1 Math Fundamentals

1.1 Integrals, factors and techniques

n=0
r
n
=
1
1 r
, (r
2
< 1)

n=0
x
n
n!
= e
x
(a+b+c)
2
= a
2
+b
2
+c
2
+2ab+2ac+2bc
b

a
udv = uv|
b
a

a
v du a special case:
b

a
xe
x
dx =
1

xe
x

a
b
+
1

2
e
x

a
b

0
x
n
e
ax
=
n!
a
n+1

0
xe
ax
=
1
a
2
and

0
x
2
e
ax
=
2
a
3
(n) =

0
x
n1
e
x
dx
(1) = 1 (n) = (n 1)!

n +
1
2

2
n
[1 3 5 (2n 1)]

1
2

3
2

2
1.2 Probability relations
If A B, then Pr(A) Pr(B).
Pr(A) = Pr(A B) + Pr(A B

)
(

A
i
)

=

A

i
(

A
i
)

=

A

i
Pr(A B) = Pr(A) + Pr(B) Pr(A B)
Pr(A B C) = Pr(A) + Pr(B) + Pr(C) Pr(A B) Pr(A C) Pr(B C) + Pr(A B C)
Pr(A B) = Pr(B|A) Pr(A) Pr(B|A) =
Pr(A B)
Pr(A)
.
Pr(B) = Pr(B|A) Pr(A) + Pr(B|A

) Pr(A

) (Law of Total Probability)

Pr(A|B) =
Pr(B|A) Pr(A)
Pr(B)
(Bayes; note the ip-op of Pr(A|B) & Pr(B|A))
Pr(A
j
|B) =
Pr(A
j
B)
Pr(B)
=
Pr(B|A
j
) Pr(A
j
)

n
i=1
Pr(B|A
i
) Pr(A
i
)
(Generalized Bayes; the A
i
s form a partition)
A, B are independent i Pr(A B) = Pr(A) Pr(B) and Pr(A|B) = Pr(A).
Pr(A

|B) = 1 Pr(A|B)
Pr((A B)|C) = Pr(A|C) + Pr(B|C) Pr((A B)|C).
If A, B are independent, then (A

, B), (A, B

), and (A

, B

) are also independent (each pair).

1.3 Counting
There are

n
r

=
n!
r!(n r)!
ways to choose r objects from a collection of n items denoted
n
C
r
. If order
is important, then there are
n
P
r
= r!
n
C
r
permutations of those objects.
There are

n
n
1
n
2
n
m

=
n!
n
1
! n
2
! n
m
!
ways to choose n
1
objects of Type 1, n
2
objects of Type 2,
etc. Note that
m

i=1
n
i
= n.
1
Binomial Theorem: When expanding (1+t)
N
, the coecient of t
k
is

N
k

, so that (1 +t)
N
=

k=0

N
k

t
k
.
Multinomial Theorem: When expanding (t
1
+ t
2
+ + t
s
)
N
where N is a positive integer, the
coecient of t
k1
1
t
k2
2
t
ks
s
(where

k
i
= N) is

N
k
1
k
2
k
s

=
N!
k
1
!k
2
! k
s
!
.
2 Probability Distributions
2.1 Essential denitions
I only list examples for continuous variables. Note that for a discrete distribution, integration is replaced
by summation.

b
a
dx

a<x<b
. If X is a random variable, then a function of it, e.g. g(X), is also a
random variable.
Cumulative Distribution Function F
X
(x) = Pr(X x) F
X
(x) =

x

f
X
(x) dx
Probability Function f
X
(x) = Pr(X = x) f
X
(x) = F

X
(x)
If X is continuous, then Pr(a < X < b) =

b
a
f
X
(x) dx = F(b) F(a)
Survival Function s
X
(x) = Pr(X > x) = 1 F
X
(x)
Hazard Rate (failure rate) h(x) = (x) =
f
X
(x)
s
X
(x)
=
d
dx
ln

1 F
X
(x)

2.1.1 Expectation values and other parameters

In general, E(g(X)) =

g(x)f
X
(x) dx. In particular, E(X) =

xf
X
(x) dx and E(X
2
) =

x
2
f
X
(x) dx.
There are a couple of special cases when X > 0:
If X is continuous, E(X) =

0
s
X
(x) dx
If X is discrete, E(X) =

n=1
Pr(X n) =

n=0
Pr(X > n) =

n
s
X
(n) = s
X
(0) +s
X
(1) +. . .
If X a almost surely, then E(X) = a +

a
s
X
(x) dx
If a X b, then E(X) = a +

b
a
s
X
(x) dx
If Pr(X 0) = 1, then we can write
E

min(X, a)

