Actuarial Statistics

BY DEFARU DEBEBE
AMU

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INTRODUCTION

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Actuarial science is the discipline that applies 

mathematical and statistical methods to assess risk in
the insurance and finance industries. 
Insurance is the equitable transfer of the risk of a
loss, from one entity to another in exchange for
payment.
 It is a form of risk management primarily used to 
hedge against the risk of a contingent, uncertain loss.

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An insurer, or insurance carrier, is a company

selling the insurance;
 the insured, or policyholder, is the person or
entity buying the insurance policy.
The amount to be charged for a certain amount of
insurance coverage is called the premium.
 Risk management, the practice of appraising and
controlling risk, has evolved as a discrete field of
study and practice.

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The transaction involves the insured assuming a

guaranteed and known relatively small loss in the
form of payment to the insurer in exchange for the
insurer's promise to compensate (indemnify) the
insured in the case of a financial (personal) loss.
The insured receives a contract, called the 
insurance policy, which details the conditions and
circumstances under which the insured will be
financially compensated.

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Insurance involves pooling funds from many insured entities

(known as exposures) to pay for the losses that some may
incur.
The insured entities are therefore protected from risk for a
fee, with the fee being dependent upon the frequency and
severity of the event occurring.
 In order to be insurable, the risk insured against must meet
certain characteristics in order to be an insurable risk.
 Insurance is a commercial enterprise and a major part of the
financial services industry, but individual entities can also 
self-insure through saving money for possible future losses.

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 1.1 Insurance Companies as Business Organization
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Insurance companies may be classified into two

groups:
 Life insurance companies, which sell life insurance,
annuities and pensions products.
 Non-life, general, or property/casualty insurance
companies, which sell other types of insurance.
General insurance companies can be further divided
into these sub categories.
 Standard lines
 Excess lines

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Life insurance- covers long term,

Non-life insurance-cover short term (a year)
Standard line insurance companies are insurers that
have received a license "admitted" insurers
Standard line insurance companies usually charge
lower premiums than excess line insurers and may
sell directly to individual insured’s.

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Excess line insurance companies typically insure risks

not covered by the standard lines insurance market, due
to a various of reasons
 new entity or an entity that does not have an adequate
loss history,
 an entity with unique risk characteristics,
 or an entity that has a loss history that does not fit the
underwriting requirements of the standard lines
insurance market. 
• They are typically referred to as non-admitted or
unlicensed insurers.

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Reinsurance companies are insurance companies

that sell policies to other insurance companies,
The reinsurance market is dominated by a few very
large companies, with huge reserves.
 A reinsurer may also be a direct writer of insurance
risks as well.

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Captive insurance companies may be defined as limited-purpose insurance

companies established with the specific objective of financing risks emanating
from their parent group or groups.
Captives may take the form of a "pure" entity (which is a 100% subsidiary of
the self-insured parent company);
 of a "mutual" captive (which insures the collective risks of members of an
industry);
 and of an "association" captive (which self-insures individual risks of the
members of a professional, commercial or industrial association).
 Captives represent commercial, economic and tax advantages to their
sponsors because of the reductions in costs they help create and for the ease
of insurance risk management and the flexibility for cash flows they generate.
 Additionally, they may provide coverage of risks which is neither available
nor offered in the traditional insurance market at reasonable prices.

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 1.2 Role of Insurance Business in Economy
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Yet, while insurance, banking, and securities

markets are closely related,
insurance fulfills somewhat different economic
functions than do other financial services,
The evidence suggests that insurance contributes
materially to economic growth by improving the
investment climate and promoting a more efficient
mix of activities than would be undertaken in the
absence of risk management instruments.

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Contributions of Insurance to Growth and Development
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Insurance serves a number of valuable economic

functions that are largely distinct from other types of
financial intermediaries.
The indemnification and risk pooling properties of
insurance facilitate commercial transactions and the
provision of credit by mitigating losses as well as the
measurement and management of non diversifiable
risk more generally.
this income smoothing effect helps to avoid excessive
and costly bankruptcies and facilitates lending to
businesses.
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Most fundamentally, the availability of

insurance enables risk averse individuals and
entrepreneurs to undertake higher risk, higher
return activities than they would do in the absence of
insurance, promoting higher productivity and
growth.
 The management of risk is a fundamental aspect of
entrepreneurial activity.
 Entrepreneurs manage the risk of accidental loss by
weighing the costs and benefits of each alternative.

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In a structured risk management process, this

involves:
(1) Identifying the exposures to accidental loss;
(2) Evaluating alternative techniques for treating each
loss exposure;
(3) Choosing the best alternative; and
(4) Monitoring the results to refine the choices.
Those who do not apply a structured process still
make decisions about risk, although sometimes by
default rather than design.
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The scope of an economy’s insurance market affects

both the range of available alternatives and the
quality of information to support decisions.
 For example, a manufacturer might produce only for
the local market, forgoing more lucrative
opportunities in distant markets in order to avoid the
risk of losing goods in shipment.
 Transport insurance can mitigate this loss exposure
and enable the manufacturer to expand.

