Week 2 Annotated

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes
ACTL2002/ACTL5101 Probability and Statistics

c Katja Ignatieva

School of Risk and Actuarial Studies
Australian School of Business
University of New South Wales
k.ignatieva@unsw.edu.au
Week 2 Video Lecture Notes

Week 2
Week 3
Week 4
Probability: Week 1
Week 6
Review
Estimation: Week 5
Week
7
Week
8
Week 9
Hypothesis testing:
Week
10
Week
11
Week
12
Linear regression:
Week 3 VL
Week 4 VL
Week 5 VL
Video lectures: Week 1 VL

Bernoulli distribution
Special Discrete Distributions
The Binomial Distribution
The Geometric Distribution
The Negative Binomial Distribution

Bernoulli Distribution
Discrete distribution.
The outcome in a Bernoulli experiment is one of two mutually
exclusive events, classified as either success (x = 1) or failure
(x = 0).
Denote the probability of success (i.e., x = 1) by p,
0 < p 1. Let X denote the Bernoulli random variable so
that:

1, w.p. p;
X =
0, w.p. 1 p.
Notation: X Bernoulli (p) .
Formulae & Tables (F&T) book page 7.
202/220

p.m.f.: pX (x) = p x (1 p)1x , for x = 0, 1, and zero

otherwise.
X
mean:
E [X ] = pX (x) x
all x
=0 (1 p) + 1 p = p.
variance:

Var (X ) =E X 2 2X
X
= pX (x) x 2 p 2
all x
2
=0 (1 p) + 12 p p 2 = p (1 p) .
m.g.f.:
h i
MX (t) =E e Xt
X
= pX (x) e xt
all x
203/220
=(1 p) e 0t + pe 1t = p e t + (1 p) .


Suppose we have n independent trials such that there is a

probability p of success for each trial, i.e., we have n
independent trials of a Bernoulli r.v..
The random variable X which represents the number of
successes out of n trials has a Binomial distribution and we
write X Binomial (n, p).
F&T book, p. 6 (values for cumulative density function given
on pp. 186188).
204/220
n = 20, p = 0.5
0.2
0.1
0
0
10
20
x
Binomial(200,0.5) p.m.f.
n = 200, p = 0.5
0.2
0.1
205/220
0
0
100
x
200
probability mass function
0.3
0.3
n = 20, p = 0.1
0.2
0.1
0
0
10
20
x
n = 200, p = 0.1
0.2
0.1
0
0
100
x
200
Binomial(20,0.5) c.d.f.
1
0.5
n = 20, p = 0.5
0
10
20
x
0.5
206/220
n = 200, p = 0.5
0
0
100
x
200
cumulative density function cumulative density function
1
0.5
n = 20, p = 0.1
0
10
20
x
0.5
n = 200, p = 0.1
0
0
100
x
200


n
p x (1 p)nx , for x = 0, 1, . . . , n,
x
and zero otherwise.
p.m.f.: pX (x) =
mean: (alternative
" n proof:
# seen slide 211)
X
X
E [X ] =E
Yi =
E [Yi ] = n E [Yi ] = n p.
i=1
i=1
variance: (alternative
see slide 211)
! proof:
n
n
X
X
Yi =
Var (X ) =Var
Var (Yi ) = n Var (Yi ) = n p (1 p) .
i=1
i=1
m.g.f.: (alternative
slide
h i proof:
h Psee
i 209)h
n i
n
Xt
Y
t
E e
=E e i=1 i = E e Yi t
n
= p e t + (1 p)
207/220
* Using Yi Ber(p) i.i.d. for i = 1, . . . , n.


By applying the binomial expansion with n 1, 2, 3, . . ., and
p [0, 1] we have:
n
X
n
x=0
p x (1 p)nx = (p + 1 p)n = 1.
Using the binomial expansion (F&T page 2):

n
(a + b) =
n
X
n
k=0
ank b k ,
for any integer n.

Hence, the sum of the probabilities of all events equals one.
208/220


Also, for the moment generating function, we have:
h i
MX (t) =E e Xt

n
X
n
xt
=
e
p x (1 p)nx
x
x=0
n
X
x
n
=
p e t (1 p)nx
x
x=0
n
= p e t + (1 p)
* again, applying the binomial expansion with a = p e t and
b = (1 p).
209/220


Recall: MX (t) = (p e t + (1 p))n .
Then we can also use the m.g.f. to find the moments. Since
n1
p et
MX0 (t) = n p e t + (1 p)
and
n2
2
MX00 (t) =n (n 1) p e t + (1 p)
p et
n1
+ n p e t + (1 p)
p et
n2

=npe t pe t + (1 p)
(n 1) pe t + pe t + (1 p) .
* using product rule:
210/220
f (x)g (x)
x
f (x)
x
g (x) +
g (x)
x
f (x).


