Therefore, in each case [1Gx) — Ip(x]u'(eo = x + Lp) — P) = [IG) - Lo(x)]u'(w ~ P ~ @*), establishing inequality (1.4.3). Now, combining inequalities (1.4.2) and (1.A.3) and taking expectations, we have Elu(w — X + IX) — P)] — Elu(w — X + IX) ~ PY] = E[UX) — 1,(X)]w'(w ~ dt — P) = (B — Byu'(w ~ d* — P) Therefore, E[u(w — X + 1X) ~ P)] = Eluw — X + Lp(X) - P)] and the expected utility will be maximized by selecting /,(x), the stop-loss policy. ——_—$_——— $$ Exercises Section 1.2 1.1. Assume that a decision maker’s current wealth is 10,000. Assign u(0) = —1 and (10,000) = 0. a. When facing a loss of X with probability 0.5 and remaining at current wealth with probability 0.5, the decision maker would be willing to pay up to G for complete insurance. The values for X and G in three situations are given below. x G 10000 6000 6000 3300 3301700 Determine three values on the decision maker's uti b. Calculate the slopes of the four line segments joining the five points de- termined on the graph u(w). Determine the rates of change of the slopes from segment to segment, c. Put yourself in the role of a decision maker with wealth 10,000. In addition to the given values of u(0) and (10,000), elicit three additional values on your utility of wealth function u. . On the basis of the five values of your utility function, calculate the slopes and the rates of change of the slopes as done in part (b). ty of wealth function 1.2. St. Petersburg paradox: Consider a game of chance that consists of tossing a coin until a head appears. The probability of a head is 0.5 and the repeated trials are independent. Let the random variable N be the number of the trial on which the first head occurs. 2 Beercsesa. Show that the probability function (p-f) of N is given by 4)" fin) = () n=1,2,3, b, Find E[N] and Var(N). © If a reward of X = 2" is paid, prove that the expectation of the reward does not exist. d. If this reward has utility u(w) = log w, find E[u(X)]. Section 1.3 13, 14. 16. 17. 18. 19. Jensen‘s inequalities: a. Assume u"(w) <0, E[X] = , and Efu(X)] exist; prove that E[u(X)] = u(w). [Hint: Express u(w) as a series around the point w = p and terminate the expansion with an error term involving the second derivative. Note that Jen- sen’s inequalities do not require that u’(w) > 0.] b. If w'(w) > 0, prove that E[u(X)] = u(y). c. Discuss Jensen's inequalities for the special case 1(w) = zw, What is E[u(X)] = u(E[X)? If a utility function is such that u'(w) > 0 and u"(w) > 0, use (1.3.1) to show G = p. A decision maker with preferences consistent with u"(w) > 0 is a risk lover. Construct a geometric argument, based on a graph like that displayed in Figure 1.3.1, that if u’(w) < 0 and w"Go) <0, then (1.3.4) follows. Confirm that the utility function 1u(«) = log w, w > 0, is the utility function of a decision maker who is risk averse for w > 0. A utility function is given by { (e-1007 200 w <100 wt 2 — erwrm008/20 wy = 100, a. Is u'(w) = 0? b. For what range of w is w"(w) < 0? If one assumes, as did D. Bernoulli in his comments on the St. Petersburg, paradox, that utility of wealth satisfies the differential equation MO) ky >0,k>0, dw w confirm that u(w) = k log w + A decision maker has utility function w(0) = k log 1. The decision maker has wealth w, w > 1, and faces a random loss X, which has a uniform distribution on the interval (0, 1). Use (1.3.1) to show that the maximum insurance pre- mium that the decision maker will pay for complete insurance is, Chapter 1 The Economics of Insurance 24o_o e(w — 1°" 1.10. a. In (1.3.1) use the approximations u(w — p) + (uw ~ G)u'(w — 1), eo — w) + (we ~ XW ~ w) +3 (w= PEW HY and derive the following approximation for G: Lew 2u'w— pn) b. If u(w) = k log w, use the approximation developed in part (a) to obtain 1.11. The decision maker has a utility function u(w) = —e~*" and is faced with a random loss that has a chi-square distribution with n degrees of freedom. If 0 n = 1.12. Rework Example 1.3.4 for a. u(w) = -e"*/40 b. uw) 1.13. a. An insurer with net worth 100 has accepted (and collected the premium. for) a risk X with the following probability distribution: 1 Pr(X = 0) = Pr(X = 51) = What is the maximum amount G it should pay another insurer to accept 100% of this loss? Assume the first insurer's utility function of wealth is u(w) = log w. b. An insurer, with wealth 650 and the same utility function, u(w) = log w, is considering accepting the above risk. What is the minimum amount H this insurer would accept as a premium to cover 100% of the loss? 1.14. If the complete insurance of Example 1.3.4 can be purchased for 40 and the 50% coinsurance of Example 1.3.5 can be purchased for 25, the purchase of which insurance maximizes the property owner’s expected utility? Section 1.4 1.15. A hospital expense policy is issued to a group consisting of n individuals. The policy pays B dollars each time a member of the group enters a hospital. 