ACTL30001 Actuarial Modeling I

Prof. Shuanming Li

Centre for Actuarial Studies

Department of Economics
The University of Melbourne

Semester I, 2022
c Shuanming Li, 2022

Unit 0: Preliminaries
This preliminaries summarize important results, concepts, and techniques that may used in this subject,
please read this note in the first few weeks

1. Conditional probability formula:

P(A ∩ B)
P(A|B) = ,
P(B)
P(A|B) = P(A|B, C)P(C|B), if A ⊂ C.

2. P(A ∪ B) = P(A) + P(Ac )P(B|Ac ).

3. Total probability formula: Suppose A 1 , A2 , . . . , An are such that Ai ∩ Aj = ∅, and ∪ni=1 Ai = Ω, then
n
X
P(B) = P(Ai )P(B|Ai),
i=1
n
X
P(B|C) = P(B|Ai , C)P(Ai |C).
i=1

4. Let X > 0 be a continuous r.v. with cdf F (x) and pdf f (x). Then
Rx
[1] F (x) = P(X ≤ x) = 0
f (y)dy [2] f (x) = F 0 (x)
R x+h
[3] P(x < X < x + h) = x
f (y)dy = F (x + h) − F (x) ≈ f (x)h, if h is very small.
R∞
[4] E[X n ] = 0
xn f (x)dx

1
5. Let X be a discrete r.v. with probability function f (x) = P(X = x), x = 0, 1, 2, . . . , and cdf F (x).
Px
[1] F (x) = y=0
f (y), x = 0, 1, 2, . . . , is a non-decreasing, right continuous, step function.

[2] f (x) = F (x) − F (x−), x ≥ 0.

P∞
[3] E[X n ] = x=1
xn f (x), n ∈ N.

6. Let X and Y be two random variables and A be an real number set.

 
P(X ∈ A) = E P(X ∈ A|Y ) ,
 
E[X] = E E(X|Y ) ,
Var[X] = E[Var(X|Y )] + Var[E(X|Y )].
In particular, if Y is a continuous random variable with PDF g(y), y ≥ 0, then
Z ∞
 
P(X ∈ A) = E P(X ∈ A|Y ) = P(X ∈ A|Y = y)g(y)dy,
0
Z ∞
 
E[X] = E E(X|Y ) = E(X|Y = y)g(y)dy,
0
Var[X] = E[Var(X|Y )] + Var[E(X|Y )]
Z ∞ Z ∞

2 
= Var(X|Y = y)g(y)dy + E2 (X|Y = y) − E(X|Y = y) g(y)dy;
0 0

2
if Y is a continuous random variable with probability mass function g(y), y = 0, 1, 2, . . ., then
∞
  X
P(X ∈ A) = E P(X ∈ A|Y ) = P(X ∈ A|Y = y)g(y),
y=0
∞
  X
E[X] = E E(X|Y ) = E(X|Y = y)g(y),
y=0
Var[X] = E[Var(X|Y )] + Var[E(X|Y )]
∞ ∞
X X  2

2 
= Var(X|Y = y)g(y) + E (X|Y = y) − E(X|Y = y) g(y).
y=0 y=0

Example: Let Y ∼Poisson(λ) representing the number of claims from a risk in a year. For each
claim, the probability that it is a large claim is p and the probability that it is a small claim is q = 1 − p.
Denote X to be number of large claims from this risk in a year. Then

(a) X|Y = n ∼ Bin(n, p)

(b) E[X] = λp

(c) Var[X] = λp

(d) X ∼Poisson(λp).
7. Let X ∼ F (x) and X ≥ 0. Then
Z ∞
E[φ(X)] = φ(0) + φ0 (x)[1 − F (x)]dx,
0
where φ(x) is a differentiable or piecewise differentiable function with E[φ(X)] < ∞. This is true
for any random variable X ≥ 0 no matter it is of continuous-type, discrete-type, or mixed-type. See
Tutorial 0 for a proof.
Remarks:
1 In particular, if φ(x) = x n , then
Z ∞
n
E[X ] = n xn−1 [1 − F (x)]dx, n > 0.
0
This is true for any positive n (not necessarily an integer).
2 If X is a discrete r.v. taking values 0, 1, 2, . . . , then
∞
X
n
E[X ] = [(k + 1)n − k n ][1 − F (k)].
k=0

3 Let Y = min(X, a) where a > 0. Then

Z a
n
E[Y ] = n xn−1 [1 − F (x)]dx.
0
Further, let X be a discrete r.v. taking values 0, 1, 2, . . . , and let Y = min(X, m) where m is a
positive integer. Then
m−1
X
E[Y n ] = [(k + 1)n − k n][1 − F (k)].
k=0