We have:
E [X ] = MX0 (0) = n p
and

E X 2 = MX00 (0) = n p ((n 1) p + 1) .
The variance is easily shown to be:

Var (X ) =E X 2 (E [X ])2
=n p ((n 1) p + 1) (n p)2
=n p (1 p) .
211/220

Examples of the Binomial Distribution
Question: The probability of one or more accidents in a year

for high risk (H) insureds is 25%. When the insurer has 10 H
insureds, whats the probability that 5 or more insured have
an accident?
Solution: X =number of insureds with at least one accident

a year. Pr(X > 4) = 1 Pr(X 4) = 1 0.9219 = 0.0781.
212/220



Consider a sequence of independent and repeated trials with p
denoting the probability of success.
Suppose X is the number of trials required up to and
including the first success. Then X has a geometric
distribution and we write X Geometric (p) where 0 < p 1
denotes the probability of a success for one trial.
F&T book page 9.
Application: the time (in years) to the first earthquake in
Australia with a magnitude larger than 8.
Note: due to i.i.d. trials: the Geometric distribution has the
memoryless property, i.e., Pr(X a|X b) = Pr(X a b)
for b < a.
213/220


p.m.f.: pX (x) = p (1 p)x1 , for x = 1, 2, . . ..
parameter constraints: 0 < p 1.
mean: X
X
E [X ] = x p (1 p)x1 = p
x (1 p)x1
all x
=p
X
x=1
x=1
(1 p)x = p
(1 p)x
(1 p)
(1 p)
x=1
(1 p)
1
1
=p
=p 2 = .
(1 p) 1 (1 p)
p
p
*PUsing geometric series:

P x
1
1
a
x
x=0 a = 1a
x=1 a = 1a 1 = 1a .

f (x)
g (x)
g (x) x f (x)
f (x)
x
** Using quotient rule: x
.
g (x) =
(g (x))2
214/220


(similar as mean).
variance: Var (X ) = 1p
p2
h
i X
m.g.f.:
X t
MX (t) =E e
=
e xt p (1 p)x1
x=1
X
t
=p e
e tz (1 p)z
z=0
=p e t
215/220
z
e t (1 p)
z=0
p et
1 (1 p) e t

1
Note: (1 p) e t < 1 t < log 1p
.
P z
1
* using geometric series:
z=0 a = 1a .

Geo(0.5) p.m.f.
p = 0.5
0.4
0.3
0.2
0.1
0
0
10
15
x
Geo(0.5) c.d.f.
1
0.5
216/220
p = 0.5
0
10
x
15
cumulative density function probability mass function
cumulative density function probability mass function
Example of the Geometric Distribution
Geo(0.1) p.m.f.
p = 0.1
0.4
0.3
0.2
0.1
0
0
20
40
x
Geo(0.1) c.d.f.
0.5
p = 0.1
0
20
40
x



Consider a sequence of independent and repeated Bernoulli
trials again with p denoting the probability of success on a
single trial. Let X represents the random variable that denote
the number of trials required until there are r successes. Then
X has a negative binomial distribution and we write
X N.B. (r , p).
F&T book page 8.
Special case: when we have r = 1, i.e., X represents the
random variable that denote the number of trials required
until there is one success: X NB (r = 1, p) = Geometric (p).
217/220


x 1
p.m.f.: pX (x) =
p r (1 p)xr , for
r 1
x = r , r + 1, . . .
parameter constraints: 0 < p 1 and r = 1, 2, . . .;
mean: E [X ] = E [Y1 + . . . + Yr ] = r E [Yi ] = pr ;
variance:
Var (X ) = Var (Y1 + . . . + Yr ) = r Var (Yi ) = r (1p)
;
p2

r
pe t
m.g.f.: MX (t) = MY1 +...+Yr (t) = MYr i (t) = 1(1p)e
;
t
Proof using i.i.d. property and geometric distribution. Let
Yi Geometric(p) for i = 1, . . . , r .
218/220

Negative Binomial(3,0.5) p.m.f.

0.2
r = 3, p = 0.5
0.15
0.1
0.05
0
0

0.2
r = 3, p = 0.1
0.15
0.1
0.05
0
10
20
0
50
100
x
x
0.2
0.2
r = 10, p = 0.5
r = 10, p = 0.1
0.15
0.15
0.1
0.05
219/220
0
0
20
x
40
Example of the Negative Binomial Distribution
0.1
0.05
0
0
100
x
200

Negative Binomial(3,0.5) c.d.f.

1
0.5
r = 3, p = 0.5
0
10
20
x
1
0.5
220/220
r = 10, p = 0.5
0
20
x
40
Example of the Negative Binomial Distribution

1
0.5
r = 3, p = 0.1
0
50
100
x
1
0.5
r = 10, p = 0.1
0
0
100
x
200
ACTL2002/ACTL5101 Probability and Statistics: Week 2
ACTL2002/ACTL5101 Probability and Statistics

c Katja Ignatieva

School of Risk and Actuarial Studies
Australian School of Business
University of New South Wales
k.ignatieva@unsw.edu.au
Week 2
Week 3
Week 4
Probability:
Week 6
Review
Estimation: Week 5
Week
7
Week
8
Week 9
Hypothesis testing:
Week
10
Week
11
Week
12
Linear regression:
Week 2 VL
Week 3 VL
Week 4 VL
Video lectures: Week 1 VL
Week 1
Week 5 VL
Last week
Introduction to probability;
Definition of probability measure, events;
Calculating with probabilities; Multiplication rule,
permutation, combination & multinomial;
Distribution function;
Moments: (non)-central moments, mean, variance (standard
deviation), skewness & kurtosis;
Generating functions;
301/354
This week
Special (parametric) univariate distributions;

