Lectures On Insurance Models

TEXTS AND READINGS
IN MATHEMATICS 54
Lectures on
Insurance Models
Texts and Readings in Mathematics
Advisory Editor
C. S. Seshadri, Chennai Mathematical Institute, Chennai.
Managing Editor
Rajendra Bhatia, Indian Statistical Institute, New Delhi.
Editors
R. B. Bapat, Indian Statistical Institute, New Delhi.
V. S. Borkar, Tata Inst. of Fundamental Research, Mumbai.
Probai Chaudhuri, Indian Statistical Institute, Kolkata.
V. S. Sunder, Inst. of Mathematical Sciences, Chennai.
M. Vanninathan, TIFR Centre, Bangalore.
Lectures on
Insurance Models
s. Ramasubramanian
Indian Statistical Institute
Bangalore
o oHINDUSTAN
f1dg1@
U UJJ UBOOKAGENCY
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ISBN 978-81-85931-93-7 ISBN 978-93-86279-44-6 (eBook)

DOI 10.1007/978-93-86279-44-6
Contents
Preface vii
1 Introduction 1
1.1 Main assumptions 2
1.2 An overview . 3
2 Poisson model 6
2.1 Preliminaries . . . . . . . . . . . . . . . . 6
2.2 Interarrival and waiting time distributions 10
2.3 Order statistics property . 17
2.4 Cramer-Lundberg Model. 20
2.5 Exercises 23
3 Renewal model 29
3.1 Preliminaries 29
3.2 Renewal function . 36
3.3 Renewal theorems 43
3.4 Sparre Andersen model 54
3.4.1 Some basic premium principles 57
3.5 Exercises 61
4 Claim size distributions 69

4.1 Light-tailed distributions. 69
4.2 Regularly varying functions and distributions 72
4.3 Subexponential distributions 84
4.4 Exercises .101
5 Ruin Problems 107

5.1 Risk process and an associated random walk . .107
5.2 Lundberg bound . . . . . . . . . . . . . . . . .112
vi CONTENTS
5.3 An integral equation in Cramer-Lundberg model . 115

5.4 Exact asymptotics in Cramer-Lundberg model . 119
5.4.1 Light-tailed claims . . . 119
5.4.2 Subexponential claims . 123
5.5 Exercises . . . . . . . . . . . . 125
6 Lundberg risk process with investment 130

6.1 Lundberg risk process and Markov property · 131
6.2 Risk process with investment · 141
6.3 Assorted comments . .166
6.4 Exercises .168
Appendix 173
A.l Basic not ions . . . . . . . . . .173
A.2 On the central limit problem · 180
A.3 Martingales . . . . . . . . . . · 185
A.4 Brownian motion and Ito integrals · 189
Bibliography 196
Index 200
Preface
This introductory book is an expanded version of aseries of lec-

tures given during the academic year 2006-2007 at the Department of
Mathematics, Indian Institute of Science (I.I.Sc.), Bangalore, organized
by IISc Mathematics Initiative. The audience consisted of students/
faculty with background in mathematics, statistics or engineering.
Our objective is to introduce the basic mathematical concepts of
insurance models. To maintain a reasonable length, we consider only
models from collective risk theory (also called non-life insurance). The
language of continuous time stochastic processes is the right medium
to mathematically formulate these models. So Poisson process, more
general renewal processes and later stochastic differential equations will
be encountered in the sequel. As the so called heavy-tailed distribu-
tions have become increasingly important in insurance, tail behaviour of
probability distributions on the positive realline is also studied at some
length. Nothing is new in the book, except perhaps parts of Chapter 6
and some details of presentation.
Good background in basic probability theory and real analysis should
suffice to follow most of the book. Some familiarity with measure theo-
retie prob ability will be more helpful. It is hoped that those preparing
to take up a career in actuarial science would find this book a useful
introductory text. Practitioners in the field who are interested in the
underlying mathematical aspects of insurance models may find it infor-
mative. In addition, this can serve as a collateral text for courses on
stochastic processes to graduate students in mathematics / statistics /
operations research / engineering.
It is a pleasure to thank Mrinal Ghosh for inviting me to lecture at
his department, and for encouraging me to write up the notes. Thanks
are due to Vivek Borkar for his interest in the project, to B.V. Rao and
two painstaking referees for their constructive suggestions on an earlier
draft, and to E. Asha Lata for her efficient typing. Also I thank my wife
Chandra for her constant support.
This book is dedicated to my parents.
S. Ramasubramanian
Chapter 1
Introd uction
Catastrophes, natural as wen as man-made, rein force the fact that al-
most everyone would like to be assured of some (non-supernatural)
agency to bank upon in times of grave need. If the affected parties are
too poor, then it is the responsibility of governments and the "haves"
to co me to the rescue. It is not uncommon that places of worship, pala-
tial buildings and schools serve as refuges for the affected. However,
there are also significant sections of the population who are willing to
pay regular premium to suitable agencies during normal times to have
insurance cover to tide over crises.
Insurance policies have been prevalent in Europe since middle ages.
Scientists like J . Graunt, E. Halley, A. De Moivre and C. Neumann are
believed to have played major roles in formulating some of the pro ce-
dures in connection with life insurance in 17th century. In India, as
advocated by educationist and social reformer I. Vidyasagar, insurance
schemes aimed at mitigating the plight of widows were introduced in
late 19th century.
By 18th century the extreme uncertainties encountered in maritime
trade gave rise to insurance covers against property loss; these included
also fairly sophisticated schemes like reinsurance policies, that is, in-
suring of insurance companies. Complexities of 20th and 21st centuries
have, of course, spawned a whole gamut of insurance schemesjproducts
(like life, healthjmedical, accident, disability, fire, theft, car, pension
funds, travel, housing, business related insurance, etc.). Thus insurance
has become apart of modern life, whether we like it or not.
In an insurance set up, a considerable proportion of the financial
risk is shifted to the insurance company. The implicit trust between
the insured and the insurance company (perhaps formalized by a legal
2 1. Introduction
contract) is at the core of the interaction. A reasonable mathemati-

cal theory of insurance can possibly provide a scientific basis for this
trust. There were sporadic attempts at this, notably by T. Thiele who
derived a differential equation in the context of life insurance in 19th
century. The first systematic step in this direction seems to have been
taken by the actuary F. Lundberg in 1903. It was furt her strength-
ened in the 1930's by the pioneering work of the actuary F. Esseher
and the probabilist H. Cramer. Not surprisingly, these developments
took place around the same time when prob ability theory acquired its
identity. Mathematics of insurance is now considered apart of applied
probability, and a major portion of it is described in terms of continuous
time stochastic processes. For more details concerning history, alld also
for quick overview of many theoretical concepts and practical aspects of
insurance, an excellent sour ce is the encyclopedic work [TS].
To keep this introductory text to a reasonable length, we shall con-
sider only some simple models of risk theory (also called non life insur-
ance or collective risk theory). A typical model will involve an ipsurance
company underwriting a large number of policies for some type of risk,
like insurance against fire or theft in a particular but fairly large 10-
cality, or insurance against fioods, or insurance against crop damage
in a region. In such a homogeneous port folio, the insured goods may
have comparable value, and chances of mishap may not be very different
from one insured to another. Such portfolios are used at least as first
approximation to real situations.
1.1 Main assumptions
One of the objectives is modelling of claims that arrive in an insurance

business. In this context the following assumptions are generally made.
1. The number of claims occurring in a given period is random.
Claims happen at times {Ti} satisfying 0 :s: Tl :s: T 2 :s: .... We
call them claim arrival tim es (or just arrival times).
2. The i th claim arriving at time Ti causes a payment Xi. The se-

quence {Xd is assumed to be an i.i.d. (independent and identically
distributed) sequence of nonnegative random variables. These are
called claim sizes.
3. The claim sizes {Xd and the claim arrival times {Tj } are assumed
to be independent.
1.2. An overview 3
The second assumption indicates a certain homogeneity of policies

which are nevertheless independent. The first two assumptions are fairly
natural, whereas the third one is more of a mathematical convenience.
We also mention two stochastic processes central to our discussions.
Take To = O. Define the claim number process by
N (t ) max {i 2: 0 : Ti ::; t},

number of claims occurring by time t, t 2: 0(1.1)
Also define the total claim amount process by
S(t) = { 0, ~f N(t) = 0 (1.2)

Xl + ... + Xk, If N(t) = k, k = 1,2, ...
for t 2: o. Clearly S(t) = cumulative claim over [0, t]. We shall write
N(t)
S(t) = z= Xi, t 2: 0 which shall stand for (1.2). An implicit assumption
i=l
here is that payment is immediate on receipt of the claim. Note that a
sampie path of N and the corresponding sampie path of S have jumps
at the same times {Td, by 1 for N and by Xi for S.
Notation: A function fC) is said to be o(h) if lim f~h) = 0; we
h->O
denote this by f(·) = o(h). That is, f(·) decays at a fast er rate than h.
1.2 An overview
We now give an overview of the book, indicating along the way relation
to the main objectives of risk theory. References to more comprehensive
works are also given.
A primary task is to model times at which claims arrive, and to
model payments involved when claims are made. In the notation of
Section 1.1, this means modelling {Td (or equivalently N(·)) and {Xj};
consequently the total claim amount process SC) can be modelled. A
reasonable model should be realistic as well as amenable to analysis.
In Chapter 2 we discuss the versatile Poisson process and introduce
the classical Cramer-Lundberg model, along with their basic properties.
As indicated earlier, this is the first mathematical model in the subject
and even after 100 years continues to hold a central place.
The renewal model, which is a genealization of the Poisson model,
is considered in Chapter 3. An important role is played by the renewal
function t ~ E(N(t) + 1), where N(·) is the counting process associated
4 1. Introduction
with the renewal model. Renewal theorems, including BlackweIl's re-

newal theorem, are proved. This gives the asymptotic behaviour of the
solution to the renewal equation, which in turn, is used in the study of
ruin problems later. Sparre Andersen model, the analogue of Cramer-
Lundberg model in the renewal set up, is introduced in Section 3.4.
Thus Chapters 2 and 3 give models for claim number process N(·).
Both these models are useful in various disciplines besides insurance;
see [KT], [Rol], [R02] in addition to [EKM], [M], [RSST].
As the insurance company is open to enormous risk, it is important
to indicate how premiums are to be charged so that the company does
not go bankrupt. A safety loading factor is more or less imperative.
Some basic premium principles are indicated at the end of Chapter 3.
Over the years actuaries have observed that claim sizes can some-
times be so huge that any finite variance assumption would be unreal-
istic. Such distributions/distribution functions were already familiar to
analysts and probabilists, thanks to the work of Karamata on Tauberian
theorems, and that of FeIler on the central limit problem; see Section
4.2 and Appendix 2. Risk theory has been among the first to recognize
that these heavy tailed distributions are not me re mathematical curiosi-
ties. A larger class, caIled subexponential distributions, is more or less
synonymous with heavy tailed (claim size) distributions in insurance
modelling. An account is given in Section 4.3. For more information see
[BGT], [Fe], [EKM] and [RSST].
Ruin problems form an essential part of risk theory. Probability of
ruin in finite time (or ruin probability, for short) is generally considered
an objective indicator of the health of an insurance company. Hence
obtaining estimates for ruin probability, asymptotic behaviour, etc. are
considered very important. In Sections 5.1, 5.2 we look at the ruin
problem for the renewal risk model (that is, Sparre Andersen model).
Sections 5.3, 5.4 specialise to the Cramer-Lundberg model, with possibly
heavy tailed claim size distribution. For additional information, besides
[EKM], [RSST], one may look up the monograph [As] which is devoted
to ruin problems.
In addition toacome by way of premiums, an insurance company
may have income from investments. Chapter 6 deals with the situation
when, under the Cramer-Lundberg framework, the insurance company
invests its surplus in a riskless bond and in a risky asset. The Markovian
nature of the set up is used extensively. Surprisingly such analysis has
been attempted only in the last decade. See [H], [HP1], [HP2] and
1.2. An overview 5
the references therein. Our approach is sümewhat different. Für the

cünvenience üf the reader, prerequisites are reviewed in an appendix.
Chapter 2
Poisson model
2.1 Preliminaries
We first consider the claim number process {N (t) : t 2: O}. We assurne

that there is a basic probability space (0" F, P) on which N(t,·) is a ran-
dom variable for each t 2: o. We list below some of the obvious/desired
properties of N (rather postulates for N), which may be taken into
account in formulating a model for the claim number process.
• (NI): N(O) == O. For each t 2: 0; N(t) is a nonnegative integer
valued random variable.
• (N2): If 0 :::; s < t then N(s) :::; N(t). Note that N(t) - N(s)
denotes the number of claims in the time interval (s, t]. So N is a
nondecreasing process.
• (N3): The process {N(t) : t 2: O} has independent increments; that
is, if 0< tl < t2 < ... < t n < 00 then N(tI}, N(t2) - N(tI}, ... ,N(tn)-
N(tn-l) are independent random variables, for any n = 2,3,.... In
other words, number of claims arriving in disjoint time intervals are
independent.
• (N4): The process {N(t)} has stationar·y increments; that is, if
0::::: s < t, h > 0 then the random variables N(t) - N(s) and N(t + h)-
N(s + h) have the same distribution. This means that the probability
law of the number of claim arrivals in any interval of time depends only
on the length of the interval
• (N5): Probability of two or more claim arrivals in a very short
span of time is negligible; that is,
P(N(h) 2: 2) = o(h), as h 1 o. (2.1)

2.1. Preliminaries 7
• (N6): There exists >. > 0 such that

P(N(h) = 1) = >'h + o(h), as h 1 o. (2.2)
The number >. is called the claim arrival rate. That is, in a very short
time interval the probability of exactly one claim arrival is roughly pro-
portional to the length of the interval.
The first two postulates are self evident. The hypothesis (N3) is
quite intuitive; it is very reasonable at least as a first step in modelling.
(N5), (N6) are indicative of the fact that between two arrivals there
will be a gap, but may be very smalI; (note that bulk arrivals are not
considered here). (N4) is a time homogeneity assumption; it is not very
crucial.
To see what OUf postulates (NI) - (N6) lead to, put
Pn(t) = P(N(t)) = n), t ;::: 0, n = 0,1,2 , .... (2.3)
Observe that
Po(t + h) P(N(t) = 0, N(t + h) - N(t) = 0) (by (Nl),(N2))

P(N(t) = 0) P(N(t + h) - N(t) = 0) (by (N3))
Po(t) P(N(h) = 0) (by (N4))
Po(t) [1 - >'h + o(h)], (by (N5), (N6))
whence it follows that Po(-) is differentiable and
d
dt Po(t) = ->. Po(t), t > O. (2.4)
By (NI), Po(O) = P(N(O) = 0) = 1. So the differential equation

(2.4) and this initial value give
Po(t) = P(N(t) = 0) = P(N(t + s) - N(s) = 0)

= exp( ->.t), t;::: 0, s;::: O. (2.5)
Similarly for n ;::: 1, using (N3) - (N6) we get
Pn(t + h) = P(N(t + h) = n) = h + 12 + Js,

where
h P(N(t) = n , N(t + h) - N(t) = 0),

h P(N(t) = n - 1, N(t + h) - N(t) = 1),
Js P(N(t + h) = n, N(t + h) - N(t) ;::: 2),
8 2. Poisson model
and hence
Pn(t + h) = Pn (t)[l -)"h + o(h)] + Pn-I(t) [)"h + o(h)] + o(h).

Right continuity and differentiability from the right of Pn (-) now follow.
Similarly differentiability from the left can be proved; see Exercise 2.1.6
below. Consequently Pn (-) is differentiable and
(2.6)
far n = 1,2, .... To solve (2.6) inductively, set Qn(t) = eAt Pn(t), t ~
0, n = 0,1,2, ... By (2.6)
d
dt Qn(t) = )..Qn-I(t), t > 0, n = 1,2,.... (2.7)
Clearly Qo(·) == 1 by (2.5). So from (2.7) it follows that QI (t) = )..t + c

where c is a constant. As QI (0) = PI (0) = P(N(O) = 1) == 0, we
have c = 0; hence QI(t) = )..t, t ~ O. Using (2.7) for Qn(-) and the
initial value Qn(O) = 0, n ~ 2 it is now simple to obtain inductively
Q(t) = 7h )..ntn . Hence we have proved
Theorem 2.1 Let the stochastic process {N(t) : t ~ O} satisfy the pos-
tulates (Ni) - (N6). Then for any t ~ 0, s ~ 0, k = 0,1,2, ...
P(N(t + s) - N(s) = k) P(N(t) = k)

()"t)k -At
IT e . (2.8)
Thus the random variable N(t) has the Poisson distribution with pa-
rameter )..t. The stochastic process {N (t) : t ~ O} is called a time
homogeneous Po iss on process with arrival rate).. > o. 0
The assumptions (NI) - (N6) are qualitative, whereas the conclusion

above is quantitative. This is the reason why Poisson distribution and
Poisson process come up in diverse fields like physics, chemistry, biology,
engineering, economics, etc.; see [Fe], [KT], [Ro1], etc.
In view of the preceding theorem we have the following definition.
Definition 2.2 Let)..(·) be a nonnegative measurable function on [0, CXl)

having finite integral over every bounded interval. A stochastic process
{N(t) : t ~ O} is said to be a Poisson process with intensity (or rate)
function )..(.) if the following hold.
(i) (NI), (N2), (N3) are satisfied.
(ii) Far P - a.e. w E 0, the sample path N(·,w) is right continuous at

every t ~ 0, and has left limit at every t > O. That is, the process
has r.c.l.l. sample paths.
(iii) For 0 :s: s < t the random variable N (t) - N ( s) has a Poisson
t
distribution with parameter J A(y) dy.
s
If A(.) == A > 0, a constant, then N is said to be a homogeneous P ois-

son process with rate A > O. If AC,) == I then N is called a standard
homogeneous Poisson process.
The above definition is not the most economical one. For example,
existence of left limits follows from the paths being nondecreasing. This
may be a small price for the sake of clarity.
As N(·) is nondecreasing, N(O) == O,N(t,w) < 00 for P - a.e. w,
note that the sampie paths have left and right limits at every t > O.
So condition (ii) above means that we have chosen a right continuous
version.
Proposition 2.3 Let A(') be a nonnegative measurable function on [0,00).

t
Assume that J.-L(t) ~ J A(s) ds < 00, for alt t ~ O. Let N(·) be a Pois-
o
son process with rate junction AC) and NC) be a standard homogeneous
Poisson process. Then the joltowing hold.
(i) {N(J.-L(t)) : t ~ O} is a Poisson process with rate junction A(')'

(ii) 1f AC) > 0 and t--->oo
lim J.-L(t) = 00, then {N(J.-L-l(t)) : t ~ O} is a
standard homogeneous Poisson process.
Proof: Left as an exercise. o

Using Kolmogorov's consistency theorem and the theory of weak
convergence of prob ability measures on D[O, 00), it can be established
that, for a given rate function A(')' a Poisson process as in Definition
2.2 exists and that the prob ability law induced on D[O, 00) is unique.
Here D[O, 00) denotes the space of all real valued functions on [0,00)
which are right continuous at every t ~ 0 and have left limits at every
t> 0; D[O, 00) is endowed with the Skorokhod topology. See [Bll], [PI],
10 2. Poisson model
[EK]. We shall assume that a Poisson process exists for a given rate
function. A constructive version of the homogeneous Poisson process
will, however, be indicated later; see Theorem 2.5.
t
For a Poisson process, let 11( t) = J ,\( s) ds, t 2: O. The function 11(')
°
can be considered as an intrinsic clock for N. If N is homogeneous the
intrinsic clock evolves linearly; that is, claims arrive roughly uniformly
over time. If N has nonconstant rate then the clock "slows down" or
"accelerates" according to ,\(.); in insurance context, nonconstant rate
may refer to seasonal trends.
The Poisson process owes its versatility to the fact that many natu-
ral functionals connected with the model can be explicitly determined.
The next two sections discuss a few examples which are relevant in the
actuarial context as weIl.
In Section 2.2 it is shown that the interarrival times (that is, time
between successive claim arrivals) of a homogeneous Poisson process
form a sequence of independent identically distributed random variables
having an exponential distribution. In fact, the homogeneous Poisson
process is characterized by this property. Section 2.3 discusses the joint
distribution of the first n claim arrival times, given that exactly n ar-
rivals have taken place during [0, t]. This has connection with the order
statistics of n independent identically distributed random variables hav-
ing uniform distribution. Both these properties play major role in the
Cramer-Lundberg risk model as will be seen in the sequel.
2.2 Interarrival and waiting time distributions
Let {N(t) : t 2: O} be a time homogeneous Poisson process with arrival

rate ,\ > O. Set To == O. For n = 1,2, ... define
Tn inf{t 2: 0 : N(t) = n}
time of arrival of n-th claim (2.9)
Tn - Tn - l (2.10)
time between (n - 1) th and n th claim arrivals.
The random variables To, Tl, T 2 , ... are called claim arrival times (or
waiting times); the sequence {An: n = 1,2, ... } is called the sequence
of interarrival times.
2.2. Interarrival and waiting time distributions 11
For any s > 0 note that {Tl> s} = {N(s) = O} Henee by (2.8)
P(A I > s) = P(TI > s) = P(N(s) = 0) = e- AS .
Therefore the random variable Al or Tl has exponential distribution

with parameter ..\; that is
P(A I E (a, b)) = P(TI E (a, b))
J. \
b
e- AS ds, 0::; a O. Let {Td denote the claim arrival times, and {A j }
the interarrival times defined by (2.9), (2.10). Then the following hold.
( a) Fix n 2 1. Then the joint probability density function 0 f Tl, T 2, ... , T n

is given by
f(hh ... ,Tn ) (tl, ... , tn)
{ ..\ne-At
n , if 0 < tl < t2 < ... < tn < 00 (2.12)
0, otherwise.
(b) {An: n = 1,2, ... } is a sequence of independent, identically dis-

tributed (i. i. d.) random variables having Exp(..\) distribution.
Proof: (a) In view of the discussion preeeding the theorem (see

(2.11)), note that we need to consider only n 2 2. Let
By postulate (N5) of Theorem 2.1 and Exercise 2.1.4 observe that 0 <
Tl < T2 < ... < T n < 00 a.s., that is, P((TI , T2, ... , T n ) E G n ) = 1.
If a "reet angle" I ~ (al, bll x (a2, b21 x ... x (an, bnl C G n then
o ::; al < b1 ::; a2 < b2 ::; ... < bn- 1 ::; an < bn < 00. Now by the inde-
pendent increment property of the Poisson process we get, taking bo = 0,
12 2. Poisson model
P((T" ... , Tn ) E I) ~ P (Ö{ai < Ti :0 b;})

= P(N(ai) - N(bi-d = 0, N(b i ) - N(ai) = 1, 1 ~ i ~ n - 1,
N(a n ) - N(bn-d = 0, N(b n ) - N(a n ) 2:: 1)
[g P(N(a;) - N(bi-l) ~ 0)· P(N(bi ) - N(ai) ~ 1)]

. P(N(a n ) - N(bn-d = 0) . P(N(bn ) - N(a n ) 2:: 1)
= [rr e->.(ai-bi-1».,(bi - ai)e->.(bi-ai)]. e->.(a n-bn- d (l_ e->'(bn-an»)
[g
~
~ (bi - ai )] "n(e- Aan _ e-Ab,,)
J... JI
).,ne->'tndtl dt2··· dt n ·
Since rectangles of the form I generate the Borel O"-algebra of G n , (2.12)

now folIows.
(b) Observe that
Al Tl
A2 T 2 - Tl
A3 T3 - T2
=
The linear transformation given by the (n x n) matrix in (2.14) has

determinant 1, and transforms the region G n in one-one fashion onto
theorthant {(al,a2, ... ,an ): ai > 0,1:S; i:S; n}. Soby (2.12) and
the change of variables formula the joint probability density function
f(A1, ... ,A n ) of Al, .. . , An is given by
f(A1, ... ,A n ) (al, a2, ... , an)

+ a2,··· , al + a2 + ... + an)
f(h .. .,Tn) (al, al
A e- Aa1 A e- Aa2 ... A e- Aan , if ai > 0, 1 :s; i :s; n
{
0, otherwise.
(2.15)
The required conclusion now follows from (2.15). 0
As Ai has EXp(A) distribution, its expectation is E(A i ) = so is ±; ±
the mean arrival time. Thus the arrival rate being A is consistent with
this conclusion.
One can also go in the other direction as the next result indicates.
Theorem 2.5 Let {Ai: i ~ 1} be a sequence of i.i.d. EXp(A) random
variables, where A > O. Set T o == 0, and T n = Al + ... + An, for n ~ l.
Define the claim number process N(-) by
N(t) = max{i ~ 0: Ti :s; t}, t ~ O. (2.16)
Then {N(t) : t ~ O} is a time homogeneous Poisson process with rate A.
Proof: As Al has an exponential distribution, Al > 0 a.s. and

hence Tl > 0 a.s. So N(O) = 0 a.s. We next prove that N(t) has
a Poisson distribution with parameter At, for any t > O. Indeed, for
k ~ 1, T k = Al + A 2 + '" + A k has r(k, A) distribution, being sum of
kindependent EXp(A) random variables. So it can be verified that
P(Tk :s; t) = j t 7::-_A_k--:-:- zk-Ie-Az dz

(k - 1)!
o
k-l (At)j
1- ~ e- At
~
j=o
--
.,'
J.
(2.17)
Consequently for n = 0,1,2, ...

P(N(t) = n) P(Tn :s; t) - P(Tn + 1 :s; t)
-At (At)n
e -- (2.18)
n!
14 2. Poisson model
proving the claim.

To prove that {N(t)} has independent stationary increments, we
shall consider only the case of N (t), N (t + h) - N (t) being independent
and N(t + h) - N(t) ~ N(h), for t, h > o. Writing
qk,kH (t, t + h) ~ P(N(t) = k, N(t + h) - N(t) = R)
note that we need to establish (why ?)
( )"t)k ()"h)€
q t t
k,kH ( ,
+ h) = e-A(t+h) - - - -
k! R! (2.19)
for t, h > 0, k, R = 0,1,2, ....