3
8. Let X ∼ exp(λ1 ), Y ∼ exp(λ2 ) and X⊥Y . Then
λ1 λ2
P(X < Y ) = , P(X > Y ) = .
λ1 + λ2 λ1 + λ2

9. Let X1 , X2 , . . . , Xn be i.i.d following CDF F and PDF f . Define Y = max(X 1 , X2 , . . . , Xn ) and

Z = min(X1 , X2 , . . . , Xn ). Then
G(y) = P(Y ≤ y) = [F (y)]n ,
g(y) = n[F (y)]n−1 f (y),
H(z) = P(Z ≤ x) = 1 − [1 − F (z)]n ,
h(z) = n[1 − F (z)]n−1 f (z).
Remarks:
(a) If Xi ∼ exp(λ), then Z ∼ exp(nλ).
(b) If Xi ∼ U (0, 1), with F (x) = x, f (x) = 1, 0 < x < 1, then g(y) = ny n−1 , 0 < y < 1, that is
to say, Y ∼ Beta(n, 1), and h(z) = n(1 − z)n−1 , 0 < z < 1, that is to say, Z ∼ Beta(1, n).

10 Some Inequalities:
e−x > 1 − x, x > 0,
− ln(1 − x) > x, 0 < x < 1,
1
x(1 − x) ≤ , 0 ≤ x ≤ 1.
4

4
11 Let X1 , X2 , . . . , Xn be independent random variables with X i following an exponential with parameter
λi . Then
Pn
(a) min(X1 , X2 , . . . , Xn ) ∼ Exp( i=1
λi ).
(b) The probability that Xj is the smallest is given by
λ
Pn j


P Xj = min(X1 , X2 , . . . , Xn ) = .
λ
i=1 i
Pn
(c) If λi 6= λj for i 6= j, then S = i=1
Xi is said to following a hyperexponential distribution with
pdf
n
X
fS (x) = Ci,n λi e−λi x , x > 0,
i=1
Qn λj
where Ci,n = j=1,j6=i λj −λi
. In particular, when n = 2,

λ1 λ2
fS (x) = λ2 e−λ2 x + λ1 e−λ1 x .
λ1 − λ2 λ2 − λ1

(d) IF λi = λj = λ, then S ∼ Γ(n, λ), this distribution is also called the Erlang(n) distribution.
(e) If λ1 , λ2 , . . . , λn may not be distinct, S is said to follow a generalised Erlang(n) distribution.

5
12. Review of continuous payment of cash-flow with rate a(t).
Let a(t) be the rate of a continuous payment at time t and A(t) be the total payment up to t. Then
(a) A(s + ds) − A(s) ≈ a(s)ds is the (approximately) total payment over the small interval (s, s + ds).
Rt
(b) A(t) = 0
a(s)ds is the total payments up to time t from time 0.
(c) dA(t) = a(t)dt.

13. Review of the force of interest

Let A(t) be the accumulation function of an account at time t. The force of interest of A(t) is defined
to be
dA(t)
A(t + dt) − A(t) A0 (t) d ln A(t)
δ(t) = lim = dt = = .
dt→0 A(t)dt A(t) A(t) dt
The force of interest is also called the continuous interest rate, the instantaneous rate of interest. Then
• A(t + dt) − A(t) ≈ A(t)δ(t)dt, if dt is very small.
• Let a(t) be the rate of a continuous payment at time t and let δ(t) be the force of interest. Then
present value of the continuous payment from 0 to time t is
Z t Rs
− δ(y)dy
Ā(t) = e 0 a(s)ds.
0

The accumulated value of the continuous payment up to time t is

Z t Rt
δ(y)dy
A(t) = e s a(s)ds.
0

6
14. Weighted average of a function f on [a, b].
Let f be a function on [a, b] and w(x) ≥ 0. Define
Rb
a
w(x)f (x)dx
Rb
w(x)dx
a
to be the weighted average of f on [a, b]. In particular, if w(x) = 1, then
Rb Rb
a
f (x)dx a
f (x)dx
Rb =
dx b−a
a

is called the average of f on [a, b].

15. Arithmetic weighted average of x 1 , x2 , . . . , xn

Let w1, w2 , . . . , wn be non-negative real numbers. Then
Pn
wi xi
Pi=1
n
i=1
wi
Pn
is called the arithmetic weighted average of x 1 , x2 , . . . , xn . In particular, if w i = 1/n, then i=1
xi /n
is the average of x 1 , x2 , . . . , xn .