Discrete distributions: Bernoulli, Binomial, Geometric,
Negative Binomial, and Poisson distributions;
Continuous distributions: Exponential, Gamma, Gaussian,
Lognormal, Uniform, Beta, Negative Binomial, Weibull, and
Pareto distributions.
302/354

The Poisson Distribution
Probability Distributions used in Insurance and Finance

Exponential & Gamma distribution
Special case of the Gamma distribution: Exponential distribution
Gamma Distribution
Bernoulli family
Exercises
The Normal (Gaussian) Distribution
The Standard Normal Distribution Table
Deriving the M.G.F. of the Normal
Lognormal Distribution
Uniform Distribution
Beta Distribution
Beta Distribution
Negative Binomial (another form (continuous) of the distribution)
Negative Binomial
Weibull Distribution
Pareto Distribution
Pareto Distribution


F&T book page 7 (values for cumulative probability
distribution given on pp. 175185).
Let X be a random variable which represents the number of
rare events that occur in a time period.
Application: number of car accidents in a week.
We write X Poisson () when X has a Poisson distribution.
Relationship with Binomial r.v.: Let the time interval go to
zero (n ), = n p, then either X takes the values zero
or one w.p. 1 (see tutorial).
303/354

Poisson p.m.f.
0.4
= 1
= 2
= 4
1
0.9
cumultative density function
0.35
Poisson c.d.f.
0.3
0.25
0.2
0.15
0.1
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.05
0
304/354
= 1
= 2
= 4
0.1
0
5
x
10
5
x
When (claim rate) increases E[X ] (expected number of claims)

increases probability mass shifts to the right.
10


Properties of Poisson random variables are:
p.m.f.: pX (x) =
e x
x! ,
for x = 0, 1, . . .;
parameter constraint: > 0;

mean:
X
X
x e
E [X ] = x pX (x) =
x
x!
x=0
all x
x1
X
x=1
z
X
=
=
(x 1)!
z=0
e
= ;
z!
* 0 pX (0) = 0; ** z = x 1 *** using:
P
all x
305/354
pX (x) = 1.


variance:

Var (X ) =E X 2 (E [X ])2 = 2 + 2 = ,
* using:
X
X
x e
E X 2 = x 2 pX (x) =
(x (x 1) + x)
x!
all x
x=0
= + 2
x!
x2
X
x=2
x=0
(x (x 1))
x=0
e
(x 2)!
= + 2
=+ ;
** z = x 2 *** using
306/354
P
all z
pX (z) = 1.
x e
x!
z
X
e
z!
z=0

m.g.f.: MX (t) = exp ( (e t 1)).

Note that:
X
e x
x!
x=0
= e e = 1,
* using the
Pseriesxexpansion for the exponential function (i.e.,
exp() =
x=0 x! ).
The m.g.f. is derived as (note: e tx = (e t )x ):
h i X
X
e x
e ( e t )x
e xt
MX (t) =E e tX =
=
x!
x!
x=0
x=0
=e e e
=
X
e e ( e t )x
x!
|x=0
{z
}
pY (y ) = 1, with Y POI( e t )
all y
307/354
= exp e t 1

Exercise
The expected number of claims for personal accident
insurance is once every ten year.
a. Question: Which distribution would you use to model the
number of claims for an insured in a year?
b. Question: What is the probability of two or more claims
using a Poisson distribution?
c. Question: What are the parameters of the Binomial
distribution?
d. Question: What are the differences between the Poisson
distribution and the Binomial distribution, especially in the
tail?
308/354

Solution
a. Solution: X POI( = 0.1) distribution.
b. Solution: Using a. and the p.m.f. we have:
Pr(X 2) =1 Pr(X < 2) = 1 Pr(X 1)
=1 (Pr(X = 0) + Pr(X = 1))
=
e 0.1 0.10 e 0.1 0.11

+
= 1.1e 0.1 .
0!
1!
c. Solution: We have n = 1. Option 1: Correct estimate the

probability of no claim:
e 0.1 0.10
= 1 e 0.1 0.0995.
0!
Option 2: Correct mean: p = E [X ] /n = 0.1.
d. Solution: The Poisson distribution allows for more claims by
one contract. Therefore, it would have fatter tails.
p = 1 Pr(X = 0) = 1
309/354


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Special case: Exponential distribution

See F&T book, p. 11:
Let X Gamma(, ) and we set = and = 1, then we
have a special case of the Gamma distribution. We say that X
is exponentially distributed: X EXP ().
Application: Three busses an hour on average arrive
randomly at a bus stop. The time elapsed after the previous
bus has arrived doesnt matter for the time the next bus is
arriving. Let X be the r.v. representing the time to the next
bus is arriving.
The density of the r.v. X becomes:
fX (x) = e x , for x 0.
310/354

Exponential p.d.f.
1
= 1
= 2
= 4
0.9
0.9
0.8
cumulative density function
0.8
probability density function
Exponential c.d.f.
1
0.7
0.6
0.5
0.4
0.3
0.7
0.6
0.5
0.4
0.3
0.2
0.2
0.1
0.1
0
0
4
x
311/354
0
0
= 1
= 2
= 4
2
4
x

increases time between claims decreases p.d.f. shifts to left.