=
a

0
s
X
(x) dx and E

max(X, a)

= a +

a
s
X
(x) dx.
The variance of X, Var(X) =
2
X
= E(X
2
)

E(X)

2
. Since the variance is not a linear operator, it
must often be calculated manually after obtaining the rst two moments. This is particularly important
for mixed distributions! Note that
E(aX +bY +c) = aE(X) +bE(Y ) +c,
and
Var(aX +bY +c) = a
2
Var(X) +b
2
Var(Y ) (X, Y independent)
The standard deviation of X is
X
=

Var(X) and the coecient of variation is

X

X
.
2
2.1.2 Moment generating function and friends
If it exists, the moment generating function (MGF) is dened as
M
X
(t) = E(e
Xt
)
d
n
dt
n
M
X
(0) = E(X
n
) and M
X
(t) =
n

i=1
p
i
e
xit
The latter is the sum of the probability of getting a particular value of x. The MGF of the sum of
independent random variables is the product of their MGFs.
Several properties of the MGF are worth remembering:
M
X
(0) = 1 M
aX
= M
X
(at)
M
X+Y
(t) = M
X
(t)M
Y
(t) if X and Y are independent
The cumulant generating function is given by

X
(t) = ln M
X
(t) which leads to
d
k
dt
k
(0) =
(k)
(0) = E

X E(X)

The probability generating function is given by P

X
(t) = E(t
X
) i E(t
X
) exists.
If 0 < p < 1, then the 100pth percentile of the distribution of X is the number x
p
which satises both
of the following inequalities:
Pr(X x
p
) p and Pr(X x
p
) 1 p.
For a continuous distribution, Pr(X x
p
) = p. The 50
th
percentile is p = 0.50, and is called the median.
For discrete distributions, the median and percentiles need not be unique!
The mode of a distribution is where f
X
(x) is maximized.
If a random variable X has mean and standard deviation , we can create a new, standardized
random variable Z =

. Then the skewness of X is dened as = E(Z

3
) and its kurtosis is
given by = E(Z
4
). A positive skewness indicates a long tail to the right. A large kurtosis indicates
that the variance is inuenced more by a few extreme outliers rather than several small deviations.
2.1.3 Important inequalities
Jensens: Pick h such that h

(x) exists. Then

if h

(x) 0 then E

h(X)

E(X)

if h

(x) 0 then E

h(X)

E(X)

Markov: Pr(X a)
E(X)
a
(a > 0 and X nonnegative real)
Chebyshev: Pr(|X | )

2

2
. Equivalently, Pr(|Z| r)
1
r
2
where Z = (X )/.
You must remember the Chebyshev Inequality!
3
2.1.4 Transformation of a random variable
Given random variable X with known functions f
X
and F
X
, and random variable Y = (X) is a function
of X. We want to nd f
Y
and F
Y
. Note that
Y = (X) = Y (X)
X =
1
(Y ) = X(Y )
The following is useful:
X continuous F
Y
=

F
X
(x(y)) if y

> 0
s
X
(x(y)) if y

< 0
f
Y
(y) = f
X
(x(y))

dx
dy

X discrete f
Y
(y) =

x
1
({y})
f
X
(x)
2.2 Commonly Used Distributions
The most commonly used distributions for the purposes of this exam are summarized in tables 1, 2,
and 3. The Binomial, Negative Binomial, and Poisson distributions all obey the following recursion
relations:
f
X
(n) =

a +
b
n

f
X
(n 1) a b
Binomial
p
q
(n + 1)
p
q
Negative Binomial q (r 1)q
Poisson 0
3 Multivariate Distributions
These are almost always best started by drawing a graph of the region where f
X,Y
> 0. This is very
useful for identifying the proper limits of integration or determining the ratio of areas.
3.1 Joint and marginal distributions
We now concern ourselves of the case when we have two random variables, call them X and Y , and wish
to know features of their joint probability. That is, we want to study the probability density function
f
X,Y
(x, y) = Pr(X = x Y = y) = Pr(X = x, Y = y)
with cumulative probability
F
X,Y
(x, y) = Pr(X x Y y) = Pr(X x, Y y)
and the two are related as before:
F
X,Y
(x, y) =
x

f
X,Y
(s, t) dt ds
Expectation values are as before: E[h(X, Y )] =

h(x, y)f
X,Y
(x, y) dxdy
4
The pdf can be found from f
X,Y
(x, y) =

2
xy
F
X,Y
(x, y)
As in the single variable case, for discrete variables, replace

