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Slides of Law of Probablity Formulas in insurance

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Management

Pooling and Hedging of Risk

Concept of probability began in 1660s

Concept of probability grew from interest in

gambling.

Mahabarata story (ca. 400 AD) of Nala and

Rtuparna, suggests some probability theory

was understood in India then.

Fire of London 1666 and Insurance

Random variable: A quantity determined by

the outcome of an experiment

Discrete and continuous random variables

Independent trials

Probability P, 0<P<1

Multiplication rule for independent events:

Prob(A and B) = Prob(A)Prob(B)

Rule

Probability of n independent accidents = Pn

Probability of x accidents in n policies

(Binomial Distributon):

f ( x) P (1 P)

x

( n x)

n! /( x!(n x)!)

E ( x) x i 1 prob ( x xi ) xi

E ( x ) x

f ( x) xdx

x xi / n

i 1

Geometric Mean

For positive numbers only

Better than arithmetic mean when used for

(gross) returns

Geometric Arithmetic

n

G( x) ( xi )

i 1

1/ n

Variance (2)is a measure of dispersion

Standard deviation is square root of

variance

i 1

s ( xi x ) 2 / n

2

x

i 1

Covariance

A Measure of how much two variables

move together

n

cov( x, y ) ( x x)( y y ) / n

i 1

Correlation

A scaled measure of how much two

variables move together

-1 1

cov( x, y ) /( s x s y )

Return XYZ Corporation against Market 1990-2001

25

20

15

Each point represents a year.

Linear (Each point represents a year.)

10

0

-10

-5

10

15

20

25

Distributions

Normal distribution (Gaussian) (bell-shaped

curve)

Fat-tailed distribution common in finance

Normal Distribution

Norm al Distribution w ith Zero Mean

0.45

0.4

0.35

0.3

0.25

f(x)

Standard Dev. = 3

Standard Dev. = 1

0.2

0.15

0.1

0.05

0

-15

-10

-5

0

Return (x)

10

15

Normal Versus Fat Tailed Distributions

0.45

0.4

0.35

0.3

f(x)

0.25

Normal Distribution

Cauchy Distribution

0.2

0.15

0.1

0.05

0

-15

-10

-5

0

Return x

10

15

Expected Utility

Pascals Conjecture

St. Petersburg Paradox, Bernoulli: Toss coin

until you get a head, k tosses, win 2(k-1)

coins.

With log utility, a win after k periods is

worth ln(2k-1)

E(U ) prob( x xi )U ( xi )

i 1

PDV of a dollar in one year = 1/(1+r)

PDV of a dollar in n years = 1/(1+r)n

PDV of a stream of payments x1,..,xn

T

PDV xt /(1 r ) t

t 1

Consol pays constant quantity x forever

Growing consol pays x(1+g)^t in t years.

Annuity pays x from time 1 to T

Consol PDV x / r

Annuity PDV x

11 /(1 r )T

r

Insurance Annuities

Life annuities: Pay a stream of income until a

person dies.

Uncertainty faced by insurer is termination

date T

Companies

Probabilities may change through time

Policy holders may alter probabilities

(moral hazard)

Policy holders may not be representative of

population from which probabilities were

derived

Insurance Companys portfolio faces risk

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