Special case: Exponential distribution

One of the interesting properties of the exponential is the
memoryless property:
Pr (X > a + b, X > a)
Pr (X > a)
Pr (X > a + b)
=
Pr (X > a)
R
x dx
a+b e
R
=
x dx
a e
Pr (X > a + b |X > a ) =
e (a+b)
= e b
e a
= Pr (X > b) .
=
312/354
Mean: E[X ] = 1 , Variance: Var (X ) =

1
and m.g.f: MX (t) = 1 t
.
1
,
2

Gamma Distribution

Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Gamma Distribution
Gamma p.d.f.
1
0.9
0.9
0.8
0.8
Gamma c.d.f.
1
= 1, = 1
= 2, = 1
= 4, = 1
0.7
0.6
0.5
0.4
0.3
0.7
0.6
0.5
0.4
0.3
0.2
0.2
0.1
0.1
0
0
4
x
0
0
= 1, = 1
= 2, = 1
= 4, = 1
2
4
x
In insurance claim modelling the Gamma distribution is often

used. We write X Gamma (, ) to denote that we have a
random variable X that has a Gamma distribution with
parameters (shape parameter) and (scale parameter).
Application: the length of time between = 5 accidents, the
claim size for a fire insurance claim.
313/354
F&T book, page 12.

Gamma Distribution
Gamma p.d.f.
0.45
0.4
Gamma c.d.f.
1
= 1, = 0.5
= 2, = 0.4
= 4, = 0.4
0.9
0.8
0.5
0.35
0.3
0.25
0.2
0.15
0.7
0.6
0.5
0.4
0.3
0.1
0.2
0.05
0.1
0
0
314/354
10
x
20
0
0
= 1, = 0.5
= 2, = 0.4
= 4, = 0.4
10
x

increases time between claims decreases p.d.f. shifts to left.
When increases more claims, more time p.d.f. shifts to right.
20

Gamma Distribution
Gamma Distribution
x 1 e x , for x 0, and zero

()
otherwise (note that Gamma random variables are
non-negative).
density: fX (x) =
parameter constraints: > 0, > 0;

mean: E [X ] = ;
variance: Var (X ) =
;
2

m.g.f.: MX (t) = E e Xt = t
,
provided t < (prove: see slide 318);
Proof of mean and variance: Use the moments (see slide 319).
315/354

Gamma Distribution
Gamma function
The Gamma function (see F&T page 5) is defined by:
Z
() =
x 1 e x dx, > 0.
0
One can show the following recursive relationships holds:

( + 1) = ()
(n) = (n 1)!,
(use integration by parts)

for n = 1, 2, 3, . . . .
Exercise: Determine (3) and (1/2).

Solution: (3) = (3 1)! = 2 1
1 = 2 and
R 1/2 x
2
R 2
(1/2) = 0 x
e dx = 0 t e t /2 dt =
R t 2 /2
p
2 0 e
dt = 2 /2 = ,
* using x = t 2 /2, dx = tdt (see slides 328-329).
316/354

Gamma Distribution
Gamma density
To show that the Gamma is a proper density, note that:
Z
Z
x 1 e x dx =
x 1 e x dx
()
()
0
0
and re-parameterising with z = x so that dx = 1 dz, we have:
()
Z
0
(z/)1 e z dz
() 0
=

z 1 e z dz
()
0
|
{z
}
x 1 e x dx =
=()
=1.
317/354

Gamma Distribution
Gamma m.g.f.
To prove the formula for the m.g.f., we have:1
Z
e xt
x 1 e x dx
MX (t) =
()
0
Z
=
x 1 e x(t) dx
()
0
Z
( t) 1 x(t)
x
e
dx
=
( t)
()
0
|
{z
}
R
=1, because
0 fY (y )dy
= 1, with Y Gamma(, t)
and the result follows.

1
318/354
The gamma variable takes non-negative values, so the

integration limits should be from 0 to .

Gamma Distribution
Gamma moments
There is a useful formula for higher (non-central or raw) moments
of the Gamma distribution.
Z
n
x 1 e x dx
E [X ] =
xn
()
0
Z
=
x (n+1) e x dx
()
0
Z n+ (n+1) x
x
e
n
=
(n + )
dx
()
(n + )
0
|
{z
}
R
=1, because
319/354
1 (n + )
.
n
()
0 fY (y )dy
= 1, with Y Gamma(n + , )

Gamma Distribution
Exercise
The Gamma(,) distribution models the time required for
events to occur, given that the events occur randomly in a
Poisson process with a mean time between events of . We
know that major flooding occurs in Queensland on average
every six years. You have to valuate a reinsurance contract
that pays:
- Zero, if there are less than two major floods in the next ten
year;
- $100 million, if there are two major floods in the next ten year;
- $150 million, if there are three or four major floods in the next
ten year;
- $200 million, if there are more than four major floods in the
next ten year.
a. Question: What is the expected value of the contract?

320/354
b. Question: The price of the contract is $65 million, would you

recommend the insurer to buy the contract?