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Similarly, to avoid the risk of total loss from drought,

a commercial farmer may keep half of his seed in
reserve. Crop insurance can protect against drought
and permit all of the seed to be planted for a smaller
premium than the cost of holding half in reserve.
Thus public policies that encourage insurance
operations improve the economy’s productivity by
broadening the range of investments.

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Insurers also contribute specialized expertise in the

identification and measurement of risk.
This expertise enables them to accept carefully specified
risks at lower prices than non-specialists.
They also have an incentive to collect and analyze
information about loss exposures, since the more
precisely they measure the cost of risk, the more they can
expand.
As a result, the insurance market generates price
signals to the entire economy, helping to allocate
resources to more productive uses.

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Insurers also have an incentive to control losses, which is a

significant social benefit.
By offering discounts for seat belts, smoke detectors, or other
measures that reduce the frequency or severity of losses,
they lower their eventual claims costs, in the process
saving lives and reducing injuries.
On the investment side, due to the long term nature of their
liabilities, sizeable reserves, and predictable premiums, life
insurance providers can serve an important function as
institutional investors providing capital to
infrastructure and other long term investments as well as
professional oversight to these investments.

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The net result of well functioning insurance markets

should be better pricing of risk, greater efficiency in the
overall allocation of capital and mix of economic
activities, and higher productivity.
 Importantly, these unique functions of insurance
should be complementary to banking and financial
sector deepening more broadly.
 For instance, insurance facilitates credit transactions
such as the purchase of homes and cars and business
operations, while depending in turn on well functioning
payment systems and robust investment opportunities.

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Measured Contribution of Insurance to Growth
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 Insurance Contributes Positively to

Economic Growth.
Strong Complementarities between
Insurance and Banking.

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 Drivers of Insurance Coverage
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 Rising Incomes, Moderate Inflation, and

Financial Deepening are Key Drivers.
Variation in Insurance Coverage.
 Household Insurance:
 Natural Disasters, Weather, and Crop Insurance
 Health Insurance
 Small-Scale Entrepreneurs

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 Principles and types of insurance
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Insurability
 Large number of similar exposure units
 Definite loss:
 Accidental loss
 Large loss
 Affordable premium
 Calculable loss
 Limited risk of catastrophically large losses

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Legal
 Indemnity 
 [nsurable interest 
 Utmost good faith
 Contribution
 Subrogation
 Causa proxima, or proximate cause
 Mitigation

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Indemnification
There are generally three types of insurance
contracts that seek to indemnify an insured:
 a "reimbursement" policy, and
 a "pay on behalf" or "on behalf of" policy, and
 an "indemnification" policy.
From an insured's standpoint, the result is usually
the same: the insurer pays the loss and claims

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Types of insurance
 Auto insurance
 Gap insurance
 Health insurance
 Accident, sickness and unemployment insurance
 Casualty Insurance
 Life Insurance
 Burial insurance
 Property Insurance

 Liability Insurance
 Credit
 Other types

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 1.1 Introduction
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We have plans and expectations about the path of

life will follow.
However, experience teaches that plans will not
unfold with certainty and sometimes expectations
will not be realized
Occasionally plans are frustrated because they are
built on unrealistic assumptions.
Insurance is designated to protect against serious
financial reversals that resulted from random events

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 1.1 Introduction
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Certain basic limitations on insurance protection

@ it is restricted to reducing those consequences of

random events that can only measured monetary
terms

@ insurance does not directly reduce the probability

of loss

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The economic justification for insurance system is that

it contributes to general welfare by improving the
prospect that plans will not be frustrated by random
events
Such systems may increase total production by
encouraging individuals and corporations to invest
Possibilities of large losses would inhibit such projects
in the absence of insurance

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If people could foretell the consequences of their

decisions, their lives would be simpler but less
interesting.
We would all make decisions on the basis of
preferences for certain consequences.
However, we do not possess perfect foresight. At best,
we can select an action that will lead to one set of
uncertainties rather than another.
An elaborate theory has be developed that provides
insights into decision making in the face of
uncertainty. This body of knowledge is called Utility
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One solution to the problem of decision making in the face

of uncertainty is to define the value of an economic
prospect with a random outcome to be its expected value.
In this principle, a decision maker would be indifferent
b/n assuming the random loss X and paying amount E(X)
in order to be relived of the possible loss.

Many decision makers do not adopt the expected value

principle. For them, their wealth level and other aspects of
the distribution of outcomes influence their decisions.

