An introduction and basic quantities of interest

Actuarial mathematics 1
Lecture 1. Introduction.

Edward Furman

Department of Mathematics and Statistics

York University

September 15, 2010

Edward Furman Actuarial mathematics MATH 3280 1 / 11

 An introduction and basic quantities of interest

Introduction.
Would people spend same money today if there were no
retirement programs, life insurance contracts or social
security systems?

Edward Furman Actuarial mathematics MATH 3280 2 / 11

 An introduction and basic quantities of interest

Introduction.
Would people spend same money today if there were no
retirement programs, life insurance contracts or social
security systems?

Definition 1.1 (Insurance.)

An insurance is a mechanism for reducing the adverse financial
impact of random events that prevent the fulfillment of
reasonable expectations (see, Bowers et al., 1997).

Edward Furman Actuarial mathematics MATH 3280 2 / 11

 An introduction and basic quantities of interest

Introduction.
Would people spend same money today if there were no
retirement programs, life insurance contracts or social
security systems?

Definition 1.1 (Insurance.)

An insurance is a mechanism for reducing the adverse financial
impact of random events that prevent the fulfillment of
reasonable expectations (see, Bowers et al., 1997).

Definition 1.2 (Insurance.)

Insurance is an equitable transfer of a risk of a monetary loss
from an insured to an insurer in exchange for premium(s) (we
shall use this one).

Edward Furman Actuarial mathematics MATH 3280 2 / 11

 An introduction and basic quantities of interest

Introduction.
Would people spend same money today if there were no
retirement programs, life insurance contracts or social
security systems?

Definition 1.1 (Insurance.)

An insurance is a mechanism for reducing the adverse financial
impact of random events that prevent the fulfillment of
reasonable expectations (see, Bowers et al., 1997).

Definition 1.2 (Insurance.)

Insurance is an equitable transfer of a risk of a monetary loss
from an insured to an insurer in exchange for premium(s) (we
shall use this one).

Insurance is thus a hedge against financial contingent losses.

Edward Furman Actuarial mathematics MATH 3280 2 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).
Insured or policyholder – an entity that purchases an
insurance. It can be a person, a company, even an insurer.

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).
Insured or policyholder – an entity that purchases an
insurance. It can be a person, a company, even an insurer.
Insurer – a seller of insurance.

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).
Insured or policyholder – an entity that purchases an
insurance. It can be a person, a company, even an insurer.
Insurer – a seller of insurance.
Premium – the amount to be charged for an insurance. It
can be a single payment or not.

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).
Insured or policyholder – an entity that purchases an
insurance. It can be a person, a company, even an insurer.
Insurer – a seller of insurance.
Premium – the amount to be charged for an insurance. It
can be a single payment or not.
We shall not distinguish between the so - called loss and
payment events, though these two can be quite different.

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Keywords.

Risk – Possibility of financial loss.

Loss – Monetary units equivalent amount of damage
suffered by the insured(s).
Insured or policyholder – an entity that purchases an
insurance. It can be a person, a company, even an insurer.
Insurer – a seller of insurance.
Premium – the amount to be charged for an insurance. It
can be a single payment or not.
We shall not distinguish between the so - called loss and
payment events, though these two can be quite different.

Where does the maths come into all these?

Edward Furman Actuarial mathematics MATH 3280 3 / 11

 An introduction and basic quantities of interest

Introductory example.

Consider the following:

Example 1.1 (A very simple example.)

A person rolls a fair die with the possible outcomes being

1, 2, . . . , 6. If the die shows a number greater than 3, the
person pays 1$. He/she is interested to transfer the risk to an
insurer. What an actuary would do?

Solution.
The risk is

Edward Furman Actuarial mathematics MATH 3280 4 / 11

 An introduction and basic quantities of interest

Introductory example.

Consider the following:

Example 1.1 (A very simple example.)

A person rolls a fair die with the possible outcomes being

1, 2, . . . , 6. If the die shows a number greater than 3, the
person pays 1$. He/she is interested to transfer the risk to an
insurer. What an actuary would do?

Solution.
The risk is the possibility that 4, 5, 6 appear. The loss equals

Edward Furman Actuarial mathematics MATH 3280 4 / 11

 An introduction and basic quantities of interest

Introductory example.

Consider the following:

Example 1.1 (A very simple example.)

A person rolls a fair die with the possible outcomes being

1, 2, . . . , 6. If the die shows a number greater than 3, the
person pays 1$. He/she is interested to transfer the risk to an
insurer. What an actuary would do?

Solution.
The risk is the possibility that 4, 5, 6 appear. The loss equals
1$, which is payed if 4, 5, 6 have appeared. As we said, the
transfer is fair. Then it is quite natural, to charge a price equal
to

Edward Furman Actuarial mathematics MATH 3280 4 / 11

 An introduction and basic quantities of interest

Introductory example.

Consider the following:

Example 1.1 (A very simple example.)

A person rolls a fair die with the possible outcomes being

1, 2, . . . , 6. If the die shows a number greater than 3, the
person pays 1$. He/she is interested to transfer the risk to an
insurer. What an actuary would do?

Solution.
The risk is the possibility that 4, 5, 6 appear. The loss equals
1$, which is payed if 4, 5, 6 have appeared. As we said, the
transfer is fair. Then it is quite natural, to charge a price equal
to π[A] = 1$ · P[{A}], where A denotes the appearance of
4, 5, 6 on the die. Is anything missing?

Edward Furman Actuarial mathematics MATH 3280 4 / 11

 An introduction and basic quantities of interest

Introductory example.

Consider the following:

Example 1.1 (A very simple example.)

A person rolls a fair die with the possible outcomes being

1, 2, . . . , 6. If the die shows a number greater than 3, the
person pays 1$. He/she is interested to transfer the risk to an
insurer. What an actuary would do?

Solution.
The risk is the possibility that 4, 5, 6 appear. The loss equals
1$, which is payed if 4, 5, 6 have appeared. As we said, the
transfer is fair. Then it is quite natural, to charge a price equal
to π[A] = 1$ · P[{A}], where A denotes the appearance of
4, 5, 6 on the die. Is anything missing? Yes, but what?

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 An introduction and basic quantities of interest

The value of 1$ changes with time, so a discounting should be

done. We neglect that discounting for a while. What is the
probability of interest?

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 An introduction and basic quantities of interest

The value of 1$ changes with time, so a discounting should be

done. We neglect that discounting for a while. What is the
probability of interest? We know that P : F → [0, 1], where F is

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 An introduction and basic quantities of interest

The value of 1$ changes with time, so a discounting should be

done. We neglect that discounting for a while. What is the
probability of interest? We know that P : F → [0, 1], where F is
the sigma - algebra over a space of elementary outcomes, i.e.,
over Ω. In our simple example, we readily have that

Edward Furman Actuarial mathematics MATH 3280 5 / 11

 An introduction and basic quantities of interest

The value of 1$ changes with time, so a discounting should be

done. We neglect that discounting for a while. What is the
probability of interest? We know that P : F → [0, 1], where F is
the sigma - algebra over a space of elementary outcomes, i.e.,
over Ω. In our simple example, we readily have that 2
Ω = {1, 2, 3, 4, 5, 6}. Then because P is countably additive,
we have that P[{ω ∈ Ω : ω > 3}] = P[{4} ∪ {5} ∪ {6}] = 1/2.
The price our actuary would come with is then

π[A] = 1$ · 0.5 = 0.5$,

which is the premium the insured would be required to pay. You

expected it, didn’t you?

Edward Furman Actuarial mathematics MATH 3280 5 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Ages of death of a couple.
Ω = {r = (r1 , r2 )′ ∈ R2+ : 0 < r1 , r2 ≤ 123}.

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Ages of death of a couple.
Ω = {r = (r1 , r2 )′ ∈ R2+ : 0 < r1 , r2 ≤ 123}.
Minimum of two ages of death.
Ω = {r ∈ R+ : 0 < r ≤ 123}.

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Ages of death of a couple.
Ω = {r = (r1 , r2 )′ ∈ R2+ : 0 < r1 , r2 ≤ 123}.
Minimum of two ages of death.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Severity of an insurance loss. Ω = {r ∈ R+ }.

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Ages of death of a couple.
Ω = {r = (r1 , r2 )′ ∈ R2+ : 0 < r1 , r2 ≤ 123}.
Minimum of two ages of death.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Severity of an insurance loss. Ω = {r ∈ R+ }.
Frequency of an insurance loss. Ω = {n ∈ N}.

Edward Furman Actuarial mathematics MATH 3280 6 / 11

 An introduction and basic quantities of interest

Very often, the sample space is much more cumbersome than

the one we have just mentioned. Think of, e.g.,
Choosing a real number in [0, 1]. Ω = {r ∈ R : 0 ≤ r ≤ 1},
which has an uncountable number of elementary events, and
similarly, but more related to our course,
An age of death of a new born child.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Ages of death of a couple.
Ω = {r = (r1 , r2 )′ ∈ R2+ : 0 < r1 , r2 ≤ 123}.
Minimum of two ages of death.
Ω = {r ∈ R+ : 0 < r ≤ 123}.
Severity of an insurance loss. Ω = {r ∈ R+ }.
Frequency of an insurance loss. Ω = {n ∈ N}.
How would our actuary determine the probability for any one of
the above being equal to a specific value? And then the price?
Let’s go back to Example 1.1.
Edward Furman Actuarial mathematics MATH 3280 6 / 11
 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.

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 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is

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 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

Edward Furman Actuarial mathematics MATH 3280 7 / 11

 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] =

Edward Furman Actuarial mathematics MATH 3280 7 / 11

 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] = P[X (ω) = 1]

Edward Furman Actuarial mathematics MATH 3280 7 / 11

 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] = P[X (ω) = 1] = P[X = 1] =

Edward Furman Actuarial mathematics MATH 3280 7 / 11

 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] = P[X (ω) = 1] = P[X = 1] = 0.5.

The price is then the amount to be payed times the expected

frequency of payments to be made. Hence π[X ] = 1$ · E[X ].
As X is an indicator r.v., we readily have that

E[X ] =

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 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] = P[X (ω) = 1] = P[X = 1] = 0.5.

The price is then the amount to be payed times the expected

frequency of payments to be made. Hence π[X ] = 1$ · E[X ].
As X is an indicator r.v., we readily have that

E[X ] = P[X = 1] =

Edward Furman Actuarial mathematics MATH 3280 7 / 11

 An introduction and basic quantities of interest

Solution of Example 1.1 (cont.)

Let’s define a function X : Ω → R, such that X (A) = 1 and
X (Ac ) = 0.The domain is in the sample space, and the range is
binary, so it’s actually an indicator random variable (r.v.). The
probability that the person pays 1$ is then

P[{ω ∈ Ω : X (ω) = 1}] = P[X (ω) = 1] = P[X = 1] = 0.5.

The price is then the amount to be payed times the expected

frequency of payments to be made. Hence π[X ] = 1$ · E[X ].
As X is an indicator r.v., we readily have that

E[X ] = P[X = 1] = 0.5,

and the price for the insurance becomes π[X ] = 0.5$ as before,

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 An introduction and basic quantities of interest

At home.
Check that if 1{A}(ω) is an indicator r.v., i.e., it is defined as
1{A}(ω) = 1 if ω ∈ A, and 1{A}(ω) = 0 if ω ∈ Ac , then

E[1{A}] = P[{A}],

Var[1{A}] = P[{A}](1 − P[{A}]),

and

Cov[1{A}], [1{B}] = P[1{A} ∩ 1{B}] − P[1{A}] · P[1{B}].

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 An introduction and basic quantities of interest

Example 1.1 (cont.)

To conclude the example, we shall augment it with the time
value of money. To this end, let v = (1 + i)−1 be the discounting
factor. Thus the present value (p.v.) of 1$ payed at time 1
is

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 An introduction and basic quantities of interest

Example 1.1 (cont.)

To conclude the example, we shall augment it with the time
value of money. To this end, let v = (1 + i)−1 be the discounting
factor. Thus the present value (p.v.) of 1$ payed at time 1
is1$ · v. Therefore if we assume that the person gets his/her
one dollar at time 1, the premium becomes
π[X ] = v · E[X ] = 0.5v. Can it anyhow be extended to a
random time of the payment?
Let’s say that the time of payment is represented by the r.v. Y
independent of X . The premium, that our actuary would now
charge, is

Edward Furman Actuarial mathematics MATH 3280 9 / 11

 An introduction and basic quantities of interest

Example 1.1 (cont.)

To conclude the example, we shall augment it with the time
value of money. To this end, let v = (1 + i)−1 be the discounting
factor. Thus the present value (p.v.) of 1$ payed at time 1
is1$ · v. Therefore if we assume that the person gets his/her
one dollar at time 1, the premium becomes
π[X ] = v · E[X ] = 0.5v. Can it anyhow be extended to a
random time of the payment?
Let’s say that the time of payment is represented by the r.v. Y
independent of X . The premium, that our actuary would now
charge, is
π[X ] = E[X · v Y ]
We shall call present values a la 1$ · v Y , actuarial present
values (a.p.v.). This completes Example 1.

The premium is nothing else but the a.p.v. of the losses.

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 An introduction and basic quantities of interest

Example 1.2

A couple wishes to insure the life of its new born child. What
would an actuary do to compute the premium for the contract if
the insurance amount of 10, 000$ is repayed upon child’s death,
and the interest rate is fixed to i throughout?

Solution.
If the length of child’s life (=time of his/her death) is described
by the continuous r.v. T (0) : Ω → A ⊂ R+ , with
Ω = {t ∈ R+ : 0 < t ≤ 123}, then the price to be payed is

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 An introduction and basic quantities of interest

Example 1.2

A couple wishes to insure the life of its new born child. What
would an actuary do to compute the premium for the contract if
the insurance amount of 10, 000$ is repayed upon child’s death,
and the interest rate is fixed to i throughout?

Solution.
If the length of child’s life (=time of his/her death) is described
by the continuous r.v. T (0) : Ω → A ⊂ R+ , with
Ω = {t ∈ R+ : 0 < t ≤ 123}, then the price to be payed is

π[T (0)] = E[10, 000 · v T (0) ].

End of Example 1.2.

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 An introduction and basic quantities of interest

Example 1.2

A couple wishes to insure the life of its new born child. What
would an actuary do to compute the premium for the contract if
the insurance amount of 10, 000$ is repayed upon child’s death,
and the interest rate is fixed to i throughout?

Solution.
If the length of child’s life (=time of his/her death) is described
by the continuous r.v. T (0) : Ω → A ⊂ R+ , with
Ω = {t ∈ R+ : 0 < t ≤ 123}, then the price to be payed is

π[T (0)] = E[10, 000 · v T (0) ].

End of Example 1.2.

This course will mostly deal with various characteristics of

the r.v.’s a la T (0).
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 An introduction and basic quantities of interest

Key points.

MATH 3280 3.00 F.

We shall in the sequel assume that life times are r.v.’s, and
we shall thus explore:
Various life formations (statuses) and their future life times
as well as sources of their deaths (decrements),
and the corresponding
cumulative and decumulative distribution functions (c.d.f’s)
and (d.d.f’s);
probability density functions (p.d.f’s) and the force of
mortality for continuous r.v.’s;
probability mass functions (p.m.f’s) and life tables for
curtuate r.v.’s;
percentiles, expectations, variances, covariances.

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