Gamma Distribution
Pr(Gamma(2, 6) 10) = 0.4963,

Pr(Gamma(3, 6) 10) = 0.2340,
Pr(Gamma(4, 6) 10) = 0.0883, and Pr(Gamma(5, 6) 10) = 0.0275.
a. Solution: Let X Gamma(2, 6) the r.v. for the time until
the second claim is filed; Y Gamma(3, 6) the r.v. for the
time until the third claim is filed, and Z Gamma(5, 6) the
r.v. for the time until the fifth claim is filed.
Two or more claims filed in ten years: Pr(X 10) = FX (10).
Probability of exactly two claims:
Pr(X 10) Pr(Y 10) = FX (10) FY (10).
Probability of exactly three or four claims:
Pr(Y 10) Pr(Z 10) = FY (10) FZ (10).
Probability of more than four claims: Pr(Z 10).
(FX (10) FY (10)) 100 + (FY (10) FZ (10)) 150 + FZ (10) 200
=100 FX (10) + 50 FY (10) + 50 FZ (10)
=49.63 + 11.70 + 1.38 = $62.71 million.
321/354

Bernoulli family
Exercises

Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Bernoulli family
Exercises
Exercises
A life insurance company offers an annuity. In order to reduce
longevity risk, the payout after age 90 depends on the number
of survival in the pool. Each pool has 20 insured.
The probability of surviving to 90, conditional on reaching 65 is:
Female Male
Both One Only
Prob surviving to 90 41.2% 29.8% 12.3%
58.7%
You want to buy a joint and survivor annuity, which pay out
$100 if both spouses are alive and $70 if only one is alive.
- The payout is reduced with 20% if for more than 17 contracts
at least one of the spouses is alive.
- The payout is increased with 20% if for less than 10 contracts
at least one of the spouses is alive.
322/354

Bernoulli family
Exercises
Exercises
a. What is the probability that the payout increases when you
reach 90?
b. What is the probability that the payout decreases when you
reach 90?
You want to reduce your risk of a reduction in your payout.
c. How many insurance contract can you buy in order to have a
probability of 5% that none of the contracts will reduce your
payments? (Hint: use Geometric distribution)
d. How many insurance contract do you need to buy in order to
have a probability of 95% that at least 3 the contracts will
increase your payments?
323/354

Bernoulli family
Exercises
Solution
a. Pr(X 9) = 0.0132.
b. Let X Bin(20, 0.71) be the number of contracts with at
least one of the spouses is alive at age 90.
1 Pr(X 17) = 1 0.9567 = 0.0433.
c. Let Y Geo(0.0433) be number of contracts which do not
get a reduction in the payment.
We have: Pr(Y 1) = 0.0433, Pr(Y 2) = 0.0847,
Pr(Y 3) = 0.1244, and Pr(Y 4) = 0.1623.
Thus, you can buy one contracts.
d. Let Z NBin(3, 0.0132) be number of contracts needed to
get a at least 3 contracts with an increase in the payment.
Pr(Z 62) = 0.0489, Pr(Z 63) = 0.0509,
Pr(Z 474) = 0.9496, and Pr(Z 475) = 0.9501.
324/354
Thus, you need to buy 475 contracts.


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution


Continuous distribution;
The normal distribution plays a very central role in
mathematical statistics.

Notation: X N , 2 denotes a normally distributed
random variable with mean (location parameter) and
variance 2 (scale parameter).
Example: the normal distribution approximates the Binomial
distribution when n p is large enough (see week 5).
325/354

The standard Normal (Gaussian) Distribution

Standard Normal: When = 0 and 2 = 1, then we have a
standard normal random variable and we use Z to denote
such, that is, Z N (0, 1).
We can always
standardise a normal random variable
X N , 2 as follows:
Z=
X
N (0, 1) ,
Var (Z ) =
X

Var X
E [Z ] = E
and
=
=
X = Z + .
E[X ]
Var (X )
2
= 0.
= 1.
F&T book, page 11 (values for cumulative probability

distribution given on pages 160-162).
326/354


1
1
density: fX (x) =
exp
2
2
< x < .
2 !
, for
parameter constraints: < < and > 0.

mean: E [X ] = .
variance: Var(X) = 2 .

m.g.f.: MX (t) = E e Xt = exp t +
(prove, see slides 335337).
1
2
2 t 2
Prove of mean and variance: use the m.g.f.!

327/354

Prove of legitimate density (OPTIONAL)

Prove thatZ the normal distribution is a legitimate density by
x 2
1
1
showing:
e 2 ( ) dx = 1.
2
x
and consider the case of the standard
Transform z =
normal where = 0 and 2 = 1.