We shall consider the case k ~ 1, R ~ 2. (The other cases are simpler
to handle.) Observe that
{N(t) = k, N(t + h) - N(t) = f}

{N(t) = k, N(t + h) = k + R}
{Tk ::; t < Tk+l, TkH ::; t + h < nH+l}. (2.20)
t::. kH
= L
A
We know that Tk, Ak+l, T Ai, Ak+H 1 are independent random

i=k+2
variables having respectively f(k, )..), Exp()..), r(R - 1, )..), Exp()..) distri-
butions. Therefore the joint probability density function of
(Tk, Ak+l, T, A kH +1 ) is given by
!(Zl,Z2,Z3,Z4)
Ak zk-le-AZ1) ()..e- AZ2 )
( (k-l)! 1
(A(€-2)!
l- 1 z€-2e-AZ3) ()..e- AZ4 )
3 ,
{
if Zl, Z2, Z3, Z4 >0
0, otherwise.
(2.21)
Using (2.20) we now get
Qk,k+e(t, t + h) = p(n ::; t < n+l, T kH ::; t + h < Tk+f'-+l)

P(Tk ::; t < Tk + Ak+l < Tk + A k+ 1 + T
::; t + h < Tk + A k+ l + T + Ak+f'-+d
JJJJ F
j(Zl, Z2, Z3, z4)dz4dz3dz2dzl
00
o
J
(2.22)
where F = {(Zl, Z2, Z3, Z4) : 0 ::; Zl ::; t < (Zl + Z2) < (Zl + Z2 + Z3) ::;
t + h < (Zl + Z2 + Z3 + Z4)}. Plugging (2.21) into (2.22), an elementary
integration now leads to (2.19).
To show that N(td, N(t2) -N(td, ... ,N(tn ) -N(tn-l) are indepen-
dent random variables, for 0 < tl < t2 < ... < t n < 00, n = 3,4, ... , it
is dear that the above approach will work though the book-keeping will
be more tedious. Also the above argument shows that N(t + s) - N(s)
and N(t) have the same distribution (viz. Poisson distribution with
parameter At) for any t 2: 0, s 2: O.
As 0 < Tl < T 2 < ... < T n < 00 a.s. it is seen from OUf construction
(that is, (2.16)) that the sampIe paths of N are right continuous at every
t 2: 0 and have left limits at every t > O. This completes the proof. 0
In the jargon of the theory of stochastic processes, time homogeneous
Poisson process is the renewal process with i.i.d. exponential arrival
rates. Proposition 2.3 and Theorem 2.5 imply the existence of Poisson
process for a large dass of intensity functions, once a sequence of i.i.d.
exponential random variables exist. The latter requirement is, of course,
guaranteed by the consistency theorem.
The next result concerns age and residual life. These terms have
come from reliability theory.
Proposition 2.6 Let N (.) be a time homogeneous Poisson process with

rate A > O. Let {Td denote the corresponding arrival times. Fix t 2: O.
Define
B(t) = t - TN(t) , F(t) = TN(t)+1 - t. (2.23)

16 2. Poisson model
B(t) is called the backward recurrence time or age, while F(t) is called
the forward recurrence time or excess life or residual life. Let G B(t),F(t)
denote the distribution function of the two dimensional random variable
(B(t), F(t)). Then
G B(t),F(t) (Xl, X2)

(1- e->"xl)(l- e->"x 2 ), ifO::; Xl< t,X2 2: 0
{ (1 - e->"x 2 ), if Xl 2: t, X2 2: 0 (2.24)
0, otherwise.
In particular (i) B(t) and F(t) are independent random variables, (ii)
F(t) has Exp(>..) distribution, and (iii) B(t) has a truncated exponential
distribution (with parameter >") with a jump at t, that is
P(B(t) ::; xd (1- e->"x 1 ), ifO::; Xl< t

P(B(t) = t) e ->..t .
So P(B(t) ::; xd = 1 if Xl 2: t. Of course P(B(t) ::; Xl) = 0 if Xl < O.
Proof: Onee (2.24) is established, the other assertions are easily

obtained. As t is fixed, note that the last arrival took plaee at time
TN(t) , and that the next arrival will happen at time TN(t)+I' Clearly
B(t) ::; t a.s. Far 0 ::; Xl < t note that
{B(t) < Xl} = {t - Xl < TN(t) ::; t} = {N(t) - N(t - xd 2: I}.
Similarly far X2 > 0
Therefore, as N has independent inerements, for 0 ::; Xl < t, X2 2: 0 we

get
P(B(t) < Xl, F(t) ::; X2)

P(N(t) - N(t - Xl) 2: 1, N(t + X2) - N(t) 2: 1)
P(N(t) - N(t - Xl) 2: 1) . P(N(t + X2) - N(t) 2: 1)
(1 - e->"x 1 )(1 _ e->"x 2 ).
Continuity of r.h.s of the above in Xl over [0, t) implies

2.3. Order statistics property 17
for 0 :::; Xl < t, X2 2: O. For Xl 2: t, X2 2: 0 it is easily seen that

P(B(t) :::; Xl, F(t) :::; X2) = P(F(t) :::; X2)
P(N(t + X2) - N(t) 2: 1) = (1 - e- AX2 ).
Thus (2.24) is proved. 0

It may look a bit paradoxical that the residuallife and the interarrival
time have the same distribution. But this is a manifestation of the
memoryless property of the exponential distribution.
2.3 Order statistics property
This is another important property of the Poisson process. We begin

with an elementary result.
Proposition 2.7 Let N(·) be a homogeneous Poisson process with rate

.A > 0, and let Tl be the first arrival time. Then for 0 :::; s :::; t,
S
P(TI < sIN(t) = 1) = -;
t
that is, given that exactly one arrival has taken place in [0, t], the time
of arrival is uniformly distributed over [0, t].
Proof: By the stationary independent increment property we obtain
P(TI < s, N(t) = 1)

P(TI < s I N(t) = 1) =
P(N(t) = 1)
P(N(s) = 1, N(t) - N(s) = 0)
P(N(t) = 1)
P(N(s) = 1) . P(N(t) - N(s) = 0)
P(N(t) = 1)
.AS e- AS e-A(t-s) s
.At e- At t
o
A natural question is: If N(t) = n, what can one say about the
conditional distribution of (Tl, T 2 , ••. ,Tn )? For fixed t > 0, n 2: 1
note that P(N(t) = n) > O. Put n
= {N(t) = n},F = F n ~ n
{E n n:
E E F}; define the pro babili ty measure P on F) by P(E) = (n,
I p(EnD)
P(fi)p(EnD.) = for E = EnD. :F. On the probablhty space
A A A A ••
P(N(t)=n) ' E
18 2. Poisson model
(n, J:, p) note that (Tl, T 2, ... ,Tn ) is an ]Rn-valued random variable. So
the quest ion is : What is the probability measure P(T1, T2, ... ,Tn )-l
on ]Rn? To appreciate the answer one needs the following.
Theorem 2.8 Let Y 1, Y 2, ... ,Yn be i.i.d. random variables with com-
mon probability density function f(·)· Let 1(1) :S Y(2) ... :S 1(n) denote
the order statistics ofY1, Y 2, ... , Y n ; that is, Y(k)(W) is the k-th smallest
value among {Y1(w), Y 2 (w), ... , Yn(w)}, k = 1,2, ... , n for any wEn.
Then the joint probability density function of 1(1)' Y(2) , ... ,Y(n) is given
by
g(Y1,Y2, ... ,Yn)
{ (n!)f(yI)f(Y2) ... f(Yn), if Y1 < Y2 < ... Yn < 00 (2.25)

0, otherwise.
In particular, ifV1, V 2, ... , Vn are i.i.d. U(O, t) random variables (that is,
having uniform distribution over [0, t]), then the joint probability density
function of the order statistics V(1)' V(2)' ... ,V(n) is given by
fV(l),v(2V.,v(n) (SI, s2,··· ,Sn)
{
(n!)/(tn), ifO< SI < S2 < ... < Sn< t
(2.26)
0, otherwise.
Proof: We need to prove only the first assertion. Since

(Y1, Y 2, ... , Y n ) is an ]Rn-valued absolutely continuous random variable,
with probability one there are no ties; that is, 1(1) < 1(2) < ... < 1(n)
a.s. Clearly the joint probability density function of Y 1, Y 2, ... , Y n is
Note that the n-dimensional random variable (Y(l)' 1(2)' ... , 1(n)) takes
values in the set H = {(Y1, Y2, ... , Yn) E ]Rn : Y1 < Y2 < ... < Yn}.
Let B S;;; H be a Borel set. Let Bi, i = 1,2, ... , (n!) correspond to
disjoint sets obtained by permutation of coordinates of elements of B,
with BI = B. Observe that
2.3. Order statistics property 19
n!
i=l
tJ
n'
!(Zd!(Z2) . . . !(zn) dZl dz2 .. . dZn
t=l Bi
n! J !(Zl)!(Z2) ... !(zn)dzl dZ2 ... dZn

B
whenee (2.25) follows. o

Here is the main result of this seetion
Theorem 2.9 Let N(·) be a homogeneous Poisson process with rate A >
0, and {Ti} the associated arrival times. Fix t > 0, n = 1,2, .... Then
the conditional probability density !unction o!
(Tl, T 2, ... , T n ) given N(t) = n is
!Tt, T 2, ... ,T n ((SI, 82,···· 8n)IN(t) = n)

{ (n!)j(tn) , if 0< 81 < 82 < ... < Sn < t (2.27)
0, otherwise.
Proof: Denote for t > 0 , n = 1,2, .. .
If a "reet angle" I = (al, bll x (a2, b21 x .. . x (an, bnl C Gn,t then 0 ~
al < bl ~ a2 < ... < bn- l ~ an < bn < t. Now by (2.12) in Theorem
20 2. Poisson model
2.4
P((Tl , T 2, ... , T n ) E IIN(t) = n)

1
P(N(t) = n) P(al < Tl S bl , ... ,an< Tn S bn, N(t) = n)
n'
) ) ~ < Tl S bl ,.·. ,an< Tn S bn,Tn+l > t)
JJ... J J
bl b2 bn 00
) )~~ ).n+le-ASn+l dsn+ldsn ... dS2dsl

t
J... ~~
al a2 an
dS l dS2.·· dSn
I
Since rectangles of the form I generate the Borel a-algebra of Gn,t, (2.27)
is now immediate. 0
Remark 2.10 By (2.26), (2.27) it is now clear that the conditional

distribution of (Tl, T 2, ... ,Tn ) given N(t) = n is the same as the order
statistics of n i.i.d. U(O, t) random variables. It is convenient to denote
this fact by
(2.29)
where U(l) < U(2) < ... < U(n) is the order statistics corresponding
to i.i.d. U(O, 1) random variables U1, U2, ... ,Un , and :1:: denotes that
the two sides have the same distribution. Moreover, by Kolmogorov
consistency theorem, the Ui's can be chosen independently of {N(t) :
t ~ O} or {Tj }. 0
2.4 Cramer-Lundberg Model
This is the classical and a very important model in insurance; it has

been extensively studied. As we will be seeing it often in the sequel, in
this section we shall just introduce the model. The basic assumptions
of the model are as follows.
1. Claims happen at the arrival times 0 < Tl < T2 < ... < Tn < ...
of a homogeneous Poisson process {N (t) : t ~ O} with rate, say,
). > O.
2.4. Cramer-Lundberg Model 21
2. The i th claim arrival at time Ti causes claim size Xi. The sequence
{Xd is an i.i.d. sequence of nonnegative random variables.
3. The sequences {Ti} and {Xj} are independent; equivalently the
process {N(t)} and the sequence {Xj} are independent.
The total claim amount upto time t in this model is given by
N(t)
S(t) = LXi, t 20 (2.30)
i=l
which is the same as (1.2).

Theorem 2.11 Let (1) - (3) above hold. Then the process {S (t) : t 2
O} has independent incretnents and is time homogeneous.
Proof: Let k == 2,3, ... ,0 < tl < t2 < ... < tk < 00. By OUf
assumptions note that
{Xl, ... , XN(tI) , N(tl)},
{XN(tl)+I' .. · ,XN(t2)' N(t2) - N(td}, ... ,
{XN(tk_l)+I, ... , XN(tk)' N(tk) - N(tk-l)}
are independent. Hence the increments
S(tl) - S(O) Xl + ... + XN(tl)'
S(t2) - S(td XN(tI)+1 + ... + X N(t2) , ... ,
S(tk) - S(tk-d XN(tk_d+1 + ... + XN(tk)
are independent. Thus {S(t) : t 2 O} has independent increments.
Next let t > 0, h > o. It is not difficult to show that
(Xl, ... ,XN(h)' N(h)) has the same distribution as
(XN(t)+I'.·.' XN(t+h) , N(t + h) - N(t)). Hence it follows that S(h) =
Xl + .. .+XN(h) has the same distribution as S(t+h)-S(t) = XN(t)+1 +
... + XN(Hh). Thus S is time homogeneous. 0
A process SO given by (2.30), where {N(t)}, {Xd satisfy (1) - (3)
ab ove , is sometimes called a compound Poisson process; the preceding
resplt says that the process S (-) is a Levy, prQcess.
Next we look at the discounted sum cQrrespondl,ng to the ~
Lundberg model. Let r > 0 denote the interest rate. Define for t 2 0
it
0, if N(t) = 0
{
So(t) = e-rTiXi , if N(t) = k, k = 1,2,... (2.31)
22 2. Poisson model
This is the "present value" (at time 0) of the cumulative claim amount
over the time horizon [0, t]. Observe that by Theorem 2.9 and (2.29),
E(So(t)) ~ E ~ )
~E (t, e-'" Xi I N(t) ~ n) . P(N(t) ~ n)
n
L L E[e-
00
rTi Xi I N(t) = n]· P(N(t) = n)

n=l . i=l
n
L L E(e-
00
E(X 1 ) rTi I N(t) = n) . P(N(t) = n)
(t,
n=li=l
E(XJ ) ~E e-,-1", I N(t) ~ n) . P(N(t) ~ n)

E(X j ) ~E (t, e- riU (.») .P(N(t) ~ n)
E(X j ) ~ (t,e-'tU') . P(N(t) ~ n)
E(Xj)E(e-'tU, )E(N(t)) ~ At E(Xj ) ( (e-.,tYdY)
). E(Xd ~ - e- rt )
r
where we have used independence of {Xi} and { N (t) }, and

n n
L e-rtU(i) = L e- rtUi . Thus we have
i=l i=l
Theorem 2.12 Let So(·) be the discounted sum process defined by (2.31)
corresponding to the Cramer- Lundberg model. Let). > 0, r > 0 denote
respectively the claim arrival rate and the interest rate. Assume that the
claim size has finite expectation. Then
E(So(t)) = ). ~ (1 - e- rt ), t> O. (2.32)

r
o
2.5. Exercises 23
In the Cramer-Lundberg model, the averagejexpected amount (dis-

counted at 0) needed to take care of claims over [0, t] is given by (2.32).
A reasonable explanation can be thus. In insurance business, consider-
able part of the financial risk is on the company. A pilot study before
starting the business might indicate average claim size, claim arrival
rate, interest rate, etc. Also it may take some time for the premium
income to stabilize, perhaps a year or so. Therefore, during the initial
period any claim settlement will have to be met from the initial capital
mobilized by the company. Hence (2.32) can be regarded as a rough
estimate of the average initial capital needed to start the business.
A related process is
0, if N (t) =0
{ (2.33)
SI (t) = ~ er(t-Ti) Xi, if N(t) = k, k = 1,2, ...
for t 2::: 0, where r > 0 again denotes interest rate. This process can
be interpreted as follows. Let t > 0 be fixed. Suppose claims which
arrive during [0, t] are settled only at time t. So there is a delay in claim
settlement, and hence the claim amount accrues an interest compounded
continuously at rate r > O. So SI (t) is the totalliability of the insurance
company at time t due to claims occurring over [0, t]. Hence E(SI (t)) is
the expected amount that the company should have at time t to honour
its commitments.
Notes: The material considered in this Chapter is standard. One
may look up [Bl2], [KT], [Re], [Rol], [Ro2], [RSST], [M], etc.
2.5 Exercises
Exercises on Section 2.1

2.1.1. Let N be a homogeneous Poisson process with rate A > o.
(a) For any fixed t > 0, show that P(N(t) = 0) > 0, and P(N(t) >
k) > 0 for k = 1, 2, ....
(b) For any fixed t 2::: 0, show that P - a.e. w the sample path N (., w)
does not have a jump at t.
(c) Show that (b) above does not mean that sampie paths of N(·)
are continuous. In fact, with prob ability one, sample paths have
discontinuities.
24 2. Poisson model
(d) For P - a.e. wEn, for any t > 0, show that the number of jumps of
N(·, w) over [0, t] is finite. That is, almost every sampIe path has
only finitely many jumps over any time interval of finite length.
2.1.2. Let NO be a Poisson process with rate function A(')' For

n = 2,3, ... and 0 < t1 < t2 < ... < t n < 00, find the joint distribution
of N(tt}, N(t2),'" ,N(tn).
2.1.3. Let NO be as in 2.1.2. For n = 1,2, ... ,0 < t1 < t2 < ... <
t n < t n+1 < 00, nonnegative integers ki with 0 :S: k 1 :S: k 2 :S: ... :S: kn :S:
k n +1 show that
N(t1) = k1,···, N(tn) = kn)

P(N(tn+l) = kn+1 I N(tn) = kn).
That is, the Markov property holds for the Poisson process.
2.1.4. Let {N(t) : t 2: 0 be a Poisson process with a continuous rate
function A(. ). For any t 2: 0 show that
(a) P(N(t + h) - N(t) 2: 2) = o(h), as h 10

(b) P(N(t+h)-N(t) = 1) = A(t)h+o(h) = A(t) h(l+o(l)), as h 1 o.
2.1.5. Let {N(t)} be a homogeneous Poisson process with rate A >
O. Show that
N(t) - At
V>:i =} N(O, 1), as t --t 00
At
where =} denotes weak convergence of probability measures (or conver-
gence in distribution) and N(O, 1) denotes the one dimensional standard
normal distribution. (Rint: Use Fourier transforms / characteristic func-
tions. )
2.1.6. Let {N(t) : t 2: O} satisfy (N1)-N(6). Fix n. Show that
t I--t Pn(t) is differentiable from the left for t > O. (Rint: Derive an
analogue of the display before (2.6) connecting Pn(t) and Pn(t - h)).
Exercises on Seetion 2.2
2.2.1. (a) Let N(·) be a Poisson process. Show that Tn given by

(2.9) is a random variable.
(b) For t 2: 0 let:Fr~ er {N (r) : 0 :S: r :S: t} be the smallest er-algebra
making the family {N (r) : 0 :S: r :S: t} measurable; {Fr : t 2: O} is said
to be the filtration generated by the process N. For t 2: 0, n = 1,2, ...
2.5. Exercises 25
show that {Tn ::; t} E Fr, {An::; t} E Fr. That is, each Tn and hence
each An is a stopping time w. r. t. the filtration {Fr}.
2.2.2. Let Tl be the first arrival time corresponding to a time ho-
mogeneous Poisson process. For t, s 2: 0 show that
P(Tl > t + slTs > s) = P(Tl > t).

This is the so called memoryless property of the exponential distribution.
Conversely, if the above equation holds for all s, t 2: 0 and Tl > 0
a.s., show that Tl has an exponential distribution.
2.2.3. Let N be a time homogeneous Poisson process with rate
). > O. Let Tl, T2 be the arrival time of the first two claims. For
o ::; tl ::; t2 show that
and hence that the joint distribution function of Tl, T 2 is given by
where H is a function depending only on tl. Find the joint probability

density function of Tl, T 2 from the above.
2.2.4. Let {N(t) : t 2: O} be a homogeneous Poisson process with
rate). > O. Let n 2: 1 be an integer and Gn be defined by (2.13).
Let 1 ::; ml ::; m2 ::; ... ::; m n < 00 each mi being an integer. For
(tl, t2, ... , tn) E G n show that
and hence is a COO-function on the region G n .

(Rint: {N(td 2: ml, N(t2) 2: m2,'" ,N(tn ) 2: m n } =
Ü .. U
k=l 1:'011 :'012:'O.·.:'OJk-1 :'0 mn -1,
{ ~~~ ~ ) ~ ) = jk-b }.
~ ... ,k-l
Also, L denotes sum of a finite number of terms.)
finite
2.2.5. Let N be as in Exercise 2.2.4. Let {Ti} be the arrival times.
Fix an integer n > 1. Let G n be given by (2.13). Let Fh .. .,Tn denote the
26 2. Poisson model
joint distribution function of Tl, T 2 , ... , T n . For i = (tl, t2,'" ,tn ) E G n

show that
ön
where Öt 1Öt 2...Öt n HW = O.
(Hint: (i) Need to consider only k = n in the hint to Exercise 2.2.4
with mi = i.
>.n-1
(ii) Show that we need to look at only {.)1·)2 '(' _.)1 ~.... (n -1-')n-2 )'}
. X
{t{1 ~ - iI)h-h ... (tn - t n _l)n-l- j n - 2 • e->'t n } where jn-l = n -1, je 2:
R, R = 1,2, ... ,n - 1, jl ~ j2 ~ ... ~ jn-l. That is, terms not of this
form will be part of H W.
(iii) Unless je = R for all R = 1,2, ... ,n - 1 show that the coefficient
of tl t2 ... tn-l in the expression in (ii) above is zero.)
2.2.6. Let {Tn } be as in Exercise 2.2.5.
(a) Show that T n has the gamma distribution r(n, >.). This distribu-
tion is also called Erlang distribution with parameters n, >. in queueing
theory.
(b) Show that 0 < Tl < T 2 < ... < T n < 00 a.s.
2.2.7. Derive (2.19) in cases other than k 2: 1, R 2: 2.
2.2.8. Let {N(t) : t 2: O} be a Poisson process with rate function
t
>.(.). Set f..l(t) = J >.(s) ds, t 2: O. Assume that >.(.) is continuous and
o
>.(r) > 0 a.e.r (w.r.t. the Lebesgue measure on [0, (0)). Let {Td be the
claim arrival times, and {A j } the interarrival times for the process N (.)
defined by analogues of (2.9), (2.10). Then the following hold.
(a) Fix n 2: 1. Then the probability density function of (Tl, T 2,···, T n )
is
fhT2, ... ,Tn (tl, t2, ... , tn)
{
e-/t(tn) >'( tl )>'( t2) ... >'( t n ), if 0 < tl < t2 < ... < t n < 00
0, otherwise.
(b) The probability density function of (Al, A 2 , . .. ,An) is given by
f A1,A2, ... ,An (al, a2, ... ,an)
{
e-/t(a1 +a2+ ... + a n) [.nt=l
>.(al + ... + ai )] , if aj > 0, 1 ~ j ~n
0, otherwise.
2.5. Exercises 27
Thus the interarrival times are Li.d. 's only when N (.) is time homoge-
neous.
2.2.9. Show that TN(t) in (2.23) is a random variable.
2.2.10. Let {Ad be the sequence of interarrival times of a homoge-
neous Poisson process with rate A. Fix n 2: 1. Find the distribution of
min{A I , A 2 ,···, An}.
2.3.1. Let N(·), AU, /1(.), {Td be as in Exercise 2.2.8. For any
t > 0, n = 1,2, ... show that
where 0 < Y(l) < Y(2) < ... < Y(n) is the order statistics correspond-
ing to an Li.d. sample YI , Y2 , ..• , Yn with common probability density
function g(x) = ~~~ I[Q,t] (x).
(Hint: Use part (a) of Exercise 2.2.8 and imitate the proof of Theo-
rem 2.9.)
2.3.2. Let N(·), {Td, {Uj } be as in Theorem 2.9 and Remark 2.10.
Let n = 1,2, ... and t > 0 be fixed. For any measurable symmetrie
function g on jRn show that
2.3.3. Suppose that customers arrive at a train station at arrival

times 0 < Tl < T 2 < . .. < Tn < .. . of a homogeneous Poisson process
N(·) with rate A > O. Suppose the train departs at time t. Note that
N(t)
I: (t - Td denotes the sum of waiting times of customers arriving in
i=l
(0, t), provided N(t) 2: 1; (if N(t) = 0 then the quantity is taken as 0).
Find E[f: (t - T;)]

2.4.1. (i) In the Cramer-Lundberg model assurne that the claim size
has finite expectation. Find E(S(t)).
(ii) Assuming that the claim size has finite second moment show that
Var(S(t)) = At E(Xr).
28 2. Poisson model
2.4.2. If Fl, F 2 are distribution functions on IR, recall that the con-
volution of F 1 and F2 is given by
F 1 * F 2 (x) = J
IR
F1(x - Y) dF2 (y) = F 2 * F1(x), x E IR.
Let F denote the common distribution function of claim size Xi. Let
F*(O)(x) = I[o,oo)(x), x E IR and F*(l) = F. For n = 2,3, ... define
F*(n)(x) = (F*(n-l) * F)(x) = (F * ... * F)(x), x E IR, the n-fold
convolution of F. Let 8(·) be given by (2.30). Show that for x E IR
P(8(t) ~ x) = f
n=O
) )~
n.
F*(n)(x).
2.4.3. Assume that the claim size Xi has moment generating func-
tion 1Yx in a nieghbourhood of O. Show that the moment generating
function of 8(t) is given by
1YS(t)(u) :@: E(euS(t)) = exp{At[1Yx(u) - I]}
for u in an appropriate neighbourhood of O.

2.4.4. Let 81(-) be defined by (2.33). Find E(8 1 (t)).
2.4.5. Let {N(t)}, {Td, {Xj} satisfy the assumptions (1) - (3) of
Section 2.4. Show that there is a sequence {Uk} of i.i.d. U(O, 1) random
variables, which is independent of {N(t)}, {Xj }, such that
holds for any bounded measurable function 9 : IR 2 - t IR.

(Rint: Enough to consider g(t, x) = IA(t) IB(X) where A, Bare
Borel sets in IR.)
Chapter 3
Renewal model
3.1 Preliminaries
Renewal process is a generalization of the homogeneous Poisson process

obtained by dropping the assumption of exponential interarrival times.
The corresponding counting process will serve as a model for claim num-
ber process. Our approach in this chapter re lies heavily on [Fe], [RSST].
All the random variables are defined on a prob ability space (0., F, P).
Definition 3.1 Let {Ai: i = 1,2, ... } be a sequence of Li.d. nonnega-

tive random variables. Set Ta == 0, T n = Al + A 2 + ... + An, n 2: 1. The
sequence {Tn } is said to be a renewal sequence. The associated counting
process
N(t) max {i 2: 0 : Ti ~ t}
#{ i 2: 1 : Ti :s t}, t 2: 0 (3.1)
is called a renewal process. The sequences {Tn } and {An} are referred
to respectively as arrival times and· interarrival times of the renewal
process N (.). T n is also called n th renewal epoch.
To avoid trivialities we shall assurne that
P(A i = 0) < 1, i 2: 1. (3.2)

It is clear that existence of i.i.d. {Ad implies that of N; moreover N (.)
has r.c.l.l. sampie paths. Also note that {Tn : n = 0,1,2, ... } is random
walk.
We have already seen in Theorem 2.5 that if {Ai} are i.i.d. Exp(A)
random variables then N (.) is a homogeneous Poisson process with rate
A > O.
30 3. Renewal model
If there are large gaps between arrivals then the Poisson process
model for claim number process is not adequate. This is the case if
interarrival times have thicker tails than the exponential distribution.
Of course, many nice properties of the Poisson process are lost in h~
renewal model. However, many asymptotic properties are similar to the
earlier model.
In this section we establish the strong law of large numbers for N ( .)
and the elementary renewal theorem.
To begin with, we want to establish that N(t) has finite expectation.
For this, and other purposes, it is convenient to treat To = 0 also as one
renewal. Indeed define for t 2 0
00
No(t) ~ L 1[o,tj(Ti ) = N(t) + 1. (3.3)
i=O
We need the following lemma
Lemma 3.2 Let {A}, {Ad be i.i.d. nonnegative random variables,

and {in, {in be the respective renewal sequences. Let the correspond-
ing counting processes N o(')' NoO be defined by the analogues of (3.3).
Suppose -"t ::; Ai a.s. for each i. Then No(t) 2 No(t) a.s. for t 2 O.
Hence E(No(t)) ::; E(No(t)).
Proof: Easy. 0
Theorem 3.3 Let the interarrival time {A} satisfy (3.2). Then
E(N(t)) < 00, t 2 O.
Proof: By assumption there exists a > 0 such that P(A i > a) > O.
By rescaling, if necessary, assurne a = 1. Define Ai = 1(1,00) (Ai), i =
1,2, .... Clearly {Ad is a sequence of i.i.d. Bernoulli random variables
with parameter p = P(A > 1). Also Ai ::; Ai for all i. So by Lemma
3.2 it is enough to prove that E(No(t)) < 00.
Denoting by fin the corresponding renewal sequence, for k 2 1
note that 'h has a binomial distribution with parameters k and p. By
monotone convergence theorem, denoting [tl = integral part of t
E(No(t))
00
1+L P(Tk ::; [tl) (.: To == 0, Tk integer valued)
k=1
00 00 [tl
1 + L(1- p)k + L LP(Tk = j)
k=1 k=1 j=1
1 [tl 00
- +L L
A
P(Tk = j)
P j=1 k=1
[tl 00
~ ~) )
p j=1 k=j J
(because P(Tk = j) = 0 if j < k)
1 [tl pi 00
- +L -:r LU: + 1) ... (R + j)(l - p)€
P j=1 J. €=o
< - +
1
L[tl pi
-:r
..
2JjJ
[00.
L
RJ (l- p)€
1
<00
P j=1 J. €=o
by ratio test, as j varies only over a finite set. o
Here is the first asymptotic result.
*
Theorem 3.4 (SLLN for renewal process). In addition to the hypoth-
esis of Theorem 3.3, let E(Ad = < 00. Then
. 1
hm -N(t) = A, a.s. (3.4)
t-+oo t
We need a lemma.
Lemma 3.5 Let {Zn: n = 1,2, ... },Z,{M(t) : t 2:: O} be random

variables on the same probability space such that (i) Zn ---> Z a.s., (ii)
M(t) integer valued, (iii) M(t) ---> 00 a.s. Then ZM(t) ---> Z a.s.
Proof: Put 0 1 = {w E 0 : M(t,w) ---> oo}, O2 = {w E 0: Zn(w) --->

Z(w)}. Note that P(Od = P(02) = 1 and hence P(01 n O2 ) = 1.
Clearly ZM(t,w)(w) ---> Z(w) for any w E 0 1 n O2 . 0
32 3. Renewal model
Proof of Theorem: As the sampIe paths of N are nondecreasing

and P(A i = 0) < 1, note that lim N(t) exists and is strict1y positive
t-H)O
with probability one. Now E(A) < 00 for all i implies P(Tn < (0) =1
for every n. It then follows that P (lim N(t)
~
= (0) = 1. Observe that
{N(t) = n} = {Tn ::; t < Tn + 1 }, n = 0,1,2,... (3.5)
and hence TN(t) ::; t < T N (t)+l' t ~ O. Therefore
TN(t) t T N (t)+l N(t) + 1

--<--< .----'....:..,-,..-- (3.6)
N(t) - N(t) - N(t) + 1 N(t)
for all sufficiently large t, with probability one. By Lemma 3.5 note that
P ~~ ;(W = A-1) = 1. The required conclusion (3.4) is now clear
from (3.6). 0
Theorem 3.4 suggests that E(N(t)) will be asymptotically linear.
Indeed we have
Theorem 3.6 (Elementary renewal theorem): Let the hypotheses be as

in Theorem 3.4. Then
lim ~ E(N(t)) = A. (3.7)

~ t
Proof: By Theorem 3.3 we know E(N(t)) < 00, t ~ o. As t N(t)

is nonnegative, by Theorem 3.4 and Fatou 's lemma
A = E [lim inf N (t )] ::; lim inf

~ t ~
!t E ( N (t ) ) . (3.8)
So it remains to establish
. 1
lImsup - E(N(t)) ::; A. (3.9)
~ t
For this we consider truncated inter arrival times. For b > 0 set
min{Ai , b}, i = 1,2,... }

_ (b) (b) (b)
= 0, Tn = Al + ... + An , n = 1,2, ... (3.10)
= max{i ~ 0 : 1j(b) ::; t}, t ~ O.
Clearly ~ ) is an i.i.d. sequence of non negative random variables,

~ ) is the corresponding renewal sequence, and {N(b)(t)} is the as-
°
sociated renewal process. Observe that Tn 2: ~ ) n 2: and N(t) :S
N(b)(t), t 2: 0.
Assuming Wald's identity
E [T(b)
Mb)(t)+1
] = E[N(b) (t) + 1] . E[A(b)]
1 ,
t > ° (3.11)
we shall proceed with the proof. (3.11) will be proved later. By (3.11)
we get
1 1
limsup - E(N(t)) :S (b) , for any b > 0.
t--'>oo t E[A 1 ]
Letting bi 00 in the above we get (3.9). 0

It remains to prove Wald's identity (3.11). A proof, which exploits
the fact that {Tn } is a random walk, is indicated in Exercises 3.1.3,
3.1.4. We give below another approach using the versatile martingale
framework, especially the optional sampling theorem. This method will
also be useful elsew here.
Set A(b)
~
= A(b)
~
- E(A(b»)
t
= A(b)
t
- E(A(b»)
1'-'0
i > 1 f?):::::::
,n
°
t(b) =
F6
Aib) + ... + ~) = ~ ) - nE(Aib»), n 2: 1. Let b) = {1>, O}, FA
b) =
~ ) : i:S n}, n 2: 1. It is easily verified that f~ ) n = 0,I,2, ... }
is a martingale w.r.t. {FA
b)}. (See Exercise 3.1.5 or Appendix A.3 for
adefinition.) It is also easily seen that (N(b) (t) + 1) is a stopping time
{FA
°
w.r.t. b )}; see Exercise 3.1.3.
Put T = N(b)(t) + 1, remembering that b> 0, t > are fixed. We

want to apply the optional sampling theorem to the stopping times T and
0, for the martingale f~ ) See [VI, V2], [BW] for more information
34 3. Renewal model
on martingales, stopping times, optional sampling theorem, etc. Abrief

account is given in Appendix A.3. For this we need to verify
(3.12)
and
lim ~ ) : {T > k}] = O. (3.13)

k--->oo
(In (3.13) and elsewhere for a random variable Y and a measurable set
B, E[Y : ~ JY dP = E[lB' Y]). Note that P(T < 00) = 1 and so
B
i';b) is well defined.
By Theorem 3.3, E( T) < 00 and hence
Eli';b) 1 E[IT;b) - T ~ ) I] ~ EIT;b) 1 + ~ ) )E( T)

