LOSS DISTRIBUTION

BAS 310-Risk Theory for Actuarial Science

Lecturer: Mr. Saviour Chibeti

August 3, 2022

1 Review of Random variables and MGFs

1.1 Random Variables and some Functions

Denition 1.1.1. A random variable is a function that assigns a numerical value to every
possible outcome.
Attaching probabilities to the various outcomes allows us to quantify our expectations and
the risk of not meeting them.
Denition 1.1.2. Let X be a random variable . Then the probability that X is less than or
equal to a given number is called the cumulative distribution function. We denote the cumulative
frequency distribution fuction of X by
Fx (x) or F (x)
i.e F (x) = P (X ≤ x)
We abbreviate the cumulative distribution function as cdf.
The cdf must satisfy a number of conditions;
1. 0 ≤ F (x) ≤ 1 for all x.
2. F (x) is non-decreasing.
3. F (x) is right- continuous.
4. lim F (x) = 0 and lim F (x) = 1
x→−∞ x→∞

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 In risk theory, the cdf represents the probability that a given loss size will be less than or
equal to x.
In the continuous case
Z x
F (x) = f (x)dx.
o
Denition 1.1.3. The set of numbers that are possible values of the random variables is called
the support.
Denition 1.1.4. A random variable;
1. Is said to be discrete if the support contains at most a countable number of values .
2. Is said to be continuous if the distribution function is continuous and dierentiable ev-
erywhere with the possible exception of a countable number of values.
3. Is called mixed if it is continuous everywhere with the exception of atleast one value
and atmost a countable number of values , thus, it is not discrete. In other words we
say that a distribution function F of mixed type is a combination of the discrete and
continuous types, being continuous and dierentiable apart from at a nite or countable
set of exception points.
Denition 1.1.5. Let X be a random variable. The survival function, usually denoted by S(x)
is the probability that X is greater than a number , say x. That is;
S(x) = P (X > x) = 1 − F (x).
As a result of the above denition , we have;
1. 0 ≤ S(x) ≤ 1 for all x.
2. S(x) is non-increasing.
3. S(x) is right- continuous.
4. lim S(x) = 1 and lim S(x) = 0
x→−∞ x→∞

It is very much possible for the survival function to jump (down) since it need not be left -
continuous.
From the denition of the survival function, we note that it is the complement of the distribution
function, and therefore knowledge of one implies knowledge of the other. Normally, when the
random variable measures time, it is best to use the survival function, while when it's measuring
currency, the distribution function can be presented.
We can either use the survival function or the distribution function to determine probabilities.
P (a < X ≤ b) = F (b) − F (a) = S(a) − S(b)
Denition 1.1.6. The probability density function, also called the density function and usually
denoted as f (x) or fx (x), is the derivative of the distribution function . Mathematically
f (x) = F ′ (x) = −S ′ (x)
Denition 1.1.7. The probability mass function also called the probability function P (x), de-
scribes the probability at distinct points when it is not 0.
Mathematically,
P (x) = P (X = x)

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1.2 Moments

As an actuary, you might be interested in nding the average amount paid on a claim that
is subject to a policy limit and the notion of moments helps us to understand the subject at
hand. The method of moments can be used to t distribution to sets of data.
Denition 1.2.1. Let X be a random variable. Then the nth moment of X is dened to be the
expected value of X n .
Mathematically,
µ′n = E[X n ]
If n = 1, we have E[x], that is the rst moment, If n = 2, we have the second moment , E[x2 ].
By the denition of expectation, we can dene the nth moment as,
Z ∞
µ′n n
= E[x ] = xn f (x)dx
−∞

For the continuous case. For the discrete we have,

X
µ′n = E[xn ] = xj P (xj )
j

Where the sum is taken to be over all xj with positive probability.