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We now study another approach to explain why a

decision maker may be willing to pay more than the
expected value.
We simply assume that, w be wealth of decision

maker and the utility function, u(w)
We assume that a decision maker has wealth equal
20,000
A linear transformation
 u * ( w)  a u ( w)  b a 0

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Let u(0)=-1 and u(20,000)=0

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We now ask a question of a decision maker:

Suppose you face a loss of 20,000 with probability
0.5, and with remain at current level of wealth with
probability of 0.5
What is the maximum amount G(premium) you
would be willing to pay for complete insurance
protection against this random loss?
For what value of G does

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After a decision maker has determined his/her utility

of wealth function by the method outlined, the
function can be used to compare two random
economic prospects.
If the decision maker has wealth w, and must
compare a random prospects X and Y,
the decision maker select X if

And the decision maker indifferent b/n X and Y if

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Utility function is a numerical description of

existing preferences
Preferences are preserved when the utility function
is increasing linear transformation of the original
form.

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J

Therefore, the expected value principle for rational

economic behavior in the face of uncertainty
consistent with expected utility rule when the utility
function is increasing linear one.

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In section 1.2, we outlined utility theory for the

purpose of gaining insight into the economic role of
insurance.
Suppose a decision maker owns a property that may
be damaged or destroyed in the next accounting
period.

The amount of the loss, which may be 0, is a random

variable denoted by X.
We assume the distribution of X is known.

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Then E(X), the expected loss in the next period, may

be interpreted as the long-term average loss if the
experiment of exposing the property to damage may
be observed under identical conditions a great many
times.

It is clear that this long-term set of trials could not be

performed by an individual decision maker.

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The amount of the premium payment is determined

after an economic decision principle has been
adopted by each of the insurer and insured.
An opportunity exists for a mutually advantageous
insurance policy when the premium for the policy set
by the insurer is less than the maximum amount that
the property owner is willing to pay for insurance.

The insurer’s utility function might be approximated

by a straight line

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In this case, the insurer would adopt the expected

value principle in setting its premium, as indicated in
section 1.2
That is, the insurer would set its basic price for full
insurance coverage as expected loss, E(X)=μ
In this context μ is called the pure/net premium for 1-
period insurance policy.
To provide for expenses, taxes, and profit and for
some security against adverse loss experience,
insurance system would decide to set the premium for
the policy by loading, adding to, the pure premium.
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The loaded premium, denoted by H, might be given

as

aμ is costs associated with vary expected losses.

C is expected expenses that do not vary with losses.

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J

It seems natural to assume that u(w) is an increasing

function “more is better”.
Each additional increment of wealth results in a
smaller increment of associated utility.
This is the idea of decreasing marginal utility

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The approximate utility function of Figure 1.2.1

consists of straight line segments with +ve slopes.
It is such that u ' ' ( w)  0
If this ideas extended to smoother functions, two
properties are suggested for utility function u(w),
and

The second inequality indicates u(w) is a strictly

concave downward function.

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F

The left-hand side of (1.3.6) is the utility attached to

the insurer’s current position.
The right-hand side is the expected utility associated
with collecting premium H and paying random loss X

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In other words, the insurer is indifferent b/n the

current position and providing insurance for X at
premium H.
If the insurer’s utility function is such that

We can use Jensen’s inequality (1.3.2) along with

(1.3.6) to obtain

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Several elementary functions are used to illustrate

properties of utility functions
@ exponential
@ fractional power, and
@ quadratic functions.

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An exponential utility function is

Therefore, u(w) may serve as a utility function of

risk-averse individual.

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Insurance premiums do not depend on wealth of

decision maker. This is verified for insured by
substituting exponential utility function into (1.3.1)

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In chapter 1 we examined how a decision maker can

use insurance to reduce the adverse financial impact of
some types of random events.
The decision maker could have been an individual
seeking protection against the loss of property, savings,
income.
The decision maker could have been an organization
seeking protection against those same types of losses.

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The theory in chapter 1 requires a probabilistic

model for a potential losses.
We examine one of two models commonly used in
insurance pricing, reserving, and reinsurance
application.


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Wrong calculation of mean and variance of X=IB
79

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Probability of
no claim when
no collision is
certain

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 How to get column (4) by (2.3.4)
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Let us set possible values of S for given values of Y

(assume y=0,1,2,3, 4) and X (x=0,1,2,3)
>>>s=0,1,2,3,4,5,6,7

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How to get column (7)? X=s-y
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Chapter 1was dedicated to showing how insurance

can increase the expected utility of individuals facing
random losses.
In chapter 2 simple models for single-period
insurance policies were developed.
Chapter 4-8 deals primarily with models for
insurance systems designed to manage random losses
where the randomness is related to how long an
individual will survive.
In these chapter the time-until-death random
variable, T(x), is the basic building block.
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This chapter develops a set of ideas for describing

and using the distribution of time-until-death and
the distribution of the corresponding age-at-death X.
We show how a distribution of the age-at-death
random variable can be summarized by a life table.
A life table is an indispensable component of many
models in actuarial science.

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In the preceding chapter we studied payments contingent

on death, as provided by various forms of life insurance.
In this chapter we study payments contingent on
survival, as provided by various forms of life annuities.
A life annuity is a serious of payments made continuously
or equal intervals while a given life survives.
Payments may be due at the beginnings of the payment
intervals (annuities due) or at the ends of such intervals
(annuities-immediate)

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