Consider then the integral:
Z
1 2
1
e 2 z dz.
I =
2
We note that I > 0 and that:

Z
2
Z Z
1
2
2
1
1
2
21 z 2
e
I =
=
dz
e 2 (y +z ) dydz.
2
2
328/354

This double integral can be evaluated by changing to polar

coordinates by setting
y = r cos()
and
z = r sin()
so that

y 2 + z 2 = r 2 sin2 () + cos2 () = r 2
{z
}
|
=1
and

dydz = det
y
r
z
r

drd = det
cos() r sin()
sin() r cos()

drd = rdrd.
(Check your calculus book for verification of this polar coordinate

transformation). We have:

Z 2 Z
Z
r 2
1
1
1 2
2
12 r 2
I =
e
rdrd =
e 2
d =
2 = 1.
2 0
2 0
2
0
0
|
{z
}
329/354
=0(1)=1

Normal p.d.f.
0.45
0.4
Normal c.d.f.
1
= 2, = 1
= 0, = 1
= 2, = 1
0.9
0.8
0.5
0.35
0.3
0.25
0.2
0.15
0.7
0.6
0.5
0.4
0.3
0.1
0.2
0.05
0.1
0
5
330/354
0
x
0
5
= 2, = 1
= 0, = 1
= 2, = 1
0
x
When (average claim size/number of claims) increases p.d.f. shifts

to right. When 2 (variance of claim size/number of claims) increases
p.d.f. shifts away from .

Normal p.d.f.
0.7
Normal c.d.f.
1
= 0, = 0.5
= 0, = 1
= 0, = 2
0.9
0.8
0.8
0.6
0.5
0.4
0.3
0.2
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
5
0.1
0
x
0
5
= 0, = 0.5
= 0, = 1
= 0, = 2
0
x
We can easily verify the following (check from F&T page 160-161):
Pr (1 Z 1) =0.6826
Pr (2 Z 2) =0.9544
Pr (3 Z 3) =0.9974
331/354


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

The Standard Normal distribution table: F&T book pages

160-162. Notation:
(z) = Pr (Z z)
is used to denote the c.d.f. of a standard normal distribution.
For example, if Z N (0, 1), then:
f(x)
Pr (Z 1.56) = (1.56) = 0.9406.

Pr(Z<z1)=1
Pr(Z>z1)=
z
0
x
z1
symmetry property: Pr(Z>z1)=Pr(Z<z)
f(x)
Pr(Z>z)=1
Pr(Z<z)=
332/354
0
x
z1

Example: the Standard Normal Distribution Table

The tables usually gives values only for positive zp but using
the symmetry property, we can easily derive for negative
values.
Note that:
Pr (Z z) = 1 Pr (Z z)
so that, for example:
Pr (Z 1.56) = 1 0.9406 = 0.0594.
We can get probability values like:
Pr (1.12 Z 1.56) = (1.56) (1.12)
=0.9406 (1 0.8686)
=0.8092.
333/354


For non-standard normal distribution, we can always
standardise using the property that if X N , 2 , then
Z=
X
N (0, 1) .
Say, X N (100, 25), then the probability that X will be

between 92 and 112 is:

112 100
92 100
Z
Pr (92 X 112) = Pr
5
5
= (2.4) (1.6)
=0.9918 0.0548 = 0.9370.
334/354


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution


Derive the moment generating function of the normal distribution:
h i
MX (t) =E e Xt

!
Z
1
1
x 2
xt
exp
dx
=
e
2
|
{z
}
=fX (x)
1
1
exp x t
2
2
Next slide: rewrite the blue part.

335/354
2 !
dx.


Consider

1
x 2
x t
2

1
=x t 2 x 2 2x + 2
2
=

1
1 2
|{z}
x 2 + 2 t x 2 2
2
2
2
|
{z
}
2
a
2ba
2
2
1
1
= 2 x + 2 t
2 2 + 2 t
2
2

1
1 2 2
2
2
= 2 x + t
+ t + t .
2
2
336/354
* using (a b)2 = a2 + b 2 2ab, with a = x and b = + 2 t.

From slide 335 we have:

!
Z
1
x 2
1
dx.
exp x t
MX (t) =
2
Using the previous slide, replace the blue part by the red part:

Z
2
1
1 2 2
1
2
MX (t) =
+ t + t
dx
exp 2 x + t
2
2
2
=e (t+ 2
2 t 2
=1, because
1 2 2
=e (t+ 2 t ) .
337/354
1
e
2
R
0
21
{z
x + 2 t
!2
dx
}
fY (y )dy = 1, with Y N( + 2 t, 2 )


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

F&T book, page 14.

Consider X Lognormal , 2 .
Density is:
1
1
exp
fX (x) =
2
x 2
log(x)
2 !
,
Parameter constraints: < < , 0 < < .

1 2
E[X ] = exp +
2
2

2
Var (X ) =e (2+ ) e 1 .
338/354
Note: parameter is not E[X ], also 2 is not Var (X )!
x > 0.


If Y N , 2 and X = e Y then X is lognormal; or
log(X ) N(, 2 ), i.e., log is normally distributed.

X = exp (Y ) Lognormal , 2 is said to have a lognormal
distribution with parameters and 2 .
LogNormal p.d.f.
0.7
LogNormal c.d.f.
1
= 0, = 1
= 0, = 0.5
= 1, = 0.5
0.9
0.8
0.8
0.6
0.5
0.4
0.3
0.2
0.7
0.6
0.5
0.4
0.3
0.2
0.1
339/354
0
0
0.1
5
10
0
0
= 0, = 1
= 0, = 0.5
= 1, = 0.5
5
10

Application: Models of stock prices (or returns in general)

are often based on the lognormal distribution.
Application: This distribution is also often used to model
claim sizes.
Property: Product of independent lognormal random
variables are lognormal (can you explain why?).
Property: To calculate probabilities for a lognormal random
variable, restate them as probabilities about the associated
normal random variable.
340/354
Pr(X a) = Pr(log(X ) log(a))

log(a)
log(X )
= Pr

log(a)
= Pr Z
.

