Understanding Binomial Distribution in Actuarial

Science
RICHARD OMBATI
 Binomial Distribution - Introduction
• Definition of Binomial Distribution
Binomial distribution is a discrete probability distribution that
describes the number of successes in a fixed number of
independent and identical Bernoulli trials, where each trial
results in either a success or a failure.
Key characteristics of binomial distribution

Distribution is characterized by two parameters:

• n, the number of trials, and;
• p, the probability of success on a single trial.Discrete,
finite number of trials, two possible outcomes (success or
failure).
 Application in Actuarial Science
• Risk Modeling:
• Uncertainty in Insurance Claims: Actuarial science
involves assessing and managing risks associated with
insurance policies. The binomial distribution is valuable in
modeling the number of insurance claims, especially
when there are only two possible outcomes (e.g., a claim
is made or not).
• Policyholder Behavior: Actuaries use the binomial
distribution to model various scenarios related to
policyholder behavior, such as lapses, surrenders, and
renewals.
Application Cont’d

Applications in Insurance:

• Claim Frequency: The binomial distribution is used to

model the frequency of insurance claims within a given
time period. This is vital for calculating the expected
number of claims and setting appropriate premium rates.
• Risk Assessment: Actuaries use the distribution to assess
the risk of adverse events, helping insurance companies
determine the level of reserves needed to cover potential
future claims.
• Policyholder Defaults: In situations where policyholders
Probability Mass Function (PMF)
Cumulative Distribution Function (CDF)
Mean (Expected Value) and Variance of Binomial
Distribution
• Mean (Expected Value):
• Formula Interpretation:
The mean (μ) represents
the average or expected
number of successes in a
given number of trials.
 Example Problem

Context
• Consider an insurance company offering a new auto
insurance policy.
• The company estimates that, on average, 10% of
policyholders will file a claim within the first year.
• The actuarial team wants to assess the risk of a specific
agent selling policies to five clients and having at least
two of them file a claim in the first year.
Example problem Contn’d
 Challenges and Limitations of the Binomial
Distribution in Actuarial Science
• Assumption of Independence(Limitation) - The binomial
distribution assumes that each trial is independent of the
others. In reality, dependencies may exist, especially in
the context of insurance policies or financial instruments
where external factors can influence outcomes.
• Fixed Number of Trials (Limitation)The binomial -
distribution is defined for a fixed number of trials (n). In
some actuarial scenarios, the number of trials may not be
fixed or known in advance, making it challenging to apply
the binomial distribution directly.
 Challenges and Limitations of the Binomial
Distribution in Actuarial Science contn’d
• Discreteness(Challenge) - The binomial distribution is
inherently discrete, modeling outcomes as integer values.
In certain actuarial contexts, especially when dealing with
continuous processes, a continuous distribution may be
more appropriate.
• Validity of Probability of Success (p) (Limitation) -The
success probability (p) is assumed to remain constant
across all trials. In practice, this may not always hold true,
as policyholder behavior, market conditions, and other
factors can change over time.