16. Geometric weighted average of x 1 , x2 , . . . , xn

Pn Qn
Let w1 , w2 , . . . , wn be such that wi ≥ 0 and w = 1. Then
i=1 i i=1
xw i
i is the geometric weighted
average of x1 , x2 , . . . , xn . Further
n n
X Y
wi xi ≥ xw
i .
i

i=1 i=1

7
17. Change the order of double summation, integration, and product

The technique of changing the order of summation, integration and product is frequently used in this subject
to simplify calculations. Here just gives some examples.

Pb Pd Pd Pb
1. x=a y=c
f (x, y) = y=c x=a
f (x, y).
When the upper and lower bound for both the inner and outer summation are constants, just change
the order without changing the lower and upper bounds.
Pa Pa Pa Py
2. x=0 y=x
f (x, y) = y=0 x=0
f (x, y).

3.
100 200−x 200 min{y,200−y}
X X X X
f (x, y) = f (x, y)
x=0 y=x y=0 x=0
100 min{y,200−y} 200 min{y,200−y}
X X X X
= f (x, y) + f (x, y)
y=0 x=0 y=101 x=0
100 y 200 200−y
X X X X
= f (x, y) + f (x, y) .
y=0 x=0 y=101 x=0

8
4.
a y+a 2a min{x,a}
X X X X
f (x, y) = f (x, y)
y=0 x=y x=0 y=max{0,x−a}
a min{x,a} 2a min{x,a}
X X X X
= f (x, y) + f (x, y)
x=0 y=max{0,x−a} x=a+1 y=max{0,x−a}
a x 2a a
X X X X
= f (x, y) + f (x, y).
x=0 y=0 x=a+1 y=x−a

R 1 R √x R 1 R √y
5. 0 x2
f (x, y)dydx = 0 y2
f (x, y)dxdy.

6.
Z 2Z x2 Z 4Z 2
f (x, y)dydx = f (x, y)dxdy
√
1 0 0 max{1, y}
Z 1Z 2
= f (x, y)dxdy
√
0 max{1, y}
4
Z Z 2
+ f (x, y)dxdy
√
1 max{1, y}
Z 1Z 2 Z 4Z 2
= f (x, y)dxdy + f (x, y)dxdy .
√
0 2 1 y
18: Ordinary Differential Equations (ODEs)

In this part, we give a very brief introduction to linear ordinary differential equations (ODEs). These ODEs
are very important in studying Markov models.

18.1. First order differential equations

f 0 (t) = a(t)f (t) + b(t), t ≥ 0, (18.1)

where a(t) and b(t) are two known functions and f (0) is known.
◦
Example 1: ex satisfies the following ODE:
d ◦ ◦
ex = µx ex − 1.
dx
Example 2: t px satisfies the following ODE:
d
t px = − t pxµx+t .
dt
Example 3: t px satisfies the following ODE:
d
t px = t px (µx − µx+t ).
dx

9
Integrating factor method to solve ODE (18.1)
Rt
− a(s)ds
Let I(t) = e 0 . Clearly I 0 (t) = −a(t)I(t) with I(0) = 1. Multiplying both sides of f 0 (t) =
a(t)f (t) + b(t) by I(t) :
I(t)f 0 (t) = a(t)I(t)f (t) + I(t)b(t) ⇐⇒ I(t)f 0 (t) − a(t)I(t)f (t) = I(t)b(t)
Z t
0
⇐⇒ [I(t)f (t)] = I(t)b(t) =⇒ I(t)f (t) = I(0)f (0) + I(s)b(s)ds.
0
This in turn means that
Z t
I(0) 1
f (t) = f (0) + I(s)b(s)ds
I(t) I(t) 0
Rt Rt Z t Rs
a(s)ds a(s)ds − a(u)du
= f (0)e 0 +e 0 e 0 b(s)ds. (18.2)
0

Equation (4.2) can be rewritten as

Rt Z t Rt
a(s)ds a(u)du
f (t) = f (0)e 0 + e s b(s)ds. (18.3)
0

Remark: If a(t) ≡ a, then

Z t Z t
y(t) = y(0)e + at
e a(t−s)
b(s)ds = y(0)e + e at at
e−as b(s)ds.
0 0

10
Interpretation of the ODE f 0 (t) = a(t)f (t) + b(t) and its solution

• An amount of money f (0) is deposited into an account at time 0;

• The account earns interest continuously at rate a(t), where a(t) is the force of interest at time t;

• More funds are deposited into the account in a continuouse fashion at rate b(t);

• Let f (t) be the total amount of money in the account at time t.

Interpretation of the ODE

In a small time interval [t, t + h], we have

f (t + h) − f (t) ≈ a(t)f (t)h + b(t)h. (1)
Divide by h, let h → 0 and use
f (t + h) − f (t)
lim = f 0 (t)
h→0 h
to get the ODE:
f 0 (t) = a(t)f (t) + b(t).

11
Interpretation of its solution in (18.3)

Recall:
Rt Z t Rt
a(s)ds a(u)du
f (t) = f (0)e 0 + e s b(s)ds.
0

1. The first term says that the amount f (0) has reached a value
Rt
a(s)ds
f (0)e 0 ;

2. the amount b(s)ds deposited in the interval (s − ds, s) has reached a value
Rt
a(u)du
e s b(s)ds;

3. the second term is the accumulated value (from time 0 to time t) of the continuous payment at rate
b(s) at time s.

12
18.2: Second order ODEs with constant coefficients

Let f (t) satisfy

f 00 (t) + bf 0 (t) + cf (t) = 0, (18.4)
where b and c are constants.

The characteristic equation: r 2 + br + c = 0.

Remark: If f (t) = ert satisfies (18.4), then r has to satisfy the characteristic equation above.

Theorem: For ODE in (18.4) with characteristic equation a 2 + ba + c = 0,

1. if ∆ = b2 − 4c > 0, i.e., r 2 + br + c = 0 has two distinct solutions

p p
−b + b2 − 4c −b − b2 − 4c
r1 = , r2 = ,
2 2
then all solutions to ODE (18.4) are of the form:
f (t) = k1 er1 t + k2 er2 t ,
where k1 and k2 are two constants to be dertermined;

2. if ∆ = b2 − 4c = 0, i.e., r 2 + br + c = 0 has one double solution r = −b/2, then all solutions to

ODE (18.4) are of the form:
f (t) = k1 ert + k2 tert ,
where k1 and k2 are two constants.

13
Remarks:

• To determine k1 and k2, we need extra conditions. For example for case 1, if f (0) and f 0 (0) are
given, we can determine k1 and k2 by solving the following equations:
k1 + k2 = f (0),
k1 a1 + k2 a2 = f 0 (0).

• If ∆ = b2 − 4c < 0, r 2 + br + c = 0 has two complex solutions, e.g.,

p p
−b + b2 − 4c −b 4c − b2
r1 = = + i = d1 + id2 ,
p2 2 p 2
−b − b2 − 4c −b 4c − b2
r2 = = − i = d1 − id2 ,
2 2 2
all solutions to ODE (18.4) are of the form:
f (t) = k1 ed1 t cos(d2 t) + k2 ed1 t sin(d2 t).

Example 1: Solve the following second-order ODE

f 00 (t) − f (t) = 0
with f (0) = 1, f 0 (0) = 0.
Solution:

1. The characteristic equation r 2 = 1 has two solutions r 1 = 1, r2 = −1.

2. The general solution is f (t) = k 1 et + k2 e−t .

3. k1 and k2 satisfies k 1 + k2 = 1, k1 − k2 = 0 which gives k1 = k2 = 0.5.

14
Example 2: Solve the following second order ODE
f 00 (t) + 4f 0 (t) + 4f (t) = 0
with f (0) = 1 and f 0 (0) = 3.
Solution:

1. The equation r 2 + 4r + 4 = 0 has a double solution r 1 = r2 = a = −2.

2. The general solution is f (t) = k 1 e−2t + k2 te−2t .

3. k1 and k2 satisfies k 1 = 1, −2k1 + k2 = 3 which gives k2 = 5.

18.3 A pair of ODE's with constant coefficients

Let us consider the following pair of ODE's:
f 0 (t) = af (t) + bg(t),
n
(a)
g 0 (t) = cf (t) + dg(t), (b)
with f (0) = y1 and g(0) = y2 .
Solution:

• f (t) satisfies the following 2nd order ODE which can be solved using the method in 18.2:
f 00 (t) = (a + d)f 0 (t) + (bc − ad)f (t).

• The initial conditions are: f (0) = y 1 , f 0 (0) = ay1 + by2 .

• Once f (t) is solved, g(t) can be calculated from Equation (a) as

1 0 
g(t) = f (t) − af (t) .
b

15
19. Simulation of random variables

19.1. Simulation of a discrete random variable

P∞
Let pj = P(X = xj ), j = 0, 1, 2, . . . , with j=0
pj = 1.

We want to generate values of X using random numbers generated from U (0, 1).

Procedure: Let u be a random number generated from U (0, 1).