2 BrercisesThe group is not homogeneous with respect to the expected number of hos- pital admissions each year. The group may be divided into r subgroups. There are n, individuals in subgroup i and ¥; n, = n, For subgroup i the number of annual hospital admissions for each member has a Poisson distribution with parameter i, i = 1, 2,..., 7. The number of annual hospital admissions for members of the group are mutually independent. a. Show that the expected claims payment in one year is B > na, = Bnk where Dm fe ” b. Show that the number of hospital admissions in 1 year for the group has a Poisson distribution with parameter n i. Section 15, 1.16, Perform the integration hy parts indicated in (1.5.2). Use the fact that if F[X] exists, if and only if, lim x{1 ~ F(x)] = 0, 1.17. a. Differentiate the right-hand side of (1.5.2B) with respect to d. b. Let B be a number such that 0 < 6 < E[X]. Show that (1.5.2) has a unique solution d* 1.18. Let the loss random variable X have a p.df. given by fa) = Oe°* x > 0. a. Calculate E[X] and Var(X). b. If P = 5 is to be spent for insurance to be purchased by the payment of the pure premium, show that 1) == 2 and 0 x VarlX — 1,()]. Appendix 1.20. 121. 1.22. 1.23, Establish the lemma by using an analytic rather than a geometric argument [Hint: Expand u(w) in a series as far as a second derivative remainder around the point z and subtract u(z).] Adopt the hypotheses of Theorem 1.5.1 with respect to B and insurance con- tracts I(x) and assume E[X] = p. Prove that VarlX — 1(X)] = EL(X = 10 ~ w + BY) is a minimum when I(x) = I,.(x). You will be proving that for a fixed pure premium, a stop-loss insurance contract will minimize the variance of re- tained claims. [Hint: we may follow the proof of Theorem 1.5.1 by first prov- ing that x? — 2 = (x — 2)(2z) and then establishing that [x — I@)P — [x — LeGOP = Ox) ~ Ie) 12x — 21 -(2)] = YAla(x) — Iey]a The final inequality may be established by breaking the proof into three cases. Alternatively, by proper choice of wealth level and utility function, the result Of this exercise is « special case of Theorem 1.5.1.] Adopt the hypotheses of Theorem 1.5.1, except remove the budget constraint; that is, assume that the decision maker will pay premium P, 0 < P = E[X] = u, that will maximize expected utility. In addition, assume that any feasible insurance can be purchased for its expected value. Prove that the optimal insurance is 1,(x). This result can be summarized by stating that full coverage is optimal in the absence of a budget constraint if insurance can be purchased for its pure premium. [Hint: Use the lemma with the role of w played by w — x + I(x) ~ P and that of z played by w ~ x + I(x) — E[X] = w — pw. Take expectations and establish that Elu(w — X) + 10) — P] = uw ~ w).] Optimality properties of stop-loss insurance were established in Theorem 1.5.1 and Exercise 1.21. These results depended on the decision criteria, the con- straints, and the insurance alternatives available. In each of these develop- ments, there was a budget constraint. Consider the situation where there is a 4 Exercisesrisk constraint and the price of insurance depends on the insurance risk as measured by the variance. (i) The insurance premium is E[I(X)] + f(Var{1(X)]), where f(w) is an increas- (i) ing function. The amount of f(Var{I(X)}) can be interpreted as a security loading. The decision maker elects to retain loss X — I(X) such that Var[X — 1()] = V = 0. This requirement imposes a risk rather than a budget constraint. The constant is determined by the degree of risk aversion of the decision maker. Fixing the accepted variance, and then optimizing expected re- sults, is a decision criterion in investment portfolio theory. (iii) The decision maker selects I(x) to minimize f(Var[I(X)]). The objective is to minimize the security loading, the premium paid less the expected insurance payments. Confirm the following steps: a. Varfi(X)] = V + Var(X) ~ 2 Cov[X, X ~ 1(X)] b. The I(x) that minimizes Var{I(X)] and thereby f(VarlI(X))) is such that the correlation coefficient between X and X ~ I(x) is 1. c. It is known that if two random variables W and Z have correlation coefficient 1, then Pr{W = aZ + b, where a > 0} = 1. In words, the probability of their joint distribution is concentrated on a line of pos- {tive slope. In part (b), the correlation coefficient of X and X ~ I(X) was found to be 1. Thus, X — I(X) = aX + b, which implies that 1(X) = (1 ~ @)X ~ b. To be a feasible insurance, 0 = I(x) = x or 0 = (1 — ax — b = x. These inequalities imply that b = 0 and 0 = 1-asland00, fi) = 26 x >0, fix) =3e* x50, Using (2.3.7) twice, we have Chapter 2 Individual Risk Models for a Short Term 7fe) = f fe — wftaddy = [ever 20 dy eae [eray =e -2* x>0, fo) = 7%) = fs = MAU) ay ices ene weer [Lemay