~ ) (t)+l) + ~ ) . E( T)
(b)
E (TMb)(t) + A(b) ) (A(b») ( )
Mb)(t)+l + E I E T
< t +b+ ~ ) . E(T) < 00,
proving(3.12). Nextnotethat {T > k} = {N(b)(t) > k-1} = {N(b)(t) ~

k} = ~ ) ::; t}. Therefore
E ~ ) : {T > k}] = E ~)- ~ ) : {T > k}]

< E [Tt) : {T > k}] + E ~ ) E[k : {T > k}]
< E ~ ) : ~ ) ~ t}] + E ~ ) E[T : {T > k}]
< t· ~ ) ~ t) + ~ ) E[T : {T > k}].
As t is fixed, by the law of large numbers, applied to ~ ) note that

~ ) ~ t) -+ 0 as k -+ 00. Since E(T) < 00, the second term on r.h.s.
also goes to O. Thus (3.13) follows.
So by the option al sampling theorem E[i';b)] = E[i'ci b)] = 0, whence
(3.11) follows. This completes the proof of the elementary renewal the-
orem. 0
Unlike the Poisson process, it is in general not possible to determine
the exact distribution of the claim number process N(·) in the renewal
model. We give below a central limit theorem which may provide an
approximation for large t. We follow [RSST].
Theorem 3.7 Assume that 0 < Var(Ad < 00. Denote E(Ad =
±'c = ),3 Var(Ad. Then for every x E IR
·
1Im P (N(t)G
- ),t
::; X
)
= ()
X (3.14)
t-.oo V ct
where (.) is the distribution function of the standard normal distribu-
tion. Moreover the convergence in (3.14) is uniform over x E IR.
Proof: By Lindeberg-Levy centrallimit theorem
T, - ),-1 )
lim sup P ( n n <x - (x) = O. (3.15)
n-.oo xElR JnVar(Ad -
In (3.15) we have also used the fact: If G n , n ::::: 1, G are distribution

functions on IR such that {G n } converges weakly to G, and G is continu-
ous, then Gn(x) -+ G(x) uniformly over x E IR. See [Bl2]. Also this fact
will give us uniform convergence in (3.14) once pointwise convergence is
established.
Clearly {N(t) < f} = {Te> t}. Denoting m(t) = lxJCt + ),tJ ~
largest integer not exceeding (xJCt + ),t), we get
N(t) - ),t )
P ( VCt ::; x = P(N(t) ::; xVct + ),t)
P(N(t) < m(t) + 1) = P(Tm (t)+1 > t)
(
T m (t)+1 - ),-1 (m(t) + 1) t - ),-I(m(t) + 1) )
P J(m(t) + l)Var(Ad > J(m(t) + l)Var(At) .
Note that m(t) -+ 00 as t -+ 00. It is easily seen that
t - (m(t) + 1),-1 t - m(t),-1

lim = lim
t-.oo J(m(t) + l)Var(Ad t-.oo Jm(t)Var(Ad
= lim t - (xJCt + )'t),-1
= -x (3.16)
t-.oo [(xvCt + ),t)Var(Adp/2
holds for each x E IR. Since the convergence in (3.15) is uniform, and
1 - <1>( -x) = (x), note that (3.16) now implies (3.14) pointwise. 0
36 3. Renewal model
3.2 Renewal function
As already seen in Section 3.1, E(N(t)) plays an important role. Since

it may be the only quantity amenable to analysis in a fairly general set
up, it is important to understand it weIl.
For any right continuous nondecreasing function G on lR with
lim G(x) = 0, the associated measure is denoted by J-le. We know
~
that J-le((a, b]) = G(b) - G(a), a, b E lR, a ::; b. By slight abuse of

terminology, G will be referred to as the "distribution function" of J-le.
Definition 3.8 The function
H(t) ~ E(No(t)) = E(N(t) + 1), t 2: 0 (3.17)
is called the renewal function corresponding to the renewal process N (.).
We have already seen in Exercise 3.1.3 that for fixed t, No(t) is a

stopping time w.r.t. the natural filtration, while N(t) is not.
To appreciate the role of the renewal function we first show h~ it
contains all the information ab out the interarrival distribution.
Definition 3.9 Let G be a right continuous nondecreasing function on

lR such that G(O-) = 0, 0 ::; G(x) < 00, x 2: O. (It is possible that
G(+oo) ~ lim G(x) = +00.) Note that J-le is a a--finite measure sup-
x--,CX)
ported on [0,(0). Define
J J
(Xl
fe(s) = e-sxdG(x) = e-sXdJ-le(x) , s 2: 0 (3.18)

o [O,CX))
whenever the integral exists. The function Ce is called the Laplace-

Stieltjes transform of G.
If J-le is a finite measure then fe(s) exists for all s 2: o.

Theorem 3.10 (a) Let F be the distribution function of a probability
measure supported on [0, (0). Then fF has derivatives f~) of all orders
on (0,00) and
(3.19)
3.2. Renewal function 37
Moreover at any point of continuity of F
F(x) = lim
8-+00
L ~)
n.
f<;)(s). (3.20)
~
(b) 1f F l , F 2 are distribution functions of two probability measures

supported on [0,(0) and f F1 = f F2 , then F l = F 2 .
We need a lemma whose proof may be amusing.
Lemma 3.11 Let x> 0, Z > O. Then
if x>
~ ~
Z
lim e- 8X (sx)k ={ if x = Z (3.21)
8-+00 ~ k'
~ 1, if x< z.
Proof: The 1.h.s. of (3.21) suggests bringing in a homogeneous

Poisson process Y with parameter x > O. Note that
1.h.s of (3.21) lim P(Y(s):S SZ)

8-+00
lim P (Y(S) - sx < sz - sx) .

8-+00 ySX - ySX
Let ~ denote the distribution function of N(O, 1) distribution. In Ex-

ercise 2.1.5 (CLT for Poisson process), observe that the convergence is
uniform over lR as ~ is continuous. So the above limit
=
.
hm ~
((Z-x))
Vx VB = r.h.s of (3.21).
8-+00 X
o
Proof of theorem: As F is the distribution function of a proba-
bility measure, by repeated application of the dominated convergence
theorem
J
00
f~) ) )~ s>O. (3.22)

o
38 3. Renewal model
By (3.22), Lemma 3.11 and again the dominated convergence theorem

we get
"(-1t sn f(n)(s) =
~
nS:sz
n! F
J"
0
00
~
nS:sz
e- sx (sx)n dF(x)
n!
J
00
-+ {1[0,z) (x) +~ ) dF(x)

o
1
F(z-) + 2(F(z) - F(z- )), as s -+ 00. (3.23)
If z is a point of continuity of F, the conclusion (3.20) is obvious. Clearly

part (b) is a corollary of (3.20). 0
Let F denote the common distribution function of the interarrival
times; let /-lF denote the corresponding probability measme supported
on [0,00). By (3.2) note that /-lF i- 60. Denote ~ ) = 60, ~) =
/-lF, ~) = ~ ) * /-lF = /-lF * ~ ) n 2: 1. Similarly F*(O) =
1[0,00)' F*(l) = F , F*(n) = F*(n-l) * F, n 2: 1. (See Exercise 2.4.2
for definition of convolution.) Clearly /-l ~ ) is a probability measme
supported on [0,00) and F*(n) is the corresponding distribution function.
Theorem 3.12 Let the hypo thesis be as in Theorem 3.3. Then the
renewal junction H is a right continuous nondecreasing junction on IR
such that H(O-) = 0, O:S H(t) < 00, t 2: 0, and hence /-lH is a er-finite
measure supported on [0,00). Moreover
L
00 00
H = L F *(n) , th at zs
· , /-lH = /-l*F(n). (3.24)
n=O n=O
Proof: By definition of N(·) and Theorem 3.3 the first assertion is

clear. As Tk rv ~ ) for all k 2: 0, by (3.17), (3.3) and the monotone
convergence theorem
L L
00 00
H(t) = P(Tn :s t) = F*(n)(t),

n=O n=O
completing the proof. o

3.2. Renewal function 39
Theorem 3.13 Let the hypo thesis be as in Theorem 3.3. Then the
Laplace-Stieltjes transform RH of H is well defined on [0,00). Moreover
RH(S) > 1, s > 0 and
(3.25)
Consequently
, 1
fF(S) = 1 - -,- , S > o. (3.26)
fH(S)
Proof: Note that RF(s) = E(e- sA1 ). As {Ad is an i.i.d. sequenee,
clearly RF*(n)(s) = E[e- STn ] = [RF(s)]n for all n. Henee for s > 0, by
Theorem 3.12
RH(S) =
00
2:
n=O
J°00
e-sxdF*(n)(x) = ~
1 - fF(S)
where the geometrie series eonverges as RF (s) < 1, S > 0, eompleting

the proof. 0
Prom (3.26) and the inversion formula (3.20) note that F ean be
obtained from the renewal function H in principle. The measure J-LH is
also ealled the renewal measure of the proeess N.
t
Now observe that F*(n)(t) = J F*(n-l)(t - s) dF(s), t ~ 0 as
°
F, F*(n-l) are supported on [0,00). Therefore by (3.24) and mono-
tone eonvergenee theorem, for t 2 0
00 00
H(t) 1+ 2: F*(n)(t) = I[o,oo)(t) + 2: F*(n)(t) (.: t ~ 0)

n=l n=l
I[o,oo)(t)
00
+ 2: J t
F*(n-l)(t - s) dF(s)
n=l °
J 2:
t oo
I[o,oo)(t) + F*(k>(t - s) dF(s)
° k=O
+J
t
= I[o,oo)(t) H(t - s) dF(s).
°
40 3. Renewal model
Thus we obtain
Theorem 3.14 With the hypo thesis as in Theorem 3.3, the renewal
junction satisfies the renewal equation
J
t
H(t) = I[o,oo)(t) + H(t - s) dF(s), t 2 0. (3.27)

o
Definition 3.15 A convolution equation of the form
J °
t
U(t) = u(t) + U(t - y) dF(y), t 2 (3.28)

o
is called a renewal equation. Here F is the distribution function of a
probability measure supported on [0,(0), u(·) is a known function and
U (-) is the unknown function both defined on [0, 00 ).
Theorems 3.12 and 3.14 suggest the,following result regarding solu-

tion to (3.28). We say a measurable function u is locally bounded if u is
bounded on every bounded set.
Theorem 3.16 Let F be the distribution junction oj a probability mea-

sure /1F =1= 150 supported on [0,(0). Let H = f:
n=O
F*(n), /1H = f:
n=O
~)
denote respectively the corresponding "renewal junction", "renewal mea-
sure". Consider the renewal equation (3.28) where u(·) is a locally
bounded measurable junction supported on [0,(0). Then
J J
t
U(t) = u(t - s) dH(s) = u(t - s) d/1H(S) (3.29)

o ~
is the unique solution to (3.28) in the class oj locally bounded measurable

junctions supported on [0,(0).
°
Proof: As /1F =1= 150 , by Theorems 3.3 and 3.12, Hand /1H are
weIl defined. As /1H([O, s]) < 00 for any < s < 00, for any 10-
cally bounded measurable function 0: supported on [0, (0) note that
3.2. Renewal junction 41
t
t I-t J a(t -
s) d/LH(S) is a well defined locaIly bounded measurable
o
function supported on [0,(0). Moreover
.I
o
t
a(t - s) d/LH(S) =
00
L
n=O
!0
t
a(t - s) ~) ) t 2: o.
Thus U( ·) given by (3.29) is a weIl defined locaIly bounded function
supported on [0,(0). Also by Exercise 3.2.1 (see below), note that
U(t) = !
o
t
u(t - s) d/LH(S) = u(t) +L
k=l
00
J
0
t
u(t - s) ~) )
u(t) +L
00
! t
u(t - s) ~ ) * /Lp)(s)
t.l [l
j=O 0
u(t) + u(t - (s + r)) dP;!j)(S)] dl'F(r)
L! !
00 t t-r
u(t) + u(t - r - s) ~) ) d/Lp(r)
+ j [f
j=O 0 0
~ u(t) l"U(t - r - s) dP;!'\S)] d/Lp(r)

o J=O 0
+ .I
t
u(t) U(t - r) d/LF(r)

o
proving that U satisfies (3.28).
To prove uniqueness, let U1, U2 be two locally bounded solutions
supported on [0,(0). Using the renewal equation (3.28), iterating and
by Exercise 3.2.1 we get for k = 1,2, . . .
t
U1(t) - U2(t) = ![Ul(t - s) - U2(t - s)] d/Lp(s)

o
t
![Ul(t - s) - U2(t - s)] ~) )

o
42 3. Renewal model
As Ul , U2 are locally bounded it now follows
for any k 2: 1. Since H(t) < 00 we have F*(k)(t) -+ 0 as k -+ 00. So

Ul = U2. 0
In the preceding discussions we have taken all the Ai 's having the
same distribution. For some purposes it is convenient to consider the
following situation.
Definition 3.11 Let Ai , i = 1,2, ... be a sequence of nonnegative in-

dependent random variables. Let Al have distribution function C, and
each Ai , i 2: 2 have distribution function F. Set TJD) == 0, ~ ) =
Al + A 2 + ... + An , n 2: 1. The sequence ~ ) is called a delayed
renewal sequence. The associated counting process
(3.30)
is called a delayed renewal process. Also the function
(3.31)
is called the delayed renewal junction. Note that
I: I[O,tj(Ti(D)) .
<Xl
N(D)(t) =
i=l
Then imitating the proofs of Theorems 3.12, 3.13 one can get the
following
Theorem 3.18 Let the hypotheses oj Theorem 3.3 and Definition 3.17
hold. Then
00
H(D)(t) = C(t) + l)C * F*(k))(t) , t 2: O. (3.32)

k=l
Moreover H D (.) satisfies the renewal equation
J
t
H(D)(t) = C(t) + H(D)(t - s) dF(s) , t 2: O. (3.33)
° o
3.3. Renewal theorems 43
A special case of interest is when the distribution function of Al is

given by
t
FI(t) = ~) j (1 - F(y)) dy, t ~ o. (3.34)

o
FI is called the integrated tail distribution of F. Sometimes it is called
the stationary excess distribution or equilibrium distribution of F. This
plays an important role later. Let H I (·) denote the corresponding re-
newal function.
Proposition 3.19 Let the hypotheses be as in Theorem 3.18, with the

distribution of Al given by (3.34). Then HI(t) = At, t ~ 0 where
E(A 2 ) = A- l .
Proof: By integration by parts

t
FI(t) = At - j A(t - s) dF(s).

o
Consequently the renewal equation (3.33) for HI can be written as
t
HI(t) = FI(t) +j HI(t - s) dF(s)
o
t
At + j[HI(t - s) - A(t - s)] dF(s),

o
whence the required assertion follows. o
3.3 Renewal theorems
Renewal theorems concern the asymptotic behaviour of the renewal

function H (-), and of the solution U (.) to the renewal equation. By
the elementary renewal theorem we know that H(·) is asymptotically
linear. We also know that H(·) is the "distribution function" of a (7-
finite measure supported on [0, (0), and that the expression for U(·)
involves a Stieltjes integral with respect to H(-). So to study the asymp-
totic behaviour of U(-) it is helpful to know the asymptotic behaviour
of H(t + h) - H(t) as t -+ 00, for each fixed h > O.
44 3. Renewal model
Definition 3.20 A distribution function G (or equivalently the corre-

sponding measure f.LG) is said to be a lattice distribution if there exists
a ~ 0 such that f.LG(E C ) = 0 where E = {ka : k E Z}. A distribution is
called nonlattice if it is not lattice. (Note that a nonlattice distribution
cannot be supported on a discrete subgroup of IR).
Theorem 3.21 (Blackwell's renewal theorem): Let the interarrival time

distribution F be supported on [0,(0), be nonlattice, and have finite ex-
pectation >.-1. Let H be the corresponding renewal junction. Then jor
any h ~ 0
lim H(t
t---+oo
+ h) - H(t) = t---+oo
lim E[N(t + h) - N(t)] = >'h. (3.35)
We shall eventually take up the proof of the theorem. Before that

we shall explore certain implications of the result.
Definition 3.22 Let G n , n = 1,2, ... and G be nondecreasing right

continuous functions on IR. We say that G n converges weakly to G,
denoted Gn .!:!!. G if lim Gn(b) - Gn(a) = G(b) - G(a) for every a <
n---+oo
b, a, b E IR being continuity points of G. This notion is also denoted
w
f.LG n ---+ f.LG·
In view of the above definition, Blackwell's renewal theorem can

be interpreted as follows. For t ~ 0 define the (i-finite measure Vt by
setting Vt(E) = f.LH(E + t) for any Borel set E; (that is, Vt((a, b]) =
H(t+b) -H(t+a), a,b E IR, a< b). Then under the hypotheses ofthe
w
theorem Vt ---+ >. ds as t ---+ 00, where ds denotes the Lebesgue measure.
Suppose u(·) is a continuous function on [0,(0) vanishing outside a
finite interval. If U (.) denotes the solution to the corresponding renewal
equation (3.28) then (see Exercise 3.3.1 (b))
J
00
lim U (t) =
t---+oo
>. u (s) ds (3.36)
o
using Blackwell's renewal theorem.

As another illustration, consider g(t) = H(t) - H(t - h) as a function
on IR, by setting H(·) = 0 on (-00,0); here h ~ 0 is fixed. By Exercise
3.2.4 we know that g(.) is the solution to (3.28) with u(t) = I[o,h) (t). In
this case (3.35) can be written as
J
00
lim g(t) = A u(s) ds. (3.37)

t---+oo
°
In the Poisson process model, and in the delayed renewal model given
in Proposition 3.19 note that (3.35) holds exactly for all t.
Having guessed the asymptotic behaviour of the solution to the re-
newal equation, we need the following definition to carry it through for
a large dass of functions.
Definition 3.23 Let u(·) be a function on [0,00). For h > 0, n =

1,2, ... denote
mn inf{u(x) : (n - l)h :::; x :::; nh}

mn sup{u(x) : (n - l)h :::; x :::; nh}.
The function u(·) is said to be directly Riemann integrable if

(i) the two se ries 'Q.(h) = h L m n , u(h) = h L m n converge absolutely
n n
for any h > 0, and
(ii) lim [u(h) - 'Q.(h)] = 0.
hlO
The above notion is perhaps due to Wiener. The following lemma

from [RSST] gives a useful sufficient condition.
Lemma 3.24 Let Ul : [0,00) --+ (0,00) be nondecreasing, U2 : [0,00) --+

00
[0,00) be nonincreasing such that J Ul(X) U2(X) dx < 00 and lim c(h) =
1, where
° h---+O
Then the product u(x) = Ul(X) U2(X) is directly Riemann integrable.
Proof: Note that c(h) > 0. By definition of c(·)

sup{U(x) : (n -l)h:::; x:::; nh}:::; ul(nh) u2((n -l)h)
< c(2h) ul((n - 2)h) u2((n - l)h), n = 2,3, ...
46 3. Renewal model
Note that ul((n - 2)h) u2((n - l)h) ~ Ul(X) U2(X) for (n - 2)h ~ x ~
(n - 1) h. Therefore
u(h) < hsup{u(x): 0 ~ x ~ h} + c(2h) J

o
=
Ul(X) U2(X) dx
< 00, for any h > O.
Similarly '!J.(h) 2: cdh) J=Ul(X) U2(X) dx. Since c(h) ----t 1 as h ----t 0 the
h
required conclusion now follows. 0
Lemma 3.25 The jollowing classes oj junctions on [0,00) are directly

Riemann integrable.
(i) Continuous junction vanishing outside a finite interval.
(ii) Indicator junction oj a finite interval.
(iii) Riemann integrable junction vanishing outside a finite interval.
(iv) u(t) = F(t + 0 - F(t), t 2: 0 where F is the distribution junction
oj a probability measure supporled on [0,00) and ~ 2: 0 is fixed.
(v) u(t) = F(t) - F(t - ~) t 2: 0 where F, ~ are as in (iv).
(vi) u(t) = 1 - F(at), t 2: 0 where F is the distribution junction oj a
probability measure supported on [0,00) having finite expectation, and
a > 0 is fixed.
Proof: We shall indicate the proof only in case (iv). Let an =

sup{u(t) : n - 1 ~ t ~ n}. Clearly an ~ F(n + ~) - F(n - 1) ~
F(n + M) - F(n - 1), where M is the smallest integer 2: ~ Therefore
k k+M
for all sufficiently large k, 2:= an ~ 2:= F(i) ~ M + 1. Now apply
n=l i=k
Exercise 3.3.3 (b). o
Theorem 3.26 Let notation and the hypotheses be as in Theorem 3.21.
Then the jollowing are equivalent.
(a) Blackwell's renewal theorem holds, that is, (3.35) is satisfied jor any
h 2: O.
(b) (Key renewal theorem) Let u(·) be a directly Riemann integrable
junction supporled on [0,00). Let U (-) be the locally bounded solution
to the renewal equation (3.28). Then (3.36) holds, that is lim U(t) =
t---+=
=
>. J u(s) ds.
o
Proof: As any directly Riemann integrable function is locally bounded

and integrable (see Exercise 3.3.4), the statement in part (b) is mean-
ingful.
(b) ~ (a) : Take u(t) = I[O,h) (t). We have already seen that (3.37)
is the same as (3.35).
(a) ~ (b) : In view of Exercise 3.3.6 (a) it is enough to consider
u(·) 2: O. With h > 0 fixed but arbitrary, and notation as in Definition
3.23, set
L m n I[(n-l)h,nh)(t),
00
u*(t)
n=l
L m n I[(n-l)h,nh)(t).
00
u*(t) =
n=l
Clearly 0 ::; u* ::; u ::; u* and hence by (3.29)
J J
t t
u*(t - r) dH(r) ::; U(t) ::; u*(t - r) dH(r), t 2: O. (3.38)

o 0
By direct Riemann integrability, L:: m n < 00. By (3.35)
sup{H(t - (n - l)h) - H(t - nh) : t 2: 0, n = 1,2, ... }

(3.39)
Now (3.35), (3.39) and the dominated convergence theorem applied to

the measure given by {mn} imply
J
t
lim u*(t - r)dH(r)

t--+oo
o
00 00
lim ~ mn{H(t - (n - l)h) - H(t - nh)}

t--+oo L......t
= )"h ~ m .
L......t n
n=l n=l
In a similar fashion
lim
t--+oo
J
o
t
u*(t - r) dH(r) = )"h ~ m n ·
L......t
00
n=l
48 3. Renewal model
Consequently by (3.38) we now get, for any h >0
)'h ~ ) ~ ~ (u.(t -r) dH(r)

< liminf U(t) ~ limsup U(t)
t-+oo t-+oo
< ~ jU'(t - r) dH(r) ~) h (f mn) .

o n=l
(3.40)
By direct Riemann integrability
J
00
lim h'""' m n
hlO ~
= lim
hlO
h '""'
~
mn = u(s) ds. (3.41 )
n n 0
The required conclusion is now clear from (3.40), (3.41). 0

Note: We now make some remarks on a result to be used in the proof
of Theorem 3.21. Let F be a probability distribution on lR.; consider the
00
convolution equation ((x) = J ((x - y) dF(y), x E R If ((.) ==

-00
constant, clearly ( satisfies the equation. In case F is nonlattice, the

celebrated Choquet-Deny theorem asserts that constants are the only
solutions in the class of bounded continuous functiüns. See [Fe] für an
analytical proof.
If F is not a probability distribution, then even non-zero constants do
not satisfy the convolution equation. See Section 5.4.1 for implications
to the asymptotics.
Now we take up
Proof of Theorem 3.21: We first claim that for any fixed finite
interval I = (a, b],
sup{lIt(I) ~ fLH(I + t) = H(b + t) - H(a + t) : t ~ O}
< 00. (3.42)
Indeed if u(t) = 1 - F(t), t ~ 0 then the corresponding solution
to the renewal equation is U(t) = 1, t ~ 0, and consequently by the
representation (3.29)
J J
t t
1 = u(t - r) dH(r) ~ (1 - F(t - r)) dH(r)

o t-h
> (1 - F(h)) [H(t) - H(t - h)]
for any t > 0, h > 0. As JLF =I=- 80 we can choose h > ° such that
(1 - F(h)) > 0. Consequently the above implies
sup{H(t) - H(t - h) : t 2: o} < 00, for some h> 0.

t
Since any finite interval is a finite union of intervals of length ::; h, the
claim (3.42) now follows.
By (3.42) and the Helly selection principle outlined in Exercise 3.3.2
there is a sequence tk -7 00 and a a-finite measure v on IR such that
Vtk ~ v. Note that v need not be supported on [0, (0). (As Vt is
supported on [-t, (0) we should expect v to be supported on IR and it
turns out to be so.)
Now let u be a continuous function supported on [0, a] for some
a > 0. Let U be the corresponding solution to the renewal equation
(3.28). By (3.29), far tk > a note that
J
X+tk
u(x + tk - r) dH(r)
o
J J
x x
u( x - s) dVtk (s) = u( x - s) dVtk (s)

(-tk)V(x-a) x-a
J
00
u(x - s) dVtk(S), if x 2: 0.
-00
°
If x < then the above equality holds for tk > a + lxi. As Vtk ~ v it
now follows by Exercise 3.3.1 (a) that
J
00
U(x + tk) -7 u(x - s) dv(s) ~ ((x) (3.43)

-00
as tk -7 00 for any x E IR. By the dominated convergence theorem and

(3.42) it is clear that ( is a bounded continuous function on IR. Since U
solves the renewal equation (3.28), by (3.43) and the dominated conver-
gence theorem again we get
50 3. Renewal model
((x) [ u(x + tk) + ! X+tk

U(x + t, - y) dF(y)
1
J
X+tk
lim
tk->OO
U(x + tk - y) dF(y)
o
(": u is supported on [0, a])
J
00
lim
tk->OO
U(x + tk - y) dF(y)
-00
(": U, F supported on [0,(0))
J
00
((x - y) dF(y).
-00
Thus
J
00
((x) = ((x - y) dF(y), xE R (3.44)

-00
As F is nonlattice, the only solution to the convolution equation (3.44)

is ((.) == constant by the Choquet-Deny theorem (see [Fe]). This means
00
that J u( x - s) dv( s) is independent of x E :IR. for any continuous func-

-00
tion with compact support in [0,(0). So by standard measure theoretic

arguments it follows that v(I + x) = v(I) for any finite interval I c R
Thus v is proportional to the Lebesgue measure. That is, we have proved
(3.45)
where 0: is a constant independent of h.

To complete the proof we need to show that 0: is independent of the
sequence {td and that 0: = A. By (3.45), and the proof of (a) =} (b) in
Theorem 3.26 we get
J
00
lim U(tk) = 0: u(s) ds (3.46)

tk->OO
o
for any directly Riemann integrable function u(·), where U (.) stands for
the corresponding solution to the renewal equation (3.28). In particular
take u(t) = 1 - F(t), t 2 o. By Lemma 3.25 (vi), as F has finite
expectation, we have r.h.s of (3.46) = aA -1. Since l.h.s of (3.46) in this
case is 1, we get a = A, completing the proof. 0
As an application of the key renewal theorem we shall now prove a
limit theorem for the residual waiting time. From the definition of N (.)
we know that for every t 2 0
(3.47)
Recall (see Proposition 2.6) that T N (t)+l - t is called the residuallife or

residual waiting time at epoch t.
Theorem 3.21 Let the notation and hypotheses be as in Theorem 3.21.

Write for t 2 0
~) = P(TN(t)+l - t ::; ~) ~ E IR. (3.48)
So Q(t,·) is the distribution function of the residual waiting time at

epoch t. Then
lim Q(t,O
t-+oo
= A /(1 - F(s)) ds ~ ~) (3.49)
o
That is, the limit distribution of the residual waiting time is the same
as the integrated tail distribution given by (3.34).
Proof: By (3.47) observe that
P(TN(t) ::; t < T N (t)+l ::; t ~)
L
00
P(Tk ::; t < Tk + Ak+1 ::; t + ~)

k=O
f/ /
t ~
dF(y) dF*(k)(x)
k=O 0 t-x
t
/[F(t - x ~) - F(t - x)] dH(x) (3.50)

o
52 3. Renewal model
by Theorem 3.12. So by Theorem 3.16, for fixed ~ ~ 0 the function

~) solves the renewal equation corresponding to u(t) = F(t + ~) -
F(t), t ~ O. By Lemma 3.25 (iv), u(-) is directly Riemann integrable.
So the key renewal theorem (Theorem 3.26 (b)) alld Exercise 3.3.7 can
now be used to obtain (3.49). 0
The next result shows that the limitillg distribution is independent
of the initial distribution. Indeed we have
Theorem 3.28 Let the notation be as in Definition 3.17. Let the hy-
potheses of Theorem 3.21 hold. For t ~ 0, denote by
the distribution function of the residual waiting time at epoch t corre-

sponding to the delayed renewal process N(D). Then
(3.52)
Thus the limiting distribution of the residual waiting time is independent

of the initial distribution G.
Proof: Proceeding as in the derivation of (3.50), and using (3.24)
~) + L
00
P(t < Al ::; t P (Tk D ) ::; t < Tk D) + Ak+l ::; t + ~)

k=l
G(t +0 - G(t)
t oo
+j 2)F(t - x +0 - F(t - x)] dG * F*(k-l)(x)

o k=l
G(t +0 - G(t)
t
+ j[F(t - x ~) - F(t - x)] d(G * H)(x). (3.53)

o
It can be shown (see Exercise 3.3.9) that
t
lim j[F(t - x
t--->oo
~) - F(t - x)] d(G * H)(x) = ~) (3.54)
o
As lim G(t + 0 - G(t) = 0, the required conclusion (3.52) is now clear

~
from (3.53), (3.54). 0
The next result reinforces the steady state behaviour of the inte-
grated tail distribution.
Theorem 3.29 Let the set up be as in Definition 3.17. Assume that

E(Ad = A-1 < 00, i ~ 2, and that the initial distribution G = FI
given by (3.34). Let Q(I)(t,.) denote the distribution function of the
corresponding residual waiting time (at epoch t) defined by the analogue
of (3.51). Then
(3.55)
Proof: The analogue of (3.53) in this case is
J
t
) ~) = FI(t ~) - FI(t) + [F(t - x + 0 - F(t - x)] dHI(x)

o
where H I denotes the corresponding delayed renewal function. By Propo-
sition 3.19 we know that dHI(x) = A dx. Hence it follows by (3.34) that
J~
~
F(y)dy - J 1
0
t
F(y)dy
completing the proof. o

Remark 3.30 There is another approach to prove Blackwell'S renewal
theorem using the so called coupling technique. It goes as follows. Take
two independent delayed renewal processes N and N with the same in-
terarrival time distribution F, but the initial distribution corresponding
to N is G while that of N is the equilibrium distribution F I . We know
that E(N(t)) = At, t ~ 0; also the residual waiting time distribution
for N is FI for any epoch t. (Note also that Blackwell's theorem or
key renewal theorem is not used in the proof of Theorem 3.292. The
coupling method involves in showing that the processes N and N come
arbitrarily close to each other in finite time resulting in coupling with
54 3. Renewal model
probability one. After coupling the two processes become (statisticaIly)

more and more indistinguishable. So one might as weIl "observe" the
process N whose asymptotics are known. Of course, all these have to
be translated into mathematics; an interested reader can look up [BW]
for details. There is yet another approach to renewal theorems using
functional analysis; see [Ru].
3.4 Sparre Andersen model
This important model is a generalization of the Cramer-Lundberg model.

Sparre Andersen proposed this set up as a way of studying lR-valued ran-
dom walks in late 1940's. Soon connections with queueing theory and
risk theory were discovered, leading to a vast literature. The approach
also simplified many asymptotic results that had been obtained earlier
using complicated techniques; see Section 5.1 below for a sampie. An
interested reader may look up Chapter XII of [Fe] to get an idea of the
implications of Sparre Andersen's work.
The basic ass um pt ions are as follows.
1. The claim number process {N(t) : t 2: O} is a renewal process.

2. The claim sizes {Xd form an i.i.d. sequence of nonnegative ran-
dom variables.
3. {N(t)} and {Xd are independent.

As in the earlier model, the total claim amount upto time t is given
by
N(t)
S(t) = LXi, t 2: 0 (3.56)
i=l
which is the same as (1.2).
Theorem 3.31 Consider the Sparre Andersen model with the inter-
arrival times {Ai} and the claim sizes {Xj } having finite expectation.
Then
. 1 ~ )
(i) 11m - S(t) = (A) a.s.; (3.57)
t-+oo t ~ 1
. 1 ~
(ii) 11m -t ~ )) = ~ ); (3.58)
t-+oo 1
3.4. Sparre Andersen model 55
(iii) for any h > °

~~ E(S(t + h)) - E(S(t)) = ~~~~ h. (3.59)
Thus analogues of SLLN, elementary renewal theorem, and Blackwell 's

renewal theorem hold for {S (t) }.
Proof: Note that S(tt) Set)

N(t)
N(t)
-t-·
Denote fl 1
n . N(t)
{ WEH. -t- ---> E(Al)
I} ,and n _
H2 -
{ n .
By
WEH.
Set)
N(t) --->
)}·
E(X1
Theorem 3.4 we know that P(fld = 1. By SLLN for the i.i.d. sequence
n
{Xd we know that ~ L: Xi ---> E(Xd a.s. As N(t) ---> 00 a.s. apply
i=l
Lemma 3.5 to get = 1. Hence P(fl 1 nfl 2 ) = 1; so (3.57) is proved.
P(fl 2 )
Rest of the proof is left as exercise; see Exercise 3.4.1. D
Our next objective is to prove a central limit theorem for {S(t)}
following [EKM]. We first need a lemma.
Lemma 3.32 Let {Zn: n 2: 1}, Z, {an: n 2: 1}, ~ : n 2: 1} be

random variables such that Zn ~ Z, an ---> a in probability, ~ ---> b in
d
probability, as n ---> 00, where a, bE IR are constants. Then an Zn ~ --->
aZ+b.
Proof: This is basically Slutsky's theorem; see leT, p.272] for a

proof. D
Theorem 3.33 (Centrallimit theorem): Consider the Sparre Andersen

model with the interarrival times {Ai} and the claim sizes {Xj } having
finite second moments. Denote A- 1 = E(Ad, ~ = Var (Al), f-l =
E(Xd and al = Var (XI). Then
1 ~ )- Af-lt) ~ N(O, 1) (3.60)

(al + f ~) Y At
as t ---> 00.
Proof: Denote a = (al + f ~) y; = (Xi - Af-lAi ) , i >

n n
1, Zn = ~ L: (Xi - Af-lAi ) = ~ L: Y;, n 2: 1. Note that
i=l i=l
56 3. Renewal model
1 1
-;; J>:t [S(t) - AJLt]
1 1 AJL
- I\";. [S(t) - AJLTN(t)] + I\";.(TN(t) - t)
(J v At (JV At
1 1 N(t) AJL
- - L(Xi - AJLAd + -- (TN(t) - t)
(J J>:t i= 1 J>:t
(J
1 1 N(t) A
- -J>:t L
(J i=1
Yi+
(JV
~
At
(TN(t) -t)
1 1 AJL
~ Z[Atj
v At
+ vI\";.
At
[ZWt) - Z[Atj]
\
+ (JVI\";.
At
(TN(t) - t)
[At]) 1/ 2 1 1
( At JIMJ Z[At j + J>:t (ZN(t) - Z[Atj )
AJL
+ I\";. (TN(t) - t) . (3.61)
(JV At
By independence of {Xd and {A j }, note that {Yi} is an i.i.d. sequence

with mean zero and variance (J2 . So by the classical centrallimit theorem
b Zn !i. N(O, 1), and hence b Z[>..tj !i. N(O, 1) as t ----> 00. In view
yn V [Atj
of the preceding lemma and (3.61) , to complete the proof it is enough
to show that
1
J>:t [ZN(t) - Z[Atj] ----> 0 in probability, (3.62)
1
yfi (TN(t) - t) ----> 0 in probability. (3.63)
Let E> 0 be arbitrary; put CE = {.At IZN(t) - Z[Atj I> E}. Let <5 > 0,
put
BI {I NY) - AI > <5} ,

B2 {I NY) - AI :s <5, ~ 1ZN(t) - Z[Atj I> E} .
Clearly CE ~ BI u B2; (dependence of these sets on t is suppressed).
By SLLN, P(B 1 ) ----> 0 as t ----> 00 for any <5 > o. Next by Kolmogorov's
inequality
P(B2) ,t] I: IT- AI ::; <5} > n/M)

2 <5
< E2 At Var (Z[(AH)t] - Z[At]) ::; K E2
°
where K is a positive constant independent of t, E, <5. For fixed E > 0,
first choose <5 > such that P(B 2 ) is very small for all t. Then choose
t large enough so that P(BJ) is small. Thus P( C€) --t as t --t 00 for °
any E > O. This proves (3.62) .
Next for E > 0,
L P(t -
00
TN(t) > elt N(t) = k) . P(N(t) = k)

1
k=O
L P(Ak+l > EVt

00
1 N(t) = k) . P(N(t) = k)
k=O
L P(A
00
1 > EVt) . P(N(t) = k) C· {Ad Li.d.'s)
°
k=O
P(A 1 > EVt) --t as t --t 00
which implies (3.63), completing the proof. D

The rest of this section is devoted to an elementary discussion of
premium principles.
3.4.1 Some basic premium principles

One 01 the main objectives of an insurance company is to determine
the premium, or the premium rate to be more precise. Loss to the
insurance company is described by the total claim amount S (. ). Clearly
the premium rate is to be chosen so that los ses over time are covered.
The premium income p( t) is taken to be a deterministic function; here
p(t) = premium income upto time t.
Though E(S(t)) may be a rather crude estimate for S(t), it is still
a very useful approximation. Often it may not be possible or easy to
determine even asymptotic behaviour of higher moments of S(t). Also
in view ofthe SLLN, if p(t) < E(S(t)) for large t then one may say that
58 3. Renewal model
the company loses on the average; similarly if p(t) > E(S(t)) for large
t, then the company may gain on the average. With this perspective,
the following premium principles are in vogue; also these are perhaps
elementary to implement.
1. Net or equivalence principle. According to this system, Pnet(t) =

E(S(t)), t 2: O. In this situation, the insurance company does not
intend to lose or gain on average; so it is sometimes called "fair
market premium" or "bechmark premium". It can serve only as
a theoretical value. Due to fluctuations the deviations from the
mean can be positive as weIl as negative, and hence it would be
unwise to charge premium according to this principle. In fact we
shall prove later that this principle leads to "ruin" of the company
in finite time with probability one.
2. Expected value principle. In view of our preliminary remarks, it

seems reasonable to choose a premium by "loading" the expected
total claim amount by suitable "safety factor". Accordingly
PEV(t) ~ (1 + p) E(S(t)), (3.64)
at least approximately, where p > 0 is the sajety loading jactor.

By Theorem 3.31 (ii), in the Sparre Andersen model
E(XI)
E(S(t)) = E(AI) t + o(t), as t --+ 00.
Hence
E(XI)
PEV(t) = (1 + p) E(AI) t, t 2: 0 (3.65)
is a reasonable way to fix the premium. This is perhaps the most

commonly used and easy to implement procedure. Of course, too
high a loading may make the premium unattractive to the prospec-
tive buyer of insurance policy.
The expected value principle, however, does not take fluctuations
into account. The next twoapproaches take cognisance of this
when the second moments exist.
3. Variance principle. In this case, assuming that the second mo-

ments exist,
PVar(t) ~ E(S(t)) +a Var (S(t)) (3.66)

where 0: > 0 is a eonstant. In view of the eentral limit theorem

for the Sparre Andersen müdel one ean take
4. Standard deviation principle. This is similar to the preeeding one

is spirit; it is desired that
PSD(t) ~ E(S(t)) + o:VVar(S(t)),. (3.68)
where 0: is a positive eonstant. So
(3.69)
in the Sparre Andersen model when the seeond moments exist.

Note that the total claim amount exeeeding the premium ineome
is an event to be avoided; so it is desirable to fix the premium
in order to make the prob ability of this eventuality small. When
seeond nlOments exist, using the eentrallimit theorem, justifieation
for PVar(-) and PSDO ean be given; see Exereises 3.4.5, 3.4.6.
5. Exponential principle. According to this not ion

1
PExp(t) = ~ log E[eaS(t)], t>0 (3.70)
where a > 0 is a eonstant ealled risk aversion jactor. The rationale

für the exponential prineiple ean be given in terms of utility theory
of eeonomics. This theory was developed by von Neumann and
Morgenstern. We give below abrief diseussion in the eontext of
insuranee.
Same remarks on utility junctions vis-a-vis insurance. We have seen

that it is desirable to have p(t) > E(S(t)), eertainly from the point
of view of the insurer (i.e. insuranee eompany). But this would mean
that the insured (i.e. the end users who avail of the poliey, eonsidered
eolleetively) pay more than wh at they expect to get on the average.
The· very faet that the insuranee business exists indieates that a large
60 3. Renewal model
section of the population is willing to pay aprice (for being insured ) that
is greater than the expected claim amount. In economics, an explanation
for such apparent anomalous situations is given in terms of the so called
utility functions. This postulates the existence of a utility function which
determines decisions, in our case, collectively for the insured.
Let I S;;; lR. be an interval; it need not be a finite interval. A function
v : I ~ lR. is called a utility junction if it is nondecreasing and concave.
For each wealth x E I a utility v(x) is attached; v(x) can be different
from x. Since utility may be assumed to increase with wealth v(·) is
assumed to be nondecreasing; this is also phrased as "marginal utility
is nonnegative" , that is, Vi (x) ;:: 0 if Vi (.) makes sense. Next, note
that giving Re.1 to a poor person makes more sense than giving it to
a millionaire. So increments of v(x) for small values of x should be
more than those for large values of x; that is, if Xl < X2, h > 0 then
V(XI + h) - v(xd ;:: V(X2 + h) - V(X2); again, this may be termed as
"decreasing marginal ~ or v" (x) ::; 0 whenever v" (.) makes sense.
Thus v(·) should be concave.
The concavity assumption is also known as risk aversion. Adecision
maker is risk averse if a fixed loss is preferred over a random loss that
has the same expected value. If we consider a random loss Y, then
the expected utility is E[v( -Y)]. By Jensen's inequality E[v( -Y)] ::;
v(E( -Y)) as v is concave. So the fixed loss E( -Y) is given greater
utility than the expected utility of the random loss. Risk averse decision
makers are generally considered 'reasonable' decision makers.
We assurne that there is a utility function v collectively for the po-
tential buyers of insurance policy. For the insured the loss is S(t) in the
absence of insurance; (if the initial wealth is x then it gets depleted to
x - S(t) if there is no insurance; for simplicity we take x = 0). So in
the absence of insurance the expected utility is E[v( -S(t))]. If ins ur-
ance cover is taken, similarly the utility at time is v( -p(t)), where p(t)
denotes the premium paid upto t. Therefore insurance will be taken by
a potential buyer only if
E[v(-S(t))] ::;v( -p(t)), t;:: 0; (3.71)

that is, only if taking insurance provides greater utility than not having
insurancecover. As v is increasing, the "maximum premium" the in-
sured may be willing to pay is determ.ined by the solution p+ (.) to the
equation
E[v( -S(t))] = v( -p+(t)), t;:: O. (3.72)

3.5. Exercises 61
Equation (3.72) is called the utility equilibrium equation, and p+ 0 is

called zero utility premium.
Our discussion regarding utility function and the insureds is appli-
cable in an analogous manner to the insurance company as weIl. If V
is the utility function for the insurer, then the company will undertake
insuring the risk only if
E[V(p(t) - S(t))] 2: V(O) (3.73)
(or more generally only if E[V(u + p(t) - S(t))] 2: V(u), where u 2: 0

is the initial capital). So p- 0, the minimum premium the company
will want, can be obtained as the solution the corresponding utility
equilibrium equation
E[V(p-(t) - S(t))] = V(O). (3.74)
A deal improving the expected utility for both sides will be possible if
p+O 2: p-O; this is a win-win situation.
Some useful utility functions are:
(i) linear utility: v(x) = x;
(ii) quadratic utility: v(x) = { 0-,(0: - x)2, x:S 0: where 0: > 0 is a
x 2:0:
constant;
(iii) exponential utility: v(x) = -ae- ax , where a > O.
The exponential premium principle (3.70) can bejustified as the zero
utility premium p+ (.) corresponding to the exponential utility function.
Though the exponential principle is very useful and has nice theoretical
features (see Exercise 3.4.8), as existence of moment generating function
of SO is assumed, it is not applicable for heavy tailed cases.
For more information on premium principles, utility function, etc.
see [RSST], [KGDD].
3.5 Exercises
3.1.1. Suppose the Li.d. interarrival times {A} satisfy P(A i > 0) =
1. For any t > 0 show that P(N(t) - N(t-) > 1) = O.
3.1.2. Let the interarrival times {Ad satisfy (3.2). Assume that
P(A i = 00) = 0; that is, the distribution of Ai is nondefective.
62 3. Renewal model
(i) Show that P(N(t) --> 00) = 1.

t
(ii) If E(A) = 00 show that N(t) --> 0 a.s.
In other words, SLLN holds in this case as weIl.
3.1.3. Let the inter arrival times {A} satisfy (3.2). Let {Tn }, {N(t)}
be the corresponding renewal sequence, renewal process respectively.
Put Fo = {</>, n}, the trivial a-algebra, F n = a{ Ai : i ::; n} = smallest
a-algebra making {Ai : i ::; n} measurable, n = 1,2, ... ; that is {Fn :
n ~ O} is the natural filtration associated with {Ai}.
(i) Fix t ~ O. Show that (N(t) + 1) is a stopping time w.r.t. {Fn };
that is, {N(t) + 1 ::; k} E Fk for any k = 0,1,2, .... (Hint: Use (3.5).)
(ii) Show that (N(t) + 1) = inf{ k ~ 0 : Tk > t}.
(iii) Show that N(t) is not a stopping time W.r.t. {Fn }.
(iv) Show that the event {N (t) + 1 ~ k} is independent of the family
{Ai: i ~ k} of random variables, for fixed t ~ 0, k = 0,1,2, ....
3.1.4. (Continuation). Let g be a bounded nonnegative measurable
function on [0,00). Fix t ~ O. For i = 0,1,2, ... define
0, if i > N(t)
{ 1, if i::; N(t)
+1
Yi = I[i,oo)(N(t) + 1) = + 1.
N(t)+l 00
(i) Show that L g(A i ) = L g(Ai)Yi.

i=l i=l
(ii) For fixed i = 1,2, ... show that Yi and Ai are independent.
(iii) Show that
L
00
E[g(Adl P(N(t) + 1 ~ i)
i=l
E [g(Adl . E [N(t) + I}
which is Wald's identity.
3.1.5. Let {Ad, {Tn }, {Fn } be as in Exercise 3.1.3. Assurne that
E(A i ) < 00. Set Ai = Ai - E(A i ), i ~ 1, and Tn = Al + ... + An =
Tn - nE(A l ), n ~ 1; of course To == O. Show that {Tn : n = 0,1,2, ... }
is a martingale W.r.t. {Fn }; that is, Tn is integrable and E [Tn+ l I Fnl =
Tn , n ~ 1.
3.1.6. Let c > 0 be a constant such that the last equality in (3.16)
holds. Show that c = A3 Yar(Ad. This observation is due to Srikant
Iyer and Adimurthy. (Note: If E(N(t)) is asymptotically At and 0 <
Yar Al< 00 one hopes for a CLT for N (. ). Exercise 2.1. 5 suggests
3.5. Exercises 63
a scaling factor in terms of Vi. Proof of Theorem 3.7 implies that if

(3.16) holds then (3.14) follows. The above observation shows that the
choice of c in Theorem 3.7 is the appropriate one.)
3.1.7. This is a variation ofLemma 3.5. Let {Zn: n ~ I}, Z, {M(t) :
t ~ O} be such that (i) Zn -+ Z a.s., (ii) M(t) integer valued, (iii)
M(t) -+ 00 in prob ability. Then ZM(t) -+ Z in probability. (Rint: For
any sequence {td get a subsequence {tkJ such that M (tkJ -+ 00 a.s.
as i -+ 00, and use Lemma 3.5).
3.2.1. Let f-L, v be finite measures on IR. Let the convolution f-L * v
be defined by (f-L * v)(E) = J f-L(E - x) dv(x), for any Borel set E. For
any Borel measurable function 9 on IR show that
J
g(z) d(f-L * v)(z) = JJ
g(z + x) df-L(z) dv(x).
3.2.2. (a) Complete the proof of Theorem 3.18.

(b) Let the hypotheses of Definition 3.17 hold. Show that G * H = H * G
is weIl defined and H(D) = G * H.
(c) Assuming E(A i ) = A- 1 < 00 for i ~ 2 show that tH(D)(t) -+ A as
t -+ 00.
3.2.3. Find the integrated tail distribution F[ in the case of a homo-
geneous Poisson process, and interpret this as a residuallife distribution.
3.2.4. Extend the renewal function H to the real line by setting
°
H(t) = 0, t < 0. Let z ~ be fixed. Consider g(t) = H(t) - H(t - z) as
a function on IR. Note that g( t) is the expected number of renewal epochs
in the interval (t - z, t]. Show that g(.) is the unique locally bounded
function supported on [0,00) solving the renewal equation (3.28) with
u(t) = I[o,z) (t).
3.2.5. Consider the renewal equation (3.28) with the following u(·)
supported on [0,00). In each case find the locally bounded solution
supported on [0,00).
(i) u(t) = F(t), (ii) u(t) = 1 - F(t); (iii) u(t) = G(t) - G(t - h) where
°
h > is fixed and G is the distribution function of a prob ability measure
supported on [0,00).
(Ans. (i) U(t) = E(N(t)); (ii) U(t) = 1; (iii) U(t) = H(D)(t) -
H(D) (t - h) where H(D) is the delayed renewal function corresponding
to the initial distribution G.)
64 3. Renewal model
3.2.6. Let the hypotheses and notation be as in Definition 3.17. Let
°
the interarrival time Ai, i ~ 2 have finite expectation A-1. If H(D) (t) =
At, t ~ show that G(t) = F[(t) given by (3.34).
3.3.1. (a) Let G n , n ~ 1, G be as in Definition 3.22; that is Gn ~ G.

Let f be a continuous function with compact support in IR. Show that
lim
n--->oo
J
f(y) dGn(y) = J f(y) dG(y).
(b) Let the hypotheses of Blackwell's renewal theorem hold. Let uC)
be a continuous function with compact support in [0, (0), and U(·) the
corresponding solution to the renewal equation (3.28). Using (a) above
show that
J
00
lim U(t) = A u(s) ds.

t--->oo
°
3.3.2. Suppose {l1n} is a sequence of o--finite measures on lR such
that {l1k([-X, xl) : k = 1,2, ... } is a bounded sequence of numbers
for each x E IR. Show that there exist a subsequence {l1 nk} and a
o--finite measure 11 such that I1 n k ~ 11 in the sense of Definition 3.22
(Rint: Imitate the proof of Helly selection principle involving Cantor's
diagonalization argument for every [-K, K]. Take furt her subsequences.
See [Fe].)
3.3.3. (a) Let uC) be a nonnegative continuous function on [0,(0).
Let an = sup{u(x): n-1::; x::; n}, n = 1,2, .... Show that u(·) is
directly Riemann integrable if and only if I: an < 00.
n
(b) Show that the assertion in (a) holds even if u(·) is a nonnegative
right continuous function having left limit at every t.
3.3.4. (a) Let u(·) be directly Riemann integrable. Show that u(·)
is integrable and lim u(x) = 0. What is lim u(h)? (Rint: Take h =
x--->+oo hl0
2- k , k=1,2, .... )
(b) Show by an example that the converse of the above is not true
in general.
3.3.5. Show that a nonincreasing, nonnegative function on [0,(0) is
directly Riemann integrable if and only if it is integrable.
3.3.6. (a) Let u(·) be directly Riemann integrable. Show that
u+C), u-O, lul are directly Riemann integrable. (Recall u+(x) =
max{O, u(x)}, u-(x) = max{O, -u(x)}.)
3.5. Exercises 65
(b) Let u(·) be continuous and lul be directly Riemann integrable.

Show that u(·) is directly Riemann integrable. Can the continuity as-
sumption be dropped?
3.3.7. (a) Complete the proof of Lemma 3.25.
00
(b) Find J u(s) ds in Lemma 3.25. (Ans. (iv) By interchanging order

o
of integration,
1
o
00
u(s) ds l(fdS) dP(r) l (f dS) dP(r) +
1(1-
o
~
F(r))dr.
(v) Similarly JOO u(s) ds = JOO ( ~ ) dF(r) =~)

o 0 r
3.3.8. Consider the delayed renewal process NCD) as in Definition
3.17. Let F be nonlattice and have finite expectation A-1. Let G be the
initial distribution, and H(D) denote the delayed renewal function
(i) Show that
1
t+h
HCD)(t + h) - HCD)(t) = [H(t +h- s) - H(t - s)] dG(s).
o
(ii) Show that lim H(D)(t

t---->oo
+ h) - H(D)(t) = A h, h > O. Thus Black-
well's theorem holds for the delayed renewal process. This also means
that the renewal rate tends to a constant, and that the constant rate is
independent of the initial distribution G.
(iii) Using Exercise 3.2.5 (iii) and the key renewal theorem give another
proof of part (ii) above.
3.3.9. (a) Let the notation be as in Theorem 3.28. Set
t
J(t) = J ~) -F(t-x)] d(G*H)(x), t 2: 0 where ~ 2: 0 is fixed.
o
Using Exercises 3.2.2 (b), 3.3.8 (ii), 3.3.7 (b), Lemma 3.25 (iv), and the
proof of (a) :::} (b) in Theorem 3.26 conclude that lim J(t) = ~)
t---->oo
(b) With notation as in (a) above show that J(.) is the locally
66 3. Renewal model
bounded solution to the renewal equation (3.28) with

s
u(s) = ![F(S +~ - y) - F(s - y)] dG(y), s ~0

o
using Exercise 3.2.1. Next using Exercise 3.3.3 (a) show that u is directly
Riemann integrable; (see also the proof of Lemma 3.25 (iv)). Show that
! !!
00 00 00
u(s) ds [F(s ~- y) - F(s - y) ds dG(y)

o o y
!!
00 00
[F(r +0 - F(r)] dr dG(y).

o 0
Applying the key renewal theorem show that !im J(t) = FI(O. Thus
t->oo
we have another way of proving the result in (a).
3.3.10. Let M ~ 1 be an integer. Let {Ai: i ~ I} be a sequence of
independent nonnegative random variables such that Ai has distribution
function Gi, i = 1,2, ... , M, and each A j , j ~ M + 1 has the distribution
function F. Define To == 0, Tn = Al +A 2 + ... +An , n ~ 1. {Tn } may be
called the M -delayed renewal sequence. Let N denote the associated M-
~ renewal process, fI the lvf-delayed renewal junction associated
with N.
(a) Find the renewal equation satisfied by the function
M-I
L(t) = H(t) - L (GI * ... * Ge)(t), t ~ o. Show that L is the re-
e=l
newal function associated with a delayed renewal process.
(b) Find the analogue of (3.53) for N.
(c) Show_ that analogues of Theorems 3.6, 3.21 and 3.28 hold for the
process N.
3.4.1. (a) In the Sparre Andersen model assurne that E(Xd < 00.
Show that E(S(t)) exists and E(S(t)) = E(XdE(N(t)).
(b) Complete the proof of Theorem 3.31.
3.4.2. Assurne that E(Xr) < 00 in the Sparre Andersen model.
Show that
Var(S(t)) = Var(XI) E(N(t)) + (E(Xd)2Var(N(t)).

3.5. Exercises 67
(Rint: Consider E[(S(t))2 I N(t) = n].)

3.4.3. Formulate a CLT for the total claim amount process in the
Cramer-Lundberg model.
3.4.4. Using the approach in the proof of Theorem 3.33 give a proof
of Theorem 3.7 (CLT for the renewal process NO).
3.4.5. Let cx > 0 and consider the standard deviation principle for
Sparre Andersen model.
a) Show that
lim P(S(t) - psdt)

~
> 0) = 1 - (cx) ,
where denotes the distribution function of the standard normal dis-
tribution.
b) Indicate how (a) above gives a justification for the standard de-
viation principle.
c) Show that PSD(t) ~ 1 as t ~ 00.
Pnet (t)
So one may say that in the standard deviation principle, as in the
net premium principle, there is no gain in the long run for the insurer.
What advantage does the standard deviation principle have over the net
principle? (Note that the premium in the former is higher; so, how to
justify it?)
3.4.6. Let cx > 0 and consider the variance principle for Sparre
Andersen model.
(a) What is lim P(S(t) - PYar(t) > O)?
~
Py (t)
(b) Show that ~ ) converges to a constant as t ~ 00.
(c) Using (a), (b) above indicate ajustification for the variance prin-
ciple, with cx serving as a safety loading factor.
3.4.7. Consider the Cramer-Lundberg model with appropriate as-
sumptions. Suppose p(t) = ct, t 2: 0 where c > 0 is a constant; c
is called the premium rate. Determine c by each of the five premium
principles discussed in this section.
3.4.8. Consider the same exponential utility function for the insurer
and the insured; that is
v(x) = V(x) = -a e- ax , x E IR
where a > 0 is the risk aversion factor. Formulate the utility equilib-
rium equations for the insurer and the insured respectively. Show that
p+(t) = p-(t) = PExp(t) given by (3.70). This gives a justification for
the exponential premium principle.
68 3. Renewal model
3.4.9. In actuarial context, so me of the desitable theoretical require-

ments on the premium principles are:
(a) Nonnegative loading: p(t) ~ E(S(t)).
(b) Consistency: If the premium for S(t) is p(t), then the premium
for S(t) + cis p(t) + c.
(c) Additivity: For independent total claim amounts S(t) , S'(t) with
respective premiums p(t), p'(t) , the premium for S(t) + S'(t) should be
p(t) + p'(t).
(d) Homogeneity: For c> 0, the premium for cS(t) should be cp(t).
Now consider the Cramer-Lundberg model with appropriate assump-
tions.
(i) Show that PNet (-) satisfies all the foUf requirements.
(ii) Show that PEV(-) satisfies (a), (c), (d) but not (b).
(iii) Show that PVar(-) satisfies (a) ; (b) , (c) but not (d).
(iv) Show that PSD(-) satisfies (a), (b), (d) but not (c).
(v) Show that PExp(-) satisfies (a), (b), (c) but not (d).
3.4.10. For the linear utility function v(x) = x, find the zero utility
premium.
Chapter 4
Claim size distributions
In principle, any distribution supported on [0,(0) can be used to model

claim size. However, in actuarial practice a clear distinction is made
between "well behaved" distributions and --Jangerous" distributions. As
we shall see later there are very good reasons for this distinction.
4.1 Light-tailed distributions
Let F be a distribution function supported on [0,(0), with X denoting

a generic random variable with distribution function F. Let
J
00
mF(s) = E(e Sx ) = eSXdF(x), sE IR. (4.1)

o
denote the moment genemting function of F, whenever the integral is

finite. Let
SF = sup{s 2: 0: mF(S) < oo}. (4.2)
Proposition 4.1 1f S F > 0 then there exists C > 0, 0 < A < s F such
that
1- F(x) :S C e- AX , for alt x 2: o. (4.3)
Conversely, if (4.3) holds for some 0 > 0, A > 0 then mF(S) < 00 for
alt s < A, and hence SF > O.
70 4. Claim size distributions
Proof: Let SF > o. So there is A > 0 such that mF(A) < 00. Now
for any x ~ 0
00 00
1 - F(x) J dF(y)::; J eA(y-x)dF(y)

x x
00
< e- AX J eAYdF(y) = [mF(A)] e- AX

o
establishing (4.3).
To prove the converse, note that for s > 0
00 00 x
mF(s) - 1 = J (e SX - 1) dF(x) = J J seSYdy dF(x)

o 0 0
s JOO( JOOdF(X)) eSYdy = s Joo(l - F(y)) eSYdy (4.4)

o Y 0
by Tonnelli's theorem, in the sense that if one side of (4.4) is infinite

then the other is also infinite, and in case of their being finite the two
sides are equal. Now suppose (4.3) holds for some ,\ > 0, C > o. Then
for 0 < s < A we get
Thus mF(s) < 00 for all 0::; S < A. As F is supported on [0,(0) it

is clear that mF(s) < 00 for all S < o. Hence SF > 0, completing the
~~ 0
Definition 4.2 Let F be a distribution function supported on [0,(0).
F is said to be light-tailed if there exist constants C > 0, A > 0 such
that (4.3) holds for all x ~ 0, or equivalently by Proposition 4.1 mF(·)
exists in a neighbourhood of O.
The above is generally regarded as the proper not ion of a well be-
haved distribution.
The following are examples of light-tailed distributions:
(i) Exponential distribution, EXp(A), with parameter A > O.
4.1. Light-tailed distributions 71
(ii) Gamma distribution, r(a, '\), with parameters ,\ > 0, a > 0.

(iii) Any distribution with compact support.
°
(iv) Truncated standard normal, that is, F(x) = P(IN(O, 1)1 ::; x), x E
IR. Note that F(x) = 2(x) - 1, x 2: where is the distribution
function of the standard normal distribution.
To any light tailed distribution a useful class of associated distribu-
tions can be defined. Let F be a light tailed distribution. Then SF > 0.
Let t < SF. Define
F,(x) ~{ m:(t) J
[O,x]
etYdF(y), if x 2: ° (4.5)
0, if x< 0.
The distribution function Pt is called an Esseher tmnsform of F or an

exponential tilting of F. (Some authors call it a emmer tmnsform.
Using Esseher transform one can get some information on the tail be-
haviour of F*(n) as given below.
Proposition 4.3 Let P be a light tailed distribution function supported

on [0, (0). Then for t < SF and n = 1,2, ...
(4.6)
and hence for alt x 2: °

1 - F*(n)(x) = (mF(t)t J =
e- ty dFt(n) (y). (4.7)
x
Proof: Note that SF > 0. By Exercise 4.1.4 below we know that the
moment generating function of Ft exists in a neighbourhood of and °
°
that for < s < SF - t, n = 1,2, ...
As (mp/))n, (mF(-))n are respectively the moment generating func-

tions of Ft(n) , F*(n) we now get from the above
(mF(t))n J e SY dFt(n) (y) = J e(t+s)y dP*(n) (y).

[0,=) [0,00)
The assertion (4.6) follows now by uniqueness of moment generating

function. (4.7) is an easy consequence of (4.6). 0
For a light tailed distribution F, it is dear that the dassical central
limit theorem is applicable to Xl + ... + X n , n 2: 1 where {Xd is a
sequence of i.i.d.'s with distribution F. So asymptotic normality can
sometimes be used as an approximation when time parameter is fairly
large.
4.2 Regularly varying functions and distributions
Any distribution function F supported on [0,00) such that mF(s) = 00

°
for all s > may be considered a heavy-tailed distribution for actuarial
purposes. However, one would like to identify smaller subdasses, para-
metric families if possible, which are useful to get reasonable models and
are mathematically amenable.
For example, if F does not have finite variance and belongs to the
domain of attraction of a non-Gaussian stable law, then it is known
that the tail behaviour of F is related to apower law; see Appendix
A.2. This suggests that one may try to define heavy tailed behaviour in
terms of apower law behaviour of the right tail. In this section we try
to make this heuristic workable. Most of the concepts discussed in this
section had been developed by Karamata in the context of Tauberian
theorems in dassical analysis. Their importance to probability theory
had been recognised by FeIler. An authoritative account of all these and
much more is given in [BGT]. We have borrowed heavily from [BGT],
[Fe], [EKM]. We begin with a notion that has played a crucial role in
the central limit problem
Definition 4.4 Let LU be a positive measurable function on (0,00).

If
. E(cx)
hm -L(
X--->OQX
) = 1, for all c > ° (4.8)
then L(·) is said to be slowly varying at 00. o

Obvious examples of slowly varying functions are: constants, loga-
rithmic function, powers of logarithm Ilog xl et , a > 0, iterates of loga-
rithm log (log x), log(log(log x)), etc.
The next result gives a useful dass of slowly varying functions
4.2. Regularly varying functions and distributions 73
Proposition 4.5 Let the function L be of the form
L(x) = c(x) exp { [ ,(tl ~ dt} , x> xo (4.9)
where Xo > 0, c(t) - t °

as t - t 00, cO > 0, c(x) - t C E (0, (0) as
x - t 00, and c(·), c(·) are measurable. Then L is slowly varying at 00.
Proof: It is enough to prove that
Jt
ax
lim
X-t(X)
c(t) dt 0, if a >1 (4.10)
x
Jt
x
lim
X-t(X)
c(t) dt = 0, if a < 1. (4.11)
ax
°
Let a > 1. For fJ > there exists to > such that
t 2: to. Without loss of generality to < x < ax. Then
° ic (t) I < fJ for all
Jt
ax
c(t) dt ::; fJ loga, for all x > to

x
whence (4.10) folIows. Similarly if a < 1, then
J~ (±) , for all x > ax > to

x
E(t) dt :::; <5 log

,ax
and hence (4.11) is evident. o
°
Proposition 4.6 Let L be a slowly varying function of the form (4.9).
Then for any a >
lim x-aL(x) = 0, lim xaL(x) = 00. (4.12)
x----+CX) x---+CX)
That is, L is "small" compared to any power function x a .
°
Proof: Let a > be fixed. For any Tl E (0, a) there exists to
such that -Tl < c(t) < Tl for all t > to. Then for x > to
> °
exp ( [ f ,(tl dt) ,; C, exp ~ ~) = C, ~
°
So, as c(t) ----t c > we now get x-aL(x) ::; C tüT/x-(a-T/) for x > to,
°
where C > is a constant. As a > 'Tl the first assertion now follows.
In d similar fashion, for x > to one can show that x aL( x) 2: C töx(a-T/);
the second assertion follows now since a > 'Tl. 0
Our next objective is to show that (4.9) gives all slowly varying
functions. For this we need a very basic result due to Karamata.
Theorem 4.7 (Uniform convergence theorem for slowly varying func-

tions): Let L be a positive measurable slowly varying function on (0,00).
Then for any compact set K C (0,00)
. L(cx) .
11m -L( ) = 1 uniformly over c E K. (4.13)
x--+oo X
Proof: Write h(x) ~ log L(e X ), xE R As L is slowly varying note

that
lim h(x
x--+oo
+ u) - h(x) = 0, for any u E R (4.14)
We need to prove that the convergence in (4.14) is uniform over u E

K', K' any arbitrary compact set in R In this case it is clear that it is
enough to consider K' = [0, Al, A > 0.
Let E > 0; without loss of generality E < A. For x > 0, set
Ix = [x,x + 2Al, Ex = {t E Ix : Ih(t) - h(x)1 2: !E}, E; = {t E
[0,2Al : Ih(x + t)·- h(x)1 2: ~ As Land hence h are measurable,
it follows that Ex, E; are measurable sets. Clearly E; = Ex - x and
hence IE;I = IExl, where 1·1 denotes the Lebesgue measure. By (4.14)
note that ~ ~ ) = °
for each t. As h;(-) ::; I[O,2Al(-) for all x 2: 0,
by the dominated convergence theorem it follows that lim IE;I = 0. So
there is Xo °
> such that
x--+oo
IE;I < ~ E for all x 2: Xo. (4.15)
Next let u E [0, Al. Clearly IIx+u n lxi = 2A - u 2: A for any x. For
x 2: Xo, by (4.15)
lEx U Ex+ul < IExl + IEx+ul = IE;I + IE;+ul

< E < A.
Hence for u E [0, Al, x 2: Xo
In particular (Ix n Ix+u)\(Ex U E x+u ) =i ep. For any

t E (Ix n Ix+u)\(Ex U E x+u ), we see that Ih(t) - h(x)1 < ~ and
Ih(t) - h(x + u)1 < !t.
Therefore for all u E [0, Al, x ~ Xo we get
Ih(x + u) - h(x)1 < t, completing the proof.
o
An immediate consequence is
Lemma 4.8 Let L be a positive, measurable, slowly varying function

on (0,00). Let h be defined by h(x) ~ logL(e X ), x E IR. Then there
is A > 0 such that L is locally bounded, and hence locally integrable, in
[A, (0). Also there is A > 0 such that h is locally bounded, and hence
locally integrable in [A, (0).
Proof: Enough to prove the result for h. By the uniform conver-

gence theorem, Theorem 4.7, one can find A > 0 such that
Ih(x + t) - h(x)1 < 1 for all x ~ A, tE [O,lJ.
Hence Ih(x)1 :::; 1 + Ih(A)1 on [A, A+ 1J. By induction Ih(x)1 :::; n+ Ih(A)1
on [A, A + nl, for n = 1,2, ... The required conclusion is now immediate.
o
Theorem 4.9 (Karamata representation theorem): Let L be a positive
measurable function on (0, 00 ). Then L is slowly varying at 00 if and
only if it can be written in the form (4.9) as in Proposition 4.5.
Proof: In view of Proposition 4.5, it is enough to prove the "only

if' part. Let h be as in the proof of Theorem 4.7 or Lemma 4.8. Note
that getting L in the form (4.9) is equivalent to writing h in the form
J
x
h(x) = d(x) + e(v) dv, x> b (4.16)

b
where d, e are measurable functions on IR such that d(x) ---t d E IR, e(x) ---t
o as x ---t 00, and b E IR; to see this take d(x) = logc(eX ), e(v) =
t( eV ), v E IR, b = log Xo. Therefore to prove the result we need to show
that (4.14) in the proof of Theorem 4.7 implies (4.16).
By Lemma 4.8, h is locally bounded and locally integrable on [A, 00)

for some A > o. Choosing a fairly large b> A > 0 we can write
J J
x+l x
h(x) (h(x) - h(t)) dt + (h(t + 1) - h(t)) dt

x b
+ J
b+l
h(t) dt, x 2: b. (4.17)
b
The last term on the r.h.s. of (4.17) is a constant, d say. Put e(x) =
h(x + 1) - h(x); then e(x) ---> 0 as x ---> 00 by (4.14). The first term
1
on the r.h.s. of (4.17) = J (h(x)
- h(x + s)) ds ---> 0 as x ---> 00 by the
o
uniform convergence theorem (Theorem 4.7). Thus (4.16) holds with
b+l 1
d(x) = J h(t) dt + J (h(x) - h(x + s)) ds, e(x) = h(x + 1) - h(x). 0
b 0
Proposition 4.6 leads naturally to the following definition, again due
to Karamata. This also plays an important role in the central limit
problem; see Appendix A.2.
Definition 4.10 (i) Let f be a measurable function on (0,00) such that

f(x) = XO L(x), x > 0 where L is a slowly varying function and <5 E lR..
Then f is said to be regularly varying with index <5.
(ii) A nonnegative random variable X, or equivalently its distribution
function F, is said to be regularly varying with tail index 0: 2: 0 if
P(X > x) = 1- F(x) = x-aL(x), x> 0 (4.18)
where L is slowly varying. We shall denote F E R_ a or X E R_ a .
.. Note that regular variation is one way to describe small deviations

from exact power law behaviour.
Our next result is a uniform convergence theorem for regularly vary-
ing functions with negative index.
Theorem 4.11 Let 0: > 0 and f be a regularly varying function with

index (-0:). Then for any A > 0
f(>"x) 1
lim >..a' uniformly over >.. E [A, 00). (4.19)
x-+oo f(x)
Proof: By Karamata representation theorem (Theorem 4.9) note

that
f(x) ~ x-Oc(x) exp ( / ~ ) dt) , x> a (4.20)
where c(·) is positive, limc(x) = c E (0,00), and limE(x) = 0; moreover

as L, c, E can be modified in any finite interval of the form [0, a], we may
take a = 1.
Now let E > O. Choose al > 1 such that 4A -a/2 < E for all A ~ al;
(without loss of generality we may assume E < 4). Note that there is
Xo > 0 such that ~ :s:; ~) :s:; 2, E(X) < ~ for all x ~ xo. For A ~ al > 1
note that AX ~ Xo if x ~ xo. Therefore by (4.20), for A ~ al, x ~ Xo we
get
f (AX) < 4A -a exp (

f(x) -
fAX ~t ~2 dt) = 4A -a/2 . (4.21)
X
Note that 4A- a / 2 > A- a and A > 1. Hence, as f(·) > 0 and 4A- a / 2 < E,
we get for A ~ al, x ~ Xo by (4.21)
- ~ I < 4 \ -a/2
Iff(x)
(AX)
Aa - A < E,
proving uniform convergence in (4.19) over [al,oo).

Finally, by the uniform convergence theorem for slowly varying func-
tions, uniform convergence in (4.19) over the compact set [A, all C
(0,00) can be obtained. Combining the two we get the desired uni-
formity. 0
Note: If f is regularly varying with index 8 > 0, and f is bounded
on each interval of the form (0, a], then it can be shown that ----+ AD f)t:/
as x ----+ 00, uniformly over A E (0, Al for any A> 0. See [BGTl.
Our next objective is to investigate the asymptotics of truncated mo-
ments with respect to regularly varying functions. We have the following
result.
Theorem 4.12 Let f be a regularly varying function with index 8 E IR.

Let K > 0 be such that f is locally bounded on [K,oo); by Lemma 4.8
X 00
such a K exists. Denote Ip(x) = J t P f(t) dt, lp(x) = J t P f(t) dt, xE

K x
(0,00), pE IR whenever the integrals exist. Then the following hold.
(i) If p > -(8 + 1) then fp(x) diverges as x ---> 00, and
lim x p+1 f(x)/fp(x)

~
= (p + 8 + 1). (4.22)
In particular fp(x) is regularly varying with index (p + 8 + 1).

(ii) Ifp = -(8 + 1) then fp(x) may converge or diverge, but
lim f p(x)/(x p+ 1 f(x)) = 00. (4.23)

~
Moreover fp(x) is slowly varying.
(iii) If p < -(8 + 1) then fp(x) converges as x ---> 00. Also
lim x p+ 1 f(x)/ Ip(x) = -(p + 8 + 1), (4.24)

~
that is, Ip(x) is regularly varying with index (p + 8 + 1).

00
(iv) Ifp = -(8 + 1) and J tPf(t) dt < 00, then

K
(4.25)
and Ip(x) is slowly varying. o

For proving the theorem it is enough to consider the case 8 = O. In
this case f is slowly varying and we denote L(x) = f(x), x > O. The
proof is in several steps. We begin with a lemma
Lemma 4.13 (Potter's bound): Let L be slowly varying at 00. Then

for any A > 1, TI> 0 there exists K = K(A, TI) such that
L(y)
L(x) ::; A max
{(Y)1/
;
(x)1/} ,V x,
'y y 2: K. (4.26)
Proof: By Karamata representation (4.9), for y 2: x 2: Xo
L(y) c(y)
L(x) = c(x) exp ( !
y1
"I'(t) dt
)
.
4.2. Regularly varying junctions and distributions 79
As c(·) --+ c E (0,00) and E(-) --+ 0, it is now clear that we can choose
K(A, 7]) > Xo such that
~~~~ ~ Aexp (7]log;) = A (;f

for all y ~ x ~ K(A, 7]). The case x ~ y ~ K(A, 7]) is similar. 0
Proof of Theorem 4.12: We consider only the case when L(x) =
j(x) is slowly varying.
Proof of (i): Note that p > -1. Take 0 < 7] < P + 1. With K(2, 7])
as in Lemma 4.13 denote K' = max{K, K(2, 7])}. Clearly
J J
x 1
~ (x) t PL (t) dt Ltx) sP L(sx) ds

K' K'/x
J
1
P L(sx) ( )d
s L(x) ~ s s.
o
By Lemma 4.13 the integrand on r.h.s. of the above is dominated by
2sP- 17 for all x 2: K'. Also as x --+ 00 the integrand converges to sp. So
by the dominated convergence theorem
·
11m
x->oo
1
x P+lL()
x
J x
tP L (t) dt -_ P
-+1- .
1
(4.27)
K'
As L is bounded on [K, K'J it is clear that
J
K'
~~ XP+11L(X) t PL(t) dt = O. (4.28)

K
Note that (4.27), (4.28) imply (4.22). Divergence of Ip(x) follows from
(4.22) and Proposition 4.6.
x
Proof of (ii): Here p = -1; write L(x) := Ip(x) = Jt L(t) dt.
K
Let 0 < () < 1 be arbitrary. Then for x ~ K such that ()x ~ K
J
_ 1
L(x) > ~ L(xt) dt.

L(x) - t L(x)
()
By the uniform convergence given in Theorem 4.7 it now follows that
~~~f ~~ ~ 2 log (t) .

As () > 0 can be arbitrarily small it is now clear that L(x)jL(x) goes to
00 as x --t 00, proving (4.23).
To complete the proof of (ii) we need to show that L(.) is slowly
varying. As L(·) > 0 note that L is strictly increasing. So it is clear
that L is locally bounded and is bounded away from 0 on [K I, (0) for
any K 1 2 K. Denote E'(x) = L(x)jL(x), x 2 K I . Note that E' is well
defined, and from the earlier part of the proof it follows that E'(x) --t 0
as x --t 00.
As . L(.) is absolutely continuous, note that L'(x) = ~ )
= ~ E'(x) L(x), a.e. on [K I , (0) and hence L'(x)j L(x) = ~ E'(x), a.e.
on [K I , (0). Consequently logL is absolutely continuous and
Jl
x
log L(x) -log L(Kd = E'(t) dt, x 2 K I.

KI
Therefore
(4.29)
By Karamata representation the required conclusion folIows.

Proof of (iii): Note that p < -1. Convergence of Ip(x) can easily
be established using Proposition 4.6.
Now set p = !(p + 1); clearly p < O. Define g(x) = x P L(x). Then 9
is a regularly varying function with index p < O. Observe that
1
x p +1 L(x)
J 00
tPL(t) dt + _1_
p +1 J
00
sP L(sx) ds -
L(x)
J 00
sPds
x I I
J(
00
g(sx) - sp) sp-Ids.

g(x)
I
By Theorem 4.11 note that ~) - sp) --t 0 as x --t 00 uniformly over

s E [1,(0). And as sp-l is integrable over [1,(0), by the dominated
convergence theorem (4.24) now follows.
t L(t) dt < 00. Write L(x) :=

00
Proof of (iv): Now p = -1, and J

K
t L(t) dt. We proceed as in the proof of (ii).

00
Ip(x) = J Let B > 1 be

x
arbitrary. Then for x >K
A
L(x) >
L(x) -
J ()
~ L(sx) ds.
s L(x)
1
By Theorem 4.7 we now have

L(x)
~~f L(x) ~ 10gB.
As B > 1 can be arbitrarily large, (4.25) is now clear.

By assumption L(x) E (0,00) for all x. As t
L(t) > 0, it is clear
that L is strictly decreasing. So on any bounded interval contained in
[K, (0) it is clear that L is bounded and bounded away from O. Set
tex) = -L(x)/ L(x), x ~ K 1 where K 1 > K. As in the proof of part (ii)
U~ dt) ,
we can establish that (analogous to (4.29))
i(x) ~ i(K,) cxp i(t) x:> K 1 (4.30)
with lim tex) = O. Again by Karamata representation we conclude

x-+oo
that L is slowly varying. This completes the proof. 0
The next result interprets the above for random variables that are
regularly varying with tail index a ~ o.
Theorem 4.14 Let X be a nonnegative random variable with distribu-
tion function F. Suppose X E R_o:. Then the following hold.
(i) If a ~ 0 then
E(XP) < 00, for 0::; p < a
00, for p> a. (4.31)
(ii) Let a > 1, and F[ denote the corresponding integrated tail distri-
bution given by (3.34); that is,
1
dF[(t) = I(Q,oo)(t) E(X) (1 - F(t)) dt. (4.32)
Then F[ E R-(O:-l).
Proof: (i) For p > 0 note that
J
00
E(XP) = psP-l(l - F(s)) ds (4.33)

o
in the sense that if one side is finite then so is the other and the equality
of the two. The first part of the theorem is now easily obtained by (i),
(iii) of Theorem 4.12.
(ii) As 0: > 1 note that E(X) < 00 and hence F[ makes sense.
Observe that
J
00
1 - F[(x) = ~) (1 - F(t)) dt, x> 0

x
which is a regularly varying function with index (0+( -0:)+1) = -(0:-1)

by part (iii) of Theorem 4.12. This completes the proof. 0
Example 4.15 Pareto distribution. Let 0: > 0, '" > O. Let the dis-
tribution function F, supported on [0,00), be such that its right tail is
given by
_ ",a
F(x) = 1 - F(x) = (",+x )'

a
x :::::: O. (4.34)
This distribution is called the Pareto (0:, "') distribution. The parameter
0: > 0 is called the tail parameter, and '" > 0 is called the scale parameter.
As the tail parameter is the important one, by usual abuse of notation
we will suppress the scale parameter, and may just write Pareto (0:)
distribution to denote (4.34). It is clear that Pareto (0:) E R_ a , 0: > O.
By Exercise 4.2.12 it follows that Pareto (0:) is heavy-tailed, that is, its
moment generating function does not exist in any neighbourhood of O.
By Exercise 4.2.13, if 0: > 1, F[ has Pareto (0: - 1) distribution and
F[ E R-(a-l).
Prom the discussion in Appendix A.2, for 0 < 0: < 2 note that
Pareto (0:) belongs to the domain of normal attraction of an o:-stable
distribution.
Pareto distribution is perhaps the most important heavy tailed dis-
tribution. It is one of the few distributions that has been found to give a
good fit to observed data, especially in actuarial context. In economics,
4.2. Regularly varying junctions and distributions 83
it has been conventionally used to describe income distribution. Because

of its very simple description (4.34) it is mathematically amenable. This,
together with the major role played in the centrallimit problem, perhaps
explain its versatility. 0
The next result shows that R_ a is closed under convolutions for any
0: ~ o.
Theorem 4.16 Let 0: ~ 0 and X I, X 2 E R_ a be independent; suppose
jor i = 1,2
Fi(x) ~ P(Xi > x) = x- aLi(x), x> 0 (4.35)
jor (possibly different) slowly varying junctions Li. Then
P(X I + X2 > x)
x-a[LI(x) + L 2(x)](1 + 0(1)), as x -+ 00. (4.36)
In particular Xl + X 2 E R- a .
Proof: Let G denote the distribution function of Xl +X2. As Xl, X2
are nonnegative, for any x ~ 0 note that
Therefore by independence of Xl, X 2 ,

G(x) = P(X I + X 2 > x)
> P(X I > x) + P(X2 > x) - P(X I > x,X2 > x)
FI(x) + F 2(x) - FI(x). F 2(x)
[FI(x) + F 2(x)] (1 _ F\(x). F 2(x) ) .
FI(x) + F 2(x)
Clearly I ~ ~~) I :s FI(x) = 0(1), as x -+ 00 and hence
G(x) ~ (FI(x) + F2(X))(1 + 0(1)), as x -+ 00. (4.37)

Next let 0 < 8 < ~ It is easily verified that {Xl + X 2 > x} ~ {Xl>
(1 - 8)x} U {X2 > (1 - 8)x} U {Xl> 8x,X2 > 8x}, and hence by
independence
Note that by (4.35)
F\ (rSx) F 2(rSx) I
I F I ((l - rS)x) + F 2((1 - rS)x)
FI(rSx) F 2(rSx) . FI(rSX) + F2(rSX)
FI(rSx) + F 2(rSx) F I ((l - rS)x) + F 2((1 - rS)x)
- (rS) -er (LI + L2)(rSx)
< F I (rSx) 1 _ rS (LI + L 2)((1 _ rS)x) = 0(1), as x -----t 00
because LI + L 2 is slowly varying. Therefore
G(x) ::; [F I ((l - rS)x) + F 2((1 - rS)x)](l + 0(1)), (4.38)
as x -----t 00. By (4.35), as LI + L 2 is slowly varying, it is clear that
By (4.37), (4.38), (4.39) it now follows that
G(x) G(x)
1 < lirninf < lirnsup =------'---==--
x-->oo FI(x) + F 2(x) - x-->oo FI(X) + F2(X)
< (1 - rS)-er
for any 0 < rS < ~ Letting rS 1 0 in the above we get (4.36) cornpleting
the proof. 0
Corollary 4.17 Let the i.i.d. randorn variables Xl, X 2 ,···, X n E R_ er

where a ~ 0; let F denote the cornmon distribution function. Let
Sn = Xl + ... + X n . Then Sn E R- er and
P(Sn > x) = n F(x)(l + 0(1)), as x -----t 00. (4.40)
4.3 Subexponential distributions
Let Xl, X 2 , ... be an i.i.d. sequence. Let F denote the common distribu-
tion function. Denote by Sn = Xl + ... + X n , Mn = max{X I , ... , X n },
n ~ 2, respectively the partial sum and the partial maximum. For n ~ 2
4.3. Subexponential distributions 85
note that
P(Mn > x) 1 - P(X I :'S x, X 2 :'S x, ... , X n :'S x)

1 - (F(x))n = 1 - (1 - F(x))n
1- t
k=ü
~) (-1)k(F(x))k
n F(x) [1 + 0(1)], as x ----? 00. (4.41 )
Comparing (4.40) and (4.41) we see that if F E R- c" 0: ~ 0 then for

n = 2,3, ...
lim P(Sn > t) = l. (4.42)

t---->oo P(Mn > t)
Thus, for regularly varying distributions, the tail behaviour of the partial
sum Sn is essentially determined by the tail behaviour of the partial
maximum Mn.
In situations involving "dangerous risks", it has been observed by
actuaries that whenever the total amount is very large, a very few of
the largest claims (in some cases may be even a single largest claim)
make up almost the entire bulk of the total claim. This is precisely the
scenario envisaged in the above discussion. So the following definition
is the next natural step.
Definition 4.18 Let F be a distribution function supported on (0,00).

Let {Xi} be a sequence of i.i.d. random variables with distribution
function F. For n ~ 2 let Sn = Xl + ... + X n , Mn = max{X l , ... , X n }.
If for all n ~ 2
P(Sn > t) = P(Mn > t)(1 + 0(1)), as t ----? 00 (4.43)
then F is said to be subexponential. The class of subexponential distri-

butions is denoted by S.
As the above not ion conforms to the intuitive idea of a dangerous

risk, it is more or less synonymous with "heavy tailedness" in insurance
mathematics.
Prom (4.40) - (4.42) it is clear that R_ a C S for any 0: > o. In
particular Pareto distributions are subexponential.
Let {Xd, F, Sn, Mn be as in the above definition. We know that the

n-fold convolution F*(n) is the distribution function of Sn. Therefore
(4.41) and (4.43) imply that FES {:} for n = 2,3, ...
. F*(n)(t) . 1 - F*(n)(t)
11m
t-+oo F(t)
= t->oo
11m
1 - F(t)
= n. (4 44)
.
We want to establish that subexponentiality is equivalent to (4.44) hold-

ing for n = 2. For this we need some preliminary results, which are also
interesting.
It is clear that any F satisfying (4.44) for n = 2 cannot have compact
support; see Exercise 4.3.3.
Theorem 4.19 (a) Let F be a distribution supported on (0,00) such

that (4.44) holds for n = 2. Then for any y 2: 0
lim F(x - y) - 1 (4.45)

x->oo F(x) - .
Moreover the convergence in (4.45) is uniform over y E K, for any

compact set K.
(b) Let F be a distribution supported on (0, (0) such that (4.45) holds
for any y 2: O. Then
(i) L(z) ::§: F(log z) is slowly varying at 00;
(ii) for any a > 0
lim eax F(x) = 00. (4.46)
x->oo
(iii) mF (s) = 00 for all s > 0; so moment generating function does not
exist in any neighbourhood of O.
In particular, any subexponential distribution F is heavy tailed, and
F(log x) is slowly varying.
Proof: (a) For any distribution supported on (0,00) note that
J J
x x
F*(2)(x) = 1- F(x - t) dF(t) = F(x) + F(x - t) dF(t)

o 0
and hence
~
F (x) = 1 +
F(x)
J x_
F (x - t) dF (t).
F(x)
(4.47)
o
Therefore for any 0 :S y :S x we get
~
F(x)
) l + J y_
F(x - t) dF(t)
F(x)
+ J x_
F(x - t) dF(t)
F(x)
o y
> 1 + F(y) + F(x - y) (F(x) - F(y)).

F(x)
Let y 2: 0 be fixed. Under our hypothesis, for all sufficiently large x note
that F(x) - F(y) > O. See Exercise 4.3.3 below. So from the above
F(x - y) (F*(2)(X) ) 1
I:S F(x) :S F(x) - I - F(y) (F(x) _ F(y))' (4.48)
By (4.44) for n = 2 we see that r.h.s. of (4.48) converges to I as x -+ 00.

This proves. (4.45). Uniform convergence over compact sets is clear by
monotonicity of F.
(b) Assertion (i) follows easily by part (a). Consequently zaL(z) -+
00 by Proposition 4.6. Putting z = eX we get (4.46). Now (4.4) and
(4.46) imply (iii). 0
Lemma 4.20 Let F be a distribution supported on (0,00) such that
(4.44) holds for n = 2. Let G be a distribution supported on (0, (0) such
that
G(x)
lim =-- = a E (0, (0). (4.49)
X--->OO F(x)
Then
lim F*G(x) = I + a. (4.50)

x--->oo F(x)
Proof: Similar to the derivation of (4.47) one can get (see Exercise
4.3.4)
__
F * G (x)
F(x)
=I + J x_
G (x - t) dF (t).
F(x)
(4.51)
o
So it is enough to prove
J-
x
lim =--
1
F(x)
x--->oo
G(x - t) dF(t) = a. (4.52)
o
Let E > 0 be arbitrary. By (4.49) there exists Xo such that G(x) <
(a + E) F(x) for all x 2: Xo. Therefore
I
x
- 1 G (x - t) dF (t)
F(x)
o
=-
1 xl-xo_G(x - t) dF(t) + =-
1 IX-
G(x - t) dF(t)
F(x)
o
F(x)
x-xo
< (a + E)_l
F(x)
I
X-Xo
F(x - t) dF(t) + F(x) - F(x - xo)
F(x)
o
< (a + E)_l
F(x)
I X
F(x - t) dF(t)
_ _
+ F(x - xo) - F(x) .

F(x)
o
By Theorem 4.19(a) and Exercise 4.3.2 we see that the r.h.s. of the
above converges to (a + E) as x -'> 00. Hence
1-
X
limsup =1 - G(x - t) dF(t) :::; a,

x--->oo F(x)
o
as E > 0 is arbitrary. In an entirely analogous manner it can be shown

that
1-
X
1
~~f F(x) G(x - t) dF(t) 2: a.
o
Thus (4.52) and hence the lemma is proved. D
Theorem 4.21 Let F be a distribution supported on (0,00). Then F

is subexponential {:} (4.44) holds for n = 2.
Proof: It is enough to prove that if (4.44) holds for n = 2 then it

holds for all n 2: 2. The required implication is now proved by induction
on n, using Lemma 4.20. D
We next present a very useful result attributed to Kesten.
Lemma 4.22 (Kesten): Let FES . Then for E > 0 there exists a
constant K E (0,00) such that
~ ) :; K(1 + Et, t~ 0, n ~ 2. (4.53)
Proof: Put an = sup F*(n)(t)/F(t); by subexponentiality an< 00

~
for all n. By (4.51) applied to G = F*(n) we see that for any a < 00,
1 + sup
~
i o
x--
F*(n)(x - t)
F(x)
dF(t)
< 1 + sup
O:S;x:S;a
i x__
F*(n)(x - t) dF(t)
F(x )
o
i
x--
F*(n)(x - t) dF(t)
+sup
~ F(x)
o
< 1 + _1
F(a)
+ an sup
x>a
J x_
F(x - t) dF(t)
F(x)
- 0
1 p;(2)(x) - F(x)
1 + =-- + an sup
F(a) ~ F(x)
by (4.47). As F is subexponential for E > 0 we can choose a > 0 such
that
F*(2l(x) - F(x)
F(x) :::; (1 + E) for all x ~ a.
So one can get a > 0 such that

1
a n +l :::; 1 + F(a) + a n (1 + E).
As a > 0 is independent of n, iterating the above, we get
an :::; (1 + _F(a) ~ (1 + t ,
1 )
E
E
completing the proof. 0

An immediate consequence of Kesten's lemma and the dominated
convergence theorem is
Proposition 4.23 Let Pi 2:: °Jor i

00
= 0, 1,2, ... and L Pi = 1; so {pd

i=O
defines a pmbability distribution on {O, 1,2, ... }. Let FES. Define
00 00
G(x) = L PkF*(k)(x). IJ L Pn(1 + E)n < 00 Jor some E > 0, then

k=O n=O
lim G(x)
F(x)
x--->oo
= f: kpk.
k=O
D
°
We say that two distributions F, G on (0,00) are tail equivalent
(denoted F ",t G) if there exists < a < 00 such that
. G(x)
11m ~ (4.54)
x--->oo F(x)
This is an equivalence relation on S as shown below.
Lemma 4.24 Let F ",t G. Then FES ~ G E S.
Proof: Let FES and (4.54) hold. By analogue of (4.47) or (4.51),

and Exercise 4.3.1 it is enough to prove that
limsup
x--->oo
1 x_
G(x - t) dG(t) ~ l.
G(x)
(4.55)
o
Let Xo > 0, to be chosen suitably later, be fixed. Write
l
x_
G(x - t) dG(t)
G(x)
o
J
x-xo_
G(x - t) dG(t)
G(x)
+ J x_
G(x - t) dG(t)
G(x)
o ~
It(x) + h(x), say, for x > Xo·

Clearly
° <C I (x) < G(x) - G(x - xo) = G(x - xo) _ 1

2 - G(x) G(x)
G(x - xo) F(x - xo) F(x) _ l.
F(x - xo) F(x) G(x)
By Theorem 4.19(a) and (4.54) it now follows that 12 (x) -+ 0 as x -+ 00.

Now let 0 < E < a be arbitrary, where a is as in (4.54). Choose
Xo > 0 such that a - E :S G (x) / F (x) :S a + E for all x 2: xo. Then
h(x) < a + E
a- E
J
x-xo_
F( x - t) dG (t) < a + E
F(x) - a- E
J x_
F( x - t) dG( t)
F(x)
o 0
x
G(x) - J G(x - t) dF(t)
a+E 0
a-E F(x)
(because F * G = G * F)
x
F(x) - G(x) + J G(x - t) dF(t)
a +E 0
a- E F(x)
1 F(x) - G(x) + xro G(x - t) dF(t) }

a+E 0
- - =--- { x
a- E F (x) + J G (x - t) dF (t)
X-Xo
F(x) - (a - E)F(x) }
a +E 1 { .+(a + E) x-xo_
< -
a- E
=---
F(x)
J0 F(x - t) dF(t)
+F(x - xo) - F(x)
:S a+E{ ~ ) ) ~ ~) ) dF(t)}.
a- E + F(x-xo)
F(x)
By Theorem 4.19(a) and Exercise 4.3.2 it now follows that

a+E
limsup h(x) :S --(1 + 2E).
X-tOQ a- E
As E > 0 can be arbitrarily small, the required conclusion (4.55) follows.

D
An immediate consequence is
Theorem 4.25 Let the notation be as in Proposition 4.23. Assume

that Po < 1 and 2:(1 + E)npn < 00 for some E > O. If FES then the
n
convex combination G ES.
00
Proof: By hypothesis note that 0 < 'L k Pk < 00. Apply Lemma
k=O
4.24. o
A converse of the above result is also true. See [EKM].
For a distribution F supported on (0,00) and with expectation I-" E
(0,00) let F[ denote the corresponding integrated tail distribution. An
important question, that will playamajor role in risk theory, is: When
is F[ subexponential? It is perhaps still not known if FES implies
F[ ES. A related quest ion is: Are there sufficient conditions that ensure
that both Fand F[ are subexponential? As an example of the latter, by
Theorem 4.14 we know that if FE R- a , 0: > 1 then F[ E R-(a-l) and
hence both are subexponential. In particular if F is Pareto (0:), 0: > 1
then both Fand F[ are subexponential.
Recall that we consider only distribution functions F on IR such
that F(O) = 0, F(x) < 1 for all x. Let F have finite expectation 1-".
Rephrasing the first quest ion in the preceding paragraph: When can we
have
lim ~ F*(2)(x) = 2? (4.56)

~ F[(x) [
We know that F[ has prob ability density function ~ ) Therefore

F;(2) = F[ * F[ has probability density function ~ F) * ~ F) and
hence
F;(2)(X) = ~ (!F(t - y) F(y) dY) dt.
Clearly (4.56) will hold if for E > 0 we can find xo > 0 such that
that is, for E > 0 there is xo > 0 such that
2(1- ,) l ~ F(t) dt < l :2 (!F(t - y) F(y) dY) dt

1/L
00
1-
< 2(1 + E) F(t) dt, for all x 2 xo·
x
The above inequalities will hold if the corresponding inequalities hold

for the integrands w.r.t. the dt integral. In other words, (4.56) would
follow, if for E > 0 one can find Xo > 0 such that
1
t
2J-L(1- E) F(t) < F(t - y) F(y) dy

o
< 2J-L(1 + E) F(t), for t ~ Xo.
This leads to the following definition
Definition 4.26 F is said to belong to the dass S* if F has finite

expectation J-L and
l
x_
lim F(x - y) F(y) dy = 2J-L. (4.57)

x->oo F(x)
o
The discussion preceding the definition can now be summarised as
Proposition 4.27 If FE S* then F[ ES. D
We will prove later that F E S* =} FES, F[ E S; hence S* is an

important dass of heavy tailed distribution amenable to analysis. For
this we need the following auxiliary dass.
Definition 4.28 F is said to belong to the dass .c if (4.45) holds for

all y ~ O. In such a case F is said to be a long-tailed distribution.
By Theorem 4.19 we know that S c .c and that any F E .c is heavy

tailed.
Lemma 4.29 S* c .c.
Proof: Let F E S* with finite expectation J-L. Let v > 0 be fixed.

For x > 2v note that
f
x/2_
F(x-y) F()d
F(x) y y
o
f
v_
F(x- y ) F(y)dy+
F(x)
f x/2_
F(x-y) F()d
F(x) y Y
o v
f f
v _ ~
> F(y) dy + ~ ) ) F(y) dy

o v
Therefore (ci. see (4.48))
1 < F(x-v)
F(x)
{ ~
f-L
f
x/2_
F(x - y) F(y) dy - F[(v)
F(x)
}
.
o
Since F E S*, by Exercise 4.3.9(b), r.h.s. ofthe above converge8 to 1 as

x --+ 00. So F E .c. 0
The next result may be compared with Lemma 4.24.
Lemma 4.30 Let F, G E.c. Suppose there exist 0 < al, a2 < 00 such
that
G(x)
al < F(x) <
- =-- - a2, J'f alt x >
or
-
o.
Then F E S* {:} G E S*. In particular, if F, G E .c and F ",t G, then

F E S* {:} G E S* .
Proof: Suppose F E S*. Then F has expectation f-LF E (0,00).

Hence OUf hypothesis implies that G has expectation f-LG E (0,00). Next
für fixed v > 0, and any x > 2v,

x/2_
j G(x - t) G(t) dt
G(x)
o
v_ x/2_
j G(x - t) G(t) dt + j G(x - t) G(t) dt.

G(x) G(x)
o v
As GEL, by Exereise 4.3.13,
v _ v
lim j G(x - t) G(t) dt = j G(t) dt.

X---+(X) G(x)
o 0
Therefüre, in view of Exercise 4.3.9(b), it would füllow that G E S* onee

we prove
°
x/2 _
lim limsup j G(x - t) G(t) dt = ,

G(x)
v---+oo x-+oo
v
whieh in turn would füllow if we have
°
x/2 _
lim limsup j F(x - t) F(t) dt = (4.58)

V---+(X) X---+(X) F (x)
v
beeause of üur hypüthesis. Nüw, as F E S* F E L, using Exereise

4.3.9(b) and Exercise 4.3.13 we get
x/2' _
limsup j F(x - t) F(t) dt

X---+(X) F(x)
v
limsup [ jX/2 F(x - t) F(t) dt _ jVF(X - t) F(t) dt]

X---+OO F(x) F(x)
o 0
v
f1F - j F(t) dt.

o
By taking v large enough the above ean be made arbitrarily small. Henee
(4.58) follows. 0
To phrase the next result we need the following definition.
Definition 4.31 Let C be a distribution supported on (0,00) with

prob ability density function g(.). The function
g(x) g(x)
qG(x) = 1 _ C(x) = C(x)' x> 0 (4.59)
is called the hazard rate (or failure rate) function.

Lemma 4.32 Let FE L. Then there exists CE L such that F rv t C, C
has a hazard rate function qG(-) satisfying lim qG(x) = O.
x--->OQ
Proof: Set MF(X) = -log F(x), x 2: O. The continuous function

MG is defined so that MG(n) = MF(n), and MG is linear on [n, n +
1], n = 0,1,2, .... Define C(x) = exp( -MG(x)), x 2: O. Clearly MG is
differentiable at x i= n; put qG(x) = Mb(x), x i= n and qG(n) = 0, n =
0,1,2, .... Note that
F(n)
qG(x) = MF(n + 1) - MF(n) = log F(n + 1)'
n < x < n + 1, n = 0,1,2, .... Details of proof are left as exercise; see
Exercise 4.3.10. D
Theorem 4.33 If F E S* then FES and F[ ES.
Proof: By Lemma 4'.29 we have F E L. So in view of Lemmas 4.32,
4.30, 4.24 and Exercise 4.3.11 we may assume without loss of generality
that F has a density function f(-) and a hazard rate function q(-) with
lim q(x) = lim f(x) = O.

X--->OQ X--->OQ F(x)
In view of Proposition 4.27 it just remains to show that F is subexpo-
nential.
Let v > 0 be fixed. For x > 2v, using (4.47) we have
p;(2)(x) =
F(x)
J
1+
x_
F(x - t) dF(t)
F(x)
o
J
1+
v_
F(x - t) dF(t) +
F(x)
J
x-v
F(x - t) f(t) dt
F(x)
o v
+J
x
F(x - t) f(t) dt. (4.60)
F(x)
x-v
Since f(y) = ~ (-F(y)), integration by parts gives

x _
F(x - t) f(t) dt
I F(x)
x-v
_ _ _ v_
F(v) F(x - v) - F(x) +I F(x - t) f(t) dt.
F(x) F(x)
So (4.60) becomes
°
v_ _ _
F*(2) (x)
2 I F(x - t) dF(t) + F(v) F(x - v)
F(x) F(x) F(x)
° x-v
+ I F(x - t) f(t) dt. (4.61)
F(x)
v
As F E 1:" for any fixed v > 0, note that I ~~~) ) I :::; ~ ~) :::; 2 for
all sufficiently large x, urtiformly over °: :;
t :::; v. So by the dominated
convergence theorem
limsup [2 IVF(X - t) dF(t) + F(v) F(x - V)]

x---->oo F(x) F(x)
2F(v) + F(v) :::; 2.
° (4.62)
In view of (4.61), (4.62) and Exercise 4.3.1, it is now enough to prove
that
x-v
lim limsup F(x - t) f(t) dt = 0. (4.63)

V'-""'+OO x--+oo
I F(x)
°
v
Now as the hazard rate function q(.) converges to 0, there is Xo >

such that f(x) :::; F(x), x ~ Xo. So for v ~ xo, and x > 2v we have
x-v x-v
F(x - t) f(t) dt:::; I F(x - t) F(t) dt
I F(x)· F(x)
v v
x_ v_
F(x - t) F(t) dt - 2 I F(x - t) F(t) dt.
I F(x) F(x)
° 0
Consequentlyas FE S* C C, by Exercise 4.3.13 we obtain
limsup jX-V F(xF(x)- t) j(t) dt ~ 2J-l - 2

jV
F(t) dt.
x---.CXJ
v 0
Letting v --; 00 in the above we get (4.63), completing the proof.

o
For an absolutely continuous distribution to belong to S* we now
give some sufficient conditions in terms of the hazard rate function.
Theorem 4.34 Let F be an absolutely continuous distribution junction

on (0,00) with finite expectation J-l and hazard rate junction qC). 1j
limsup xq(x) < 00 then FE S*, and hence F, F 1 are both subexponen-
X---'CXJ
tial.
Proof: We shall first establish that
limsup 1
~ -F (X) < 00. (4.64)
X---'CXJ F(x) 2
By hypothesis there exist a > 0, Xo > 0 such that yq(y) < a for all
y :2 Xo· Therefore
limsup [logF ~) -logF(x)]

X-+QO
= limsup
X---'CXJ
j q(y) dy ~ alog2 < 00
x/2
whence (4.64) follows.

Note that q converges to 0, and hence by Exercise 4.3.10(a) F E C.
x x/2 x
For X > 2v > 0 note that (by splitting f = f + f , and changing the
o 0 x/2
variable t' = (x - t) in the second integral)
j
x_ x/2_
j F(x - t) F(t) dt
F(x)
=2 F(x - t) F(t) dt
F(x)
o 0
j j
v _ 00
< 2 F(x - t) F(t) dt + ~) F(t) dt. (4.65)

F(x) F(x)
o v
As F has finite expectation, because of (4.64), the second term on r.h.s.
°
of (4.65) can be made arbitrarily small by choosing a large enough v.
With such a v > (chosen and fixed), as F E .c, by Exercise 4.3.13, it
now follows that
l
x_
F(x - t)
lim F(t) dt ~ 2J-L.
x---+oo F(x)
o
As the reverse inequality always holds (Exercise 4.3.9(a)) we now have
FE S*. 0
The next result can be useful if q(x) = ~) x ~ 00 does not hold.
Theorem 4.35 Let F be an absolutely continuous distribution supported

on (0, (0) with hazard rate junction q (.). A ssume that
(i) q(.) is eventually decreasing to 0; that is, there is a ;::: such that
q(xI) ;::: q(X2) ij a ~ Xl ~ X2 and lim q(x) = 0; and
°
x---+oo
f
00
(ii) exq(x) F(x) dx < 00.
o
Then F E S*.
Proof: Without loss of generality we may assume that q(.) is nonin-

creasing on [0, 00 ). Otherwise, one can define a hazard rate function qo (.)
such that qo(-) = q(-) on [vo, (0), qo(-) = q(vo) on [O,vo) for a suitable
Vo > 0, so that qo(-) is nonincreasing on [0,00) and the corresponding
distribution function Fo is tail equivalent to F. Clearly F, Fo E .c by
Exercise 4.3.10, and hence Lemma 4.30 implies that F E S* {::} F o E S*.
Also the integrability condition (ii) holds for F if and only if it holds for
F o.
Note that (ii) implies that F has finite expectation, say J-L. Write
Q(x) = -logF(x). SO Q'(.) = q(-). By Exercise 4.3.9(b), to prove
F E S* it is enough to show that
lim
x---+oo
1 x/2
eQ(x)-Q(x-y) F(y) dy = J-L. (4.66)
o
Monotonicity of q over [0,(0) gives
1 ~ eyq(x) ~ eQ(x)-Q(x-y) ~ eyq (x/2)

for 0 :::; y :::; x/2. This, in turn, gives
J
x/2
F(y) dy :::; Jx/2

eQ(x)-Q(x-y) F(y) dy
o o
J
x/2
< e yq (x/2) F(y) dy. (4.67)

o
Clearly l.h.s. of (4.67) tends to J-L as x -t 00. Note that
~ e yq (x / 2) F(y) = F(y) for all y. Also I[o,x / 2](Y) e yq (x / 2) F(y) :::;
eyq(y) F(y) for all x ~ 0; by (ii), r.h.s. is integrable. So by the domi-
nated convergence theorem
J
x/ 2
lim eyq (x / 2) F(y) dy = fl,.

x-->OO
o
Hence, by (4.67), now (4.66) follows. D
The preceding theorem is apparently inspired by Pitman's criterion
for subexponentiality of F. See [EKM] for a discussion on Pitman's
result. Our ~ of S* follows closely [RSST].
Example 4.36 Lognormal distribution. Let , cp denote respectively

the distribution function and the density function of the N(O , l) dis-
tribution. Then X = e Z has the lognormal distribution, where Z has
N(O, 1) distribution. The tail and the hazard rate function of X are re-
spectively given by F(x) = 1 - (log x), q(x) = ~ ~ ) Therefore
exq(x) F(x) = [1 - (log x)] . exp { [1 ~~~~ ~ x)] } .

By Exercise 4.1.2(a) we know that
cp(x) rv x(l - <l>(x), as x -t 00 (4.68)
and hence q(x) rv ~ X - t 00; so q(x) -t 0 as x -t 00 . Again by (4.68)
exq(x) F(x) (1 - <l>(log x) . exp (x 10! x)

x
x(l- <l>(logx) = -1-{(logx)[l- <l>(logx)]}
ogx
x
-1- cp(logx), as x -t 00.
ogx
4.4. Exercises 101
Note that cp(logx) = vk ~ ) and that
J
00
x cp(log x)dx = JJ27f

00
_1_ ~ log x dx < 00.
1 I
So it follows that exq(x) F(x) is integrable. Hence by Theorem 4.35 it

follows that F E S*. Thus Fand F[ are both subexponential when F
is lognormal.
o
We conclude this section with a result concerning the distribution of
total claim amount for subexponential claims. Recall that in the Sparre
Andersen model the total claim is given by S(t) -= Xl + .. .+XN(t), t 2:: 0
(with, of course, S(t) = 0 if N(t) = 0). Here {N(t)} is a renewal process
independent of the i.i.d. claims {Xi}.
Proposition 4.37 Suppose Xi '" FES. Let GtO denote the ~

tion of S(t). Assume that P(N(t) = 0) < 1. Let t > 0 be fixed. Suppose
00
2: (1 + E)n P(N(t) = n) < 00 for some E > O. Then G t ES.

n=O
Proof: See Exercise 4.3.16. o
4.4 Exercises
4.1.1. Let F be a distribution function supported on [0, 00 ). Show

that F is light tailed if and only if
1 - F(x)
lim sup -'xx < 00 for some A. > O.
x-+oo e
4.1.2. (a) Let <1>, cp denote respectively the distribution function

and the probability density function of the standard normal distribution.
Using l'Hospital's rule show that
lim 1 - <1>(x) =1
x-+oo x-Icp(x) ,
and hence conclude that the truncated standard normal distribution is

light tailed.
(b) Show that the truncated N (f-L, (J2) distribution is light tailed;
here F(x) = P(IN(f-L, (J2)1 ~ x), x E IR. (Of course parts (a), (b) can
also be shown by proving that the moment generating function exists in
a neighbourhood of 0.)
4.1.3. Show that the r(a,.\) distribution is light tailed for .\ >
0, a > O.
4.1.4. (a) For a light tailed distribution F, show that the Esscher
transform Pt given by (4.5) is indeed a distribution function supported
on [0,00) for any t < SF.
(b) Show that the moment generating function mpt of Pt is given by
mF(t + s) c
mp, s - ,lor s < t,
A _ ( ) _
SF -
mF t
A ()
where t < SF.

- nPl (t)
(c) Show that the expectation of F t is ~ for t < Sp.
4.1.5. Let F denote the r(a,.\) distribution, where a > 0, .\ > O.
(i) Find SF.
(ii) For t < SF, find the Esscher transform of F.
4.2.1. Show that the following functions are slowly varying at 00.
(i) L(·) > 0, measurable with lim L(x) = c > o.
X-+OO
(ii) [log(l + x)]b, bE ffi. (Rint: First consider b = integer).
(iii) 10g2 x ~ log(log x), logk x ~ 10g(10gk_1 x).
. 4.2.2. Let L be slowly varying and nondecreasing (resp. nonin-
creasing). Show that the function !() in Karamata representation can
be taken to be nonnegative (resp. nonpositive).
4.2.3. If LI, L2 are slowly varying (at 00), then so are L I L2, f~
LI + L2· (Rint: Take max{EI(t),E2(t)} in Karamata representation.)
4.2.4. If L varies slowly at 00 show that
lim log L(x) = O.

x-+oo log x
4.2.5. If L varies slowly at 00 show that so does (L(.))b for any

b E ffi. (Rint: Enough to consider the case L(x) ----t 00 and b = positive
integer.)
4.4. Exercises 103
4.2.6. Show that f is regularly varying with index 8 {:} lim

~
ff((cx)) =
x
CD for an c > o. Here f is a positive measurable function on (0, (0).
4.2.7. Let f be a positive continuous function on (0, (0) such that
lim ff((tx)) = 'Ij;(t) < (X) for an t > O. Assurne 'Ij; is continuous.
x->oo x
(i) Show that 'Ij;(tlt2) = 'Ij;(tl) 'Ij;(t2) for an tl, t2 > O.
(ii) Show that 'Ij;(t) = t D, t > 0 for some 8 E IR.
(Hint: Put ~ = logt, ~) = 'Ij;(eE.); then w(6 + 6) = w(6) .
w(6), V ~ 6 E IR and hence w(O = (eD)E. for some 8 as w is positive
and measurable.)
4.2.8. Let h(·) > 0 be a measurable function on (0, (0). Show that
h(·) is regularly varying with index 0: {:} h(·) can be represented as
h(x) = c(x)exp ( [~ ort) dt), x> a
where c(-) > 0 is a measurable function such that c(x) ----- Co > 0, 8(·) is
a measurable function such that lim 8(t) = 0:.
t->oo
4.2.9. Let L be a slowly varying function. For 0: E IR, let Lo,{x) =
x
J taL(t) dt, x > 1. Show directly, using Proposition 4.6, that La(x)
1
diverges as x ----- (X) if 0: > 0, and that La(x) converges if 0: < -1.
4.2.10. a) Let L(t) = ~ ) t 2: e. Show that L is a slowly varying
J t
00
function such that L(t) dt < (Xl for sorne K > O.

K
b) U se (a) to get a distribution function on (0, (0) having a slowly
varying tail, that is, regularly varying distribution with tail index 0: = O.
Note that such a distribution does not belong to the domain of attraction
of any nondegenerate distribution. (See Appendix A.2)
c) Let X be a nonnegative random variable having distribution de-
scribed in (b). Show directly that E(X T ) = (X) for any r > O.
4.2.11. Prove (4.33) by a Fubini argument.
4.2.12. Let FE R_ a , 0: 2: O. Show that mF(s) = (X) for any s > o.
So moment generating function of F does not exist in any neighbourhood
of O.
4.2.13. Let F be supported on [0,(0) and specified by (4.34); that
is, F has Pareto (0:) distribution.
(i) Show that F is indeed a distribution function.
(ii) Find the expectation when 0: > 1.
(iii) If a > 1 show that F I E 'R.-(a-l), where FI is the integrated tail

distribution corresponding to F. Show also that FI has Pareto (a - 1)
distribution.
(iv) If X has Pareto (a) distribution where a > 0 show that E(X a ) = 00.
4.3.1. (a) For any distribution F supported on (0,00) show that
p;(2)(x)
~~~f F(x) ~ 2.
(b) Let F be a distribution supported on (0,00) such that
F*(2)(X)
limsup < 2.
x--->oo F(x)-
Show that F is subexponential.
4.3.2. If F satisfies (4.44) for n = 2 show that
lim
x--->oo
J x
F(x - y) dF(y)
F(x)
= l.
o
(Rint: Use (4.47)).
. 4.3.3. Using (4.44) for n = 2, show that F(x) > 0 for all x ~ O.
4.3.4. Derive (4.51).
z=
n
4.3.5. Let PO, PI, ... ,Pn 2: 0 such that Pi = 1; so {pd gives
i=O
z=
n
a probability on {0,1, ... ,n}. Let FES and G(x) = pjF*(j) (x).
j=o
Note that G is a distribution function. Show that
. G(x) ~
11m ~ ~ kpk.
x--->oo F(x)
k=O
4.3.6. (a) Let F be a distribution function supported on (0,00). For

any integer m ~ 1 show that
F*(m+l) (x) = F*(m) (x) + J x
F(x - t) dF*(m)(t).
o
4.4. Exercises 105
(b) Using a) show that
F*(m+l) (x) F*(m) (x)

lim sup > 1 + lim sup
x-.oo F(x) - x-.oo F(x)
(c) If there is an integer n 2: 2 such that
F*(n) (x)
limsup < n
x-.oo F(x)-
show that FES. In particular if (4.44) holds for one n 2: 2, then it

holds for all n 2: 2 and F is subexponential.
4.3.1. If F is subexponential, then so is F*(k) for any k = 2,3, ....
4.3.8. (a) Let F, G be subexponential and assume that
lim
X-+OO
= c, where 0 < C < 00. Let the probability distribution
=pG((x»
x
Q be defined by Q(x) = p F(x) + (1 - p) G(x) where 0 < p < 1. Show
that Q is subexponential.
(Hint: Note that
Q*(2) (x) p2 F*(2)(x) + 2p(1 - p) F * G(x) + (1 - p)2G*(2)(x),

Q(x) p F(x) + (1 - p) G(x),
and use Lemma 4.20).

(b) Prove that G in Exercise 4.3.5 is subexponential, if Po < 1.
4.3.9. (a) Let F have finite expectation p,. Show that
. J
hm
x-.oo
x_
F(x-y)-
F(x)
F(y) dy 2: 2p,.
o
(b) Show that F E S* {:}
J
x/2 _
F(x-y)-
lim F(y) dy = p,.
x-.oo F(x)
o
4.3.10. (a) Let G be a distribution on (0,00) with hazard rate
function qG. If qG(x) ~ 0 as x ~ 00 show that GEL.
(b) Complete the proof of Lemma 4.32.
4.3.11. Let F, G be distributions supported on (0,00). Assume
that lim
x-.oo
=GP((X»
x
= C E (0,00). Suppose F has finite expectation p,p.
(i) Show that G has finite expectation.

(ii) Show that
where MG is the expectation of G, and FI , GI respectively are the inte-

grated tail distributions of F, G.
(iii) F rv t G =? FI rv t GI.
4.3.12. A distribution F on (0,00) is said to be dominatedly varying
if (4.64) holds; it is written F E 'D. Show that R_ a C 'D for 0: > O. If
F has finite mean and F E L n 'D show that F E S*.
4.3.13. Let F E L. For any fixed v > 0 show that
lim j v F(x - t) -
F(t) dt =
jV _F(t) dt.
x--->oo F(x)
o 0
4.3.14. Let 0 < T < 1, c> 0, and F(x) = exp( -cx T ), x > O. This
is the heavy-tailed Weibull distribution. Show that F E S* and hence
F, FI are both subexponential.
4.3.15. Let F be a distribution function supported on (0,00) with
x
hazard rate function qp(.). Define Q(x) = J qp(t) dt, x> O.
o
(a) Show that F(x) = exp( -Q(x)), x > O.
(b) Using (4.47) show that
-- x
l (x_) _ 1 = j{exP[Q(x) - Q(x - t) - Q(t)]} qp(t) dt.
---::F*=:-(2_
F(x)
o
4.3.16. Let the notation and hypotheses be as in Proposition 4.37.

00
(i) Show that Gt(x) = L F*(kl(x)· P(N(t) = k).

k=O
(ii) Prove Proposition 4.37.
(iii) Show that Gt(x) rv E(N(t)) F(x), x ---+ 00.
(iv) In the case of the Cramer-Lundberg model note that the hypotheses
of Proposition 4.37 are satisfied.
4.3.17. Give an example of a subexponential distribution having
finite moments of any order.
Chapter 5
Ruin Problems
Ruin prob ability is the probability of the insuranee eompany getting

ruined in finite time. It is eonsidered to be a reasonably objective indi-
eator of the health of the eompany. So problems eentering around ruin
probability have a prominent plaee in mathematieal ~ of insur-
anee models. We shall first eonsider some general results in the Sparre
Andersen model; later we shall speeialise to the ease of the Cramer-
Lundberg model.
5.1 Risk process and an associated random walk

N(t)
Reeall S(t) = LXi, t 2: 0 is the total claim amount proeess, where the
i=l
claim number process {N (t)} is a renewal process independent of the
Li.d. claim sizes {Xd; Xi > 0 a.s.; 0 = Ta < Tl < T 2 < ... < T n < ...
are claim arrival times; also Ai = 'Fi, - Ti-I, i 2: 1 are i.i.d. interarrival
times.
We assume that the premium ineome p(.) is a deterministie linear
funetion, that is, p(t) = ct, t 2: 0; here c > 0 is the premium rate. Define
N(t)
R(t)=x+ct-S(t)=x+ct- LXi, t2:0. (5.1 )
i=l
R(·) is ealled the risk or surplus process; in the Sparre Andersen model
it is ealled the renewal risk process; in the Cramer-Lundberg model it
is ealled the Lundberg risk process. Here x is the initial eapital of the
eompany. Note that R(t) gives the surplus or capital balance of the
eompany at time t.
108 5. Ruin Problems
The event that R(·) falls below zero is called ruin; that is, ruin is
{R(t) < 0 for some t 2: O} = U {R(t) < O}. Define the ruin time TO by
t2':O
TO = inf{t 2: 0 : R(t) < O} (5.2)
and the ruin probability 'IjJ(.) by
'IjJ(x) = P(TO < ooIR(O) = x) ~ Px(TO < 00). (5.3)
Finding appropriate equations, expressions, estimates for 'IjJ(.) and

analysing the asymptotics of 'IjJ(.) form the core of "ruin problems".
By the definition of the risk process, it is clear that R(·) is increasing
on [Tn , T n+1 ), n 2: O. So ruin can occur only at so me T n . The sequence
{R(Tn ) : n 2: O} is called the skeleton process of the risk process R(·).
Now observe that, as N(Tn ) = n,
Ruin = {R(t) < 0 for some t 2: O} = {inf

t2':O
R(t) < O}
inf R(Tn )
{ n>O < O} = {inf
n>O
[x + cTn - ~
~
Xi] < O} .
- - i=l
n
Write So == 0, Zn = X n - cAn , Sn = L Zi, n 2: 1. It is now clear that
i=1
'IjJ(x) = P {inf (-Sn) < -x} = P {sup Sn > x} . (5.4)

n2':O n2':O
As {Ai}' {Xj } are i.i.d. sequences, and the sequences are mutually
independent, note that {Zi : i 2: 1} is a sequence of real valued i.i.d.
random variables. Thus {Sn: n 2: O} is random walk on R So the ruin
prob ability is just the tail probability of the supremum functional of the
random walk {Sn}. The main result of this section is
Theorem 5.1 With the notation as above, assume that Zl "I- 0, and
that E(Zl) exists.
a) If E(Zl) > 0 then lim Sn = +00, a.s.
n->oo
b) If E(Zl) < 0 then lim Sn = -00, a.s.
n->oo
c) If E(Zl) =0 then
limsup Sn = +00, liminf
n->oo
Sn = -00, a.s.
n->oo
o
5.1. Risk process and an associated random walk 109
Assertions (a) and (b) are easy consequences of the strong law of
large numbers, and hence left as exercise. Though assertion (c) may not
be surprising to those familiar with the symmetrie simple random walk
on Z, its proof is by no means obvious. In fact we need to introduce the
following before taking up the proof.
For n = 0,1,2, ... let On ~ a{ Si : i ::; n} denote the filtration
generated by the random walk. Note that On = a {Zi : i ::; n}. Define
v+ min{n> °: Sn > O}, (5.5)
V min{n> °: Sn ::; O}; (5.6)
v+ (resp. v-) is called the first entrance time 01 {Sn} into (0, (0) (resp.
(-00,0]). Set vet = 0, vi= v+, Va
= 0, v[ = v-; for n 2: 1 define
min{j > v; :Sj > Sv+} n
(5.7)
min{j > v;; : Sj ::; Sv-n }. (5.8)
Note that one can define S !In+ (resp. S V n-) in an unambiguous manner
whenever v; < 00 (resp. v;; < (0); see Exercise 5.1.4. The stopping
time v; is called the n th strang ascending ladder epoch of {Sn}; similarly
v;; is called the n th (weak) descending ladder epoch of {Sn}. Note the
slight asymmetry between (5.5), (5.7) on the one hand and (5.6), (5.8)
on the other.
Proof of Theorem 5.1: In view of Exercise 5.1.3 we need to con-
sider only case (c); so assume E(ZI) = 0. We first prove
P(v+ < (0) = 1; (5.9)
that is, the random walk {Sn} enters (0, (0) in finite time with probabil-
ity 1. Put M = min {n : Sn = sup Sj} = first time maximum is reached;
j?O
of course, M = 00 if supremum is not attained. For any n 2: 0, note that
the events {Si< Sn, i ::; n - 1} and {Sj ::; Sn, j > n} are independent,
because the former involves ZI, Z2, ... , Zn, while the latter depends on
d
Zn+1, Zn+2, .... Clearly (ZI, Z2,.·· ,Zn) = (Zn, Zn-I,··. ,Zd. There-
fore
P(Si < Sn, i ::; n - 1) = P (t e=i+1

Ze > 0, i ::; n - 1)
P(Zn > 0, Zn-I + Zn > 0, ... ,ZI+ Z2 + ... + Zn > 0)

P(ZI > 0, ZI + Z2 > 0, ... ,ZI + Z2 + ... + Zn > 0)
P(v- > n)
where the last step follows by the definition of IF. Next note that
j j-n
L Zk 4. L Zc for j > n. Hence using the definition of v+ we have
k=n+l C=l
P (t
k=l
Zk :S O,j > 0) = P(v+ = 00).
Consequently it now follows that
L
00
1 :2 P(M < 00) = P(M = n)

n=O
00
n=O
00
n=O
L
00
P(v+ = 00) P(v- > n)

n=O
(5.10)
Now, if possible let P(v+ = 00) > O. Then (5.10) implies E(v-) <
00. Consequently Wald's identity and our hypothesis give E(Sv-) =
E(v-) E(Zd = O. By definition of Sv- note that Sv- :S O. Hence
Sv- = 0 a.s. Now P(ZI = 0) < 1, E(Zd = 0 imply P(ZI < 0) > O.
This would mean P(Sv- < 0) :2 P(ZI < 0) > 0 which contradicts
Sv- = 0 a.s. Hence P(v+ = 00) = 0, proving (5.9).
We want to prove next that for any m = 1,2, ...
~ < 00) = 1. (5.11)
As vi= v+ we may take m :2 2. Note that ~ is increasing and

SV m+ > SVm+ _ 1 > ... > SVI+ > O. Suppose (5.11) holds for m :S k; we
want to prove that it holds for m = k + 1. Denote
(5.12)
5.1. Risk process and an associated random walk 111
Then one can get the following analogue of (5.10) by proceeding simi-
larly:
(5.13)
This in turn leads to (5.11), just like (5.9) was derived from (5.10). See
Exercise 5.1.6.
By (5.11) and Exercise 5.1.5, it now follows that {S V ++ - SV n+ :
n 1
n 2: O} is a sequence of i.i.d. random variables taking values in (0,00).

Clearly E(S1/n++ 1 - S V n+) = E(Sv+) > O. So the strong law of large
numbers implies
Even if E(Sv+) = 00 the above conclusion holds since the summands

are positive. Therefore lim S + = 00 a.s., and hence lim sup Sn = 00,
n----+CX) Vn n----+oo
a.s.
By considering {-Sn: n 2: O} in the place of {Sn} with E( -Zd = 0,
a similar analysis gives lim inf Sn = -00 a.s. This completes the proof.
n--->oo
D
By Theorem 5.1 and (5.4) we now have
Corollary 5.2 Let E(Ad, E(Xd be finite. If E(Zd = E(Xd -

cE(Ad 2: 0 holds then 'I/J(x) = 1 for all x > 0; that is, if E(Zd 2: 0
then ruin occurs in finite time with probability 1 whatever be the initial
~ ~~ D
In particular, note that the net premium principle discussed in Sec-
tion 3.4 leads to ruin.
Definition 5.3 We say that the renewal risk model satisfies the net
profit condition (NPC) if E(Xd - cE(Ad < O.
It is clear that the premium rate has to be chosen so that NPC

is satisfied, as NPC basically means that the average cashflow in the
portfolio is on the positive side. This does not mean that ruin is avoided;
it only means that one can hope 'I/J(x) < 1, x > O.
Our proof of Theorem 5.1 is based on the approach given in [RSST].
Note: An interesting offshoot of ruin problem of insurance models is
the branch of probability theory called Zarge deviations. Let the notation
be as in Section 5.1. A quest ion related to ruin is, what is the rate at
which P( n n > x) tends to 0 forany x > E(Xd7 More precisely,
. IS
does there exist a nice function I, called the rate lunction, such that for
x> E(Xd
~ P~ > x) -> -I(x) as n -> 007
This quest ion was studied by Esscher and Cramer. If {Zd has moment
generating function, a satisfactory answer can be given, with Esscher
transform (see (4.5)) playing a major role. Under suitable conditions,
Esscher trans form converts an event of "smalI" probability into one of
"considerable" probability, thus facilitating analysis.
It turns out that the above quest ion in terms of rate function is
meaningful in problems arising in diverse disciplines. A far reaching
abstract framework of large deviation principles has been synthesized
by Indian born probabilist S.R.S. Varadhan with implications in statis-
tics, PDE theory, physics, engineering, etc. For this outstanding work
Varadhan has been awarded the prestigious Abel prize for 2007. For a
quick overview, an interested reader may see M. Raussen and C. Skau:
Interview with Srinivasa Varadhan, Notices 01 the American Mathemat-
ical Society, vol. 55 (2008) Feb. 2008 issue, pp. 238-246, and R. Bhatia:
A Conversation with S.R.S. Varadhan, The Mathematical Intelligencer,
vol. 30, No. 2, Spring 2008, pp. 24-42. The role of Esscher tilt is
highlighted in these interviews. See also S. Ramasubramanian: Large
deviations: an introduction to 2007 Abel prize. Proceedings 01 the Indian
Academy 01 Sciences (Mathematical Sciences), 118 (2008), 161-182.
5.2 Lundberg bound
We continue with the renewal risk model. We assume that the net
profit condition holds; see Definition 5.3 in the preceding section. We
also assume that the claim size distribution is light tailed, that is, the
claim size Xl has moment generating function in a neighbourhood of
zero.
Definition 5.4 Let Zl = Xl - CAI, and assume that the moment gen-
erating function mz(-) of Zl exists in (-ho, ho), where h o > O. Suppose
h = r is the unique positive solution to the equation
mz(h) = E[exp(h(X I - cAd)] = 1. (5.14)

5.2. Lundberg bound 113
Then r is called the adjustment coejJicient or Lundberg coejJicient.
Proposition 5.5 Assume that (i) E(ZI) < 0, that is, the net profit
condition holds, (ii) there exists h o > 0 such that mz(h) < 00 lor alt
Ihl < h o, and hjho
lim mz(h) = 00. Then the Lundberg coejJicient is welt
defined.
Proof: Clearly h = 0 is a solution to (5.14). So we want a unique so-

lution to (5.14) in (0, h o ). Put I(h) = mz(h) = E(e hZ1 ), hE (-ho, h o ).
Note that 1 has derivatives of all orders in (-ho, h o ). Also f'(h) =
E(Zle hZ1 ), f"(h) = E(ZrehZ1), for h E (-ho, h o ). Since (NPC) holds,
1'(0) = E(ZI) < O. This together with continuity of 1 implies that f de-
creases in a neighbourhood of O. But as Zl 1= 0 (that is, P(ZI = 0) < 1),
we see that f"(h) = E(ZrehZ1) > 0; 1 is convex. As f(h) --+ 00 as
h i h o , it now follows that there is h 1 > 0 such that 1'(hI) = 0, 1 is
increasing on (h 1 , h o), and there is a unique r E (h 1 , h o) C (0, h o ) such
that 1(r) = 1. This completes the proof. D
The next result gives a probabilistic significance of the Lundberg
coefficient.
Proposition 5.6 Assume that the (NPC) holds and that Lundberg co-
ejJicient r exists. Let {Sn: n ~ O} be the random walk as in Section
5.1. Then {erSn: n = 0,1,2, ... } is a martingale with respect to {Qn}.
Proof: Integrability of erSn is dear. It is left as an exercise to the

reader to show that E[e rSn + 1 I Qn] = erSn a.s. See Exercise 5.2.2. D
Theorem 5.7 (Lundberg bound): Consider the renewal risk model. As-
sume that the (NPC) holds and that the Lundberg coejJicient r > 0 exists.
Then
'ljJ(x) ::; exp( -rx), x> O. (5.15)
Proof: We give two proofs.

1 st Proof: Let TO denote the ruin time. For k = 1,2, ... note that
TO 1\ k is a stopping time W.r.t. {Qn}. So by the preceding proposition
and the optional sampling theorem E[exp(rS(TOi\k))] = E[e rSo ] = 1.
Therefore E[erSroI{To::;k} + erSkIh>k}] = 1. Note that STO > x, where
x is the initial capital. Hence
whence it follows that Px(TO :S k) :S e- rx . Letting k i 00 we get (5.15).

2 nd Proof: Thisproofisbyinduction. Write1Pn(x) = P( max Sk>
I::;k::;n
x), X > 0, n = 1,2, .... Note that 1Pn(x) i 1P(x) as n i 00 for every
x > 0. So it is enough to prove that
1Pn(x) :S exp( -rx), V n 2': 1, x> 0. (5.16)
The case n = 1 is dealt with in Exercise 5.2.3. Assume that (5.16) holds
for n :S k. We need to show that it holds for n = k + l.
Let Fz denote the distribution function of Zl . As Z2 + ... + Zi is
independent of ZI, and Z2 + ... + Zj+1 4. Sj, we obtain
1Pk+1 (x) = P(ZI > x) +P (Zl :S x , (max Si) > x)

2::;i::;k+ I
P(ZI > x)
+ J
(-oo,x]
P (C::;If::;akx+ I Si) > x - z I Zl = z) dFz(z)
P(ZI > x) + J
(-oo,x]
P ~~ Sj > x - z) dFz(z)
= PI + P2, say. (5.17)
By induction hypothesis note that
P2 = J 1Pk(X - z) dFz(z):S J e-r(x-z) dFz(z). (5.18)

(-oo ,x] (-oo,x]
Next , by proof of Chebyshev's inequality
P(ZI > x) :S E [e:r: {Zl > x}]

1
PI :
< e- rx J erz dFz(z) = J e-r(x-z) dFz(z). (5.19)

(x,oo) (x,oo)
It is now clear that (5.17) - (5.19) give (5 .16) for n = k + 1, completing

the proof. 0
Example 5.8 Consider the Cramer-Lundberg model with. claim sizes

{Xd having Exp( 0) distribution and interarrival times {Ad having
5.3. An integral equation in Cramer-Lundberg model 115
Exp(..\) distribution. It can be verified that
(5.20)
and hence that mz(h) i 00 as h i O. Note that
1 c ..\
(NPC) holds {::} - - - < 0 {:} 0 - - > O. (5.21)
o ..\c
Clearly
mz(h) = 1, h> 0 {:} h = 0 - ~c > O. (5.22)
Thus, if (NPC) holds then the Lundberg coefficient is r = 0 - ~

Now suppose premium rate c is determined using expected value
principle so that
ct = (1 + p) E(S(t)) = (1 + p) e..\ t (5.23)
where p > 0 is the safety loading factor. Clearly (NPC) holds as E(Zl) =
~ < O. So the Lundberg coefficient is r = ~ 0, and hence the
Lundberg bound is
7jJ(x) :s: exp { -0 1 : p x}, x > O. (5.24)
From the above we see that ruin is unlikely if the initial capital is large.
Also note that Ifp i 1 as p ---t 00; so the bound does not change signif-
icantly if p is very large. On the other hand, for large p the premium
will be high, and hence the policy may look unattractive to a buyer.
5.3 An integral equation in Cramer-Lundberg model
As we know, in the Cramer-Lundberg model the claim number process

{ N (t) : t :?: O} is a homogeneous Poisson process with rate ..\ > 0; so the
interarrival times {Ad is an i.i.d. sequence having Exp(..\) distribution.
We assume Xi > 0 a.s. and J.l = E(Xi ) where {Xd denote i.i.d. claim
sizes independent of {N (t) }. Set
'P(u) = 1 -7jJ(u) = P(ro = 00 I R(O) = u). (5.25)

The function rp is called the survival probability.

We assurne the net profit condition
c . c
J-L - - < 0 or eqmvalently \ > 1. (5.26)
A AJ-L
We will derive an integral equation for the survival probability rp.
Let Zi = Xi - cAi , for i ~ 1, and {Sn} be the random walk as in Section
5.1. Let FA, Fx, Fz denote respectively the distribution functions of
Ai, Xi, Zi· As {Zd is an i.i.d. sequence note that Sn - Zl 1:: Sn-l for
n ~ 2. Consequently as Xl and Al are independent and nonnegative,
we have for x ~ 0
rp(x) = P(Sn :S x for all n ~ 1)
P(ZI :S x, Sn - Zl :S x - Zl for all n ~ 2)
J
~
(t
I(-oo,x] (z)P
t=2
Zi :S x - z , V n ~ 2 I Zl = z) dFz( z )
= J I(-oo ,x](z) P(Sm :S (x - z) V m ~ 1) dFz(z)

~
JJ
oox+CW
P(Sm:S x - (u - cw) V m ~ 1) dFx(u) dFA(W)
o 0
JJ +
00 x+cw
rp(x - u cw) dFx(u) Ae-).w dw
o 0
~ ~ J ~ J
00 z
rp(z - u) dFx(u) dz (5.27)

x 0
where we have used the fact that Al has EXp(A) distribution. Hence
rp(.) is absolutely continuous and
J
X
rp'(x) = ~c rp(x) - ~c rp(x - u) dFx(u) , for a .e. x> O. (5.28)

o
Note that (5.28) holds a.e. with respect to the Lebesgue measure. By
integration by parts
J J
x x
rp(x - u) dFx(u) = Fx(x) rp(O) + Fx(u) rp'(x - u) du.

o 0
5.3. An integral equation in Cramer-Lundberg model 117
So integrating (5.28) over (0, t) we get
'P(t) - '1'(0)
~ jv>(X)dX - ~ j ['P(O)FX(X) + IX Fx(u)'P'(x - U)dU] dx

o 0 0
I I
t t
~ 'P(t - x)dx - ~ ) Fx(x) dx

o 0
II
t x
~ Fx(u)'P'(x - u) du dx
o 0
~I I
t t
'P(t - x)dx - ~ ) Fx(x) dx

o 0
t
~ 1['P(t - u) - 'P(O)]Fx(u) du
o
I
t
~ 'P(t - x)(l - Fx(x))dx.

o
Consequently, as Fx(x) = 1 - Fx(x) we have
AI -
t
'P(t) = '1'(0) + ~ 'P(t - x) Fx(x) dx. (5.29)

o
As the net profit condition holds, by Exercise 5.1.7 (see below), '1'(00) ~
lim 'P(t) = 1. So letting t i 00 in (5.29) we get
t->oo
AI1
'1'(0) = 1 - - . (5.30)
c
We know that the integrated tail distribution corresponding to Fx is
given by dFx,I(x) = ~ Fx(x) dx. So, using (5.30), we can now write
(5.29) as
'P(t) = ( c - c AI1) + -z
AI1 I t
'P(t - x) dFx,I(x). (5.31)
o
Denote p = ~ - 1; by the net profit condition (5.26) note that p > 0;

this is a safety loading factor. We can summarize the above discussion
in the form of the following theorem.
Theorem 5.9 Consider the Cramer-Lundberg model. Assume that the

claim sizes Xi > 0 a.s., and that the net profit condition (5.26) holds.
Then the survival probability <p(') satisfies the integral equation
PI!
t
<p(t) = -1-
+p
+ -- l+p
<p(t - x) dPx I(X),
,
t;:::: 0 (5.32)
o
where p = ~ - 1) 0,
> and PX,I is the integrated tail distribution of
the claim size distribution Fx. 0
Though the integral equation (5.31), or equivalently (5.32), looks

like the renewal equation (3.28) in Definition 3.15, there is a crucial
difference. Note that ~ ) dFx,I(') is only a subprobability measure.
So (5.31) or (5.32) is called a defective renewal equation.
Even though ~ ) dPX,I(-) is not a probability measure, mimicking
the proof of Theorem 3.16 we get the following
Theorem 5.10 Let the notation and hypotheses be as in Theorem 5.9.

Then the unique bounded solution, 'supported on [0,00), to the defective
renewal equation (5.32) is given by
00
<p(t) = -p- ~ 1 F*(n) (t) t;:::: 0 (5.33)

l+p L (l+p)n X,I ,
n=O
where p*(n)
X,I denotes the n-fold convolution of FX,I. Consequently
'ljJ ( t ) -_ 1 - <p ( t ) _ p
- -1-
+p
2: (1 +p
00
1 ) ~
n
F
,
X I ) t;:::: O.
t, (5.34)
n=l
(5.33) 01' equivalently (5.34) is called the Pollaczek-Khinchin formula.

o
The following definition gives a way of describing formulae like (5.33),
(5.34).
5.4. Exact asymptoties in Cramer-Lundberg model 119
Definition 5.11 Let 0 < P < 1. Let J be a random variable having

a geometrie distribution so that P(J = k) ::;= (1 - p)pk, k = 0,1,2, ....
Note that p = P(J 2 1). Let {Ui : i 2 I} be an i.i.d. sequenee with
eommon distribution function F u supported on (0, (0). Assurne that J
and {Ud are independent. Define
v~ t.
t=I
Ui ={ 0 if J = 0 . _
UI + ... + Uk, If J - k.
(5.35)
Then V is said to have a eompound geometrie distribution (or V is geo-

metrie eompound) with eharaeteristies (p, Fu).
In view of Exereises 5.3.4, 5.3.5, the Pollaezek-Khinehin formula ean

now be interpreted as folIows: Survival probability cp(.) is the geometrie
eompound with eharaeteristies (l!P'FX,I); similarly ruin prob ability
'IjJ(.) is the tail of the above eompound geometrie distribution.
5.4 Exact asymptotics in Cramer-Lundberg model
In this seetion we look at the problem of exaet asymptotic behaviour

of ruin probability in the Cramer-Lundberg model. First we eonsider
light-tailed claim size distributions, and then take up the ease when
claim sizes are subexponential. As we will see, the qualitative behaviour
in these eases are quite different.
5.4.1 Light-tailed claims

To obtain the Pollaezek-Khinehin formulae (5.33), (5.34) it was suffieient
to follow the approach in renewal theory, as in Theorem 3.16 for solving
the renewal equation. However, imitation is not good enough to get
the exaet asymptoties of ruin probability. The reason is the following.
As 'IjJ(.) satisfies a renewal type equation, one would like to use the key
renewal theorem (Theorem 3.26 (b)) to get the asymptoties. We know
that the key renewal theorem is equivalent to Blaekwell's renewal theo-
rem (Theorem 3.21). One ingredient in the proof of Blaekwell's theorem
is the Choquet-Deny theorem, viz. eonstants are the only solutions to
the eonvolution equation (3.44). This eonclusion, however, is not valid
unless F in (3.44) is a probability distribution; see Exercise 5.4.1. Our
analysis below will also indieate that the key renewal theorem is not
valid if F is a subprobability measure, as is the ease in (5.32).
To deal with the situation we use an Esscher transform (or exponen-

tially tilted transformation) of the subprobability distribution
~ ) dFx '!(·). So we assume that there is 1/ > 0 such that
1
(1 + P) dFX ,I (x) = l. (5.36)
Then the defective renewal equation for 1jJ(-) given in Exercise 5.3.2 (see
below) leads to
evt 1jJ(t) = evt [_1_

Fx let)
l+p'
+ _1_
l+p
jt1jJ(t - x) dFx I(X)]
,
o
t 1 -
eV ) Fx l(t)
1+P
(
,
+j
o
t
[e v(t-x)1jJ(t - x)] { eVx (1: p) dFx,!(x)} . (5.37)
By (5.36), eVx ~ ) dFx,!(x) is a prob ability distribution supported on

(0,00). Therefore (5.37) is a standard renewal equation for the unknown
function evt 1jJ(t) , with evt ~ ) Fx,!(t) as the given function. The as-
sumption (5.36) is called the Cramer-Lundberg condition; by Exercise
5.4.2 1/ > 0 in (5.36) is the Lundberg coefficient as defined in Section
5.2. We now have the following result.
Theorem 5.12 (Cramer-Lundberg approximation) Consider the Cramer-

Lundberg model. Assume the net profit condition (5.26); denote p =
~ - 1. Let the Cramer-Lundberg condition (5.36) hold, and
00
j x eVx Fx(x) dx < 00 (5.38)

o
where 1/ > 0 is as in (5.36). Then
lim evt 1jJ(t) = C- 1 (5.39)

t-too
5.4. Exact asymptotics in Cramer-Lundberg model 121
where
J
00
C= ~ x eI/x Fx(x) dx. (5.40)

PM
o
In particular the ruin probability 'ljJ(.) decays exponentially.
Proof: In view of the preceding discussion we would like to apply
the key renewal theorem to renewal equation (5 . 37). For this put Ul(t) =
el/t , U2(t) = ~ ) ) t 2: O. We want to establish that Ul(-)U2(-)
is directly Riemann integrable using Lemma 3.24; for this note that it
is enough to show that U1 (-)U2 (.) is integrable on (0, 00 ). Indeed
J J
00 00
Ul(t)U2(t) dt = el/ t (1 ~ p)FX,I(t) dt

o 0
J
00
eI/
t
(1
1
+ p) J 00
l-
-p,Fx(x)dx dt
o t
J J
00 x
1 Fx(x) el/tdt dx
M(1+P)
o 0
Vi'(I\P) [[eVXFX(X)dX-[FX(X)dx]
t ~ ) = V(l:P) (5.41)
by (5.36). Therefore applying the key renewal theorem (Theorem 3.26
(b)) to the renewal equation (5.37) we get
lim el/t'ljJ(t)
t---+oo
[[x eVx (I: pli' Fx(x) dX] [[e -1 v! (I ~ p) FX,I(t) dt]

V(I: p)i'(1 + p) ( [X eVx Fx(x) dX) -1
whence the result follows; in the above we have used (5.38), (5.41).
o
Example 5.13 This concerns Cramer-Lundberg approximation when

the claim size has an exponential distribution. In addition to the hy-
potheses of Theorem 5.12 ass urne that Xi has Exp( ()) distribution. It is
easily proved that the integrated tail distribution is
Fx,I(x) = Fx(x) = (1 - e- OX ), x 2: o. (5.42)
From Example 5.8 we know that the Lundberg coefficient is 11 = r =

nfpy(). Therefore it can easily be verified that the probability distribu-
tion in the standard renewal equation (5.37) is given by
dG(x) ~ ( () ) exp {- ( () ) x}
l+p l+p
·1(0
,
oo)(x) dx. (5.43)
So, by Theorem 3.16, the solution to (5.37) can be given in terms of an

00
integral with respect to the renewal measure L G*(n)(.) corresponding
n=O
to G(·). From (5.43) it is clear that G(·) is the EXP(l!p) distribution.
Hence by Theorem 2.5, the corresponding renewal process is the Poisson
process with rate C!p). Consequently the renewal function is m(t) =
1+ l!pt, t 2: o. Thus the renewal measure has a jump at 0, and hence
(5.44)
Therefore, by Theorem 3.16
f
o
teV(t-X) 1
(1 + p)
e-O(t-x) (d fn=O
G*(n)(x))
_l_ e -(O-v)t
l+p
+ f t
1 e-(O-v)(t-x).
(l+p)
()
(l+p)
dx
o
+ f () {() ( )}
t
1
-:-----:-e _(1+p)
_
IJ t exp - - - t ---' x dx
(l+p) (l+pF l+p
o
1
l+p
5.4. Exact asymptotics in Cramer-Lundberg model 123
Hence we have
7jJ (t ) = (1
1
+ p) e
-vt
= (1
1
+ p) exp
{PO}
- (1 + p) t
~ exp { - (CO; A) t}, t 2 O. (5.45)
Thus we have an explicit expression for the ruin probability in this case.
o
5.4.2 Subexponential claims
We had already mentioned in an earlier section that the distributions
that actually fit claim size data are heavy tailed distributions like the
Pareto, lognormal or heavy tailed Weibull distributions. Clearly the
discussion in subsection 5.4.1 does not apply to such distributions.
To get a handle on the situation we return to the Pollaczek-Khinchin
formula (5.34) for the ruin probability 7jJ(.). Recall that essentially only
the net profit condition is assumed here in the Cramer-Lundberg model.
Dividing (5.34) by FX,I(t) we get
7jJ(t) P ~ (1 + )-n F*(n)(t)

(5.46)
FX,I(t) - (1 + p) ~ P FX,I(t) .
Now, if Fx,I ES, (that is, if Fx,I is subexponential) , then
~ ~) ) ) -t n as t - t 00, for each n.
By net profit condition, p = ) ~ - 1 > O. Choose 0 < E < p. Then by

Kesten's lemma (Lemma 4.22) there is constant 0< K < 00 such that
(1 + ) ~) ) )~K ( : : ;) n, V t 2 O.
As L ~ ) n < 00, by (5.46) and the dominated convergence theorem

(applied to the counting measure) we get
lim
t--->oo
7jJ (t) = -p-
FX,I(t) 1+p
f
n=l
n(l + p)-n = ~
p
Thus we have proved the following important result

Theorem 5.14 (Embrechts- Veraverbeke approximation): Consider the

Cramer-Lundberg model with the net profit condition (5.26); so safety
loading factor p = )..cJt - 1 > O. Let F denote the claim size distribution,
and F] the corresponding integrated tail distribution. Assume that F] E
S. Then
(5.47)
o
Example 5.15 Consider the Cramer-Lundberg model with the net profit
condition. Suppose the claim size distribution F is Pareto (0:), 0: > l.
As 0: > 1 we know that the claim size distribution has finite expectation.
Also the integrated tail distribution F] is Pareto (0: - 1) and hence is
subexponential. So by Theorem 5.14
1 l'i: a - 1
'IjJ(t) = P (I'i: + t)a-l (1 + 0(1)) , as t -t 00 . (5.48)
Here I'i: > 0 is a constant.
When claim size is Pareto (0:), 0: > 1, ~ ) indicates that the ruin
probability decays only at a power rate. Exercise 5.4.5 shows that a
similar behaviour is exhibited when claim size distribution is R_o., with
0: > 1; (in fact, Example 5.15 is a special case of Exercise 5.4.5). This
is In sharp contrast to the situation in Theorem 5.12 where the ruin
probability decays exponentially. So Pareto distributed risks, and risks
with regularly varying tails are more dangerous than light-tailed risks.
For Cramer-Lundberg model with net profit condition p > 0, the
following are, in fact, equivalent:
(a) F] ES; (b) <pe) = 1 - 'IjJ(.) ES; (c) lim .l(t) = p-l
t ..... oo FJ(t)
While (a) => (c) is proved in Theorem 5.14, (a) => (b) is given in Exercise
5.4.4. For a proof the reader is referred to an appendix in [EKM].
Our presentation of this section is heavily influenced by [EKM].
Remark 5.16 For the Sparre Andersen model also similar analysis is
possible. For analogues of Theorems 5.10, 5.12, 5.14 see, respectively,
Theorems 6.5.1, 6.5.7, 6.5.11 in Section 6.5 of [RSST]. These results
make use of the so called ladder height distributions.
5.5. Exercises 125
5.5 Exercises
5.1.1. (a) Show that TO is a stopping time with respect to the filtra-
tion {Ft : t ?: O}, where F t is the smallest IT-algebra making the family
{S(r) : 0:::; r :::; t} measurable; that is, show that {TO :::; t} E F t for all t.
°
(Rint: {TO > t} = {R(s) ?: for all s:::; t} = n{R(s) ?: 0: s:::; t, s
rational} n { R( t) ?: O}. Rere we are using the special structure of R(·),
viz. it is increasing except at jumps which are negative.)
(b) Show that "Ruin" is an event.
5.1.2. Show that inf R(t) is a (possibly extended real valued) ran-
t2':O
dom variable.
5.1.3. As E(Zd exists, prove assertions (a), (b) of Theorem 5.1
using the strong law of large numbers.
5.1.4. (a) Let j = 0,1,2,.... Show that {vi = k}, {vj- = k} E
(;h, k = 0, 1,2, ... ; that is, vi, vj- are stopping times w.r.t. {9n}.
(b) Show that Sv; (resp. Sv;;) is a random variable on {V;{ < oo}
(resp. {v;;- < oo}).
(c) Show that S V ++ - S V + takes values in (0, (0).
k 1 k
5.1.5. (a) For any interval (a,b) C (0,00) show that
P(Sv+ - Sv+ E (a, b))
00
1 0
L P(Sj E (-00,0], j ::; n - 1, Sn E (a, b)).

n=1
(b) For i = 0,1,2, ... , k = 0,1, ... show that {v: = i} is indepen-
dent of {ZiH : € ?: 1}; in fact 9i and {ZiH : € 2 1} are independent.
I(t
(c) Let k?: 1. For any interval (a,b) C (0,00) show that
P(S + - S + E (a, b))
Vk +1 Vk
L00 (00
i=1
L
n=1
P
(=1
~
(2: ZiH
ZiHl E (-00,0], j:::; n -1,
E (a,b) ))
. P(v: = i)
00
L P(Sj E (-00,0], j :::; n - 1, Sn E (a, b)).
n=1
Thus (SV ++ - SV +) has the same distribution as (Sv+I - Sv+0 ) if

k 1 k
1 < 00 v:+
a.s. for k = 0,1,2, ....
(d) Assume vi
< 00 a.s. Let BI, B 2 C (0, (0) be Borel sets. Using
the fact that {Zq : q 2: I} is an i.i.d. family show that
P(Sv+ - Sv+ E BI, Sv+ - Sv+ E B 2 )
I 0 2 I
L Bd
00
P(Sj E (-00,0], j ::::; k 1 - 1, SkI E

kl,k2=1
.p ~ f) E (-oo,OI,m S k, -1, ~ f) E B2)

[f
kl=1
P(Sj E (-00,0], j::::; k 1 - 1, Skl E Bd].
[f:/(Sm (-00,01, E m S k, -1, Sk, E B2)]
P(S VI+ - S V + E Bd . P(SV + - SV + E B 2 ).
o l o
Hence conclude that (SVI+ - SV o+) and (SV 2+ - S V l+) are i.i.d. 's taking
values in (Ö, 00 ), provided < 00 a.s. vi
(e) By an analogous argument, assuming vj < 00 a.s., j = 0,1,2, ...
show that {S V ++ - SV + : j = 0,1,2, ... } is an i.i.d. sequence taking
j 1 j
values in (0, (0).
5.1.6. (a) Let M be given by (5.12) with k 2: 1 fixed. For n =
0,1,2, ... show that P(M = n)
f
N=1
P(v: = N)· P ( ~ Ze > 0, V j::::; n -1)
e=N+j+l
P ( L
N+j
Zq ::::; 0, V j > n
)
.
q=N+n+l
(b) Using (a), derive (5.13) and hence (5.11).

5.1. 7. Consider the renewal risk model with the net profit condition
(NPC) as given in Definition 5.3.
(a) Show that {sup Sn > x} decreases to a set of measure zeroas
~
xi 00.
5.5. Exercises 127
(b) Show that lim 'ljJ(x)

x->oo
= O.
(e) Show that R(t) --) +00 a.s. as t i 00.
5.2.1. a) Show that the moment generating function of Zl exists in

a neighbourhood of 0 if the moment generating functions of Xl and cA I
do.
b) In the Cramer-Lundberg model, mz exists in a neighbourhood of
o if mx does.
5.2.2. Complete the details of the proof of Proposition 5.6.
5.2.3. Applying Chebyshev's inequality to the random variable erz!
appropriately, where r is the Lundberg eoeffieient, establish (5.16) for
n=1.
5.2.4. Verify (5.20) - (5.22) in Example 5.8.
5.3.1. Let the claim size distribution function F x have a probability

density funetion. Show that the survival probability function <p(') is
differentiable and that <p' (.) is given by (5.28) for all x > O.
5.3.2. Under the hypotheses of Theorem 5.9 show that the ruin
probability 'ljJ(.) satisfies the integral equation
'ljJ(t) = (1
1
+ -
p) FX,I(t)
1
+ (1 + p) J t
'ljJ(t - x) dFx,I(x), t ~ 0
o
where F X,I denotes the tail of the integrated tail distribution Fx,I.
5.3.3. Give a proof of Theorem 5.10.
5.3.4. Let V have a eompound geometrie distribution with eharae-
teristies (p, Fu) where 0 < P < 1 and Fu is supported on (0,00). Show
that the distribution function of V is given by
L
00
Fv(x) = (1 - p) pk ~ ) ) X ~ O.
k=ü
5.3.5. a) Let V be as in Exereise 5.3.4. Show that F v satisfies the

defeetive renewal equation
Fv(t) = (1 - p) + (pFu * Fv)(t), t ~ O.

b) In fact, Fv given in Exercise 5.3.4 is the unique bounded solution

supported on (0,00) to the defective renewal equation in (a) above.
5.4.1. This exercise concerns the convolution equation (3.44) when

F is not a probability distribution. Let 0: > 0 be a constant, and G(·)
be the distribution function of a prob ability measure. Consider the
convolution equation
«(x) = J «(x - y) 0: dG(y), x E IR.

JE.
(i) If 0 < 0: < 1 show that «(-) == 0 is the only bounded solution to
the convolution equation. (Rint: Iterate).
(ii) Let 0 < 0: < 1. Let dG(y) = I(-oo,o)(Y) ß eßY dy; so G is
supported on (-00,0). Show that we can have solution of the form
«(x) = e>'x, x E IR.
(iii) Let 0: > 1. Let dG(y) = I(o,oo)(Y) ß e-ßYdy. Show that we can
have solution of the form «(x) = e>'x, x E IR. Thus it is possible to
have unbounded solutions to the convolution equation (3.44) if Fis not
a probability distribution.
5.4.2. Consider the Cramer-Lundberg model with the net profit
condition (5.26); denote p = ~ - 1.
(i) Show that (5.36) is equivalent to
J
00
eI/x Fx(x) dx =~
o
hence conclude that if a v > 0 satisfying (5.36) exists then it is unique.
(ii) If (5.36) holds, show that the claim size X has moment generating
function in a neighbourhood of O. So X is light..,tailed. (Rint: Use (4.4).)
(iii) Show that (5.36) holds {:} v is the Lundberg coefficient as defined
in Section 5.2.
5.4.3. Assume that the claim size X has moment generating func-
tion mx(-) in (-ho, ho), ho > 0 and that there is v E (0, ho) satisfying
(5.36). Show tha,t (5.38) holds, and in fact
J
00
x eI/x Fx(x) dx = )..lv ) ~) ) - cl

o
5.5. Exercises 129
where ~ ) denotes the derivative of mx(')'

5.4.4. Under the hypotheses of Theorem 5.14 show that the survival
probability 1,
that is, regularly varying with tail index 0: > 1. Show that the ruin
probability satisfies
'lj;(t) rv C(a-l) L(t), as t ---7 00,
where L is slowly varying.

Chapter 6
Lundberg risk process with investment
Around the same time Lundberg formulated his risk model, French
mathematician Louis Bachelier worked out a quantitative theory of
Brownian motion from a study of stock price fluctuations. (It is in-
teresting to note that Bachelier's pioneering work predated the famous
work of Einstein on Brownian motion by five years!) Though risk models
perturbed by Brownian motionjLevy process and diffusion approxima-
tion of risk processes have been studied since 1970's, (see Chapter 13
of [RSST]), interaction between these two important stochastic models
has been sporadic till recently.
Hipp and Plum [HP1, HP2] formulated a few years back a model
in which part of the surplus can be invested in a risky asset, and ob-
tained some interesting results. Such a model requires degeneracy of the
diffusion at the origin. A systematic study of the set up will be very
useful. This chapter is just an attempt at that. Needless to emphasize,
the results are far from complete.
In this chapter we consider the Cramer-Lundberg model with the
possibility of investments in a riskless bond and in a risky asset. The
investment strategy may help in reducing the ruin prob ability.
The prerequisites needed for this chapter are substantially more than
the earlier chapters. Reasonable familiarity with the Brownian motion
process, stochastic calculus, stochastic differential equations, and rudi-
ments of continuous time Markov processes will be helpful. Some of
the excellent books are [0], [Du], [KS], [lW], [BW]. We shall freely use
results from these sources, of course, with appropriate reference. A con-
eise account of Browian motion and Ito integrals is given in Appendix
A.4.
6.1. Lundberg risk process and M arkov property 131
6.1 Lundberg risk process and Markov property
Recall from Chapter 5 that the Lundberg risk process is given by (5.1)
where {N(t)} is a homogeneous Poisson process with rate). > o. In
the Cramer-Lundberg model, by Theorem 2.12 we know that the total
claim amount process {S (t)} has independent increments. Hence the
Lundberg risk process {R(t)} also has the independent increment prop-
erty. That is, R(·) is a Levy process. Though the Markov property is
intuitively obvious for a Levy process, we put it in a convenient form.
For t 2': 0 define F t = a{R(s) : 0 :S s :S t} = the smallest a-
algebra making the family {R( s) : 0 :S s :S t} measurable; here R( t) =
N(t)
x + ct - S(t) = x + ct - z=
i=l
Xi, t 2': 0 as given by (5.1). {Ft : t 2': O} is
the filtration generated by R(·).
If A, C are sub a-algebras in (0, F, P) such that P(A n C) = P(A) .
P(C) for any A E A, CE C we say that the sub a-algebras A and C are
independent. In addition, if C = a(Y) where Y is a random variable, we
say that the sub a-algebra A and the random variable Y are independent.
So the independent increment property of R(·) can also be stated as: for
any 0 :S s :S t, the sub a-algebra F s and the random variable R( t) - R( s)
are independent.
Lemma 6.1 Let A, ß, C be sub a-algebras of F such that ß ~ A, and A

and C are independent. Let ß V C = a{ß U C} be the smallest a-algebra
containing ßuC. IfY is a (ßVC)-measurable integrable random variable
then E(Y I A) = E(Y I ß) a.s.
Proof: Let
:J = {Q (Bi n Ci) : Bi E B, Ci E C, 1" i " n, n = 1,2, " ,} ,
It is easily seen that .:1 is an algebra, and hence ß V C = a(.:1). So

by standard measure theoretic arguments it is enough to consider Y =
Y1 Y2 where Y1 is bounded ß-measurable function and Y2 is bounded
C-measurable function. As A and C are independent note that E(Y2 I
A) = E(Y2) a.s. Note that ß and C are independent and hence E(Y2 I
ß) = E(Y2) a.s. It is now easily proved that E(Y1 Y 2 I A) = Y 1 E(Y2 I
A) = Y 1 E(Y2) = Y 1 E(Y2 I ß) = E(Y1Y2 I ß) a.s. 0
For any random variables Y, X we shall denote E(Y I X) ~ E(Y I
a(X)).
132 6. Lundberg risk process with investment
Proposition 6.2 (Markov property): Let t 2: O. For k = 1,2, ... ,

t < tl < t2 < ... < tk, B E ß(IR k ) we have
P((R(tI), . .. ,R(tk)) E B I Fd
P((R(tI), ... ,R(tk)) E B I R(t)) a.s. (6.1)
Proof: Put Et = a{R(u) : u 2: t}. In Lemma 6.1 take A = F t , ß =

a(R(t)), C = {R(u) - R(t) : u 2: t}. Note that Et = ß V C, and that A
and C are independent. 0
Let k 2: 1, 0 ::; SI < S2 < ... < Sk, B E ß(IR k ); take ti = t + Si,_ 1 ::;
i ::; k in (6.1). As the r.h.s. of (6.1) is a(R(t))-measurable, there is a
measurable function 9 on IR such that
P((R(t + SI), ... , R(t + Sk)) E B I R(t)) = g(R(t)).

It is clear that
g(y) P((R(t + sd, ... , R(t + Sk)) E B I·R(t) = y)

P((R(sd,··· ,R(Sk)) E B I R(O) = y)
E[IB(R(sd,···, R(Sk)) I R(O) = y]
_. Ey[IB(R(sd,.··, R(Sk))] (6.2)
where we have used time homogeneity of the Levy process R(·).

Using (6.1), (6.2) and standard arguments one can prove
Proposition 6.3 (Markov property): Let t 2: O. For k 2: 1, 0::; SI <

S2 < ... < Sk and any bounded measurable function f on IRk
E[J(R(t + sd,··· ,R(t + Sk)) 1Ft]

E[J(R(t + SI), ... ,R(t + Sk)) I R(t)]
Ey[f(R(SI),"" R(Sk))]ly=R(t), (6.3)
where r.h.s. of (6.3) stands for h(R(t)) with h denoting the measurable
function
h(y) Ey[f(R(sd, ... ,R(Sk))]

'- E[f(R(sd,···, R(Sk)) I R(O) = y]. (6.4)
Note: The right hand side of (6.3) is often written as

E R(t)[J(R(SI),'" ,R(Sk))]' This may be confusing to a beginner. A
better way of writing is touse the "inhomogeneous" notation. With

Si,f as above define
h(t, y) Et,y[f(R(t + Sl), ... ,R(t + Sk))]
= E[f(R(t + sd,··· ,R(t + Sk)) I R(t) = y]. (6.5)
In this case, by time homogeneity of Re) it follows that h(t, y) = h(O, y)

for all t 2': O. Thus there is no inconsistency. 0
Using the inhomogeneous notation, define the transition probability
function by
P(S,Xit,A) P(R(t) E A I R(s) = x)

_. Ps ,x(R(t) E A) = Es,x[IA(R(t))] (6.6)
for 0 :s: s :s: t,

x E IR, A E ß(IR). Note the connection with (6.2), (6.3),
(6.5). As the notation indicates Es,x denotes expectation w.r.t. Ps,x.
It is easily seen that (s, x, t) f--+ P(s, Xi t, A) is a bounded measurable
function for fixed A E ß(IR), and A f--+ P(S,Xit,A) is a probability
measure on ß(IR) for fixed s, x, t.
Proposition 6.4 The transition probability function satisfies the

Chapman-Kolmogorov equation, viz. for s :s: t :s: r, x E IR, A E ß(IR)
P(s,x;r,A) = J
IR
P(t,y;r,A) P(S,Xit,dy). (6.7)
Proof:
P(s, Xi r, A) Es,x[IA(R(r))]
Es,x[Es,x[IA(R(r)) I O"(R(t))]]
Es,x[Et,R(t) (IA(R(r))] (by (6.3), (6.5))
Es ,x[P(t, R(t)i ri A)] (by (6.6))
J P(t, R(t,W)i r, A) dPs,x(w)
J
n
P(t, Yi r, A) P(s, Xi t, dy) (by (6.6)).

IR
o
Time homogeneity of R(·) implies that for r, r' 2': 0, xE lR, A E ß(lR)
P(r', x; r + r', A) = P(O, x; r, A). (6.8)
Also the Chapman-Kolmogorov equation can be written as
P(O, x; t + s, A) = J
lR
P(O, y; t, A) P(O, x; s, dy) (6.9)
for s, t 2': 0, xE lR, A E ß(lR).

Our objective now is to identify the infinitesimal generator of the
Markov process R(·). For this we define the following semigroup of
operators. For any bounded measurable function f on lR, t 2': 0 define
Td(x) ~ Ex[f(R(t))] = E[f(R(t)) I R(O) = x], xE R (6.10)
Note that Tof == f. See Exercise 6.1.3 for elementary properties of

{Tt : t 2': O}.
For any function f on lR, we shall denote by ~f ) ~ f(x) respec-
tively the derivative, right derivative of f at x whenever they exist.
Definition 6.5 We shall denote by V the collection of all functions

f : lR -+ lR such that the following hold:
(i) f is a bounded right continuous function with 0 as the only possible
discontinuity point;
(ii) f(y) = constant, y E (-00,0);
(iii) the function f' is weIl defined, bounded and right continuous with
o as the only possible discontinuity point, where
i f(x), x>O
f'(x) = { ~f ) x=O (6.11)
0, x< O.
o
If f
E V, then f restricted to [0,(0) is an element of [0,(0), that Cl
is, f, f'
restricted to [0,(0) are bounded continuous functions.
As indicated in Chapter 5, ruin probability plays an important role.
However, ruin probability as a function of the initial capital, is not left
continuous at 0; see (6.21), (6.22) below and (5.26), (5.30). This is the
reason for accommodating certain discontinuous functions in the above
definition.
Theorem 6.6 For any J E V we have
1
lim - [Td(x) - J(x)] cf'(x) + >'E[J(x - X) - J(x)]
HO t
J
oe
cf'(x) + >. (J(x - z) - J(x))dFx(z)

o
~ LJ(x), x E IR. (6.12)
Here Fx denotes the common distribution Junction oJ claim size Xi; and
X denotes a generic random variable with distribution Junction Fx .
Proof: Note that the r.h.s. of (6.12) is well defined for any J E V.
Now conditioning with respect to N(t), we see that for t ~ 0, x E IR
Td(x) - J(x) = E[J(x + ct - S(t))]- J(x)

oe
L E[{J(x + ct - S(t)) - J(x)} I N(t) = n]P(N(t) = n)
n=O
[J(x + ct) - J(x)]P(N(t) = 0)
+E[{J(x + ct - XI) - J(x)} I N(t) = l]P(N(t) = 1)
+ L E[{J(x + ct - S(t)) - J(x)} I N(t) = n]P(N(t) = n)
e- At [J(x + ct) - J(x)]

+>.t e- At E[J(x + ct - Xd - J(x)] + o(t)
J1 (t) + h(t) + o(t), say, (6.13)
as t 1 o. Here we have used the independence of {X;} and {N(t)}, and

the fact that P(N(t) ~ 2) = o(t) far a Poisson process.
Let x ~ O. Then by mean value theorem
~ Jdt) = e- At ct ~) --t cf'(x), as t 1 0 (6.14)

t t
where 0 :S x < ~ < x + ct, for t > 0 with ~ possibly depending on t. If
x < 0 then x + ct < 0 for all sufficiently small t. As J is constant on
(-00,0), we now have J 1 (t) = 0 far all sm all t. So (6.14) again holds,
with J'(x) = O.
Next, by right continuity of J, and as c > 0, note that
J(x + ct - z) --t J(x - z) as t 1 0, for all z, for any x E IR. So by
the dominated convergence theorem we get
1
- h(t) A e->.t j[J(x + ct - z) - f(x)] dFx(z)
t
--t A j[J(x - z) - f(x)] dFx(z) (6.15)
as t 1 O. The required conclusion now follows from (6.13) - (6.15).

o
The integro-differential operator L defined by (6.12) is called the
infinitesimal generator of the Markov process R(·). The preceding result
says that Lf(x) = ~ Tt!(x) It=o for f E V, x E R The next result is
an extension of this idea.
Theorem 6.7 For any f E V, x E lR the function t f--t TI f (x) has right
derivative at any t 2: 0, and ~ Tt!(x) = T t Lf(x). Moreover for any
o ~ s ~ t,
t
Tt!(x) - Tsf(x) = j T r Lf(x) dr. (6.16)

s
Proof: By Exen;ise 6.1.8 note that Lf is a bounded right continuous

function on lR, and r f--t T r Lf(x) is a bounded continuous function for
fE V, x E R So r.h.s. of (6.16) is differentiable in t. Also by Exercise
6.1.7, l.h.s. of (6.16) is continuous in t.
Let f E V, x E R For any t 2: 0 note that
as h 1 0, by the semigroup property and Theorem 6.6. This proves the

first assertion of the theorem.
Next let s 2: 0 be fixed. For t 2: s put
t
H(t) = Tt!(x) - Tsf(x) - j Trf(x) dr.
s
By the preceding part of the proof, t f--t H(t) is continuous, has right
..
derIVatIve, and = 0, t 2: s. Also note that H ( s ) = O. We
d+ H(t)
--d-t-
now claim that H(t) = 0, t 2: s. To prove the claim we proceed as
in the proof of Lemma 0.8, pp.235-236 of [Dy, Vo1.2]. If possible let

H(td i=- 0 for some tl > 0; without loss of generality we may assume
H(h) > o. So H(tl) - H(s) > 0; hence there is E > 0 such that
H(tl) - H(s) > E(tl - s). Set ~ ) = H(r) - H(s) - E(r - s), r 2: s,
f = {r 2: s : ~ ) :S O}, and ro = supf. Clearly s E f, tl rf- f. So
continuity of H implies that ro i= tl. Hence ro < tl. For rE (ro,td note
that 0 < ~ ) :S ~ ) - ~ ) = H(r) - H(ro) - E(r - ro). Consequently
~ ) > E for all r E (ro, tl]. This contradicts d:fI (t) = 0, t 2: s.
Therefore the claim and hence (6.16) is proved.
o
Theorem 6.8 For f E 1) we have
J
t
Mf(t) ~ f(R(t)) - f(R(O)) - Lf(R(r)) dr, t 2: 0 (6.17)
°
is a martingale w. r. t. {:Ft }.
Proof: It is easily verified that M f ( t) is :Fr measurable and inte-

grable for any t 2: O. It remains to prove
(6.18)
By Markov property (Proposition 6.3) note that
E(f(R(t)) I :Fs ) Ey(f(R(t - s))) ly=R(s)

Tt-sf(y) ly=R(s) a.s. (6.19)
Again by the Markov property we have
E [IL!(R(UJJdU IF,] ~ IE(L!(R(U)) IF,Jdu
(I E y ( Lf (R( U - s))) dU) ~ )

( /Tu_,Lf(YJ dU) a.s. (6.20)
s y=R(s)
By (6.19), (6.20) we now obtain
E[Mf(t) - Mf(s) I Fsl
(Tt-,j(y) - J(y) - /Tu-,LJ(Y) dU)

y=R(s)
(Tt-,J(Y) - J(y) - l'TcLf(Y) dr)

y=R(s)
= 0 a.s.
by Theorem 6.7, proving (6.18). 0

Our next objective is to connect the ruin/survival prob ability with
the infinitesimal generator. Building on the definitions (5.3), (5.25)
given in Chapter 5, set
1jJ(x) = { P(TO < 00 I R(O) = x) = Px(TO < (0), if x 2: 0

(6.21)
1, if x< 0
'P(x) = 1 -1jJ(x), x E IR. (6.22)
Theorem 6.9 Assume that the claim size distribution Fx has a prob-
ability density junction. Assume also the net profit condition (NPC)
(5.26). Then 1jJ, 'P E D. Moreover
(i) 1jJ solves the problem:
L1jJ(x) = 0, x 2:0, 1jJ(x) = 1, x< 0, }.

(6.23)
lim 1jJ(x) = 0 '
x--->oo
(ii) 'P solves the problem
L'P(x) = 0, x 2: 0, 'P(x) = 0, x <0 }

lim 'P(x) = 1 . (6.24)
x--->oo
Proof: It is enough to prove the assertions concerning 'P. As Fx

has a probability density function, by Exercise 5.3.1, (5.27), (5.28) it
follows that 'P is clon
(0, 00 ). The same arguments also imply that 'P
has right derivative at x = 0, and that d;x'P is right continuous at x = O.
It is now clear that 'P E D.
6.1. Lundberg risk process and Markov property 139
By continuity of <p' on [0, (0), the expression (5.28) holds for all
°
x 2: 0. As <pe) = on (-00,0), and Fx is supported on (0,00) it is now
easily seen from (5.28) that L<p(x) ~ 0, x 2: 0. Finally, as the (NPC)
holds, by Exercise 5.1.7 (b) it follows that lim <p(x) = 1. 0
x---->oo
Theorem 6.10 Assume the net profit condition in the Cramer-Lundberg

model. Let 9 E V be such that
Lg(x) = °for x 2: 0, g(x) lim g(x) = 0.

= 1 for x< 0, x---->oo (6.25)
Then g(x) = 'l/J(x) = Px(ro < (0).
°
Proof: As 9 is constant on (- 00, 0) and F,x is su pported on (0, 00 ),
note that Lg(y) = 0, y < 0. So Lg(·) = on IR. Let x 2: 0. If R(O) = x,
by Theorem 6.8 it follows that g(R(t)) - g(x) is a martingale. So by the
optional sampling theorem g(x) = Ex [g(R(ro 1\ t))], for all t 2: 0.
°
By Exercise 6.1.10, R(ro) < and hence g(R(ro)) = 1, whenever
ro < 00. Therefore it follows that
g(x) lim Ex[g(R(ro 1\ t))]

ti 00
lim{Px(ro < t) + Ex [I{ro>t}g(R(t))]}. (6.26)
ti 00 -
As the net profit condition holds, by Exercise 5.1. 7 (c), R( t) ---- +00 a.s.
as t ---- 00. So on the set {ro = oo}, R(t) ---- +00 a.s. Since lim g(y) = 0,
yjoo
we ,now get ti
lim00
Ex [I{T<o>t}g(R(t))]
-
= 0. Consequently from (6.26) we
now get g(x) = lim Px(ro ~ t) = Px(ro < (0) = 'l/J(x) as required. 0
tjoo
Thus, if Fx has a density function, and if (NPC) holds, by Theorems
6.9, 6.10, it follows that the ruin probability 'l/JO is the unique solution
in V to the problem (6.25). So (6.25) can be used to find the ruin
probability. We illustrate this in the case of exponentially distributed
claim sizes. We follow [H].
b.
*.
Example 6.11 Let Fx = Exp (0), 0 > 0; so JL = E(x) = The net
profit condition here means c> AJL = Put h(x) = E['l/J(x - X)], xE
IR. Since 'l/J(.) = 1 on (-00,0) note that h(x) = 1, x < 0. For x 2: it °
is easily seen that
J
00
h(x) 'IjJ(x - z) () e-ozdz

o
e- ox + J x
'IjJ(z) () e-O(x-z)dz. (6.27)

o
Clearly h(·) is bounded continuous on IR. As 'IjJ is continuous on [0,(0),
from (6.27) it follows that h(·) is differentiable on (0, (0) and that d;xh (.)
exists at x = 0; moreover
h'(x) = _()e- OX - () J x
'IjJ(z) ()e-O(x-z)dz + ()'IjJ(x)
°
o
()['IjJ(x) - h(x)], x ~ (6.28)
°
and hence h' is bounded continuous on [0, (0); (that is h restricted to
[0,(0) is a CC-function). From L'IjJ(x) = 0, x ~ we get
-c 'IjJ'(x) = A h(x) - A'IjJ(X), x ~ 0. (6.29)
As the r.h.s. of (6.29) is Clon [0, (0), it now follows that 'IjJ is C 2
on [0,(0). So differentiating (6.29), and using (6.28), (6.29) we obtain
'IjJ"(x) = ~ 'IjJ'(x) , x ~ 0. That is 'IjJ(.) satisfies the ODE:
'IjJ"(x) + (c() ~ A) 'IjJ'(x) = 0, x ~ 0. (6.30)
Here note that 'IjJ"(0) = ~ ~ 'IjJ(x))] Ix=o. The general solution to

(6.30) is of the form
'IjJ(x) = K l + K 2 exp [- (c() ~ A) x] , x ~ °

where K l , K2 are constants. Since c ()> A, and x--+oo
lim 'IjJ(x) = is a °
requirement, it follows that K l = 0. So 'IjJ(0) = K2. As 'IjJ has right
°
derivative at we get 'IjJ'(0) = -K2 (cO;>"). Plugging the above values
in (6.29) with x = 0, and as h(O) = 1 we obtain K = Therefore 2 ;0.
'IjJ(x) = ~ {- (c() ~ A) x}, x ~ °
which agrees with (5.45) in Example 5.13. o
6.2. