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    Principles of Actuarial Science Games of Chance (1) : Week 1

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    Principles of Actuarial Science Games of Chance (1) : Week 1

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    Principles of Actuarial Science Games of Chance (1) : Week 1

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    Games of Chance I

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    1

    Week 1 1

    Principles of Actuarial Science;


    Games of Chance (1)
    Outline:
    1. Traditional Actuarial Application: Insurance
    2. Principles of Actuarial Science
    3. Probability Basics (Revision?)
    4. Poisson and Binomial Distributions

    Reading
    (Req) Sherris, 1.3-1.4, 2.1-2.3
    (Recc) Sherris 1.1-1.2

    1
    Version: 15 July 2010. Copyright UNSW Actuarial Studies
    2

    Traditional Application of Actuarial Science - Insurance


    What is insurance?
    Examples:
    – Life (Death)
    – Life (Survival)
    – Health
    – Disability
    – Motor
    – House
    – Home Contents
    – Workers Compensation
    Fundamental Idea: Payment(s) that are incurred when a (random) event occurs
    Other actuarial applications: Superannuation, Risk Management
    (Will discuss in much more detail later in the course)
    3

    Discussion
    Consider a life insurance policy that:
    – pays $100 at the end of the year if the policyholder ("Harry P") dies during the year
    – assume that Harry has a 50% chance of dying
    Q: Suppose that you are the actuary of the insurance company. Suggest how you
    would determine the premium of this policy (making any additional assumptions if
    required)
    4

    Basic Principles of Actuarial Science


    Probability and Statistics
    – quantify future uncertainty
    – probability models - Binomial, Poisson, Normal, Log-Normal
    – Survival models
    Risk Pooling
    – Independent Risks
    – Risk Factors (age, sex, smoker status etc)
    Law of Large Numbers
    – Expected values
    – Variability of averages less for pools of independent risks
    5

    Interest Rates
    – Time Value of money
    – economics of interest rates
    – present values
    Risk
    – Utility Theory and Ranking of risky outcomes
    – expected utility principle, certainty equivalents
    6

    Discussion (ctd)
    Suppose the premium for the policy has been set at $55, and that interest rates are
    0.
    What are some of the practical issues the company must now consider? Consider:
    – (i) What to do with the $55 received as a premium?
    (ii) How should this policy be reflected in the company’s financial reports?
    7

    Basic Principles of Actuarial Science (ctd)


    Financial Principles
    – Accounting and Market values
    – Fair Value of Liabilities
    Actuarial Modelling
    – Contingent Cash flows
    – Death, survival, illness, financial asset returns
    8

    Risk Management
    – What is risk?
    – Pooling and Diversification of Risk
    – Experience Rating
    – Profit Sharing
    – Solvency
    Risk Classification
    – Moral Hazard
    Careless or deliberate actions of insured affect payments
    – Adverse Selection
    Worse than average risks have incentives to purchase insurance
    – Information Asymmetry
    9

    Probability and Games of Chance


    Probability
    Permutation and Combinations
    Useful Result: Binomial Theorem:
    Xn
    n n r r
    (x + y)n = x y
    r=0
    r
    Simple method of determining probabilities (where/if possible!):
    – Evaluate all possible equally likely cases
    – Count the Frequency or proportion of times that the event occurs
    10

    Example
    What is the probability of rolling a total of 12 with three dice?
    11

    Sum F requency
    3 1
    4 3
    5 6
    6 10
    7 15
    8 21
    9 25
    10 27
    11 27
    12 25
    13 21
    14 15
    15 10
    16 6
    17 3
    18 1
    T otal 216
    12

    Random Variables
    A random variable X is a function that assigns values to possible outcomes.
    Discrete random variables - fixed number of finite values or countably infinite possible
    values.
    Continuous random variables - values on a continuous scale
    Examples in Actuarial Science:
    – Number of motor vehicle accidents occurring during a particular month
    – Number of lives who die from cancer who are aged 40 last birthday during a par-
    ticular time period.
    – Time until the first accident for a particular car insurance policy
    – Claim payment for a fire insurance policy
    13

    Probability Density and Distribution Functions


    Probability a discrete random variable X takes a particular value x is denoted
    f (x) = P (X = x)
    Probability density has the properties
    X
    f (x) 0 and f (x) = 1
    all x

    Distribution function, (= "cumulative distribution function") of X; is the probability that


    the random variable takes a value less than or equal to a specified value x
    F (x) = Pr (X x)
    14

    For continuous random variables the probability density function (p.d.f.) f (x) is de-
    fined such that
    Z b
    Pr (a X b) = f (x)dx
    a
    with

    Z f (x) 0 for 1<x<1


    1
    f (t)dt = 1
    1

    CDF:
    F (x) = Pr
    Z x(X x)
    = f (t)dt
    1
    15

    Expectation
    Discrete random variable - expectation of a function of a random variable g(X) is
    defined as
    X
    E [g (X)] = g (x) f (x)
    all x

    Continuous random variable


    Z 1
    E [g (X)] = g (x) f (x)dx
    1
    16

    Moments
    Moments (about the origin) of a random variable are defined as
    E [X r ] r = 1; 2; : : :
    First moment (r = 1) is the mean of the distribution of the random variable - usually
    denoted by .
    Discrete random variable
    X
    E [X] = = xf (x)
    all x

    Continuous random variable


    Z 1
    E [X] = = xf (x)dx
    1
    17

    Moments - Variance
    The mean is a measure of central tendency for a distribution.
    The second moment about the mean is referred to as the variance of the distribution.
    2
    Variance usually denoted by
    h i
    2 2
    V ar [X] = = E (X )
    The standard deviation is the square root of the variance, .
    The variance is a measure of dispersion or spread of the distribution.
    18

    Example
    Consider a random variable X which takes the value 1 if Harry P dies and 0 if he
    survives the year.. Find the mean, variance and standard deviation of X:
    19

    Common Distributions in Actuarial Science


    Poisson
    Binomial
    Geometric
    Exponential
    Normal
    Log-Normal
    Weibull
    20

    Poisson Distribution
    The Poisson distribution
    - often used to model the probability of occurrence of rare events such as insurance
    claims
    - also as an approximation for the chance of dying for a small enough parameter .
    P oisson ( )
    x
    e
    Pr (X = x) = x = 0; 1; 2 : : :
    x!
    E [X] =

    V ar [X] =
    21

    Exercise
    Assume that the probability of an insurance claim on a particular insurance policy
    1
    during a year has a Poisson distribution with = 10 :
    Calculate the probability that there will be
    (a) no claims during the year on the policy?
    (b) exactly 2 claims?
    (c) at least one claim?
    22

    Binomial Distribution
    Number of successes (x) in a series of n independent trials where each success has
    probability p.
    In actuarial science
    – probability that a number of lives in a group of lives with the same chance of dying
    will die assuming independence between the lives.
    Binomial (n; p)
    n x
    Pr (X = x) = p (1 p)n x
    x = 0; 1; 2 : : :
    x

    E [X] = np

    V ar [X] = np (1 p)
    23

    Example
    Suppose we have 100 policyholders, each with a probability of 0.2 of dying within the
    next year. What is the probability that we observe a total of 10 or less deaths by the
    end of the year?

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