em [lerty Ger — 30) — (66° - 6) =3e7—b6e* 430% x > 0. v Another method to determine the distribution of the sum of random variables is based on the uniqueness of the moment generating function (m.g.f.), which, for the random variable X, is defined by My(t) ~ Ele. If this expectation is finite for all t in an open interval about the origin, then M,(t) is the only m.g.f. of the distri- bution of X, and it is not the mg¥. of any other distribution. This uniqueness can be used as follows. For the sum $ = X, + X,+ +++ + Xy M(t) = Efe*] = Elect. eX, 23.8) Blettx0e--80] If X,, X,,..., X, are independent, then the expectation of the product in (2.3.8) is equal to Efe**] Efe™] «++ Efe] so that Mg(t) = My,(t) My,() +++ Mx,(8) (2.3.9) Recognition of the unique distribution corresponding to (2.3.9) would complete the determination of $’s distribution. If inversion by recognition is not possible, then inversion by numerical methods may be used. (See Section 2.6.) rn Consider the random variables of Example 2.3.3. Derive the p.d.f. of $ = X, + Xz + Xj by recognition of the mg-f. of S. Solution: By (2.3.9), M(t) = (Ale eS ‘)(=35). which we write, by the method of partial fractions, as 38 ‘Section 2.3 Sums of Independent Random VariablesThe solution for this is A = 3, B = -3, C = 1. But B/(B ~ #) is the moment generating function of an exponential distribution with parameter B, so the p.d.f for S is fale) = 3(e*) — 3Q2e*) + Be), Vv ‘The inverse Gaussian distribution was developed in the study of stochastic pro- cesses. Here it is used as the distribution of B, the claim amount. It will have a similar role in risk theory in Chapters 12-14. The p.d.f. and m.g.f. associated with the inverse Gaussian distribution are given by Sid) M(t) = exp [« ( Find the distribution of S = X, + X, + X, + +++ + X, where the random variables Xy Xp. ++, X, are independent and have identical inverse Gaussian distributions. Soluti Using (2.3.9), the m.g.f. of S is given by M(t) = IM,(Or" = ovn[ na ( - fi- x) The mg-f. Mg(t) can be recognized and shows that $ has an inverse Gaussian dis- tribution with parameters na and B. v 2.4 Approximations for the Distribution of the Sum The central limit theorem suggests a method to obtain numerical values for the distribution of the sum of independent random variables. The usual statement of the theorem is for a sequence of independent and identically distributed random variables, X,, X;,..., with E[X,] = » and Var(X,) = 0%. For each n, the distribution of Vn (X, — w)/o, where X, = (X, + X, + +++ + X,)/n, has mean 0 and vari- ance 1, The sequence of distributions (n = 1, 2, . . . ) is known to approach the standard normal distribution. When 1 is large the theorem is applied to approxi- mate the distribution of X, by a normal distribution with mean p. and variance o?/n, Equivalently, the distribution of the sum of the # random variables is ap- proximated by a normal distribution with mean np. and variance no?. The effect- iveness of these approximations depends not only on the number of variables but also on the departure of the distribution of the summands from normality. Many elementary statistics textbooks recommend that 1 be at least 30 for the Chapter 2 individual Risk Models for a Short Term 39approximations to be reasonable. One routine used to generate normally distrib- uted random variables for simulation is based on the average of only 12 inde- pendent random variables uniformly distributed over (0, 1) In many individual risk models the random variables in the sum are not iden- tically distributed. This is illustrated by examples in the next section. The central limit theorem extends to sequences of nonidentically distributed random variables, To illustrate some applications of the individual risk model, we use a normal approximation to the distribution of the sum of independent random variables to obtain numerical answers. If S=X FX te +X, then E[S] = = EX, and, further, under the assumption of independence, Var(S) = 2 Var(X,). For an application we need only + Evaluate the means and variances of the individual loss random variables + Sum them to obtain the mean and variance for the loss of the insuring orga- nization as a whole + Apply the normal approximation. Illustrations of this process follow. —— 2.5 Applications to Insurance In this section four examples illustrate the results of Section 2.2 and use of the normal approximation. k= 8 =— A life insurance company issues 1-year term life contracts for benefit amounts of 1 and 2 units to individuals with probabilities of death of 0.02 or 0.10. The following table gives the number of individuals n, in each of the four classes created by a benefit amount b, and a probability of claim 4,. . b, k 1, me 1 002 1 500 2 002 2-500 3 010 300 4010 2 10 40 Section 2.5 Applications to Insurance‘The company wants to collect, from this population of 1,800 individuals, an amount equal to the 95th percentile of the distribution of total claims. Moreover, it wants each individual's share of this amount to be proportional to that individual's ex pected claim, The share for individual j with mean E[X,] would be (1 + 9)E[X|]. The 95th percentile requirement suggests that @ > 0. This extra amount, 0E[X)], is the security loading and @ is the relative security loading. Calculate 8. Solution: The criterion for @ is Pr(S = (1 + @)E[S]) — 0.95 where § — X, + X, + +++ + Xs: This probability statement is equivalent to [8 = F{S] _ _eE(S] VWarS) VVar(S) Following the discussion of the central limit theorem in Section 2.4, we approximate the distribution of (S — E[S])/‘VVar(S) by the standard normal distribution and use its 95th percentile to obtain #5 IS] Waris) It remains to calculate the mean and variance of $ and to calculate 0 by this equation. For the four classes of insured individuals, we have the results given below. Variance k — big ms 1 002 0.0196 +500 2 0.0784 500 3 0.0900 300 4 7 0.3600 500 Then 100 ‘ E[S] = > FIX] = > mbes = 160 a a and Var(S) = 5) Var(x) = 3) mbigi(l ~ 44) = 256. Thus, the relative security loading is 0 = 1645 SYS) — 9 645 15 - 0 1645, : ES] 160 v Chapter 2 Individual Risk Models for a Short Term a—_k == =—“‘“‘C:;‘CS;C;~O~™~™~™~C~COC The policyholders of an automobile insurance company fall into two classes. Distibution of Claim Amount, By Parameters Number of Truncated Class in Class Exponential emg 1 500 ox0 125 22000 ____o0s_ 280 A truncated exponential distribution is defined by the df. 0 x<0 F@)=f1-e* Osx rbiqu = 8,000 (1)(0.02) + 8,000 (2)(0.02) = 480 and Var(S) = > mbiq(l — 4.) = 8,000 (1)(0.02)(0.98) + 8,000 (4)(0.02)(0.98) = 784. In addition to the retained claims, S, there is the cost of reinsurance premiums. The total coverage in the plan is 8,000 (1) + 3,500 (2) + 2,500 (3) + 1,500 (5) + 500 (10) = 35,000. The retained coverage for the plan is 8,000 (1) + 8,000 (2) = 24,000. Therefore, the total amount reinsured is 35,000 — 24,000 = 11,000 and the reinsur- ance cost is 11,000(0.025) = 275. Thus, at retention limit 2, the retained claims plus reinsurance cost is $ + 275. The decision criterion is based on the probability that this total cost will exceed 825, a ‘Section 2.5 Applications to InsurancePr(S + 275 > 825) = Pr(S > 550) os [s = BIS] , 550 HSI] WVar(S) VVar(S) pleted in Exercises 2.13 and 2.14, v In Section 1.5 stop-loss insurance, which is available as a reinsurance coverage, was discussed. The expected value of the claims paid under the stop-loss reinsur ance coverage can be approximated by using the normal distribution as the distri bution of total claims. Let total claims, X, have a normal distribution with mean p and variance 6? and let d be the deductible of the stop-loss insurance. Then, by (1.5.2A), the expected reinsurance claims equal BIL) = Ae fF do [- Changing the variable of integration to z = (x — 4)/o and defining B by d= » + Bo, we obtain the following general expression for the expected value of stop-loss claims under a normal distribution assumption: ° [oe ~ Bll - oor} 252) where (x) is the distribution function for the standard normal distribution. (25.1) EUL(X)] ‘Consider the portfolio of insurance contracts in Example 2.5.3. Calculate the ex- pected value of the claims provided by a stop-loss reinsurance coverage where a. There is no individual reinsurance and the deductible amount is 7,500,000 b. There is a retention amount of 20,000 on individual policies and the deductible amount on the business retained is 5,300,000. Solutio a. With no individual reinsurance and the use of 10,000 as the unit, E{S] = 0.02[8,000(1) + 3,500(2) + 2,500(3) + 1,500(5) + 500(10)] = 700 and Var(S) = (0.02)(0.98){8,000(1) + 3,500(4) + 2,500(9) + 1,500(25) + 500(100)] 587.2 Tapter 2 Individual Risk Models for a Short Term’(5) = 50.86. Then, with = = w) _ (750 — 700 © 50.86 the application of (2.5.2) gives us P = 50.86(0.24608 — (0.983)(0.16280)] = 4.377. This is equivalent to 43,770 in the example as posed. b. In Example 2.5.3 we determined the mean and the variance of the aggregate claims, after imposing a 20,000 retention limit per individual, to be 480 and 784, respectively, in units of 10,000. Thus o(S) = 28. B 0.983 Then, with d—p _ 530 ~ 480 _ B= 2B 1.786 the application of (2.5.2) gives us P = 28{0.08100 ~ (1.786)(0.03707)] = 0.414. This is equivalent to 4,140 in the example as posed. v 2.6 Notes and References The basis of the material in Sections 2.2, 23, and 2.4 can be found in a number of post-calculus probability and statistics texts. Mood et al. (1974) prove the theo- rems given in (2.2.10) and (2.2.11). They also provide an extensive discussion of properties of the moment generating function. For a discussion of the advanced mathematical methods for deriving the distribution function that corresponds to a given moment generating function, see Bellman et al. (1966). Methods are also available to obtain the p.f. of a discrete distribution from its probability generating function; see Kornya (1983). DeGroot (1986) provides a discussion of several conditions under which the cen- tral limit theorem holds. Kendall and Stuart (1977) give material on normal power expansions that may be viewed as modifications of the normal approximation to improve numerical results. Bowers (1967) also describes the use of normal power expansions and gives an application to approximate the distribution of present values for an annuity portfolio. ra Section 2.6 Notes and ReferencesExercises Section 2.2 24. 2.2. 23. 24. 25. 26. Use (2.2.3) and (2.2.4) to obtain the mean and variance of the claim random variable X where q = 0.05 and the claim amount is fixed at 10. Obtain the mean and variance of the claim random variable X where q = 0.05 and the claim amount random variable B is uniformly distributed between 0 and 20. Let X be the number of heads observed in five tosses of a true coin. Then, X true dice are thrown. Let Y be the sum of the numbers showing on the dice. Determine the mean and variance of Y. (Hint: Apply (2.2.10) and (2.2.11),] Let X be the number showing when one true die is thrown. Let Y be the number of heads obtained when X true coins are then tossed. Calculate E[Y] and Var(¥). Let X be the number oblained when one uue die is tossed. Let Y be the sunt of the numbers obtained when X true dice are then thrown. Calculate E[Y] and Var(Y). The probability of a fire in a certain structure in a given time period is 0.02. Ifa fire occurs, the damage to the structure is uniformly distributed over the interval (0, a) where @ is its total value. Calculate the mean and variance of fire damage to the structure within the time period. Section 2.3 27. 28. Independent random variables X; for four lives have the discrete probability functions given below. Prix, PAX, = 2) PAX, Pe(X, =») 06 07 06 9 00 02 00 00 03 on 00 00 00 00 o4 00 01 0.0 00. ol Use a convolution process on the non-negative integer values of x to obtain F(x) for x = 0, 1,2,..., 13 where $ = X, + X, + X + Xy Let X, for i = 1, 2, 3 be independent and identically distributed with the d.f. 0 x<0 Fo)=4x 0Sx<1 1 x21 Chapter 2 Individual Risk Models for a Short Term 7Let § = X, + X, + Xy a, Show that F.(x) is given by 0 x<0 : fa O 4). Compare this with the exact answer. 2.11. a. Use the central limit theorem to calculate b, ¢, and d, for given a, in the statement ml where the X/s are independent and identically distributed with mean and variance o? and (2) is the d.f. of the standard normal distribution. b. Evaluate the probabilities in Exercise 2.8(c) by use of the normal approximation developed in part (a). coe avi) + bea) 2.12, A random variable U has mg.f M,(t)= (1-2) ot } a, Use the mg.f. to calculate the mean and variance of U. b. Use a normal approximation to calculate points yogs and yoo, Such that Pr(U > y,) = € 3... >seeNote the random variable U has a gamma distribution with parameters a = and B = 1/2, Gamma distributions with a = n/2 and B = 1/2 are chi-square distributions with 1 degrees of freedom. Thus U has a chi-square distribution with 18 degrees of freedom. From tables of dif’s of chi-square distributions, we obtain yoqs = 28.869 and yao, = 34.805. Section 2.5 2.13. 214. 215. 2.16. Calculate the probability that the total cost in Example 2.5.3 will exceed 8,250,000 if the retention limit is a. 30,000 b. 50,000. Calculate the retention limit that minimizes the probability of the total cost in Example 2.5.3 exceeding 8,250,000. Assume that the limit is between 30,000 and 50,000. A fire insurance company covers 160 structures against fire damage up to an amount stated in the contract. The numbers of contracts at the different con- tract amounts are given below. Contract Amount ‘Number of Contracts 10000 80 20000 35 30000 2B 50 000 6 100 000, 5 Assume that for each of the structures, the probability of one claim within a year is 0.04, and the probability of more than one claim is 0. Assume that fires in the struchires are mutually independent events. Furthermore, assume that the conditional distribution of the claim size, given that a claim has oc- curred, is uniformly distributed over the interval from 0 to the contract amount. Let N be the number of claims and let S be the amount of claims in a 1-year period. a. Calculate the mean and variance of N. b. Calculate the mean and variance of S. c. What relative security loading, 8, should be used so the company can collect an amount equal to the 99th percentile of the distribution of total claims? (Use a normal approximation.) Consider a portfolio of 32 policies. For each policy, the probability q of a claim is 1/6 and B, the benefit amount given that there is a claim, has p.d.f. ad-y) O 4). Chapter 2_ Individual Risk Models for @ Short Term 8SURVIVAL DISTRIBUTIONS AND LIFE TABLES 3.1 Introduction Chapter 1 was dedicated to showing how insurance can increase the expected utility of individuals facing random losses. In Chapter 2 simple models for sin- gle-period insurance policies were developed. The foundations of these models were Bernoulli random variables associated with the occurrence or nonoccurrence of a loss. The occurrence of a loss, in some examples, resulted in a second random process generating the amount of the loss. Chapters 4 through 8 deal 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 chapters the time-until-death random variable, T(x), is the basic building block. 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 sum- marized by a life table, Such tables are useful in many fields of science. Conse- quently a profusion of notation and nomenclature has developed among the vari- ous professions using life tables. For example, engineers use life tables to study the reliability of complex mechanical and electronic systems. Biostatisticians use life tables to compare the effectiveness of alternative treatments of serious diseases. Demographers use life tables as tools in population projections. In this text, life tables are used to build models for insurance systems designed to assist individuals facing uncertainty about the times of their deaths. This application determines the viewpoint adopted. However, when it provides a bridge to other disciplines, notes relating the discussion to alternative applications of life tables are added. A life table is an indispensable component of many models in actuarial science. In fact, some scholars fix the date of the beginning of actuarial science as 1693. In that year, Edmund Halley published “An Estimate of the Degrees of the Mortality of Mankind, Drawn from Various Tables of Births and Funerals at the City of Chapter 3 Survival Distributions and Life TablesBreslau.” The life table, called the Breslau Table, contained in Halley's paper re- mains of interest because of its surprisingly modern notation and ideas. 3.2 Probability for the Age-at-Death In this section we formulate the uncertainty of age-at-death in probability concepts. 3.2.1 The Survival Function Let us consider a newborn child. This newborn’s age-at-death, X, is a continuous- type random variable. Let Fy(x) denote the distribution function (4.f.) of X, FQ) =Pr(X<3x) x20, 21) and set s(x) =1-FyQ)=PHX>x) x20. (3.2.2) We always assume that F,(0) = 0, which implies s(0) = 1. The function s(x) is called the survival function (s.f.). For any positive x, s(x) is the probability a new- born will attain age x. The distribution of X can be defined by specifying either the function F,(x) or the function s(x). Within actuarial science and demography, the survival function has traditionally been used as a starting point for further devel- opments. Within probability and statistics, the d.f. usually plays this role. However, from the properties of the df, we can deduce corresponding properties of the survival function. Using the laws of probability, we can make probability statements about the age- at-death in terms of either the survival function or the distribution function. For example, the probability that a newborn dies between ages x and z (x < z) is Pr(x < X <2) = Fy(z) — Fy(x) = s(x) — st). 3.2.2 Time-until-Death for a Person Age x The conditional probability that a newborn will die between the ages x and z, given survival to age x, is '¢(2) = F(x) T= Fy@) Priv < X= 7|X > 2) = 908) = st2) eae 3.2.3) The symbol (2) is used to denote a life-age-x. The future lifetime of (x), X = x, is denoted by T(). 52 ‘Section 3.2 Probability for the Age-at-DeathWithin actuarial science, itis frequently necessary to make probability statements about T(2). For this purpose, and to promote research and communication, a set of symbols, part of the International Actuarial Notation, was originally adopted by the 1898 International Actuarial Congress. Symbols for common actuarial functions and principles to guide the adoption of new symbols were established. This system has been subject to constant review and is revised or extended as necessary by the International Actuarial Association's Permanent Committee on Notation. These no- tational conventions are followed in this book whenever possible. ‘These symbols differ from those used for probability notation, and the reader may be unfamiliar with them. For example, a single-variate function that would be written q(x) in probability notation is written q, in this system. Likewise, a multi- variate function is written in actuarial notation using combinations of subscripts, superscripts, and other symbols. The general rules for defining a function in ac- tuarial notation are given in Appendix 4. The reader may want to study these forms before continuing the discussion of the future-lifetime random variable. To make probability statements about T(x), we use the notations ae = PHT) t] FeO. (3.2.5) The symbol ,q, can be interpreted as the probability that (x) will die within t years; that is, q, is the d.f. of T(2). On the other hand, ,p, can be interpreted as the prob- ability that (x) will attain age x + 1; that is, »p, is the sf. for (x). In the special case of a life-age-0, we have T(0) = X and Po= SX) x20. 3.2.6) If t = 1, convention permits us to omit the prefix in the symbols defined in (3.2.4) and (3.2.5), and we have 4 r{(x) will die within 1 year}, Py = Pr{(x) will attain age x + 1]. There is a special symbol for the more general event that (x) will survive f years and die within the following u years; that is, (x) will die between ages x + + and x +f + u, This special symbol is given by ahs = Pelt < Tex) st + u] tells ~ = Pe Ps 27) As before, if u = 1, the prefix is deleted in ,,9,, and we have ,, At this point it appears there are two expressions for the probability that (x) will die between ages x and x + u. Formula (3.2.7) with t = 0 is one such expression; (823) with z = x + wis a second expression. Are these two probabilities different? Formula (3.2.3) can be interpreted as the conditional probability that a newborn Chapter 3 Survival Distributions and Life Tableswill die between ages x and z = x + u, given survival to age x. The only information on the newborn, now at age x, is its survival to that age. Hence, the probability statement is based on a conditional distribution of survival for newborns. On the other hand, (3.2.7) with t = 0 defines a probability that a life observed at age x will die between ages x and x + 1. The observation on the life at age x might include information other than simply survival. Such information might be that the life has just passed a physical examination for insurance, or it might be that the life has commenced treatment for a serious illness. Life tables for situations where the observation of a life at age x implies more than simply survival of a newborn to age x are discussed in Section 3.8, where additional notation for those life tables is introduced. We will continue development of the theory without further refer- ence to the distinction between (3.2.3) and (3.2.7), and we assume that until that section, observation of survival at age x will yield the same conditional distribution of survival as the hypothesis that a newborn has survived to age x; that is, wiPo _ 0 +f) Po SIX) six + 8) 3a)” 1 (8.28) (3.2.9) Under this approach, (3.2.7), and its many special cases, can be expressed as s(x + t) — sx +t +n) 3@) [sen] fe t= set tt s(x) s(x +t) Px Ave (3.2.10) —_———_ 3.2.3 Curtate-Future-Lifetime ‘A discrete random variable associated with the future lifetime is the number of future years completed by (x) prior to death. It is called the curtate-future-lifetime of (x) and is denoted by K(x). Because K(x) is the greatest integer in T(x), its p.f. is Pr{Kix) = Prik = Tx) 0 f(x) = 0 ni) =0 Fy@)=1 s(@) =0 lim fgfG)dt=1 SS weeds = » Funetinna in Terms of Relationships FyQ) Fy (x) 1 Fx) F(z) FxQX)/T1 = Fy) sx) 1 sta) 500) (a) 5'@)/ 0) fx) Se fetwdu SE fwd Sxl) AOS: food wx) 1 = expl=S5 wit) dtl expl—Ji w(t) dt} wxexpl=S5 w(t) df} w(x) k= = =— If A refers to the complement of the event A within the sample space and Pr(A) + 0, the following expresses an identity in probability theory: Pr(A U B) = Pr(A) + Pr(A) Pr(B\A). Rewrite this identity in actuarial notation for the events A = [T(x) = #] and B = [F< T@s0 ELE] = by s(x). We denote E[¢(3)] by 1,; that is, I, represents the expected number of survivors to age x from the /, newborns, and we have 1, = hy s(u). 3.1) Moreover, under the assumption that the indicators J; are mutually independent, 8(Q) has a binomial distribution with parameters 1 = I, and p = s(x). Note, however, that (3.3.1) does not require the independence assumption. 38 Section 3.3 Life TablesIna similar fashion, ,9, denotes the number of deaths between ages x and x + 1 from among the initial /y lives. We denote E[,.9,] by ,,. Since a newborn has prob- ability s(x) — s(x + m) of death between ages x and x + m we can, by an argument similar to that for [,, express 1d, = EL,9,) = bfs(x) ~ soe + 1] by ~ deans (33.2) When 1 = 1, we omit the prefixes on ,9, and ,4, From (3.3.1), we see that mo = we) (3.3.3) and 34) Since Fy pA) = In Po MX) = In fx), the factor 1, (x) in (3.3.4) can be interpreted as the expected density of deaths in the age interval (x, x + dx). We note further that I, = Ip exp[—So u(y) dy], (3.3.5) dosn = be expl— Fe w(y) dy], (3.3.6) Fe deen = FE" Ly wy) ay. 3.7) For convenience of reference, we call this concept of |, newborns, each with survival function s(x), a random survivorship group. 3.3.2 Life Table Example In “Life Table for the Total Population: United States, 1979-81” (Table 3.3.1), the functions ,q,,1,, and ,d, are presented with I, = 100,000. Except for the first year of life, the value of t in the tabulated functions ,q, and ,d, is 1. The other functions appearing in the table are discussed in Section 3.5, ‘The 1979-81 US. Life Table was not constructed by observing 100,000 newborns until the last survivor died. Instead, it was based on estimates of probabilities of death, given survival to various ages, derived from the experience of the entire US. population in the years around the 1980 census. In using the random survi- vorship group concept with this table, we must make the assumption that the probabilities derived from the table will be appropriate for the lifetimes of those who belong to the survivorship group. Chapter 3 Survival Distributions and life Tables 59Life Table for the Total Population: United States, 1979-81 wm @) ) «@) © © a Average Proportion Remaining Dying lifetime Proportion of ; , ‘Average Persons Alive Stationary Population” __ Number of at Beginning __Of 100,000 Born Alive _ Years Lived Years of ‘Age Interval Cfage ber in This, Remaining Period of Interval ing at_ Number Years Lived and All__at Beginning Life between Dying during Beginning of Dying during inthe Age Subsequent of Age Two Ages Interval "Age Interval Age Interval Interval Age Intervals Interval xtortt a 1 le is T. a Days 04 0.00469 100 000 463 2737387758 73.88 17 0.00246 99597 245, 16857387485, 7422 7-28 0.00139 99292 138 5708 7385850 7438 28-365 0.00418 99154 a4 913577380142 7443 Years 0-4 0.01260 100000 1260 98973 7387758, 73.88 12 0.00093 98 740 92 98694 7 DARTRE 7382 23 6.00065 93 648 64 98617 7190091 72.89 34 6.00050 98 584 49 98560 7091474 7193 +5 0.00040 98 535 40 98515 6 992914 7097 5-6 0.00037 98.495 36 98477 6 894399 70.00 6? 0.00033 98 459 33 98442 6 795922 69.02 7-8 0.00030 98426 30 98.412 6 697 490 68.05 89 0.00027 98396 26 98383 6 599068 67.07 9-10 0.00023 98370 2 98358 6 500685 66.08 10-11 .00020 98347 19 98338 6402327 «65.10 na 0.00019 98.328 19 98319 6303989 6.11 3 0.0005 98 309 24 982976205670 «63.12 44 0.00037 98 285 7 98266 © G1U7373— «GA 115 0.00053 98 248 52 98222 6009107 61.16 15-416 0.00069 98 196 oa 98163 5.910885 60.19 16-17 0.00083 98129 2 98087 5.812722 59.24 17-18 0.00095 98 047 34 98000 5714635, 58.28 1819 0.00105 97953 102 97902 5616635 5734 19-20 0.00112 97 851 no 9779 5518733. 5640 20-21 0.00120 ora 118 97682 5.40937 58.46 a2 0.00127 97 623 14 97561 5323255 5453, 2-23 0.00132 97 499 129 97435 5225684 «53.60 23-24 o.00134 97370 130 97306 5.128259 5267 24-25 0.00133 97240 130 97175 5030953 5174 25-26 0.00132 97110 128 97046 4.93378 5081 26-27 0.00131 96982 126 96919 4836732 99.87 27-28 0.00130 96 856 126 96793 «4739813. «48.94 23-29 0.00130 96730 126 96667 4643020 48.00 29-30 0.00131 96 604 7 96541 4546 4706 “Stationary population Is @ demographic concept vested in Chapter 19. 60 ‘Section 3.3 Life Tablespes ‘Continued [i Life Table for the Total Population: United States, 1979-81 @ ® @ @ © a Average Remaining Proportion of a Fereons Average ‘alive . Stationary Population” __ Number of at Beginning __OFf 100,000 Born Alive Years Lived Years of Age Interval “of age ‘Number ‘in This Remai Period of Interval _Living at_ _ Number Years Lived _and All Life between Dying during Beginning of Dying during in the Age Subsequent Two Ages Interval Age Interval Age Interval Interval Age Intervals xtoxit ra 1 a, Pa tr, a 0.00133 96477 wz 96 414 4449 812 46.12 0.00134 96 350 130 96 284 4353 398, 45.18 0.00137 96 220 132 96 155 4257 114 44.24 0.00142 96 088 137 96.019 41160959 43.30 0.00150 95951 43 95 880 4064 940 12.36 0.00159 153 3.969 060 41.43 0.00170 163 3.873.329. 4049 0.00183 175 3777 755 39.56 0.00197 188 3.682.351 38.63 0.00213 203 3587 127 3771 0.00232 20 3.492.100 36.79 0.00254 241 3397 283, 35.87 0.00279 264 3 302.698, 34.96 0.00306 288 3208 364 34.06 0.00335 314 3.114307 33.16 0.00366 93.599 343 3020551 32.27 0.00401 93.256 374 2927 124 31:39 0.00442 92 882 410 2.834 055 3051 0.00488 92472 451 2741378 29.65 0.00538 92.021 495 2649 132 28.79 0.00589 91526 540 91256 2557359 27.94 0.00642 90 986 584 90695 2.466 103 27.10 0.00699 90 402 631 goss 2375408 26.28 0.00761 8971 684 99430 2285322 25.46 0.00830 89.087 739 88717 2195892 24.65 0.00902 88.348 707 87950 2107175 23.85 0.00978 87551 856 87122 2.019 205 23.06 0.01059 36 695 919 36 236 41932 103 22.29 0.01151 8576 987 85283, 1.845 867 21.52 amass 84759 1063 BADR, 17601584 2076 60-61 0.01368 83.726 1145 83.153 1676 326 20.02 61-62 0.01493 82581 1233 81.965 1.593.173 19.29 62-63 0.01628 81348, 1324 80 686 1511 208 18.58 63-64 0.01767 80024 1415 79316 1430 522 1788 64-65 0.01911 78.609 1502 77859 1.351 206 17:19 “Stationary population is @ demographic concept treated in Chapter 19. Chapter 3 Survival Distributions and Life Tables 61