and

.
If one plots the probability distribution as a function of X and Y , then it may be interesting to note how
X behaves for a xed value of Y , or vice-versa. Holding X xed, we can sum F
X,Y
over all the allowed
y for that X, and record it next to the graphin the margin. We dene the marginal distribution of
X as
f
X
(x) =

f
X,Y
(x, y) dy and the marginal dist. of Y f
Y
(y) =

f
X,Y
(x, y) dx
The marginal CDFs are given by
F
X
(x) = lim
y+
F
X,Y
(x, y) F
Y
(y) = lim
x+
F
X,Y
(x, y)
If the random variables are independent, then the joint probability can be factored:
f
X,Y
(x, y) = f
X
(x)f
Y
(y) F
X,Y
(x, y) = F
X
(x)F
Y
(y)
The expectation values can be factored as well:
E(XY ) = E(X)E(Y ) E(X
2
Y
2
) = E(X
2
)E(Y
2
)
A plot of f
X,Y
will be a rectangle with sides parallel to the axes if X and Y are independent.
The conditional distribution of Y given X has a direct analog to basic conditional probability. Recall
that
Pr(B|A) =
Pr(A B)
Pr(A)
so that f
Y |X=x
(y|X = x) = f
Y
(y|x) =
f
X,Y
(x, y)
f
X
(x)
The expectation value is found in the usual way; E(Y |X = x) =

yf
Y
(y|x) dy. There are two
important results:
E(Y ) = E[E(Y |X)] Var(Y ) = E[Var(Y |X)] + Var[E(Y |X)]
3.2 Covariance
The covariance and correlation coecient are given by

2
XY
= Cov(X, Y ) = E(XY ) E(X)E(Y )
(X, Y ) =
Cov(X, Y )

Var X

Var Y
=

2
XY

Y
Note that = Cov = 0 if X and Y are independent.
Covariance is a linear operator:
Cov(aX
1
+bX
2
+c, Y ) = a Cov(X
1
, Y ) +b Cov(X
2
, Y )
and we can generalize the variance of a multivariate distribution to
Var(aX +bY ) = a
2
Var(X) +b
2
Var(Y ) + 2ab Cov(X, Y )
Let X
1
, X
2
,. . . ,X
n
make a random sample from a distribution with variance
2
, then the above rule
(with a = b = 1) can be extended as Var(X
1
+X
2
+ +X
n
) = n
2
.
5
3.3 Moment generating functions and transformations of a joint distribution
Similar to the single-variable case,
M
X,Y
(s, t) = E(e
sX+tY
)
The relations are explicitly M
X
(s) = M
X,Y
(s, 0) and M
Y
(t) = M
X,Y
(0, t). If X and Y are independent,
then M
X,Y
(s, t) = M
X
(s) M
Y
(t). Expectation values of the moments can be found from the relation

m+n
s
m
t
n
M
X,Y
(s, t)

s=t=0
= E(X
m
Y
n
)
3.4 Transformations and Convolution
Let (U, V ) = (X, Y ) be a dierentiable function of two random variables such that X and Y have a
known joint probability function. Then the joint pdf of U and V is given by
f
U,V
(u, v) = f
X,Y
(x(u, v), y(u, v))

(x, y)
(u, v)

where
(x, y)
(u, v)
= det

x
u
x
v
y
u
y
v

Convolution is especially pertinent for the sum of two random variables. It is the weighting of one
variable by the other when the two are constrained by a condition such as a sum. The following table
summarizes f
X+Y
(k) = Pr(X + Y = k) for discrete and continuous random variables for independent
and dependent X, Y pairs. Note that since X +Y = k, Y = X k.
Discrete Continuous
General case
k

x=0
f
X,Y
(x, k x)

f
X,Y
(x, k x) dx
X, Y indpt
k

x=0
f
X
(x)f
Y
(k x)

f
X
(x)f
Y
(k x) dx
If we have a collection of several random variables, X
i
, with dierent weights,
i
such that

i
= 1,
we can construct a new mixed distribution of f
X
(x) =
1
f
X1
(x) +. . . +
n
f
Xn
(x). Then the various
moments are weighted averages of the individual moments. For example, to nd the variance, you must
rst nd the 1
st
two moments for each X
i
, then weight them to get the moments of mixed distribution,
then nally compute E(X
2
) [E(X)]
2
.
3.5 Central Limit Theorem
For any suciently large sample size, e.g. 30, any distribution can be approximated by a normal
with the same mean and variance of the original. The practical implication that a sum of independent
identically distributed random variables can be approximated by a normal distribution with the same mean
and variance as the sum.This means that several of our earlier distributions become normal distributions:
b(n, p) N(np, npq)
NEGBIN(r) N(
rq
p
,
rq
p
2
)
Poisson N(, )
N(

2
)
Sample Avg. (X) N(
X
,

2
X
n
)
6
In principle, one must be careful about approximating a discrete distribution with a continuous one.
We therefore have the continuity correction: Let X be the original discrete distribution and Y the
continuous approximation. Then, Pr(X n) Pr(X n +
1
2
) Pr(Y n +
1
2
). Also, Pr(X < n)
Pr(Y < n
1
2
) and Pr(X n) Pr(Y > n
1
2
). In practice, though, the dierence is small and not
likely to be a factor in choosing between multiple choice options on the exam.
3.6 Order Statistics
Let X
1
through X
n
be a collection of independent random variables. Let Y
1
be the smallest of the X
i
,
and Y
n
be the largest. The collection of Y
i
has the same mean and variance as the collection of X
i
,
but the Y are now dependent. There are two interesting cases: when the smallest Y is larger than a
particular value, and when the largest Y is smaller than some limit.
Pr(Y
1
> y) = s
Y1
(y) = [s
X
(y)]
n
Pr(Y
n
< y) = F
Yn
(y) = [F
X
(y)]
n
If the X
i
come from a continuous distribution, then the ordered pdf is
f
Y1,Y2,...,Yn
(y
1
, . . . , y
n
) = n!f
X
(y
1
)f
X
(y
2
) f
X
(y
n
)
and the k
th
order is
f
Y
k
(y) =
n!
(k 1)!(n k)!

F
X
(y)
k1

1 F
X
(y)

nk
f
X
(y)

where the bracketed terms represent the probability of k 1 samples being less than y, the probability
of nk samples being greater than y, and the probability of one sample being in the interval [y, y +dy].
4 Risk Management
Some general denitions that are common to describing losses:
X = loss, actual full loss, ground up loss Y = claim to be paid
E(Y ) = net premium, pure premium, expected claim

Y
= unitized risk, coecient of variation
4.1 Risk models
The individual risk model considers n policies where the claim for policy i has a random variable X
i
.
All the X
i
are independent and identically distributed, with nite mean and variance.
S =
n

i=1
X
i
is the aggregate claim random variable.
E(S) =

i
E(X
i
) = n Var(S) =

i
Var(X
i
) = n
2
The coecient of variation is then

Var(S)
E(S)
=
1

n 0.
The collective risk model is an extension of the IRM by allowing n to also be a random variable, N.
Note that often S =

N
i=1
can be approximated as N(n, n
2
). If S is the total loss paid to an individual
or group, then E(S) is the pure premium for the policy. The actual premium before expenses and
prots is given by Q = (1 +)E(S) where is the relative security loading.
7
4.2 Deductibles and policy limits
Let X represent the loss amount, d, the deductible on the policy, and Y the amount paid on the claim.
Ordinary deductible insurance is sometimes called excess loss insurance and has Y = max(X d, 0) =
(X d)
+
. The pure premium is E(Y ) =

d
s
X
(x) dx =

d
(1 F
X
(x)) dx =

d
(x d)f
X
(x) dx.
There are two common variations on the deductible. The franchise deductible pays in full if loss ex-
ceeds the deductible. The disappearing deductible has both upper (d
U
) and lower (d
L
) deductibles,
and the payout increases linearly from zero to full loss between the limits.
The franchise deductible:
Y =

0 X d
X X > d
The disappearing deductible :
Y =

0 X d
L
d
U

X d
L
d
U
d
L

d
L
< X d
U
X X > d
U
A policy may have a limit of u on the maximum payout on a policy. Then Y = max(X, u) and
E(Y ) =

0
s
Y
(y) dy =

u
0
s
X
(x) dx. Note the similarity to the ordinary deductible.
An insurance cap species a maximum claim amount m on a policy. If there is no deductible, then
this is identical to a policy limit. If there is a deductible, then m = u d is the maximum payout.
Proportional insurance pays a fraction, , of the loss X. For example 80-20 medical plans. When
the amount paid is not the same as the loss, the following random variables are sometimes used:
Y

is the amount paid, conditional on the event that payment was made, sometimes termed payment
per payment.
Y is the amount paid per loss.
For example, a policy with deductible d has
Y

= (X d)|(X > d) and Y = max(X d, 0).

The mean excess loss in this case is E(Y

)
The loss elimination ratio is dened as
expected loss eliminated from a claim
expected total loss
. Note that the loss
eliminated from payment is made up by the insured (customer).
Reinsurance is an insurance policy purchased by an insurance company, primarily to limit catastrophic
claims or tax purposes. These policies can have caps, deductibles, and proportional payments.
8
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11