From the denition above , we can have a situation where the integral or sum will not
converge and if that happens, the moment is said not to exist.
Denition 1.2.2. The nth central moment of a random variable is dened as the expected value
of the nth power of the deviation of the variable from the mean. Mathematically,
µn = E[(x − µ)n ].
If we have that n = 2, we have the second central moment called the variance and it is
denoted as σ 2 or Var(x). It's square root ,σ is called the standard deviation. The ratio of the
standard deviation to the mean is called the coecient of variation.
By the denition of expectation , we dene the nth central moment as
Z ∞
n
µn = E[(x − µ) ] = (x − µ)n f (x)dx
−∞

for the continuous case and for the discrete case, we write
X
µn = E[(x − µ)n ] = (x − µ)n P (x)dx
j

A straight forward computation of the moments often turns out to be dicult or sometimes
impossible. We now present a method that will facilitate in calculating the moments called the
moment generating function abbreviated as MGF's.
Consider a portfolio of insurance risk that are covered by an insurance company's policies. The
total claims paid by the insurance company on all policies are the sum of all payments made
by the insurer . If the random variable X represents the amount of single randomly selected
claim and E(x) represents the mean claim for all risks in the portfolio. then if we assume that
the total claims is given by,
Y = X1 + X 2 + · · · + Xk .
Where Xk′ s are claims, it is useful to be able to determine the properties of Y .

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Denition 1.2.3. Let X be a random variable. the moment generating function of X is a
function Mx (t) dened as
Mx (t) = E[etx ]

If there exists a constant λ > 0 such that Mx (t) is nite for some t ∈ [−λ, λ] then we can say
that the moment generating function of X exists.
Example 1.2.4. For the random variable stated . Compute the MGF's
(a) X is a discrete random variable, with the PMF
(
1
3
k=1
Px (k) = 2
3
k=2

(b) Y is a uniform (0, 1) random variable

Solutions
(a) for the random variable X , we have the denition
Mx (t) = E[etx ]
2
X
= Px (k) · etx
k=1
1 2
= et + e2t
3 3
Which is well dened for all t ∈ R.
(b) For the random variable Y , we can write
MY (t) = E[ety ]
Z 1
= f (y)ety dy
Z0 1
= ety dy
0
 t 1
e
=
t 0

et − 1
=
t

We also note that MY (0) = E[e0·Y ] = 1, thus MY (t) is also denes for all t ∈ R.
Moment generating functions are useful because they give us all the moments of X , they
are also important because they uniquely determine the distribution.

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2 Finding Moments from MGF
The moment µ′n is the nth derivative of the Mx (t) evaluated at the origin, t = 0, that is,
µ′ = Mn(n) (0)
Recall that
∞
x 2 x3 X xn
x
e =1+x+ + + ··· = (1)
2! 3! n=0
n!

From 1, we have that,

∞ ∞
X (tx)n X xn tn
etx = =
n=0
n! n=0
n!

The nth moment of the random variable X is the coecient of tn

n!
in the taylor series expansion
of Mx (t).
Proposition 2.0.1. Let X be a random variable. The probability of X is uniquely dened by
MGF.

2.1 Properties of MGF's

1. Let X1 , X2 , . . . Xn be independent random variables and MX1 (t), MX2 (t), . . . , MXn (t) be
the MGF's of X1 , X2 , . . . Xn . then the MGF of the sum of the random variables
Y = X1 + X2 + . . . Xn
is the product of the individual MGF's. That is,
MY (t) = MX1 (t) · MX2 (t) · . . . . . . · MXn (t)

Proof
By the denition of MGF's , we have that
MY (t) = E[etY ]
= E[et(X1 +X2 +...+Xn ) ]
By the properties of an exponential function we have,
MY (t) = E[etX1 · etX2 · . . . . . . · etXn ]
By the properties of the expectations,
MY (t) = E[etX1 ] · E[etX2 ] · . . . . . . · E[etXn ]
= MX1 (t) · MX2 (t) · . . . . . . · MXn (t)

2. Let X be a random variable. Then for the constants a and b , the MGF's of the linear
transformation Y = aX + b is given by
MY (t) = E[etY ]
= ebt MX at