1. X = x0 , if P
u < p 0;
j−1 Pj
2. X = xj , if i=0 i
p ≤ u < p , for j = 1, 2, . . . .
i=0 j

Proof: If U ∼ U (0, 1), P(a ≤ U < b) = b − a then

P(X = x0 ) = p0 = P(U < p0 ),
j−1 j
X X

P(X = xj ) = pj = P pi ≤ U < pi .
i=0 i=0

Example: Let X ∼ Possion(1). Then

P(X = 0) = e−1 = 0.3679,
P(X = 1) = e−1 = 0.3679 =⇒ P(X ≤ 1) = 0.7538,
P(X = 2) = e−1 /2 = 0.1839 =⇒ P(X ≤ 2) = 0.9197.
If u = 0.251, then X = 0

if u = 0.822, then X = 2

16
19.2. Simulation of a continuous r.v

Let F be a continuous CDF F and let U ∼ U (0, 1). Define r.v. X by

X = F −1 (U ).
Then X ∼ F, since
P(X ≤ x) = P(F −1 (U ) ≤ x) = P(U ≤ F (x)) = F (x).

If u is a random number generated from U (0, 1), then x = F−1 (u) is random number
generated from distribution F .

Example: Let X ∼ Exp(λ) with CDF F (x) = 1 − e−λx , x > 0. Then

x = F −1(u) = − ln(1 − u)/λ

is a random number generated from distribution F .

17
19.3. Generalized Inverse Method to Simulate of a general random variable

Let random variable X be a general random variable (discrete, or continuouse, or mixed)

following CDF F (x). Let u ∈ [0, 1] and define
x = F −1(u) := min{y : F (y) > u}.
Then x = F −1 (u) is called the generalised inverse function of F . Further if u is a random
number generated from U (0, 1), then x = F −1 (u) is a simulated value for X, or a
simulated value for distribution F .

Remarks:

• If X is a discrete random variable taking values x0 , x1, . . . , xk , . . . , with pj = P(X =

xj ), then

x0 , if 0 ≤ u < p0 ,
x = F −1(u) = Pj−1 Pj
xj , if p
i=0 i ≤ u < i=0 pj .

• If X is a continuous random variable with CDF F (x), then the generalised inverse is
the usual inverse, with
F −1 (u) = {x : F (x) = u}.

18
20. Hazard rate function of a continuous random variable
Let X ≥ 0 be a continuous random variable with pdf f (x), cdf F (x), and survival function S(x) = 1−F (x).
Define
f (x)
µx =
S(x)
to be the hazard rate function of X. Then R x
− µy dy
S(x) = e 0 .
21. Hazard function of a discrete random variable
Let X be a discrete random variable taking values 0 < x 1 < x2 < . . . < xk with pmf f (xj ) = P(X =
xj ), j = 1, 2, 3, . . . , and cdf F (x) = 1 − S(x) = P(X ≤ x), with F (0) = 0. Define
P(X = xj ) F (xj ) − F (xj −)
λj = P(X = xj |X ≥ xj ) = = .
P(X ≥ xj ) 1 − F (xj −)
λj (0 < λj < 1) is called the Hazard function of X at x j .
Show that
1. For j = 1, 2, . . . , k,
1 − F (xj ) S(xj )
1 − λj = = ,
1 − F (xj−1 ) S(xj−1 )
where x0 = 0.
Qr
2. j=1
(1 − λj ) = P(X > xr ) = 1 − F (xr ) = S(xr ), r = 1, 2, . . . , k.

3. For a general value x > 0,

jx
Y
S(x) = 1 − F (x) = P(X > x) = (1 − λj ), jx = max{j : xj ≤ x},
j=1
where jx is the number of x1 , x2 , . . . , xk less than x.

19
22. Proper random variables and defective random variables

22.1 Proper random variables

If X ∼ F, with pdf or pmf f (x). If

F (∞) = P(X < ∞) = 1,
then X is called a proper random variable.

Remarks:

• X only takes finite values, i.e., P(X = ∞) = 0.

R∞
• If X is a proper continuous random variable with pdf f (x), then P(X < ∞) = −∞
f (x)dx = 1.

P
• If X is a proper discrete random variable with pmf f (x), then P(X < ∞) = f (x) = 1.

22.2 Defective random variables

Definition: τ is called a defective random variable, if

P(τ < ∞) < 1 ⇐⇒ P(τ = ∞) > 0.
In particular, if τ is a defective discrete random variable taking non-negative integer values, then
∞
X
P(τ < ∞) = P(τ = k) < 1.
k=0

20