Exercise Lognormal Distribution

Losses from large fires can often be modelled using a
lognormal distribution.
Suppose that the average loss due to fire for buildings of a
particular type is $25 million and the standard deviation of the
loss is $10 million.
Question: Determine the probability that a large fire results
in losses exceeding $40 million.
Solution: Let X be the loss, we have
E[X ] = 25m, Var (X ) = (10m)2 .

Var (X )
2
= log 1 + E[X ]2 = log(1 + 100
625 ) = log(1.16),
= log(E[X ]) 21 2 = log(25)
log(1.16)
.
2
Pr(X >
log (40))
40) = 1 Pr (Y log(1.16)
=
log(40)log(25)+ 2
1Pr Z
= 1(1.4126) = 0.0789.
341/354
log(1.16)


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

F&T book, page 13.

Consider an experiment where all outcomes in a range [a,b]
are equally likely to happen, and outcomes outside this range
have probability zero.
The variable X is called Uniform distributed and we write
X UNIF(a, b).
density: fX (x) =
1
(ba) ,
for a x b, and zero otherwise.
Uniform p.d.f.
Uniform c.d.f.
1
a= 0, b= 0.5
a= 0, b= 2
a= 1, b= 2
0.9
0.8
1.5
0.5
0.7
0.6
0.5
0.4
0.3
0.2
a= 0, b= 0.5
a= 0, b= 2
a= 1, b= 2
0.1
0
342/354
1
x
1
x

cumulative distribution:
Rx
0dx
R
x
1
fX (x)dx =
FX (x) =
a (ba) dx
R
1
dx
Z
a (ba)
= 0,
if x < a;
xa
= ba , if a x b;
= 1,
if x > b.
parameter constraints: a < b.

Z
mean:
E [X ] =
x fX (x)dx
Z
=
a

b
1 x2
a+b
1
dx =
=
.
x
(b a)
2ba a
2
variance:

Var (X ) =E X 2 (E [X ])2

b

Z b
1
a + b 2 1 x3
a + b 2 (b a)2
=
x2
dx
=
=
.
(b a)
2
3ba a
2
12
343/354
a

Beta Distribution
Beta Distribution

Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Beta Distribution
Beta Distribution
We write X Beta (a, b) to denote a Beta random variable X

with parameters a (shape parameter) and b (shape
parameter).
Generally used to model proportions because the range of x is
between 0 and 1
Application: percentage of loss on default of a company on
its debt.
F&T book, page 13.
See Excel file for relation with Binomial (e.g. application on
slide 347).
344/354
Beta function:
R 1 1
(1 x)1 dx =
B(, ) = ()()
(+) = 0 x
* using density of Beta function (next slide),
** if and are integers.
(1)!(1)!
(+1)! .

Beta Distribution
Beta Distribution
Beta Distribution
density: fX (x) =
(a + b) a1
x
(1 x)b1 , for 0 x 1.
(a) (b)
| {z }
1/B(a,b)
parameter constraints: a > 0, b > 0.

Z 1 a1
mean: Z
x
(1 x)b1
E [X ] =
x fX (x)dx =
x
dx
B (a, b)
0
Z 1
1
B (a + 1, b)
=
x a (1 x)b1 dx =
B (a, b) 0
B (a, b)
(a + b) (a + 1) (b)
=
(a) (b) (a + b + 1)
(a + b)
a (a) (b)
a
=
=
(a) (b) (a + b) (a + b)
a+b
variance: Var (X ) =
345/354
ab
.
(a+b)2 (a+b+1)

Beta Distribution
Beta Distribution
Beta p.d.f.
Beta c.d.f.
1
a=
a=
a=
a=
2, b= 4
0.2, b= 1
4, b= 2
0.5, b= 0.5
0.9
0.8
2.5
1.5
0.7
0.6
0.5
0.4
0.3
0.2
0.5
0.1
0
0
346/354
0.5
x
0
0
a=
a=
a=
a=
0.5
x
2, b= 4
0.2, b= 1
4, b= 2
0.5, b= 0.5
When a (number of successes) increases or b (number of failures)

decreases proportion of successes increases p.d.f. shifts to right.

Beta Distribution
Beta Distribution
Application
An insurance company offers nuclear incident insurance for
n = 10 years.
In these ten years there have been x = 3 years with a claim.
The insurer does not price idiosyncratic risk, but does price
systematic risk (i.e., uncertainty in p).
The insurer has only limited information of the true value p.
Assume claims are $1 billion each.
a. Question: What is the price of the contract when the price is
the mean half the standard deviation?
b. Question: What is the price of the contract when the price is
the 75% quantile?
a. Solution: (See Excel file) $0.398705 billion.
347/354
b. Solution: (See Excel file) $0.420471 billion.

Negative Binomial

Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Negative Binomial
Negative binomial (another form of the distribution)

We look at a model of heterogeneous risks.

k +x 1
Pr (X = x) =
p k (1 p)x for x = 0, 1, 2, . . ..
x
Consider an insurance portfolio of risks, e.g., the spectrum of
drivers, from good drivers to bad drivers.
For each, assume the number of claims, conditional on , is
Poisson().
Assume has a Gamma distribution, i.e.,
e u ( u)1 du.
Pr (u < < u + du) =
()
348/354
We have already assumed (X |) is Poisson distributed with

parameter . Or, that (X | = u) Poisson(u). Thus:
ux
Pr (X = x|u < < u + du) = e u .
x!

Negative Binomial
Probability a policyholder chosen at random has x claims is:

Z
ux
LTP
Pr (X = x) =
e u
e u ( u)1 du
x!
()
0

x
1
+x 1
=
x
1+
1+
i.e., NB(p =
, k = ), using:
1+
R +x1 u(+1)
e
du =
0 u

x+1
R z x+1
1
1
e
dz =
1+
1+
0
(+x)
(+1)+x .
dz
= +1
)
(** change of variables: z = u( + 1), du

+x 1
(x + 1)!
1 ( + x)
* using
=
=
.
x
x! ( 1)!
x!
()
349/354


Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

F&T book, page 15.
Application: Survival function: used for modelling lifetimes
(time to failure).
Let X Weibull(c, ) is Weibullly distributed variable.
probability density: fX (x) = c x 1 exp (c x ), for
x > 0, and zero otherwise.
cumulative distribution function:
FX (x) = 1 exp (c x ).

moments: E [X r ] = 1 + r c r1/ .
Parameters: < 1 ( = 1/ > 1): decreasing
(constant/increasing) failure rate over time.
350/354

Pareto Distribution
Pareto Distribution

Gamma Distribution
Bernoulli family
Exercises
Beta Distribution
Beta Distribution
Negative Binomial
Pareto Distribution
Pareto Distribution

Pareto Distribution
Pareto Distribution
Pareto Distribution
Heavy tailed distribution (an extreme value distribution).
Often used for reinsurance purposes. The Pareto distribution
tapers away to zero much more slowly than LogNormal.
Hence, it is more appropriate for estimating reinsurance
premium in respect of very large claims.
F&T book page 1415. Used to model r.v. with very large
values with very low probabilities (e.g. incomes).
Cumulative distribution function ( > 0, > 0):

, x > 0.
FX (x) = 1
+x
351/354
Probability density function:

fX (x) =
=
.
+1
(1 + x/)+1
( + x)

Pareto Distribution
Pareto Distribution
Pareto p.d.f.
=
=
=
=
1.8
1.6
3,
3,
3,
1,
Pareto c.d.f.
=
=
=
=
1.4
1.2
1
0.8
0.6
1
1
2
4
4
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.4
0.2
0.2
0.1
0
0
4
x
352/354
When increases p.d.f. shifts to right.

When increases p.d.f. shifts to left.
0
0
=
=
=
=
2
3,
3,
3,
1,
=
=
=
=
4
1
2
4
4

Pareto Distribution
Pareto Distribution
Pareto Distribution
Moments do not always exist:
E [X r ] =
( r ) (1 + r ) r
,
()
r = 1, 2, and 3, provided r < .
For example:
Var (X ) =
and only exists if > 2.
Prove: see exercise 8.
353/354
2
( 1)2 ( 2)

Pareto Distribution
Pareto Distribution
Software packages (Not in exam)

Distributions are not uniquely specified.
Common differences:
- Geometric (r = 1) & Negative Binomial: change of variables:
z = x r . Support: z 0.
- Exponential distribution: = 1/. Parameter constraint:
> 0.
- Gamma distribution: = 1/. Parameter constraint: > 0.
- Normal & Lognormal distribution defined as: N(, ) and
LN(, ) instead of N(, 2 ) and LN(, 2 ).
- Pareto distribution: z = x + . Support: z > (see exercise
8).
Be careful how to use pre-programmed c.d.f. and p.d.f.

functions in software packages!
354/354
In this course we will follow notation from F&T.

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ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

ACTL2002/ACTL5101 Probability and Statistics

Week 2 Video Lecture Notes

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

Special Discrete Distributions

The Binomial Distribution

The Geometric Distribution

The Negative Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

p.m.f.: pX (x) = p x (1 p)1x , for x = 0, 1, and zero

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

Special Discrete Distributions

The Binomial Distribution

The Geometric Distribution

The Negative Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Binomial Distribution

Suppose we have n independent trials such that there is a

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

probability mass function

probability mass function

probability mass function

probability mass function

The Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

cumulative density function cumulative density function

cumulative density function cumulative density function

The Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

* Using Yi Ber(p) i.i.d. for i = 1, . . . , n.

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Binomial Distribution

Using the binomial expansion (F&T page 2):

for any integer n.

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

Examples of the Binomial Distribution

Question: The probability of one or more accidents in a year

Solution: X =number of insureds with at least one accident

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

Special Discrete Distributions

The Binomial Distribution

The Geometric Distribution

The Negative Binomial Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Geometric Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Geometric Distribution

*PUsing geometric series:

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

The Geometric Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

cumulative density function probability mass function

cumulative density function probability mass function

Example of the Geometric Distribution

ACTL2002/ACTL5101 Probability and Statistics: Week 2 Video Lecture Notes

Special Discrete Distributions

The Binomial Distribution

* 0 pX (0) = 0; z = x 1 * using: