s a) = 0 esx [eax f (x)]dx;
R
2. eas LTf (s) = a
esx f (x a)dx;
R
3. 1
a
LTf ( as ) = 0
esx f (ax)dx;
R
4. sLTf (s) f (0) = 0
esx f 0 (x)dx;
R R x
5. 1s LTf (s) = esx

0 0
f (y)dy dx;
R
6. d
ds
LTf (s) = 0
esx [xf (x)]dx;
dn
R
7. dsn
LTf (s) = 0
esx [(1)n xn f (x)]dx;
R R h i
f (x)
8. s
LTf (v)dv = 0
esx x
dx;
R
9. If LTi (s) = esx fi (x)dx, i = 1, 2, then
0
Z Z x
sx
LT1 (s)LT2 (s) = e f1 (y)f2 (x y)dy dx.
0 0
10. For a distribution function F with density f
LTf (s) = LSTF (s) = sLTF (s).
2.4 Counting Random Variables

1. Bernoulli random variables. The random variable X has a Bernoulli
distribution with parameter p, if P (X = 1) = 1 P (X = 0) = p. It is easy
to check that
EX = EX 2 = p and V ar(X) = p(1 p).
2. Geometric distribution. The random variable N has a geometric

distribution with parameter p, (N Ge1 (p)) if
P (N = k) = p(1 p)k1 , k = 1, 2, . . . .
The mean and the distribution function are given by

1
EN = , P (N n) = 1 (1 p)n .
p
The random variable N is interpreted as the number of trials up to the first
success in a sequence of independent Bernoulli trials. The moment generating
function is
pes
MN (s) = , s < log(1 p)
1 (1 p)es
and the PGF
ps
PN (s) = .
1 (1 p)s
A characterization property of the geometric distribution is a lack of
memory:
P (N = n + k) (1 p)n+k1 p
P (N = n + k|N > k) = = = P (N = n),
P (N > k) (1 p)k
for any n > 0 and k > 0.
3. Binomial distribution. The random variable N has binomial dis-
tribution with parameters n and p (0, 1), (N Bi(n, p)) if

n k
P (N = k) = p (1 p)nk , n = 0, 1, . . . n.
k
The mean and the variance are given by
EN = np and V ar(N ) = np(1 p).
The MGF is
MN (s) = [1 p(1 es )]n
2.5. CONTINUOUS RANDOM VARIABLES 11
and the PGF

PN (s) = [1 p(1 s)]n .
The binomial distributed random variable N is interpreted as the number

of successes in a sequence of n independent Bernoulli trials.
4. Poisson distribution. The random variable N has a Poisson distri-
bution with parameter , (N P o()) if
k
P (N = k) = e , k = 0, 1, . . . .
k!
The mean and the variance of the Poisson distribution are equal:
EN = V ar(N ) = .
The MGF is
s)
MN (s) = e(1e
and the PGF

PN (s) = e(1s) .
2.5 Continuous random variables

2.5.1 Exponential distribution and lack of memory prop-
erty
The random variable X is exponentially distributed with parameter > 0,
(X exp ()), if
F (x) = 1 ex and f (x) = ex , x 0.
The MGF of the exponential distribution is

MX (s) = EesX = , t< (2.7)
s
and the Laplace transform

LTX (s) = .
+s
All the moments of the random variable could be determine by differen-

tiation of (2.7).
1 1
EX = , and V ar(X) = 2

and
n!
EX n =
.
n
If = 1, the r. v. X exp(1) is called a standard exponentially
X
distributed. Let X exp(1) and Y = a +
, > 0, < a < . Then
the distribution of Y is determined by the following distribution function and
probability density function
F (x) = 1 e(xa) and f (x) = e(xa) , x a
and is noted by Y exp(a, ).

The advantages in applications of the exponential distribution is the lack
of memory property.
The random variable X satisfies the lack of memory property, if for
any t, s 0 such that P (X t) > 0
P (X t + s|X t) = P (X s). (2.8)
Let X be the lifetime distribution. Then (2.8) means the probability

that the individual will survive another s years, after having attained the
age t is equal to the probability that the individual will survive age s. If
the distribution function is not degenerate at zero, the condition (2.8) is
equivalent to
P (X t + s, X t)
= P (X s)
P (X t)
or
P (X t + s) = P (X s)P (X t). (2.9)
The equation (2.9) contains also the degenerated case. The decision is given
by the following theorem [5].
Theorem 2.1 There are only two solutions of the equation (2.9) among dis-
tribution functions. Either F (x) is degenerate at zero, or, with some constant
> 0, F (x) = 1 ex , x 0.
Since e(t+s) = et es , the only exponentially distributed random vari-

ables are memoryless. If the lifetime distribution is exponential the hazard
rate function is constant:
et
(t) = = .
et
Let X and Y be independent exponentially distributed random variables

with respective parameters and . Then the distribution of Z = min(X, Y )
is given by
P (Z z) = 1 P (Z > z) = 1 P (X > z, Y > z) =
= 1 P (X > z)P (Y > z) = 1 ez ez = 1 e(+)z .
Consequently, Z = min(X, Y ) is again exponentially distributed with

parameter + .
2.5.2 Gamma distribution

R
Let () = 0
x1 ex dx, > 0 be the Gamma function.
Properties of the Gamma function
() = ( 1)( 1),
(n) = (n 1)!, n 1
and

1
= .
2
The random variable X is Gamma distributed with parameters > 0
and > 0, (X (, )), if the density function is given by
1 x
f (x) = x e , x > 0.
()
The parameter is called a shape parameter. Small value of results in a

long tail to the right, or right skewed distribution.
In the special case integer, it is an Erlang distribution.
The MGF is
s
M (s) = 1 , t>

and the n th moment
( + n)
EX n = .
() n
In particular

EX = and V ar(X) = .
2
2.5.3 Beta distribution

For > 0 and > 0, the function
Z 1
B(, ) = x1 (1 x)1 dx
0
is called a Beta function. The most important property of the Beta function:
()()
B(, ) = .
( + )
The random variable X is Beta distributed (X B(, )) with parame-

ters and , if the density function is
1
f (x) = x1 (1 x)1 , x (0, 1).
B(, )
The moments of the Beta distributed random variable:
B(n + , ) (n + )( + )
EX n = = .
B(, ) (n + + )()
2.5.4 Weibull distribution

The random variable X has Weibull distribution with parameters > 0 and
> 0, (X W (, )) if the distribution function and density function are
x
F (x) = 1 e( ) , x 0
and
x 1 ( x )
f (x) = e , x 0.

The mean and the variance:
" 2 #
1 2 1
EX = (1 + ), V ar(X) = 2 (1 + ) (1 + ) .

If = 1, W (1, ) = exp().
2.5.5 Pareto distribution

The random variable X has a Pareto distribution with parameters > 0 and
> 0, (X P ar(, )), if the distribution function is given by

F (x) = 1 , x > 0.
+x
The density function is

f (x) = , x > 0.
( + x)+1
The distribution defined by the density

f1 (x) = f (x ) = , x>
x+1
is called a shifted Pareto distribution.
The moments of the random variable with density f (x) are
Z +1
k
mk = x dx.
0 +x

The change of variables y = +x
leads to
1 k Z 1
(1 y)
Z
+1 2 k
mk = y y dy = y k1 (1 y)k dy,
0 y 0
which is a Beta function and

( k)(k + 1) ( k)
mk = k = k k! , > k.
( + 1) ()
The mean and the variance are

EX = m1 = , >1
1
and
2
V ar(X) = , > 2.
( 1)2 ( 2)
It is easy to see that only finite number of moments exist. Even the mean
and the variance not always exist. This means that the Pareto distribution
is a heavy tailed.
2.5.6 The normal distribution

The normal distribution is important in insurance and finance since it appears
like limiting distribution in many cases. The normal density function is
(x )2

1
f (x) = exp , < x < .
2 2 2
The notation X N (, ) means that X has a normal distribution with
parameters and .
The mean value and the variance are EX = and V ar(x) = 2 . The
X
most important property is that the random variable Z =
is normally
distributed with parameters 0 and 1 (Z N (0, 1)). The distribution function
is denoted and Z x
1 x2
(x) = e 2 dx.
2
The characteristic function of X is
s2 2
X (s) = eis 2 , sR
and the MGF
s2 2
MX (s) = es 2 .
2.5.7 Log-normal distribution

The random variable X has a log - normal distribution, if Y = log X has a
normal distribution. If Y N (, ), the density function of X is
1 1 1 log x 2
fX (x) = fY (log x) = e 2 ( ) , x > 0,
x x 2
where > 0, < < . The distribution function of X is defined by

log x
F (x) = , x > 0,

where (.) is the standard normal distribution function. The moments of

the lo g- normal distribution can be calculated from the standard normal
distribution function.
2 k2
mk = EX k = E(ekY ) = MY (k) = ek+ 2 ,
where MY (k) is the MGF of the normal distribution. Particular, the mean
and variance are
2
EX = m1 = e+ 2
and
2 2
V ar(X) = e2+ [e 1].
2.5.8 Inverse Gaussian distribution

If the random variable X is defined by the density
(x)2
f (x) = p e 2x , x 0, (2.10)
2x3
where > 0, then X has Inverse Gaussian distribution (X IG(, )).

In the special case of = 1, (2.10) is called Wald distribution. The In-
verse Gaussian distribution has greater skewness and a sharper peak then
Gaussian.
The distribution function is

x 2 x +
F (x) = +e , x > 0.
x x
The Laplace transform:

Z
(x)2 1
LT (s) = esx p e 2x dx = e [1 1+2s] , s .
0 2x 3 2
The mean and the variance:
EX = and V ar(X) = .
2.6 Functions of random variables

Theorem 2.2 Let X be a continuous random variable and (x) is a strictly
increasing function, defined on the set of values of X. Let Y = (X) and
FX and FY are the distribution functions of X and Y . Then
FY (y) = FX (1 (y)).
If (x) is strictly decreasing over the set of values of X, then
FY (y) = 1 FX (1 (y)).
Proof. Since (x) is strictly increasing over the set of values of X, the events
{X 1 (y)} and {(X) y} are equivalent. Consequently
FY (y) = P (Y y) = P ((X) y) = P (X 1 (y)) = FX (1 (y)).
If (x) is strictly decreasing, then
FY (y) = P (Y y) = P ((X) y) =
= P (X > 1 (y)) = 1 P (X 1 (y)) = 1 FX (1 (y)).

2
If fX and fY are the density functions of X and Y and (x) is strictly
increasing, then
d 1
fY (y) = fX (1 (y)) (y).
dy
If (x) is strictly decreasing, then
d 1
fY (y) = fX (1 (y)) (y).
dy
2.7. JOINT DENSITY AND DISTRIBUTION FUNCTION 19
The method is applicable in same cases even if the function (x) is neither
increasing nor decreasing. For example, if Y = X 2 , the function is (x) = x2 .
Then

FY (y) = P (Y y) = P ( y < X y)

= P (X y) P (X y) = FX ( y) FX ( y).
For the density we obtain
d d 1
fY (y) = FY (y) = (FX ( y) FX ( y)) = (fX ( y) + fX ( y)) .
dy dy 2 y
2.7 Joint density and distribution function

Let X = (X, Y ) be a random vector.
Definition 2.7 The joint distribution function of X is the function H :

R2 [0, 1], defined by
H(x, y) = P (X x, Y y), (x, y) R2 .
If X and Y absolutely are continuous random variables, the joint density

function satisfies the equation
Z x Z y
H(x, y) = f (t1 , t2 )dt2 dt1 .

Consequently
2 H(x, y)
f (x, y) = .
xy
If the random variables X and Y are mutually independent
H(x, y) = FX (x)FY (y).
The random variables X and Y are called marginal variables and the
distribution functions FX and FY - marginal distributions of (X, Y ). The
joint distribution function is right continuous and satisfies the properties:
1) limy H(x, y) = FX (x) and limx H(x, y) = FY (y),
2) lim(x,y)(,) H(x, y) = 1, where (x, y) (, ) means that both

variables x and y tend to infinite,
3) limx H(x, y) = limy H(x, y) = 0,
4) for all (x1 , x2 ) and (y1 , y2 ), such that x1 < x2 and y1 < y2 ,
H(x2 , y2 ) H(x1 , y2 ) H(x2 , y1 ) + H(x1 , y1 ) 0.
For the random variables X and Y, the second moment
Cov(X, Y ) = E[(X EX)(Y EY )] = E(XY ) (EX)(EY ),
is called a covariance. Note that the variance V ar(X) of a square integrable

random variable is Cov(X, X). The Pearson correlation coefficient is one of
the most useful measures of dependence and is defined by
Cov(X, Y )
= Corr(X, Y ) = p p .
V ar(X) V ar(Y )
The random variables X and Y are positively correlated if Cov(X, Y ) > 0,

and negatively correlated if Cov(X, Y ) < 0.
2.8 Conditional distributions

If X and Y are defined over the same probability space, then the conditional
distribution function of X given Y = y is defined by
FX|Y (x|y) = P (X x|Y = y). (2.11)
The following equality gives the relation between the conditional distribution
function and the distribution function of the random variable X
Z
FX (x) = FX|Y (x|y)dFY (y).
The similar relation exists between the density of X and the conditional
density Z
fX (x) = fX|Y (x|y)fY (y)dy.
2.9. SUM OF RANDOM VARIABLES 21
For discrete random variables:

X
P (X = xk ) = P (X = xk |Y = yi )P (Y = yi ), k = 0, 1, 2, . . . .
i=0
If X and Y are independent random variables:
FX|Y (x|y) = FX (x).
According (2.11) the conditional mean of X given Y = y:

Z
E(X|Y = y) = xdFX|Y (x|y),
0
provided that the random variables are nonnegative. Consequently E(X|Y )

is a random variable. For independent random variables
E(X|Y = y) = EX.
For any function h(x), the conditional mean of h(X) given Y = y is:
Z
E[h(X)|Y = y] = h(x)dFX|Y (x|y). (2.12)
From (2.12) it follows that
E[h(X)] = EY EX [h(X)|Y ],
where on right is taken mathematical expectation of X given fix Y and after

that mathematical expectation of Y .
Exercise 2.1 Prove that for the nonnegative random variable X :

a) E[E(X|Y )] = EX;
b) V ar(X) = E[V ar(X|Y )] + V ar[E(X|Y )].
2.9 Sum of random variables

Let X and Y be independent random variables. The distribution function of
the sum Z = X + Y, noted
FZ (z) = FX FY (z)
is called a convolution of FX and FY and is defined by

R
FZ (z) = P (Z z|Y = y)dFY (y)
R
= P (X z y|Y = y)dFY (y) (2.13)
R R
= FX|Y (z y|y)dFY (y) = FX (z y)dFY (y).
If X and Y are continuous random variables, the density of Z is obtained
by differentiation of (2.13) relative to z:
Z
fZ (z) = fX fY (z) = fX (z y)fY (y)dy.
If X and Y are discrete random variables

Xk
P (Z = k) = P (X = k i)P (Y = i), k = 0, 1, 2, . . . .
i=0
In the multivariate case, if X1 , X2 , . . . Xn are random variables, the dis-
tribution of the sum Sn = X1 + X2 + . . . + Xn is obtained by recursions. Note
S1 = X1 and Sj = Sj1 + Xj , j = 2, 3, . . . n. The Laplace transform of the
sum is n
Y
LTSn (t) = LTXj (t), (2.14)
j=1
the distribution function is noted by
FSn (x) = FX1 FX2 . . . FXn (x)
and the density
fSn (x) = fX1 fX2 . . . fXn (x).
If X1 , X2 , . . . Xn are identically distributed with distribution function FX (x)
and density function fX (x), then
FSn (x) = FXn (x)
and
fSn (x) = fXn (x).
Here n denotes n th convolution of X. In that case (2.14) implies that the
transforms of Sn = X1 + X2 + . . . + Xn are nth power of the corresponding
transform of X. For example, the PGF is
PSn (t) = [PX (t)]n .
2.9. SUM OF RANDOM VARIABLES 23
2.9.1 Negative binomial distribution

Let X1 , X2 , . . . Xr be independent Ge1 (p) distributed random variables. The
random variable N = X1 + X2 + . . . Xr has probability mass function

k1 r
pk = p (1 p)kr , k = r, r + 1, . . .
r1
and is called negative binomial distributed (N N B(r, p)). The interpreta-

tion of the NB distributed random variable is the number of trials up to the
rth success in a sequence of Bernoulli trials. The PGF is given by
r
pet

MN (t) = , t < ln(1 p).
1 (1 p)et
The mean value and the variance:

r r(1 p)
EN = V ar(N ) = .
p p2
An alternative representation of the NBD is by the random variable Y

- the number of failures in Bernoulli trials until r successes. In this case
Y = N r and the distribution function is

r+k1 r
pk = p (1 p)k , k = 0, 1, 2, . . .
k
The MGF is
r
p
MY (t) = , t < ln(1 p).
1 (1 p)et
The mean and the variance are

r(1 p) r(1 p)
EY = V ar(Y ) = .
p p2
2.9.2 Erlang distribution

Let X1 , X2 , . . . Xn be independent, exponentially distributed with parameter
. Let us find the distribution of the random variable Sn = X1 + . . . + Xn .
It is known that the exponential distribution is (1, ).
Suppose that
(t)n2
fX1 +...+Xn1 (t) = et .
(n 2)!
For Sn we obtain
R
fX1 +...+Xn (t) = 0
fXn (t s)fX1 +...+Xn1 (s)ds

(s)n2 (t)n1 t
Z
= e(ts) es ds = e .
0 (n 2)! (n 1)!
Definition 2.8 The random variable with density function
(t)n1 t
fX (t) = e , t 0, (2.15)
(n 1)!
is called Erlang distributed random variable with parameters n and , X
Erl(n, ), n = 1, 2, . . . .

k1
X (t)j
F (t) = 1 et , t 0. (2.16)
j=0
j!
The is a location parameter, n a shape parameter.

The mean and the variance are given by
n n
EX = and V ar(X) = 2 .

The Laplace - Stieltjes transform:
n

LSX (t) = .
+t
It is known that (2.15), with real n is the density of Gamma distributed

random variable (X (n, ).)
2.10 Mixed distributions

Let X be a random variable with distribution function FX (x, ) and density
function fX (x, ), where is a parameter.
2.10. MIXED DISTRIBUTIONS 25
Suppose that is a realization of a continuous, positive random variable

. For fixed we use the notation FX (x|), i.e. conditional distribution
function. Let U () and u() be the distribution function and density function
of the random variable . The distribution function of X is defined by
Z
FX (x) = FX (x|)dU () = E FX (x|), (2.17)

where E denotes the mathematical expectation relative .
Definition 2.9 The random variable X with a distribution (2.17) is called

mixed by mixing distribution U ().
The equation (2.17) gives the unconditional distribution of X. Uncondi-

tional density function of X is defined by
Z
fX (x) = fX (x|)dU () = E fX (x|).

The moments:
Z
k
EX = E(X k |)dU () = E E(X k |), k = 1, 2, . . .

The unconditional transforms are obtained by the mathematical expec-

tation over the set of all possible values of :
MX (z) = E MX (z|)
PX (z) = E PX (z|)
X (z) = E X (z|)
LTX (z) = E LTX (z|).

Example 2.2 (Poisson mixture) Let X be a Poisson distributed random

variable with MGF
s
MX (s|) = e(e 1) .
Then, for any distribution (), the unconditional MGF of X is
s 1)
MX (s) = E MX (s|) = E [e(e ] = M (es 1),
wich is the MGF of with the argument es 1.
Example 2.3 (NBD) Let X be a Poisson distributed random variable with

probability mass function
k
P (X = k|) = e , k = 0, 1, . . . .
k!
The parameter is a realization of Gamma distributed random variable with
r
density function f () = (r) r1 e , > 0, > 0, where is the Gamma
function, r is the shape parameter and the scale parameter. Prove that
r k
r+k1 1
P (X = k) = , k = 0, 1, . . . .
1+ k 1+
The following construction is again a mixture. Let p1 , p2 , . . . be a sequence

of nonnegative numbers, such that
P
i=1 pi = 1. Let F1 (x), F2 (x), . . . be a
sequence of distribution functions. Then

X
FX (x) = pi Fi (x) (2.18)
i=1
is again a distribution function and is called a mixture.

Here the weights {pi } are not related to any parameter.
Example 2.4 Let us construct the mixture between the degenerate at zero
distribution (
0, x < 0
F1 (x) =
1, x 0
and the exponential distribution
F2 (x) = 1 ex , x > 0
2.11. COMPOUND DISTRIBUTIONS 27
by weights and 1 . The distribution function is given by
FX (x) = .1 + (1 )(1 ex ) = 1 (1 )ex , x 0.
The Laplace transform of X is

LTX (s) = LT1 (s) + (1 )LT2 (s) = + (1 ) .
+s
If all Fi (x) in (2.18) are the same, the mixture coincides with (2.17) in
the case of discrete parameter .
2.11 Compound distributions

Let X1 , X2 , . . . be a sequence of independent identically distributed random
variables with distribution function FX (x), characteristic function X (z),
2
mean and variance X . Then the sum X1 + X2 + . . . + Xn , n 1 has
a distribution function FXn (x), characteristic function [X (z)]n , mean nX
2
and variance nX .
Consider the sum
SN = X1 + X2 + . . . XN , (2.19)
where N is a discrete random variable and SN = 0 if N = 0. Then the
distribution function of SN is

X
X
FSN (x) = P (SN x) = P (SN x|N = n)P (N = n) = P (N = n)FXn (x),
n=0 n=0
where
0, x < 0
FX0 x) =
1, x 0.
Definition 2.10 The distribution of the random sum (2.19) is called com-
pound distribution.
The MGF of the compound distribution is given by
MSN (s) = EesSN = s(X1 +...Xn )

P
n=0 E[e |N = n]P (N = n)
P
= n=0 P (N = n)[MX (s)]n = E[[MX (s)]N ],
or
MSN (s) = PN (MX (s)).
Analogously
PSN (s) = PN (PX (s))
SN (s) = PN (X (s))
LTSN (s) = PN (LTX (s)).
Exercise 2.2 Show that
ESN = E(N )E(X) (2.20)
and
V ar(SN ) = V ar(N )(EX)2 + E(N )V ar(X). (2.21)
If N has a Poisson distribution, (2.19) is called compound Poisson distri-

bution.
Theorem 2.3 Let Si CP o(i , Fi (x)), i = 1, . . . n be independent Com-

pound Poisson random variables with parameters i and Z Fi (x), x > 0.
Show that Sn = S1 + . . . Sn is also Compound Poisson with parameters
= ni=1 i and F (x) = ni=1 i Fi (x).
P P
Example 2.5 (Compound geometric - exponential distribution) Let X1 , X2 , . . .

be independent, identically exponentially distributed with parameter > 0,
density function
fX (x) = ex x > 0
and

LTX (s) = .
+s
The Laplace transform of SN is
n
X
LTS (s) = P (N = n) .
n=0
+s
2.11. COMPOUND DISTRIBUTIONS 29
Suppose that N has a geometric distribution with PMF
P (N = n) = p(1 p)n , n = 0, 1, 2, . . .
and PGF
p
PN (s) = .
1 (1 p)s
In that case the LT of SN is
1
+s p
LTS (s) = p 1 (1 p) =p = p + (1 p) .
+s p + s p + s
The LT of SN is a mixture of the Laplace transform of degenerate at zero
random variable and the Laplace transform of exp(p) random variable.
According the properties of the LT , the density function of SN is
(
p, x=0
fSN (x) = px
(1 p)pe , x>0
and the distribution function
FSN (x) = 1 (1 p)epx , x 0.
Example 2.6 (Polya - Aeppli distribution). Let X1 , X2 , . . . be independent

identically Ge1 (1 ) distributed random variables with parameter [0, 1)
and probability mass function
P (X1 = i) = i1 (1 ), i = 1, 2, . . . .
The random variable N P o() is independent of Xi , i = 1, 2, . . . . The

probability mass function of SN = X1 + X2 + . . . + XN is given by

e , k = 0,

P (SN = k) = k (2.22)
[(1 )]i ki

X k 1
e , i = 1, 2, . . .

i 1 i!

i=1
Definition 2.11 The distribution, defined by the PMF (2.22) is called a

Polya - Aeppli distribution.
2.11.1 Hiperexponential distribution

Let Xi exp(i ), i = 1, 2, 1 6= 2 be independent. The distribution of the
sum X1 + X2 is given by
Rt Rt
fX1 +X2 = 0 fX1 (s)fX2 (t s)ds = 0 1 e1 s 2 e2 (ts) ds
Rt 2 1
= 1 2 e2 t 0
e(1 2 )s ds = e1 t
2 1 1
+ e2 t .
1 2 2
It can be proved by induction that the density function of Sn = X1 +

. . . + Xn , where Xi exp(i ), i = 1, . . . , n, i 6= j for i 6= j, is
n
X
fSn (t) = pi i ei t , (2.23)
i=1
j
pi = j6=i .
j i
Definition 2.12 The random variable defined by density function (2.23) for
Pn
some weights pi , i=1 pi = 1 is called hiperexponential distributed random
variable.
The notation is Hn (p1 , . . . pn ; 1 , . . . n ) or Hn . That is a random variable

equal to Xi with probability pi , i = 1, . . . n. The distribution (2.23) is a
mixture of exponentially distributed random variables. The mean value is
n
X pi
ESn =

i=1 i
and the Laplace transform

n
X i
LTSn (s) = pi .
i=1
i + s
Chapter 3
Counting processes
The stochastic process {N (t), t 0} is called a counting process, if N (t) is

equal to the number of events occurred up to time t.
The counting process satisfies the following:
1. N (t) 0;
2. N (t) has integer values;
3. If s < t, then N (s) N (t);
4. For s < t, N (t) N (s) is the number of events in the time interval
(s, t).
The counting process is called a process with independent increments if
the number of events in disjoint intervals are independent random variables.
The counting process has stationary increments if the distribution of the
number of events occurred in a given time interval depends only on the
length of the interval. This means that for t > 0 and h > 0 the distribution
of N (t + h) N (t) coincides with the distribution of N (h).
3.1 Poisson process

One of the basic counting processes is the Poisson process.
Definition 3.1 The counting process {N (t), t 0} is called a Poisson pro-

cess with intensity rate > 0, if
1. N (0) = 0;
31
32 CHAPTER 3. COUNTING PROCESSES
2. The process has stationary independent increments;

3. P (N (h) = 1) = h + (h);
4. P (N (h) 2) = (h).
f (h)
(The function f is called (h), if limh0 h
= 0.) It is clear that the
process is integer valued and nondecreasing.
Notation: Pn (t) = P (N (t) = n). We will show that the following system
of differential equations follows from the postulates in the definition.
P00 (t) = P0 (t)
(3.1)
Pn0 (t) = Pn (t) + Pn1 (t), n = 1, 2, . . .
For n = 0
P0 (t + h) = P (N (t) = 0, N (t + h) N (t) = 0) =
= P (N (t) = 0)P (N (t + h) N (t) = 0) = P0 (t)[1 h + (h)]

and
P0 (t + h) P0 (t) (h)
= P0 (t) + .
h h
By h 0 we obtain the first equation of (3.1).
Let n 1
Pn (t + h) = P (N (t) = n, N (t + h) N (t) = 0)
+P (N (t) = n 1, N (t + h) N (t) = 1)+

P
+ k=2 P (N (t) = n k, N (t + h) N (t) = k).
According to the fourth postulate, the sum is (h). Consequently
Pn (t+h) = Pn (t)P0 (h)+Pn1 (t)P1 (h)+(h) = (1h)Pn (t)+hPn1 (t)+(h),
or
Pn (t + h) Pn (t) (h)
= Pn (t) + Pn1 (t) + .
h h
For h 0 we obtain the second equation of (3.1).
To solve (3.1), we use the method of integrating factor. The condition
N (0) = 0 implies the initial conditions
P0 (0) = 1 and Pn (0) = 0, n = 1, 2, . . . . (3.2)

3.1. POISSON PROCESS 33
The solution of the first equation of (3.1) is given by
P0 (t) = C0 et .
Together with (3.2) this leads to
P0 (t) = et . (3.3)
Inserting (3.3) in the second equation of (3.1) for n = 1 yield
P10 (t) + P1 (t) = et
with the solution

P1 (t) = (t + C1 )et .
By the initial condition (3.2) for n = 1, the solution is
P1 (t) = tet .
In the general case we suppose that
(t)k t
Pk (t) = e , k = 1, 2, . . . , n 1.
k!
By the second equation of (3.1)
(t)n1 t
Pn0 (t) + Pn (t) = Pn1 (t) = e
(n 1)!
with the solution
(t)n

Pn (t) = + Cn et .
n!
Together with the initial condition this gives the solution
(t)n t
Pn (t) =
e , n = 1, 2, . . . (3.4)
n!
The Poisson process: the number of events in (0, t] has a Poisson
distribution with parameter t, i.e. EN (t) = t.
This leads to the second definition.
Definition 3.2 The counting process {N (t), t 0} is called a Poisson pro-

cess with intensity rate > 0, if
1. N (0) = 0;
2. The process has independent increments;
3. For s < t, the number of claims in the interval (s, t] has a Poisson
distribution with parameter (t s) :
((t s)n (ts)
P (N (t) N (s) = n) = e , n = 1, 2, . . . .
n!
By the law of large number or by the Chebyshevs inequality, it follows
P
that Nt(t) , as t . In fact, almost sure convergence holds. This
means that the intensity measures the average frequency or density of claim
arrivals.
According to the second definition, if h > 0 is small
P (N (t + h) N (t) = 1) = heh = h h(1 eh ) = h + o(h),
as h 0. The last equality follows from the inequality 0 < 1 ex < x, for
x > 0.
Furthermore, for h (0, 21 )

X (h)n 1X 1 (h)2
(h)n = (h)2 .
n=2
n! 2 n=2 2 1 h
This implies that, as h 0

X (h)n
P (at least 2 claims arrive in(t, t + h]) = eh (h)2 = o(h),
n=2
n!
which is the fourth postulate of the first definition.

In order to prove that the definitions 3.1 and 3.2 are equivalent, we have
to show that the increments N (t) N (s) P o((t s)), 0 s < t. It
follows from the stationarity condition.
The interarrival times
Let T1 be the time until the first claim. For n 2, Tn is the time between
the (n 1)th and the nth claim. T2 , T3 , . . . is a sequence of the interarrival
times.
3.1. POISSON PROCESS 35
The distribution of Tn : Note that the event {T1 > t} occurs if and
only if, no one event occurs up to time t and
P (T1 > t) = P (N (t) = 0) = et .
Hence T1 is exponentially distributed with parameter . Given T1 , the dis-

tribution of T2 is
P (T2 > t) = P (T2 > t|T1 = s) =

(3.5)
t
= P (0 claims in(s, s + t]|T1 = s) = P (0 claims in(s, s + t]) = e ,
where the last two equalities follow from the conditions of independent, sta-
tionary increments. From (3.4) it follows that T2 is independent of T1 and is
exponentially distributed with parameter . By the same arguments and by
induction it could be proved the following.
Theorem 3.1 The interarrival times Tn , n = 1, 2, . . . are independent, iden-

tically exp() distributed random variables.
Exercise 3.1 Prove that the waiting time k = T1 + . . . + Tk (k, ), k =

1, 2, . . . , i.e.

fk (t) = (t)k1 et , t > 0
(k)
and
k1
X (t)j
Fk (t) = 1 et .
j=0
j!
The properties of Theorem 3.1 and Exercise 3.1 characterize the Poisson
process. This states in the following
Theorem 3.2 Let N (t), t 0 be a stochastic process with N (0) = 0. T1 is

the time until the first claim, T2 , T3 , . . . the interarrival times. Let Tk , k =
1, 2, . . . be independent, identically exp() distributed random variables and
N (t) = the number of claims up to time t. Then N (t) is a Poisson process.
Proof. Follows from
P (k t) = P (N (t) k), k = 0, 1, . . .
and the lack of memory property of the exponential distribution.

2
The Fisher index of dispersion for the Poisson process is:
V ar(N (t))
F I(t) = = 1.
EN (t)
3.1.1 Order statistics property

Let U1 , . . . Un be independent uniformly distributed random variables (Ui
U ([a, b]). The order statistics of this sample are
U(1) U2 . . . U(n) ,
where U(n) = max{Ui , i = 1, . . . , n}, U(1) = min{Ui , i = 1, . . . n}. The joint

density function of (U(1) , . . . U(n) ) is given by
n!
f (u1 , . . . un ) = I{a<u1 ...<un <b}
(b a)n
and is called the Dirichlet distribution (Dn ([a, b]).
Theorem 3.3 Let T1 , . . . , Tn be independent exp() distributed random vari-

ables and k = T1 + . . . Tk , k = 1, . . . n. Then
a) (1 , . . . n ) has a probability density in Rn given by
f1 ,...,n (t1 , . . . tn ) = n etn (t1 , . . . , tn ), t1 < t2 < . . . < tn . (3.6)
b) The joint conditional density of (1 , . . . n ), given that N (t) = n is

n!
tn , t1 < t2 < . . . < tn

f1 ,...,n |N (t)=n (t1 , . . . tn ) = (3.7)

0, otherwise.

Proof. a) The joint distribution of T1 , . . . , Tn is given by

n
Y Pn
fT1 ,...,Tn (x1 , . . . xn ) = n exi = n e i=1 xi
, xi 0.
i=1
3.2. RENEWAL PROCESS 37
Change of variables
t1 = x1 x1 = t1
t2 = x1 + x2 x2 = t2 t1
t3 = x1 + x2 + x3 and x3 = t3 t2
... ...
tn = x1 + . . . xn xn = tn tn1
yields (3.6).
b)
P (1 t1 , . . . n tn , N (t) = n)
P (1 t1 , . . . n tn |N (t) = n) =
P (N (t) = n)
R R
... P (N (t) N (sn ) = 0)f1 ,...n (s1 , . . . sn )ds1 . . . dsn
=
P (N (t) = n)
R t1 R t2 R tn
0 s1
... sn1
e(tsn ) n esn dsn dsn1 . . . ds1
= (t)n t
n!
e
Z t1 Z t2 Z tn
n!
= ... dsn dsn1 . . . ds1 .
0 s1 sn1 tn
2
3.2 Renewal process

In terms of point processes: Suppose that 0 = 0 1 . . . are random
points in R+ , at which a certain event occurs. The counting process is defined
by the number of points in the interval (0, t] and is given by

X
N (t) = I{n t} , t 0.
n=1
Assume this counting process has finite values for each t. This is equivalent
to n a.s. as n . The point counting process N (t) is simple if the
occurrence times are distinct: 0 < 1 < 2 < . . . a. s.
Definition 3.3 A simple point process {n , n 1} is a renewal process if

the inter - arrival times Tn = n n1 , n 1 are independent, identically
distributed with common distribution function FT , FT (0) = 0 and 0 = 0.

The points {n } are called renewal times.
Suppose that the time between claims are not concentrated at zero, i. e.
P (T = 0) < 1. Let
N (t) = max{n, n t} = min{n, n+1 > t}, (3.8)
or N (t) is equal to the number of renewals in the interval (0, t].
Definition 3.4 The process (3.8) is called a renewal counting process.
The equivalence of the processes {n } and {N (t)} follows from the equiva-
lence of the events
{N (t) = n} and {n t < n+1 } (3.9)
and
{N (t) n} = {n t}, n = 1, 2, . . . . (3.10)

Note that {N (t), t 0} is defined in continuous time and the sample
paths are continuous on the right.
For the risk model, again (n ) is a sequence of arrival times and (Tn ) is
the sequence of inter - arrival times.
Example 3.1 (Homogeneous Poisson process) Let Tn exp(). The

renewal process is called a homogeneous Poisson process with intensity . In
this case, by the convolution properties
Z t
n (x)n1
P (n t) = FT (t) = ex dx.
0 (n 1)!
This is gamma distribution with parameters n and and
n1
X (t)k
P (n t) = 1 et .
k=0
k!
Using the relation (3.10) we arrive at

n
X (t)k
P (N (t) n) = 1 P (N (t) n + 1) = 1 P (n+1 t) = et .
k=0
k!
The motivation for introducing the renewal counting process is that the
homogeneous Poisson process does not describe in an adequate way the claim
arrivals. In many cases it is quite natural to model the inter - arrival times
by log - normal, Pareto or another distribution.
In general, the Poisson process is a special case of renewal process, but
many of the asymptotic properties are the same.
Suppose that the inter - arrival times T are defined by the probability
distribution function FT (x) and ET = 1 . In some cases the distribution FT
is defective. This means that limx FT (x) < 1, or the random variable
T can be equal to with positive probability 1 F (). Here F () =
limx F (x). We will call in this case the renewal process terminating. We
will show that the limit N () = limt N (t) < with probability 1 and
N () has a compound geometric distribution.
Theorem 3.4 (Strong law of large numbers) If F () = 1, then the

samples of {N (t), t 0} are increasing with probability 1 and
N (t)
lim = = (ET )1 a. s. (3.11)
t t
Proof. The limit limt N (t) exists, since the sample paths of the process
are increasing. From (3.10) it follows that limt N (t) = with probability
1. The strong law of large numbers for (Tn ) yields that limn nn = 1 >
N (t) 1
0 with probability 1. Consequently, limn N (t)
=
with probability 1.
Again from (3.10), it follows that N (t) t < N (t)+1 and
N (t) t N (t)+1 N (t) + 1

< .
N (t) N (t) N (t) + 1 N (t)
Let t and obtain (3.11) in the case of > 0. When = 0, ET = .

Note that
N () = lim N (t) = min{n : Tn = } 1,
t
i. e. N () is geometrically distributed with parameter P (N () = 0) =

1 F (). From the total probability law it follows that the random variable
N () has a geometric distribution with parameter F ().
2
The strong law of large numbers for the renewal process shows that the
mean value EN (t) is approximated by t and plays a key role in the asymp-
totic analysis. Note that in the case of homogeneous Poisson process the
exact mean value EN (t) = t is known.
Theorem 3.5 (Elementary Renewal Theorem) Suppose that FT () =

1. Then
EN (t)
lim = .
t t
Proof. Since N (t) is not always a stopping time we define the first passage
time
(t) = min{n : n > t}.
Note that (t) = N (t) + 1. It follows that
EN (t) = E(t) 1 = E(t) 1 = t + E((t) t) 1,
and
N (t) E((t) t) 1
=+ . (3.12)
t t t
Since (t) t 0, we obtain that
EN (t)
lim inf . (3.13)
t t
Note that for some M 0,
P (Tk M ) = 1, k = 1, 2, . . . .
Together with (3.12) this implies that

EN (t) M
+
t t
and
EN (t)
lim sup ,
t t
which together with (3.13) proves the theorem.
2
The next theorem states the asymptotic behavior of the variance of the
renewal process.
Theorem 3.6 Suppose that V ar(T ) < . Then
V ar(N (t)) V ar(T1 )

lim = .
t t (ET1 )3
Theorem 3.7 (Central Limit Theorem) Let V ar(T1 ) < . Then for
t
N (t) t
q Z N (0, 1).
V ar(T1 )
(ET1 )3
t
3.2.1 Renewal function

Definition 3.5 The mean value
m(t) = 1 + EN (t) = E(t), t 0
is called a renewal function.
Since {N (t) k} = {k t}, k = 1, 2, . . . we have

X
X
X
m(t) = 1 + P (N (t) k) = 1 + P (k t) = FTk (t), (3.14)
k=1 k=1 k=0
that is m(t) is the expected number of renewals in [0, t] and is called also a
renewal measure.
Note that m(t) is similar to a distribution function. It is nondecreasing
and right - continuous on R, but has a unit jump at t = 0 and m(t) as
t .
An important property of the renewal function is that it determines
uniquely the distribution FT . Taking the Laplace transform of both sides
in (3.14) we have

X X 1
LTm(t) (s) = LTFTk (s) = (LTFT (s))k = .
k=0 k=0
1 LTFT (s)
This yields the following theorem.

Theorem 3.8 The Laplace transforms of m(t) and FT are determine each
other uniquely by the relation
1
LTm(t) (s) = .
1 LTFT (s)
Hence m(t) and FT uniquely determine each other.
This result can be used for identification of the renewal process. For example,
the renewal function of the Poisson process is m(t) = t + 1 and any renewal
process with this type of renewal function is a Poisson process.
Theorem 3.9 (The Integral Equation for Renewal process) The re-
newal function m(t) satisfies the integral equation
Z t
m(t) = I[0,) (t) + FT (t) + m(t s)dFT (s). (3.15)
0
Moreover, m(t) is the unique solution of (3.15), which is bounded on finite

intervals.
Proof. According to (3.14), it follows that

(k+1)
m(t) = 1 + FT (t) +
P k
P
k=2 FT (t) = I[0,) (t) + FT (t) + k=1 FT (t)

X
= 1 + FT (t) + (FTk FT )(t),
k=1
or
m(t) = I[0,) (t) + FT (t) + (m FT )(t),
which is equivalent to (3.15).
2
The equation (3.15) is called a renewal equation. In the general case the
renewal equation is given by
Z t
U (t) = u(t) + U (t y)dF (y), (3.16)
0
where all functions are defined on [0, ). The function U (t) is unknown, u(t)
is given and F (y) is a distribution function. If F is a defective distribution,
then (3.16) is called a defective renewal equation.
The solution of the equation (3.16) is defined by the next theorem.
Theorem 3.10 If u(t) is bounded on finite intervals, then

Z
X t
U (t) = u(t s)dF k (s)
k=0 0
Z
= u(t s)dm(s), t 0,
0
is the only solution of the renewal equation (3.16).
Theorem 3.11 (Key renewal theorem) If in addition u(t) is directly Rie-

mann integrable, then
Z
lim U (t) = u(s)ds.
t 0
3.2.2 Recurrence times of a renewal process

Consider the renewal sequence {n , n = 1, 2, . . . 0 = 0} and Tn > 0. Note
that
{N (t) = n} = {n t < n+1 }.
In particular,
N (t) t < N (t)+1 .
For t 0, B(t) = t N (t) is the time since the last renewal prior to t and is
called a backward recurrence time of the renewal process (or the age process).
F (t) = N (t)+1 t is the time to the next renewal after t and is called
forward time (or excess life or residual life).
We will show that for fixed 0 x < t, the distribution function P (B(t)
x) satisfies the renewal equation. Since B(t) t a.s. it is sufficient to
consider x < t. Hence for x t, P (B(t) x) = 1.
Let us start with the identity
P (B(t) x) = P (B(t) x, T1 t) + P (B(t) x, T1 > t), x > 0. (3.17)
If T1 > t, no jumps occur up to t and N (t) = 0. Consequently B(t) = t, and

hence
P (B(t) x, T1 > t) = (1 FT1 (t)), x t.
For T1 t we will show that

Z t
P (B(t) x, T1 t) = P (B(t y) x)dFT1 (y). (3.18)
0
According to the properties of the renewal process

P (B(t) x, T1 t) = P (t N (t) x, N (t) 1)
P
= n=1 P (t N (t) x, N (t) = n)
P
= n=1 P (t n x, n t < n+1 ).
For every one of the summands, given {T1 = y} for y t we have
P (t n x, n t < n+1 |T1 = y)
Pn Pn Pn+1
= P (t [y + i=2 Ti ] x, y + i=2 Ti t < y + i=2 Ti )
= P (t y n1 x, n1 t y n )
= P (t y N (ty) x, N (t y) = n 1),
and hence
P R t
P (B(t) x, T1 t) = n=1 0
P (t y N (ty) x, N (t y) = n)dFT1 (y)
Rt
= 0
P (B(t y) x)dFT1 (y),
which proves (3.18).
Combining (3.17) and (3.18) we get
Z t
P (B(t) x) = (1 FT1 (t))I[0,x] (t) + P (B(t y) x)dFT1 (y),
0
which is the renewal equation for u(t) = (1 FT1 (t))I[0,x] (t) and U (t) =
P (B(t) x).
Similarly
Z t
P (F (t) > x) = P (F (t y) > x)dFT1 (y) + (1 FT1 (t + x)).
0
It is known that the only solution of the renewal equation is given by

Z t
U (t) = P (B(t) x) = (1 FT1 (t y))I[0,x] (t y)dm(y).
0
Consider the case of homogeneous Poisson process with intensity . In

this case m(t) = t + 1, 1 FT1 (x) = ex and
1 ex , x < t

P (B(t) x) = P (t N (t) x) =
1, x t.
Analogously,
P (F (t) x) = P (N (t)+1 t x) = 1 ex , x > 0.
3.2.3 Delayed Renewal process

In many cases the renewal process starts at random point. In this case the
time T1 has a different distribution. The process N (t) is called a delayed
renewal process. The distribution of T1 is called the delayed distribution.
Definition 3.6 A continuous time stochastic process N (t), t 0 is station-

ary or has stationary increments, if for every points 0 = t1 < . . . < tk and
h>0
d
(N (t1 + h), . . . , N (tk + h)) = (N (t1 ), . . . , N (tk )).
A basic property of the stationary point process is that the mean value
function is linear.
Theorem 3.12 Let N (t) be a stationary point process and EN (1) is finite.
Then EN (t) = EN (1)t.
Proof. Consider
EN (s + t) = EN (s) + [EN (s + t) EN (s)]
= EN (s) + EN (t).
This is a functional equation f (s + t) = f (s) + f (t), s, t 0. The only

nondecreasing function that satisfies this equation is f (ct) for some constant
c. In our case c = f (1) = EN (1), and hence EN (t) = EN (1)t.
2
We are ready to characterize the stationary renewal process.
Theorem 3.13 The delayed renewal process N (t) is stationary if and only
if the forward recurrence time process F (t) = N (t)+1 t is stationary.
Proof. Using n = inf{s, N (s) = n}, we have
F (t) = N (t)+1 t = inf{s t : N (s) = N (t) + 1}
d
= inf{s : N (t, s] = 1} = {N (0, s t] = 1}.
d
Consequently, the stationarity property of N implies F (t) = F (0), t 0.
Then F is stationary process (it is a Markov process). Conversely, since N
counts the number of times F (t) jumps upward,
X
N (A + t) = I{F (u+s)>F ((u+t)) .
sA
Therefore the stationarity of F implies N is stationary.

2
Theorem 3.14 Let N (t) be a stationary delayed renewal process. Then

a) EN (t) = t, t 0.
Z t Z t
1
b) FT1 (t) = [1 FT2 (s)]ds = [1 FT2 (s)]ds.
0 ET2 0
Proof. a) Let N (t) be stationary. Theorem 3.12 ensure that EN (t) =

EN (t)
EN (1)t. Also EN (1) = , since t
, t . Therefore EN (t) = t.
b) Please, see the proof in [19].
2
3.3 Mixed Poisson process

The modeling by homogeneous Poisson process is not realistic.
Suppose that the parameter is a realization of the random variable
with distribution function F . Then

(t)k t
Z
pk (t) = P (N (t) = k) = e dF (),
0 k!
3.4. COMPOUND POISSON PROCESS 47
where F () = P ( ) is the distribution function of the mixing distribu-

tion .
For the mixed Poisson process Fisher index of dispersion is
V ar()
F I(t) = 1 + > 1,
E
i. e. it is over - dispersed related to the Poisson process.
Example 3.2 Let (, ) with density function
1 x
f (x) = x e , x > 0.
()
Then
k
+k1 t
pk (t) = P (N (t) = k) = , k = 0, 1, 2, . . . ,
k +t +t
(3.19)
i. e. the number of claims has negative binomial distribution with parameters

and +t (N (t) NBD (, +t )). The counting process, defined by (3.18)
is called a Polya process.
3.4 Compound Poisson process

Let N1 (t) be a homogeneous Poisson process and X1 , X2 , . . . a sequence of
independent, identically distributed random variables, independent of N1 (t).
Define the process
N (t)
X
N (t) = Xi . (3.20)
i=1
Definition 3.7 The process (3.20) is called a compound Poisson process.
The distribution of X is called a compounding distribution.

3.4.1 P
olya - Aeppli process
The Polya - Aeppli process is defined in [16]. Suppose that the compounding
random variable X has a geometic distribution with parameter 1 , i. e.
P (X = i) = i1 (1 ), i = 1, 2, . . . . Then, the compound Poisson process
is called a Polya - Aeppli process.
Definition 3.8 A counting process {N (t), t 0} is said to be a Polya -

Aeppli process if
a) N (0) = 0;
b) N (t) has independent, stationary increments;
c) for each t > 0, N (t) is Polya - Aeppli distributed.
Theorem 3.15 Suppose that the inter-arrival times {Tk }k2 of the station-
ary renewal process are equal to zero with probability and with probability
1 exponentially distributed with parameter . Then the number of re-
newals up to time t, has the Polya - Aeppli distribution with parameters
and .
Chapter 4
Claim Size Models
The claim amounts to the insurance company can be described by discrete

and by continuous random variables. In the case of continuous distributed
claims, the basic is to find an adequate model for the claim amount. The
probability distributions are separated in two families - light tailed and heavy
tailed distributions. The exponential distribution is the border one.
Definition 4.1 The distribution F is called light tailed, if for > 0,
F (x)
lim sup < .
x ex
For the light tailed distribution there are constants a > 0 and > 0, such
that F (x) aex and there is z > 0, such that MX (z) < .
According to the definition, the exponential distribution is light tailed for
every > 0.
Definition 4.2 If for every > 0,
F (x)
lim inf > 0,
x ex
the distribution F has a heavy tail.
For the heavy tailed distributions, for every a > 0 and > 0, F (x) > aex
and for every z > 0, MX (z) = .
49
50 CHAPTER 4. CLAIM SIZE MODELS
The truncated normal distribution is called a standard distribution. This

is a random variable Z = |Y |, where Y is a normal distributed random
variable with distribution function F (z) = P (|Y | z). If Y has a standard
normal distribution, F (z) = 2((z) 21 ), x > 0, where (z) is a standard
normal distribution function.
It is easy to show that if (z) is a standard normal density, then
z(z)
lim = 1,
z (z)
and hence the truncated normal distribution is a light tailed.

The Pareto distribution with parameters > 0 and > 0

1 F (x) = , x >0
+x
has a heavy tail.
The Weibull distribution
x
1 F (x) = e( ) , x > 0, > 0
is heavy tailed for < 1 and light tailed for 1.
The most useful light tailed and heavy tailed distributions are given in
the next tables.
Light tailed distributions

Name Parameters Density
Exponential >0 fX (x) = ex
1 x
Gamma > 0, > 0 fX (x) = () x e

Weibull > 0,P 1 fX (x) =P x 1 ex
n n i x
Hyperexponential i > 0, i=1 pi = 1 fX (x) = i=1 pi i e
Heavy tailed distributions

Name Parameters Density

Weibull > 0, 0 < < 1 fX (x) = x 1 ex
(ln x)2
Lognormal R, > 0 fX (x) = 1

x 2
e 22
(ln x)1
Loggamma > 0, > 0 fX (x) = x+1 ()

Pareto > 0, > 0 fX (x) = +x +x
x 1
Burr > 0, > 0, > 0 fX (x) = (+x )+1
4.1. HEAVY TAILED DISTRIBUTIONS 51
4.1 Heavy tailed distributions

(x)
Let F = lim supx x
, where (x) = log F (x) is the hazard function
of F . If F is continuously differentiable, then (x) is also differentiable
d(x)
and dx
= (x), where (x) is the intensity rate function. Suppose that
F (0) = 0.
Theorem 4.1 If F = 0, then F is heavy tailed distribution function.
(x)
Proof. Suppose that F = 0, i. e. lim supx x
= 0. Then, for every
> 0, there is x0 > 0, such that for x > x0 , (x) x. Consequently, there
is a constant c > 0, such that for every x 0, F (x) cex , and therefore
for every t , Z
etx F (x)dx = . (4.1)
0
Letting 0 yields that (4.1) holds for every t > 0.

2
Remark 4.1 Suppose that F is heavy tailed distribution function. Then for
every t > 0,
lim etx F (x) = . (4.2)
x
The most popular heavy tailed distributions are the distributions with
regularly varying tails and subexponential distributions.
4.2 Regularly varying functions

Definition 4.3 The positive, measurable function f is called regularly vary-
ing at with index R, if
f (tx)
lim = t for every t > 0. (4.3)
x f (x)
If = 0, f is called slowly varying function.

The family of regularly varying functions with index is denoted by

RV().
Suppose that in (4.3) the limit, if it exists, is finite and positive for every
t > 0. Then the limiting function satisfies the equation K(ts) = K(t)K(s).
The only solution of this equation is the power function.
Remark 4.2 If f RV () then
f (x) = x L(x),
where L(x) is a slowly varying function (L(x) RV (0)).
Remark 4.3 The function f (x) is called regularly varying at 0, if f ( x1 ) is

regularly varying at .
Examples: Slowly varying functions are the positive constants and the func-
tions log(1 + x), log log(e + x).
According the Remark 4.1, the following functions:
x , x ln(1 + x), [x ln(1 + x)] , x ln(ln(e + x))
are in RV (). Probability distributions whose tails are regularly varying are
1 F (x) = x , x 1, > 0
and the extreme value distribution
(x) = exp(x ), x 0.
4.2.1 Properties
Theorem 4.2 (Karamatas theorem) Let L be a slowly varying function.
Then there exists t0 > 0 such that L is locally bounded over [t0 , ) and
a) For > 1
Z t
s L(s)ds ( + 1)1 t+1 L(t), t . (4.4)
t0
R L(s)
b) For < 1 or = 1 and 0 s
ds < ,
4.2. REGULARLY VARYING FUNCTIONS 53
Z
s L(s)ds ( + 1)1 t+1 L(t), t . (4.5)
t
Conversely, if (4.4) holds with > 1, then L RV (0). If (4.5) holds
with > 1, then L RV (0).
Remark 4.4 Let f RV () and local bounded over [t0 , ) for some t0 0.
Then
a) For > 1 Rt
f (s)ds 1
lim t0 = .
t tf (t) +1
b) For < 1 R
t
f (s)ds 1
lim = .
t tf (t) +1
If = 1 and for some positive function f , local bounded over [t0 , )
one of the conditions a) or b) satisfies, then f RV ().
Theorem 4.3 (Representation theorem) Let f RV (). Then there

exist measurable functions : R+ R and c : R+ R, such that
lim (t) = and lim c(t) = c0 > 0 (4.6)

t t
and t0 R+ , such that for t > t0

Z t
(s)
f (t) = c(t) exp ds . (4.7)
t0 s
Conversely, if (4.7) holds with and c satisfying (4.6), then f RV ().
For example, the function L(t) = ln t is slowly varying and the representation
(4.7) holds with t0 = e, c(t) = 1 and (t) = (ln t)1 .
Remark 4.5 From the representation theorem, it follows that the functions
of RV () satisfy (
, > 0
lim f (t) =
t 0, < 0.
If L is slowly varying, then for every > 0,
lim t L(t) = 0 and lim t L(t) = .

t t
4.2.2 Regularly varying random variables

Definition 4.4 The nonnegative random variable X and its distribution are
called regularly varying with index 0, if the right tail distribution F X (x)
RV ().
Theorem 4.4 (Regularly varying distributions) Let F be a distribution

function and F (x) < 1 for every x 0.
an
a) If the sequences (an ) and (xn ) satisfy an+1 1, xn and for
some real function g and all values of some subset of (0, ),
lim an F (xn ) = g() (0, ),

n
then g() = for some 0 and F RV.

xf (x)
b) Let F be absolutely continuous with density f , such that limx F (x)
=
for some > 0. Then f RV ((1 + )) and F RV ().
xf (x)
c) Let f RV ((1 + )) for > 0. Then limx F (x)
= . This means
that if for > 0, F RV (), then the density f is monotone function.
d) Let X RV () be a nonnegative random variable and > 0. Then
EX < , if < ;
EX = , if > .
e) Suppose that F RV (), > 0, . Then
x F (x)
lim x
R = .
x
0
y dF (y)
The opposite holds if > . If = , the only that we can say is that
F (x) = (x L(x)) for some slowly varying function L.
f ) The following are equivalent:
Rx
(1) 0
y 2 dF (y) RV (0),
Rx
(2) F (x) = (x2 0
y 2 dF (y)), x .
4.3. SUBEXPONENTIAL DISTRIBUTIONS 55
Example 4.1 Distributions similar to Pareto These are the Pareto dis-
tribution, Cauchy distribution, Burr distribution, stable distribution with in-
dex < 2. The right tails of all these distributions are given by
F (x) Kx , x
for some constants > 0 and K. It is clear that F (x) RV ().
The regularly varying distributions are widely used in practice. The mo-
tivation is given in the next
Lemma 4.1 Let X and Y be independent nonnegative random variables
from RV (), 0. Then X + Y RV () and
P (X + Y > x) P (X > x) + P (Y > x), x .
4.3 Subexponential distributions

Let F (x) be a regularly varying distribution function, defined on (0, ), such
that for every n 2,
F n (x)
lim = n, (4.8)
x F (x)
where F n (x) means the nth convolution of F (x) = 1 F (x).

The condition (4.8) means that for x
P (X1 + . . . + Xn ) > x) nP (X1 > x).
It is easy to show that (4.7) for n = 2, implies n 2.

Let X1 , X2 , . . . be nonnegative identically distributed random variables.
Then for x ,
P (max(X1 , . . . Xn ) > x) = 1 [F (x)]n =
Pn1 ,
k
= [1 F (x)] k=0 [F (x)] n[1 F (x)],
and hence (4.8) is equivalent to

P (X1 + . . . + Xn ) > x)
lim = 1. (4.9)
x P (max(X1 , . . . Xn ) > x)
This means that the largest claims have the main contribution to the sum
X1 +. . .+Xn . This property defines a large family of probability distributions.
Definition 4.5 Subexponential distribution The nonnegative random

variable X and the distribution of X are called subexponential if the inde-
pendent copies X1 , X2 , . . . , Xn satisfy (4.8) and (4.9).
The family of subexponential distributions (SE) is introduced by V. Chistyakov

in 1964.
4.3.1 Properties
The main properties are given in the next lemma
Lemma 4.2 Let F SE. Then

a) For all y R
F (x y)
lim = 1. (4.10)
x F (x)
b) If (4.10) holds, then for every r > 0
lim erx (1 F (x)) =

x
and Z
erx dF (x) = .
0
c) For given > 0, there is a finite constant K, such that for n 2

1 F n (x)
K(1 + )n , x 0. (4.11)
1 F (x)
Proof. a) For 0 y x we have
1 F 2 (x) F (x) F 2 (x)
=1+
1 F (x) 1 F (x)
y x
1 F (x t) 1 F (x t)
Z Z
=1+ dF (t) + dF (t)
0 1 F (x) y 1 F (x)
1 F (x y)
1 + F (y) + (F (x) F (y)).
1 F (x)
Thus for large x, such that F (x) F (y) 6= 0, we have
1 F 2 (x)

1 F (x y)
1 1 F (y) (F (x) F (y))1 .
1 F (x) 1 F (x)
The assertion (4.10) follows by letting x .

If y < 0 then
1
1 F (x y) 1 F (x y) 1 F (v (y))
lim = lim = lim = 1,
x 1 F (x) x 1 F ((x y) (y)) v 1 F (v)
where v = x y.
b) For the MGF we have
Z Z Z x
rx
e dF (x) = 1 + rery dydF (x)
0 0 0
Z Z Z
ry
=1+r e dF (x)dy = 1 + r ery (1 F (y))dy = .
0 y 0
c) Let
1 F n (x)
Cn = sup .
x0 1 F (x)
Then
Z x
1 F (n+1) (x) F (x) F (n+1) (x) 1 F n (x t)
=1+ =1+ dF (t)
1 F (x) 1 F (x) 0 1 F (x)
Z x
1 F n (x t) 1 F (x t)

=1+ dF (t).
0 1 F (x t) 1 F (x)
For T < and n 1
x x
F n (x y) F n (x y) F (x y)
Z Z
Cn+1 1+ sup dF (y)+sup dF (y)
0xT 0 F (x) xT 0 F (x y) F (x)
1 F (x) F 2 (x)
1+ + Cn sup ,
F (T ) xT F (x)
1
where F (T )
< .
Since F SE, then for a given > 0, one can choose T = T () such that
F (x) F 2 (x)
sup < 1 + ,
xT F (x)
and hence
1
Cn+1 1 + + Cn (1 + ).
F (T )
Note that C1 = 1. We obtain the assertion recursively
1 1 1
Cn 1 + F (T )
+ Cn1 (1 + ) 1 + F (T )
+ (1 + F (T )
)(1 + ) + Cn2 (1 + )2 . . .
1
Pn1 (1+ )
1 i
(1 + F (T )
) i=0 (1 + )
F (T )

((1 + )n .
Remark 4.6 The assertion b) explains the name of the sub - exponential
distributions F SE. Since for every > 0
Z
ex dF (x) ey F (y), y 0,
y
MGF of the distributions F SE, doesnt exist. Consequently, the Laplace -

Stieltjes also doesnt exist.
The following lemma gives a sufficient condition for subexponentiality.
Lemma 4.3 Let for z (0, 1] the limit
1 F (zx)
(z) = lim
x 1 F (x)
exists and is left - continuous at 1. Then F is a subexponential distribution

function.
Proof. Note that
F 2 (x) = P (X1 + X2 x) P (X1 x, X2 x) = [F (x)]2 .
Assume that F (0) = 0. Hence
1 F 2 (x) 1 [F (x)]2
lim inf lim inf = lim inf [1 + F (x)] = 2.
x 1 F (x) x 1 F (x) x
For fixed n 1
x
1 F 2 (x) 1 F (x y)
Z
lim sup = 1 + lim sup dF (y)
x 1 F (x) x 0 1 F (x)
n kx
1 F (x

X
n
) kx (k 1)x
1 + lim sup F F
x
k=1
1 F (x) n n
1
= 1 + (1 ).
n
Since n is arbitrary, is left continuous at 1.
2
Example 4.2 Consider the P areto(, ) distribution.

1 F (zx) +zx +x
= = z ,
1 F (x) + zx
+x
as x . It follows that Pareto distribution is subexponential.
Remark 4.7 The condition (4.10) gives another definition of the heavy tailed
distributions. For the random variable X with distribution F, the condition
(4.10) can be written as
F (x + y)
lim P (X > x + y|X > x) = lim = 1, y > 0.
x x F (x)
The light tail of the exponential distribution F (x) = ex , x > 0, for > 0,
satisfies the condition
F (x + y)
lim = ey , y > 0.
x F (x)
Chapter 5
Cram
er - Lundberg model
5.1 Ruin probability

The ruin probability is a measure for the risk related to the some company.
For convenience we consider an insurance company.
Consider the usual risk model. Let (, F, P ) be a complete probability
space with
a) Counting process N (t), N (0) = 0;
b) A sequence {Zk }
1 of independent identically distributed random vari-
ables with distribution function F such that F (0) = 0, mean and variance
2.
The risk process is given by
N (t) 0
def
X X
X(t) = ct Zk ( = 0),
k=1 k=1
where c is a positive constant, representing the premium incomes per unit

time. The constant c is called gross risk premium rate.
Suppose that N (t) has an intensity and EN (t) = t. The profit of this
risky business in (0, t] is X(t). The expected profit is
EX(t) = ct EN (t)EZk = (c )t.
Define the safety loading coefficient by

c c
= = 1.

61
62 - LUNDBERG MODEL
CHAPTER 5. CRAMER
The risk process X(t) has a positive safety loading, if > 0, i. e. c > .
In this case X(t) has a trend to + and we say that there is a net profit
condition, (NPC).
The ruin probability (u) for the insurance company with initial capital
u is defined by
Definition 5.1
(u) = P {u + X(t) < 0 for some t > 0}.
Sometimes it is more convenient to use the probability of non ruin (u) =

1 (u).
From the definition it follows that (u) = 1 for u < 0.
Definition 5.2 If N (t) is a homogeneous Poisson process with intensity ,

i. e. N (t) P o(t), X(t) is called a classical risk model, or Cramer -
Lundberg model.
5.2 Integral equation of ruin probability

Consider the Poisson process as a renewal process. At first we will derive the
equation for the non-ruin probability (u). Let T1 be the time to the first
claim. Then X(T1 ) = cT1 Z1 . Conditioning on the no claim in (0, T1 ), we
obtain
(u) = E[(u + cT1 Z1 )] =
Z Z u+cs
s
= e (u + cs z)dF (z)ds.
0 0
The change of variables x = u + cs leads to
u x x
Z Z
(u) = e c e c (x z)dF (z)dx,
c u 0
and since is differentiable we have

Z u
0
(u) = (u) (u z)dF (z). (5.1)
c c 0
5.2. INTEGRAL EQUATION OF RUIN PROBABILITY 63
Integrating from 0 to t leads to
(t) (0)
Z t Z tZ u

= (u)du + (u z)d(1 F (z))du
c 0 c 0 0
Z t Z t Z u
0
= (u)du + (0)(1 F (u) (0) + (u z)(1 F (z))dz du
c 0 c 0 0
Z t Z t Z t

= (0) (1 F (u))du + (1 F (z))dz 0 (u z)du
c 0 c 0 z
Z t Z t

= (0) (1 F (u))du + (1 F (z))((t z) (0))dz
c 0 c 0
and to the equation

Z u

(u) = (0) + (u z)(1 F (z))dz. (5.2)
c 0
It follows that for u , () = (0) +

c
(). According to the law
of large numbers we have
X(t)
lim = c with probability 1.
t t
The NPC says that > 0 and c > . Consequently there is a dependent of
N and {Zk } random variable T , such that X(t) > 0 for every t > T. Since
only a finite number of claims can arrive up to T,
inf X(t) < with probability 1

t>0
and () = 1. Consequently

1 = 1 (0) + ,
c
i. e.
1
(0) = = .
c 1+
64 - LUNDBERG MODEL
CHAPTER 5. CRAMER
Example 5.1 Suppose that the claims are exponentially distributed with mean
x
, i. e. F (x) = 1 e , x 0. The equation (5.1) is given by
u u
Z Z
z uz
0
(u) = (u) (u z)e dz = (u) (z)e dz.
c c 0 c c 0
The second derivative
1
00 (u) + 0 (u) = 0.
1+
and the initial conditions

() = 1 and (0) =
1+
give the solution
1 1 1+

u
(u) = 1 e .
1+
From the equation (5.2) and (u) = 1 (u) it follows that
u
Z Z
(u) = (1 F (z))dz + (u z)(1 F (z))dz. (5.3)
c u c 0
5.3 Cram
er - Lundberg approximation
1
From the definition of the safety loading coefficient it follows that c
= (1+)
.
Denote by
1 z
Z
FI (z) = (1 F (x))dx,
0
the integrating tail distribution related to F (x). In terms of the safety
loading, the equation (5.2) for the nonruin probability has the form
Z u
1
(u) = + (u z)dFI (z).
1+ 1+ 0
1
Denote q = 1+
and rewrite the equation for (u).
Z u
(u) = qF I (u) + (u x)d(qFI (x)). (5.4)
0
This is a renewal equation relative the measure qFI (x). It is easy to see that
limx qFI (x) = q < 1, i. e. qFI (x) is not a probability measure. The
equation (5.4) is a defective renewal equation.
- LUNDBERG APPROXIMATION
5.3. CRAMER 65
For some r and x > 0, we define

Z x
q x rz
Z
(r) rz
F (x) = e d(qFI (z)) = e (1 F (z))dz,
0 0
which is a distribution function. It is nondecreasing and limx F (r) (x) = 1,

i. e. Z
q
erz (1 F (z))dz = 1. (5.5)
0
The distribution, generated by F (r) (x) is called Esscher transform of F .

The equation (5.5) is called a Cram
er condition.
From (5.5) it follows that
q rx
f (r) (x) = e (1 F (x)), x > 0.

is a density of a proper probability distribution.
Multiplying the equation (5.4) by eru :
Ru
eru (u) = qeru F I (u) + 0
er(ux) (u x)erx d(qFI (x))
Z u
ru
= qe F I (u) + er(ux) (u x)dF (r) (x)). (5.6)
0
This is a renewal equation

Z t
U (t) = u(t) + U (t y)dF (y),
0
for u(t) = qeru F I (u), F = F (r) and U (t) = ert (t). The function U (t)
is bounded on finite intervals. By the Theorem 3.10, the solution of the
equation (5.6) is given by
Z t Z t
rt (r)
U (t) = e (t) = u(t y)dm (y) = q er(ty) F I (t y)dm(r) (y),
0 0
where m(r) is the renewal function, corresponding to the renewal process with
F (r) distributed interarrival times. In general, the function m(r) is unknown.
The Key renewal theorem gives the asymptotic solution of the equation for
u .
66 - LUNDBERG MODEL
CHAPTER 5. CRAMER
R R
If the integrals C1 = q 0
erz F I (z)dz and C2 = q 0
zerz F I (z)dz exist,
then for the solution of (5.6) we obtain
C1
lim eru (u) = . (5.7)
u C2
From (5.5) it follows that the Cramer condition is given by
MZ (r) 1
= (1 + ),
r
where MZ (r) is the MGF of Z. We can see that the adjustment coefficient
is independent of the Poisson parameter .
It can be shown that the function MZ (r) 1 r(1 + ) is convex. The
equation
MZ (r) 1 = r(1 + ) (5.8)
has a solution equal to zero. If no zero solution exists, it is positive. Let R

be the positive solution of (5.8). Then for C1 and C2 we get
1
C1 =
R1+
and
1 1 1
C2 = (MZ0 (R) (1 + ))
R1+
and the limit (5.7) is

lim eRu (u) = . (5.9)
u MZ0 (R) (1 + )
Definition 5.3 (5.9) is called Cram er - Lundberg approximation. The

constant R, the non negative solution of the equation (5.5) is called a Lund-
berg exponent or adjustment coefficient.
Example 5.2 We continue the Example 5.1 for exponentially distributed

R z
claims. The MGF is given by MZ (r) = 1 0 erz e dz = 1r
1
. The con-
stant R is the positive solution of the equation
r
= r(1 + ),
1 r
5.4. MARTINGALE APPROXIMATION 67
and hence
1
R= .
1+
The derivative of the MGF is MZ0 (r) = (1 + )2 and (5.9) is given by
1
lim eRu (u) = .
u 1+
This result and the ruin probability of Example 5.1 show that the Cramer -
Lundberg approximation for exponentially distributed claims is exact.
5.4 Martingale approximation

Remember two theorems, important for the approximation.
Theorem 5.1 (Stopping Time Theorem) Let be a finite stoping time

(markov moment), i. e. t0 < and M is a right continuous F
martingale (supermartingale). Then
E[M ( )|F0 ] = ()M (0), P a. s.
Theorem 5.2 Let X(t) be a continuous process such that

1. X(0) = 0 P a. s.;
2. X has stationary independent increments;
3. EX(t) = t, > 0;
4. EerX(t) < for r > 0.
Then EerX(t) = eg(r)t for some function g().
If X(t) is a classical risk model with NPC, then X(t) has stationary
independent increments with = c and
P (t)k t
EerX(t) = erct Eer(Z1 +...+ZN (t) ) = erct k=0 k!
e [MZ (r)]k
= erct eMZ (r)t et = e[(MZ (r)1)cr]t .
In this case
g(r) = (MZ (r) 1) cr.
68 - LUNDBERG MODEL
CHAPTER 5. CRAMER
It is easy to show that

er(u+X(t))
Mu (t) =
eg(r)t
is a martingale relative the algebra, generated by the process X.
Let Tu = inf{t 0 : u + X(t) < 0} be the time to ruin for a company
with initial capital u. Tu is a stoping time relative the filtration F X and the
ruin probability is
(u) = P (Tu < ).
For t0 < , t0 Tu is finite F X - stoping time. F0X is a trivial
algebra and Mu > 0. According to the Theorem 5.1
eru = Mu (0) = E[Mu (t0 Tu )] =
= E[Mu (t0 Tu )|Tu t0 ]P (Tu t0 ) + E[Mu (t0 Tu )|Tu > t0 ]P (Tu > t0 )
E[Mu (t0 Tu )|Tu t0 ]P (Tu t0 ) = E[Mu (Tu )|Tu t0 ]P (Tu t0 ).
Since u + X(Tu ) 0 for Tu < , then er(u+X(Tu )) 1. Consequently
eru eru
P (Tu t0 ) eru sup eg(r)t .
E[Mu (Tu )|Tu t0 ] E[eg(r)Tu ) |Tu t0 ] 0tt0
Let t0 and obtain
(u) eru sup eg(r)t .

t0
Let R = sup{r : g(r) 0}, i. e. R is the positive solution of the equation

g(r) = 0. This is just the equation (5.8) and R is the Lundberg exponent.
We obtain the inequality
(u) eRu , (5.10)
named a Lundberg inequality.
This approximation gives an interpretation of the Lundberg coefficient.
Consider the surplus process U (t) = u + X(t). We can show that the process
erU (t) is a martingale:
EerU (t) = Eer(u+ctS(t)) = eru erct e[MZ (r)1]t = eru .
So, R is the unique positive number, such that erU (t) is a martingale. It is
known that the martingale property is related to the fair game.
We are ready to give the basic theorem.
5.4. MARTINGALE APPROXIMATION 69
Theorem 5.3 (Cram er - Lundberg)

1. If the constant R > 0 exists and
Z
eRx dFI (x) = 1 + ,
0
then
(u) eRu ,
where R is the Lundberg exponent.
R
2. Suppose that the integral 0 xeRx F I (x)dx = C is finite. Then
ru
lim (u) = e .
u RC
70 - LUNDBERG MODEL
CHAPTER 5. CRAMER
Chapter 6
Renewal Risk Model
Consider the surplus process
U (t) = u + ct S(t),
PN (t)
where S(t) = k=1 Zk , the counting process N (t) is a renewal process,
0 = 0 1 2 . . . are the claim arrival times. The inter-arrival
times Tk = k k1 , k = 1, 2, . . . are independent identically distributed
random variables with mean value ETk = 1 . The claims Zk are independent
identically distributed random variables, independent of N (t).
Let FT1 (t) be the distribution function of the time to the first claim and
FT (t) be the distribution function of T2 , T3 , . . . . If FT1 (t) = FT (t), the count-
ing process is called an ordinary renewal process and the risk model is called
a Sparre Andersen model.
If the stationarity condition
Z t
FT1 (t) = [1 FT (x)]dx (6.1)
0
holds, the counting process is stationary and the risk model is called a sta-
tionary renewal risk model.
6.1 Ordinary renewal risk model

In the ordinary case we use 0 (u) and 0 (u) = 1 0 (u) for ruin and non
ruin probability. According to the argument that ruin can occur only at
71
72 CHAPTER 6. RENEWAL RISK MODEL
claim times, the ruin probability for this model 0 (u) = P (U (t) 0, t 0)
can be given by
0 (u) = P (u + cn S(n ) 0, n 1)
Pn
= P (u + k=1 (cTk Zk ) 0, n 1)
Pn
= P supn1 k=1 (Zk cTk ) u .
Pn
Notation: Xk = Zk cTk , Wn = k=1 Xk and
n
X
Mn = sup Xk = sup Wn . (6.2)
n1 n1
k=1
Then 0 (u) = 1 0 (u) = P (Mn u). The defined random variables

Xk , k = 1, 2, . . . are independent identically distributed. A sum of indepen-
dent identically distributed random variables is called a random walk. This
proves the following
Proposition 1 The ruin probability for the zero-delayed case can be repre-
sented as 0 (u) = P (Mn > u), where Mn is given by (6.2) with Wn a discrete
time random walk with increments distributed as the difference Z cT be-
tween claims Z and the interarrival time cT.
The relative safety loading = cET
EZ1
1 c
1 = 1 > 0, i.e. the premium
received per unit time exceeds the expected claim payments per unit time.
The NPC implies that
c
EX1 = E(Z1 cT1 ) = <0

and that Wn , a.s. It is easy to proof that 0 Mn < .
The safety loading coefficient is the same like in the Cramer - Lundberg
model. The difference is that here EN (t) 6= t, and hence excluding the case
T exp(),
E (U (t) u) 6= (c )t.
According to the Law of large numbers
E(U (t) u)
lim = c ,
t t
and (u) 0 for u .
6.1. ORDINARY RENEWAL RISK MODEL 73
6.1.1 Lundberg exponent

Let U (t) be an ordinary renewal risk model.
Lemma 6.1 Suppose that MZ (r) < and for r 0, g(r) is the unique
solution of the equation
MZ (r)MT (g(r) cr) = 1. (6.3)
Then the discrete time process erUk g(r)k is a martingale.
Proof. If r 0, then MZ (r) 1. MT (r) is increasing continuous function,

defined for r 0. Consequently MT (r) 0 for r and there is an
unique solution g(r) of the equation (6.3). Then
h i
E erUk+1 g(r)k+1 |Fk = E er[c(k+1 k )Zk+1 ]g(r)(k+1 k ) |Fk erUk g(r)k

= E erZk+1 e(cr+g(r))(k+1 k ) |Fk erUk g(r)k

= E [MZ (r)MT (cr g(r))] erUk g(r)k = erUk g(r)k .

2
Example 6.1 For exponentially distributed interarrival times F (t) = 1

et . The equation (6.3) is given by

MZ (r) = 1.
+ g(r) + cr
As in the classical case, the function g(r) is convex and g(0) = 0. There
exists a nonnegative solution R to the equation g(R) = 0. This solution is
called again adjustment coefficient or Lundberg exponent.
Recall that R is the only positive solution of the equation
MZ (r)MT (cr) = 1. (6.4)
Example 6.2 Let U (t) be a renewal risk model with exp(1) distributed claims,
premium rate c = 4 and iterarrival time distribution F (t) = 1 21 (e2t + e3t ) .
It follows that MZ ((r) exists for r < 1, MT ((r) exists for r < 2 and = 2.4.
The NPC 4 > 2.4 is fulfilled. The equation to solve is

1 1 2 3
+ = 1.
1 r 2 2 + 4r 3 + 4r
Thus
2(3 + 4r) + 3(2 + 4r) = 2(1 r)(2 + 4r)(3 + 4r)
or equivalently
4r3 + r2 r = 0.
We find the solutions r = 0 and

1 17
r1,2 = ,
8

such that r1 = 1+8 17 > 0 and r2 = 18 17 < 0. We proved that there is only
no negative solution. Why do we get r2 < 0. Obviously MZ (r2 ) < 1 < .

But cr = 1+2 17 > 2 and thus MT (cr2 ) = and r2 is not a solution of
(6.4).
6.1.2 Pollaczeck - Khinchine formula (Ruin probability

as a compound geometric probability)
The Poisson process is an ordinary renewal process. By the renewals argu-
ments we can proof the following. If > 0, then
n
X 1
0
(u) = FIn (u), (6.5)
1 + n=0 1+
where FIn is the n th convolution of FI . From the equation of the non ruin
probability Z u
0 0 1
(u) = (0) + 0 (u z)dFI (z) (6.6)
1+ 0
by the Laplace transform follows (6.5). Denote by

Z
LT0 (s) = esz 0 (z)dz
0
6.1. ORDINARY RENEWAL RISK MODEL 75
the Laplace transform and

Z
LST0 (s) = esz d0 (z)
0
the Laplace - Stieltjes transform of 0 . Recall the relation LT0 (s) =

1
s
LST0 (s). Taking the Laplace transform in both sides of the equation (6.6)
gives
z
0 (0)
Z Z
1 sz
LT0 (s) = + e 0 (z t)dFI (t)dz
s 1+ 0 0

0 (0)
Z Z
1
= + esz 0 (z t)dzdFI (t)
s 1+ 0 t

0 (0)
Z Z
1
= + es(x+t) 0 (x)dxdFI (t)
s 1+ 0 0

0 (0)
Z Z
1 st sx 0
= + e e (x)dx dFI (t)
s 1+ 0 0

0 (0)
Z
1
= + LT0 (s) est dFI (t)
s 1+ 0
0 (0) 1
= + LT0 (s)LSTFI (s).
s 1+
Hence, for the Laplace transform we have
0 (0)
LT0 (s) = 1
. (6.7)
s 1 1+
LSTFI (s)
The Laplace - Stieltjes transform is

n
0 (0) 0
X 1
LST0 (s) = 1 = (0) LSTFI (s) .
1 1+ LSTFI (s) n=0
1+

According to the inversion formula with initial condition 0 (0) = 1+
, the
probability of non ruin 0 (u) in the ordinary case is given by
n
X 1
0
(u) = FIn (u), (6.8)
1 + n=0 1+
called Pollaczeck - Khinchine formula.

It is easy to see that this formula is a compound geometric sum, i. e. a
geometric sum of independent, identically distributed random variables with
distribution function FI (z).
Exercise 6.1 Show that the ruin probability for the ordinary renewal risk
model is given by
n
0 X 1 n
(u) = F I (u),
1 + n=1 1+
6.2 Stationary case

Note that the ruin probability for the delayed case with T1 = s can be
expressed in terms of the zero - delayed case as
Z u+cs
(u) = 1 F (u + cs) + 0 (u + cs y)dF (y).
0
Indeed, the first term represents the probability P (U1 cs > u) of ruin at
the time s of the first claim. The second term is P ( (u) < , U1 cs u),
as follows easily by noting that the evolution of the risk process after time s
is that of a renewal risk model with initial reserve U1 cs.
Proposition 2 The non - ruin probability (u) and the ruin probability (u)
in the stationary case satisfy the integral representations
u 0
Z
(u) = (0) + (u z)(1 F (z))dz (6.9)
c 0
and
Z Z u
0
(u) = (1 F (z))dz + (u z)(1 F (z))dz . (6.10)
c u 0
Since () = 0 () = 1 when c > , we have

(0) = 1 .
c
6.3. RUIN PROBABILITY FOR HEAVY TAILED DISTRIBUTIONS 77
Taking the Laplace transform of (6.9) and applying (6.7) we have
(0) 0 (0)
LT (s) = + LSTFI (s) .
s c s[1 LSTFI (s)]
Again, the standard properties of the transforms lead to

n
0 X 1
LST (s) = 1 + (0)LSTFI (s) [LSTFI (s)]n .
c c n=0
1 +
So, the ruin probability in the stationary case is given by

" n #
X n
(u) = F I (u) + [1 ] FI (u) F I (u) , (6.11)
c c n=1
c
where F I (u) = 1 FI (u).

In terms of the relative safety loading the ruin probability is given by
" n #
1 X 1 n
(u) = F I (u) + FI (u) F I (u) .
1+ 1+ n=1
1 +
Example 6.3 Consider again the case in which the claim amount distribu-
tion is exponential with mean value . Applying the argument of the ordinary
case we obtain the ruin probability

1 1
(u) = exp u . (6.12)
1+ 1+
6.3 Ruin probability for heavy tailed distri-

butions
Recall that in the Cramer - Lundberg model the following relation for (u)
holds n
X 1 n
(u) = F I (u),
1 + n=1 1+
Ru
where FI (u) = 1 0 [1 F (x)]dx is the integrated tail distribution. Under
the condition that F I RV () for some 0 we might hope that the
following asymptotic estimate holds

n n
(u) X 1 F I (u)
= (6.13)
F I (u) 1 + n=1 1+ F I (u)
n
X 1 1
n = , u . (6.14)
1 + n=1 1+
(6.13) is a natural estimate of ruin probability whenever F I is regularly

varying. We shall show that a similar estimate holds true for much wider
class of distribution functions. (6.13) can be reformulated as follows.
Proposition 3 For claim size distributions with regularly varying tails, the
ruin probability (u) for large initial capital u is essentially determined by
the tail F (z) of the claim size distribution for large values of z, i. e.
Z
1
(u) F (z)dz, u .
u
The main step in obtaining (6.14) is the property of the subexponential

distributions
FIn (u) nF I (u) for any arbitrary n 2 and u .
This leads to
Theorem 6.1 (Cram er - Lundberg theorem for large claims, I) Con-

sider the Cramer - Lundberg model with NPC and FI (z) SE. Then
1
(u) F I (u), u . (6.15)

1 1
Proof. Since 1+
< 1, there exists an > 0 such that 1+
(1 + ) < 1.
Together with the basic property
n
F (u)
K(1 + )n , u 0
F (u)
it follows that
n
1 F (u) 1
n
K(1 + )n , u 0,
(1 + ) F (u) (1 + )n
6.3. RUIN PROBABILITY FOR HEAVY TAILED DISTRIBUTIONS 79
which allows by dominated convergence the interchange of limit and sum in

(6.14), yielding the result.
2
For claim size distributions with subexponential integrated tail distribu-
tion, ultimate ruin probability (u) is given by (6.15).
From mathematical point of view this result can be substantially im-
proved.
Theorem 6.2 (Cram er - Lundberg theorem for large claims, II)

Consider the Cramer - Lundberg model with NPC. Then the following as-
sertions are equivalent.
a) F I (u) SE.
b) 1 (u) SE.
(u) 1
c) , u .
F I (u)
Consequently, the estimate (6.15) is possible only under the condition

F I (u) SE.
Chapter 7
Premium Calculation
Principles
Denote by X the premium that an insurer charges to cover the risk X. The
risk X means that claims from this risk are described by the random variable
X and the distribution of X. The premium X is a function X, for example
X = (X). The rule that assigns the numerical value of X is referred to
as a premium calculation principle.
Properties of premium principles:
1. X EX (nonnegative loading);
2. If X1 and X2 are independent, then X1 +X2 = X1 + X2 (additivity);
3. If Z = aX, where a > 0, then Z = aX (scale invariance);
4. If Y = X + c, where c > 0, then Y = X + c (consistency);
5. If there is a finite maximum value of the claim amount xm then
X xm .
7.1 Premium calculation principles

7.1.1 Pure premium principle
X = EX.
The pure premium is not very attractive.
81
82 CHAPTER 7. PREMIUM CALCULATION PRINCIPLES
7.1.2 Expected value principle

X = (1 + )EX,
where > 0 is the safety loading factor. EX is the loading in the premium.
The premium is easy to calculate. It assigns the same premium to all risks
with the same mean value and is not sensible to heavy tailed distributions.
7.1.3 The variance principle

X = EX + V ar(X),
where > 0. The loading is proportional to V ar(X). This principle counts

two characteristics of the risk - the mean value and the variance and is more
sensible to higher risks.
7.1.4 Standard deviation principle

p
X = EX + V ar(X),
where > 0. The loading is proportional to the standard deviation of X.

The loss can be written as
!
p X EX
X X = V ar(X) p ,
V ar(X)
or the loss is equal to the loading parameter minus a random variable with
mean value 0 and variance 1.
7.1.5 Modified Variance Principle

In the Variance Principle, the changing in monetary unite changes the secu-
rity loading. The following modification
EX + V ar(X)

, EX > 0
X = EX
0, EX = 0
for > 0 can change this.

7.1. PREMIUM CALCULATION PRINCIPLES 83
7.1.6 The Principle of Zero Utility

The worst thing that may happen for the company is a very high accumulated
sum of claims. Therefore high losses should be weighted stronger then small
losses. Hence, the company chooses an utility function v, which should have
the following properties:
1) v(0) = 0.
2) v(x) is strictly increasing.
3) v(x) is strictly concave.
The first property is for convenience. The second means that less losses
are preferred. The last condition gives stronger weights for higher losses.
The premium is defined by the equation
v(u) = E[v(u + X X)], (7.1)
where u is the insurers surplus. This means that the expected utility is the
same whether the insurance contract is taken or not. In general, the premium
depends on the surplus.
Lemma 7.1 1. If the solution of (7.1) exists, it is unique.

2. If for every x < , v 00 (x) < 0, then > EX;
3. The premium is independent of u if and only if v 00 (x) = 0 or v(x) =
A(1 ex ), A > 0, > 0.
Proof.
1. Let 1 > 2 be two solutions of (7.1). Since v 0 (x) > 0, then
v(u) = E[v(u + 1 X)] > E[v(u + 2 X)] = v(u),
which is a contradiction.
2. The Jensens inequality is fulfilled
v(u) = E[v(u + X)] < v(u + EX)
and since v 0 (x) > 0, we obtain u + EX > u.

3. It is easy to see that if v 00 (x) = 0 or v(x) = A(1 ex ), then the
premium principle is independent of u.
Suppose that the premium is independent of u. Let P (X = 1) = 1

P (X = 0) = q and (q) is the premium. Then
qv(u + (q) 1) + (1 q)v(u + (q)) = v(u). (7.2)

Differentiation in (7.2) relative to u leads to
qv 0 (u + (q) 1) + (1 q)v 0 (u + (q)) = v 0 (u). (7.3)
The derivative of (7.2) relative to q is
v(u+(q)1)v(u+(q))+0 (q)(qv 0 (u+(q)1)+(1q)v 0 (u+(q)) = 0.

(7.4)
Insert (7.4) in (7.2) and obtain
v(u + (q) 1) v(u + (q)) + 0 (q)v 0 (u) = 0. (7.5)

Note that 0 (q) > 0. The derivative of (7.5) relative to u is
v 0 (u + (q) 1) v 0 (u + (q)) + 0 (q)v 00 (u) = 0,
and relative to q
0 (q) (v 0 (u + (q) 1) v 0 (u + (q))) + 00 (q)v 0 (u)
= [0 (q)]2 v 00 (u) + 00 (q)))v 0 (u) = 0.

Consequently 00 (q) 0 and for 0,
v 00 (u)
=
v 0 (u)
which proves the statement.
2
Remark 7.1 In the case of exponential utility function from the equation
(7.1) we obtain
X = 1 log EeX (7.6)
and it is called an exponential principle.
7.1.7 The Esscher Principle

E[XehX ]
X = ,
E[ehX ]
where h > 0.
The Esscher premium can be interpreted as a pure premium for Y, related
to X as follows. Let X be a continuous nonnegative random variable with
density function f. Define the function g, such that
ehX f (x)
g(x) = R hx . (7.7)
0
e f (x)dx
The function g, defined by (7.7) is the density of the random variable Y.
The distribution function of Y is given by
R t hy
e f (y)dy
G(x) = 0
MX (h)
and is called Esscher transform for the function F with parameter h. G(x) is
related to the distribution function of the risk X, but does give more weight
to larger losses. From the equation (7.7), the MGF of Y is
MX (t + h)
MY (t) = .
MX (h)
Example 7.1 Let F (x) = 1 exp(x), x 0 be the distribution function
of the random variable X. Find the Esscher transform with parameter h < .

The MGF is given by MX (t) = t , and hence
MX (t + h) h
MY (t) = = .
MX (h) ht
The Esscher transform of the function F is
G(x) = 1 e(h)x .
The density g is an weighted version of f. From (7.7) it follows that

ehx
g(x) = w(x)f (x), where w(x) = MX (h)
. Since h > 0, then the weights increase
when x increases. This means that the transforms are useful for the heavy
tailed distributions. The expected value of Y is
R hx
xe f (x)dx E[XehX ]
EY = R0 hx = hX ]
= X .
0
e f (x)dx E[e
Example 7.2 Let X exp(1). Find the premium by the Esscher principle
with parameter h < 1.
7.1.8 Risk adjusted premium principle

Z
1
X = [1 F (x)] dx,
0
where 1 is called a risk index.

This principle is defined for nonnegative random variable X with distri-
bution function F .
Let Z be a random variable with distribution function H, defined by the
equation
1
1 H(x) = [1 F (x)] .
The expected value of Z :

Z
EZ = [1 H(x)]dx,
0
and hence X = EZ.
Example 7.3 Let X exp( 1 ). Find the risk adjusted premium X .

Here
1 F (x) = ex
and
x
1 H(x) = e .
Consequently Z exp( ) and X = .
Example 7.4 Let X P ar(, ). Find the risk adjusted premium X .

In this case

1 F (x) =
+x
and

1 H(x) = .
+x

So Z P ar( , ) and X =
, < .
If X is a continuous random variable with density function f, then the

density of Z is h, defined by
1 1
h(x) = [1 F (x)] 1 f (x). (7.8)

This means that the density of Z is an weighted version of f.
Chapter 8
Diffusion Approximation
Consider the surplus process
U (t) = u + ct St , t 0,
where St = Z1 + . . . + ZN (t) is the accumulated loss process. N (t) is a

homogeneous Poisson process with intensity and St = 0 for N (t) = 0. The
individual losses Z1 , Z2 , . . . are positive, independent, identically distributed
random variables, independent of N (t). Suppose that MZ (r) exists.
Here we will give an approximation of the surplus process by a Wiener
process with trend, called a generalized Wiener process.
The process U (t) increases continuously with slot c, which is the premium
per unit time and in random times 1 , 2 , . . . has jumps equal to Z1 , Z2 , . . . .
Remember that the risk process X(t) = ct St , t 0 satisfies the
properties:
1. X(0) = 0;
2. EX(t) = ct tEZ;
3. V ar(X(t)) = tEZ 2 .
The goal is to construct a continuous time process with the same prop-
erties.
Remember the definition of the Wiener process.
Definition 8.1 Continuous time stochastic process {Wt , t 0} is called a

Wiener process, if
89
90 CHAPTER 8. DIFFUSION APPROXIMATION
1. W0 = 0;
2. {Wt , t 0} has stationary independent increments;
3. Foe every t > 0, Wt N (0, 2 t), where > 0 is a constant.
Definition 8.2 The continuous time stochastic process {Wt , t 0} is called

a generalized Wiener process (Wiener process with drift), if it is a Wiener
process, with EWt = t, i. e. Wt N (t, 2 t). This process is called also a
diffusion process.
We shall prove that the surplus process {U (t), t 0} can be approxi-

mated by a Generalized Wiener process. Consider the limit of the surplus
process U (t), conditioning on large expected number of jumps with small
sizes. Suppose that the expected values and the variances of the processes are
the same. Under these conditions, the surplus process with Poisson counting
process can be approximated by a generalized Wiener process.
Let
= c EZ
and
2 = EZ 2
be the mean value and the variance of the generalized Wiener process. Then
EZ
c = + 2 .
EZ 2
Suppose that the claim size Z is given by Z = Y, for some random
variable Y with arbitrary mean and variance. Then
2 1
=
EY 2 2
and
EY 1
c = + 2 .
EY 2
Let 0, then . Since the processes {St , t 0}, U (t) and X(t), t
0 have stationary independent increments, then the limiting process is the
same. X(0) = 0, consequently we have to prove only that for every t, the
limit of X(t) is normally distributed with parameters t and 2 t.
8.1. RUIN PROBABILITY FOR DIFFUSION PROCESS 91
Let
MX(t) (r) = Eer(ctSt ) = e[rc+(MZ (r)1)]t
be the MGF. Then
log MX(t) (r)
= rc + [MZ (r) 1]
t
r2 r3
= r[ + EZ] + [1 rEZ + 2!
EZ 2 3!
EZ 3 + . . . 1]
r2 3 r4
= r + 2
EZ 2 [ r3! EZ 3 4!
EZ 4 + . . .]
r2 2 3 4
= r + 2
2 [ r3! EY 3 2 r4! EY 4 + . . .].
For 0 we obtain
log MX(t) (r) r2
lim = r + 2 ,
0 t 2
and then
r2 2
lim MX(t) (r) = e(r+ 2 )t .
0
This is the MGF of N (t, 2 t) - distributed random variable, consequently

the limiting process is a generalized Wiener process with mean value t.
From the definition of the surplus process U (t) it follows that the sample
paths are differentiable everywhere except in the jump points. Since in the
limiting case the number of points increases, the sample paths of the limiting
process are not differentiable. Also, for 0, the jumps size tends to zero,
consequently the sample paths of the limiting process are continuous with
probability 1.
8.1 Ruin Probability for diffusion process

We proved that if Wt is N (t, 2 t) - distributed Wiener process, U (t) = u+Wt
is a risk process with initial capital U (0) = u. Consider the ruin probability
in a finite time interval (0, ) and let . The ruin probability up to
time is given by
(u, ) = 1 (u, ) = P (Tu < ) = P ( min U (t) < 0) = P ( min Wt < u).
0<t< 0<t<
Theorem 8.1 The ruin probability of the defined diffusion process is given
by
u + 22 u u
(u, ) = +e ,
2 2
where is the standard normal distribution function.
From this result, letting , we obtain
Corrolary 8.1 The ultimate ruin probability is given by

2
(u) = 1 (u) = P (Tu < ) = e 2 u .
Corrolary 8.2 The distribution of the time to ruin, given that ruin occurs
is

(u, ) 2
u u + u
= P (Tu < |Tu < ) = e 2 + , > 0.
(u) 2 2
(8.1)
Corrolary 8.3 Differentiation in (8.1) relative to u gives the probability

density function of the time to ruin
u 3 (u )2
fTu ( ) = 2 e 22 , > 0. (8.2)
2
u2 u
Substituting 2
= and
= a in the density function we obtain
12
a 2
fTu ( ) = e 2 ( ) , > 0,
2 3
which is the standard Inverse Gaussian distribution.
Hence, the time to ruin conditioning that ruin occurs has an Inverse
u u 2
Gaussian distribution with expected value
and variance 3
. If = 0 ruin
occurs with probability 1 and the density function is obtain from (8.2) with
= 0, i. e.
u 3 u2
fTu ( ) = 2 e 22 , > 0.
2

u
FTu ( ) = 2 , > 0.

8.1. RUIN PROBABILITY FOR DIFFUSION PROCESS 93
This is one - ided stable distribution with index 12 .

These results could be applied like approximation to the arbitrary risk
process U (t), with Poisson counting process. For the approximated risk pro-
cess we obtain

u + EZ 2EZ2 u u EZ
(u, ) = + e EZ , u > 0, > 0,
EZ 2 EZ 2
2EZ
(u) = e EZ 2 u , u > 0
and
u 3 (u EZ)2
fTu ( ) = 2 e 2 EZ 2 , > 0.
2EZ 2
Here is the safety loading factor and c = (1 + )EZ.
Similarly, for a given risk process with Poisson counting process there
exists a simple numerical approximation.
For example, the expected value of the time to ruin if ruin occurs is given
by
u u
ETu = = .
EZ
It is easy to see that it depends on four parameters. If the initial capital
is large, the time to ruin increases. The increasing in all the other three
parameters causes a decreasing of the time to ruin.
Chapter 9
Reinsurance
In many cases the premiums to the insurance company are not enough to
carry the risk. This is the case of large claims. In that cases the insurer shares
a part of the risk with other companies. Sharing the risk as well as the premi-
ums is done by reinsurance contracts, which are mutual agreements between
insurance companies. Sometimes the insurance companies have agreements
about reinsuring certain parts of the portfolios.
We consider reinsurance that applies to the individual claims. If the claim
size is z the insurer retains a part h(z), where h : R+ R+ is an increasing
function, such that h(0) = 0 and 0 h(z) z for all z 0. The reinsurer
covers the remain part z h(z). We assume that reinsurance premiums are
payable continuously and that the reinsurer pays its share of a claim as soon
as that claim occurs. The function h(x) determines the rule of reinsurance.
The aggregate sum of claims for the insurer is equal to StI = N
P (t)
i=1 h(Zi ).
The sum of claims for reinsurer is StR = St StI .
9.1 Proportional Reinsurance

Suppose the insurer chooses proportional reinsurance with retention level
b [0, 1]. In this case, the function h is h(z) = bz. The premium rate for the
reinsurance is given by
(1 + )(1 b),
95
96 CHAPTER 9. REINSURANCE
where > 0 is the relative safety loading, defined by the reinsurance com-
pany. We consider the case > . The premium rate for the insurer is:
[(1 + ) (1 + )(1 b)] = [b(1 + ) ( )],
and the surplus process becomes

N (t)
X
U (t, b) = u + [b(1 + ) ( )]t bZk . (9.1)
k=1
In order that the net profit condition is fulfilled we need
[b(1 + ) ( )]
> 1,
b
i. e.

b>1 .

Let MZ (r) be the moment generating function of the individual claim
amount distribution evaluated at r. Then the adjustment coefficient R(b)
under proportional reinsurance is the unique positive solution of the equation
[MZ (br) 1] [b(1 + ) ( )]r = 0. (9.2)
Let (u, b) denote the probability of ultimate ruin when the proportional
reinsurance is chosen. Then
(u, b) = P (U (t, b) < 0 for some t > 0).
Our objective is to find the retention level that minimizes (u, b). Ac-
cording to the Lundberg inequality, the retention level will be optimal, if the
corresponding Lundberg exponent R is maximal. We know that there is a
unique b [0, 1] where the maximum is attained. If the maximizer b > 1, it
follows from the uni-modality that the optimal b is 1, i. e. no reinsurance is
chosen.
The next result gives the optimal retention level b and maximal adjust-
ment coefficient R(b), see [9].
9.1. PROPORTIONAL REINSURANCE 97
Lemma 9.1 The solution of equation (9.2) is given by
(1 + )r [1 MZ (r)]
R(b(r)) = , (9.3)
( )
where b r(b) is invertible.
Proof. Assume that r(b) = bR((b)), where R(b) will be the maximal value of
the adjustment coefficient and r(b) is invertible. If we consider the function
r b(r), it follows that
( )r
b(r) = . (9.4)
(1 + )r [1 MZ (r)]
r
Now R(b(r)) = b(r)
in details is given by (9.3).
2
Theorem 9.1 Assume that MZ (r) < . Suppose there is a unique solution
r to
MZ0 (r) (1 + ) = 0. (9.5)
Then r > 0, the maximal value of R(b(r)) and the retention level b(r) are
given by (9.3) and (9.4).
Proof. The necessary condition for maximizing the value of the adjustment
coefficient is given by equation (9.5).

Since R0 (b(0)) =
> 0, the function R(b(r)) is strictly increasing at
0. The second derivative in zero R00 (b(0)) = ()
1
EZ 2 < 0 shows that
R(b(r)) is strictly concave. Consequently, the function R(b(r)) has an unique
maximum in r, which is the solution of (9.3). The retention level is given by
(9.4).
2
Remark 9.1 Note that the value of the adjustment coefficient does not de-
pend on c but on the relative safety loadings only.
9.2 Excess - of - Loss Reinsurance(XL)

The Excess - of - Loss reinsurance is nonproportional type of reinsurance.
The insurer covers each individual claim up to a certain retention level M, i.
e. when a claim of size Z occurs, the insurer pays ZM = min(Z, M ) = h(z)
and the reinsurer ZR = Z ZM = max(Z M, 0) = (Z M )+ so that
Z = ZM + ZR . Suppose the number of claims N (t) follows an ordinary
renewal process. Hence the insurer risk process at time t is
N (t)
X
XM (t) = (c cM )t min(Zi , M ),
i=1
where cM is the XL reinsurance premium. For a given M , the adjustment

coefficient RM is the unique positive root of
gM (r) = 1,
if it exists with
gM (r) = E[erZM ]E[e(ccM )rT ].
9.3 Stop - Loss Reinsurance

The Stop - Loss reinsurance works similarly to the XL reinsurance, but it
covers the total amount of claims. For stop - loss contract with retention
level (deductible) d, the amount paid by reinsurer to the insurer is

0, if S d
Id =
S d, if S > d.
Sometimes: Id = (S d)+ . Note that Id as a function of the aggregate

claims S is also a random variable. The amount of claims retained by the
insurer is
S, if Sd
min(S, d) = S Id =
d, if S > d.
Thus, the amount retained is bounded by d, which explains the name stop -
loss contract.
9.3. STOP - LOSS REINSURANCE 99
The expected claims paid by the reinsurer is given by

R
EId = d
(x d)fS (x)dx (9.6)
Rd
= ES d + 0
(d x)fS (x)dx (9.7)
R
= d
[1 FS (x)]dx (9.8)
Rd
= ES 0
[1 FS (x)]dx. (9.9)
When ES is available, (9.7) and (9.9) are preferable by numerical integration.

(9.8) and (9.9) hold for general distribution, including discrete and mixed. If
the distribution is given, (9.6) is the most tractable formula.
Example 9.1 Let S Gamma(, ). Then

R
EId = d
xf (x)dx d[1 FS (d)]

x
Z
= x e dx d[1 G(d; , )]
d ()

= [1 G(d; + 1, )] d[1 G(d; , )],

Z d
1
where G(d; , ) = x1 ex dx.
() 0
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Insurance Risk Theory

1 Basic Risk Model 1

2.9.1 Negative binomial distribution . . . . . . . . . . . . . . 23

4 Claim Size Models 49

6 Renewal Risk Model 71

7 Premium Calculation Principles 81

Basic Risk Model

X(t) = (t) S(t) (1.1)

(ii) N (t) = sup{n : n t}, t 0 is the number of claims up to time

{N (t) = n} = {n t < n+1 }, n = 0, 1, . . . .

(iii) The sequence {Zn , n = 1, 2, . . .} of independent identically dis-

The accumulated sum of claims up to time t is given by

The process S = (S(t))t0 is defined by the sum Sn = Z1 + . . . + Zn , where

S(t) = Z1 + . . . + ZN (t) = SN (t) , t 0,

or a random sum of random variables. Suppose that S(t) = 0, if N (t) = 0.

All the random variables are defined on a complete probability space (, F, P ).

Definition 2.1 The function

FX (x) = P (X x) = P (X (, x]). (2.1)

is called a distribution function of the random variable X.

The distribution function FX (x) satisfies the following conditions.

d) FX (x) is a right continuous, i. e. for any x,

The function F X = 1 FX (x) = P (X > x) is called a survival function

For the discrete random variable there exists a countable subset E =

and the distribution function

where the sum is over all jump points of FX (x).

The r. v. X is called continuous, if the distribution function FX (x) is

In a more general case for any event A,

Intuitively, we could write that P (X = x) = f (x)dx and consider P (X = x)

The r. v. X is of a mixed type, if it is neither discrete nor continuous. If

2.1 Hazard rate function

Definition 2.2 The function

is called hazard rate function for the r. v. X.

P (X (t, t + dt), X > t) P (X (t, t + dt))

is called a hazard function.

In this case (k) 1.

Definition 2.3 The Probability generating function (PGF) is defined

2.3.2 Moment Generating Functions

is called a Moment generating function (MGF) of the random variable

2.3.3 Characteristic Functions

is called a characteristic function of X.

2.3.4 Laplace Transform

Definition 2.6 The function

if it exists is called Laplace transform (LT) of the random variable X or its

The Laplace transform is defined for complex values of s with positive

Example 2.1 Let us find the Laplace transform of f (x) = ex , x > 0.

Suppose that the LTf (s) in (2.6) exists. Then

10. For a distribution function F with density f

LTf (s) = LSTF (s) = sLTF (s).

2.4 Counting Random Variables

EX = EX 2 = p and V ar(X) = p(1 p).

2. Geometric distribution. The random variable N has a geometric

The mean and the distribution function are given by

EN = np and V ar(N ) = np(1 p).

and the PGF

The binomial distributed random variable N is interpreted as the number

and the PGF

2.5 Continuous random variables

F (x) = 1 ex and f (x) = ex , x 0.

The MGF of the exponential distribution is

All the moments of the random variable could be determine by differen-

F (x) = 1 e(xa) and f (x) = e(xa) , x a

and is noted by Y exp(a, ).

P (X t + s|X t) = P (X s). (2.8)

Let X be the lifetime distribution. Then (2.8) means the probability