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Maximum Likelihood function

In BAS260, statistical inference , we discussed maximum likelihood functions of a random

variable. Here we have a review of maximum likelihood estimation. The method of maximum
likelihood estimation can also be used to t distributions to sets of data.
Denition 2.1.1. The likelihood function of a random variable , X , is the probability (or
PDF) of observing what is observed given a hypothetical value of a parameter , θ.
n
P (X = Xi |θ), for discrete random variable
Y
L(θ) =
i=1
n
f (X = Xi |θ), for continuous random variable
Y
L(θ) =
i=1

Denition 2.1.2. The maximum likelihood function (estimation) of a random variable is one
that yields the highest probability. That is the maximum likelihood estimate (MLE) maximises
the likelihood function.
The steps involved in nding a maximum likelihood estimate (MLE) are as follows.
1. For the set of known values x1 , x2 , . . . xn , the likelihood function can be written as
n
P (X = Xi |θ) = f (x1 ) · f (x2 ) · . . . · f (xn ), for discrete random variable
Y
L(θ) =
i=1
n
f (X = Xi |θ) = P (x1 ) · P (x2 ) · . . . · P (xn ), for continuous random variable
Y
L(θ) =
i=1

2. For the likelihood function in (1), take the natural logs and this will simplify the algebra.
3. Dierentiate the log-likelihood function with respect to each of the unknown parameters
and set the resulting expression(s) equal to zero.
4. Solve the resulting equations(s) to nd the MLE's of the parameters.
Example 2.1.3. An insurance company uses an exponential distribution to model the cost of
repairing insured vehicles that are involved in accidents. Find the maximum likelihood estimate
of the mean cost, given that the average cost of repairing a sample of 1, 000 vehicles was K2, 200.
Solution
Suppose that x1 , x2 , . . . , xn denote the individual repair costs. Now we have 1, 000 vehicles,
that is, n = 1, 000. Now following the steps, we rst compute the likelihood. Since the com-
pany uses an exponential distribution, the distribution is given by
f (x) = λe−λx ,
thus the likelihood function is given by
n
Y
L(λ) = f (x|λ)
i=1
Yn
= λe−λxi
i=1
n −λ n
P
=λ e i=1 xi

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To simplify the algebra, we take the log of the likelihood function, that is
n
X
ln L = n ln λ − λ xi
i=1

We now dierentiate the above expression

 n 
∂ ∂ X
ln L = LL = n ln λ − λ xi
∂λ ∂λ i=1
n
n X
= − xi
λ i=1

Setting the above expression to zero, we have

n
n X
LL = − xi = 0
λ i=1
n
n X
=⇒ 0 = − xi
λ i=1
1
=⇒ λ =
1 Pn
xi
n i=1
1
λ=
x̄
The average of repairing a sample of 1, 000 vehicles x̄ = 2, 200

We now have that

1
λ=
x̄
1
=
2, 200

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Quantiles

Let X be a random variable. Then the characteristics of the distribution of X can also be
described using quantiles. When X has a continuous distribution, the associated quantile is
the solution of the equation
FX (πp ) = p,

for a given fraction 0 ≤ p ≤ 1.

The median, for example, is located in the middle of the distribution, and we denote it as
π0.5 . We dene a percentile as a type of quantile and a 100p percentile is the number such that
100 × p percent of the data is below it. For a random variable X , we say that it is the smallest
value below which the probability of not surpassing it is p percent; a 100 × p percentile is the
number below which 100% of the data falls.
Example 2.1.4. Let X be a continuous random variable with density function give by
for x > 0
(
λe−λx
f (x) =
0 elsewhere.
If the median of this distribution is 1/3, compute λ.
Solution
Given the above probability density function, we rst compute the cdf by integrating the pdf,
we have
Z ∞
F (x) = f (x)dx
Z0 ∞
= λe−λx dx
0
= 1 − e−λx

So we have that F (π0.5 ) = 0.5, so that

F (π0.5 ) = 0.5
=⇒ 1 − e−λ/3 = 0.5
=⇒ e−λ/3 = 0.5
=⇒ λ = 3 ln 2

The median is the number such that approximately half of a data set is below (or above) it.
The rst quartile is the number such that approximately 25% of the data is below it and the
third quartile is the number such that approximately 75% of the data is below it.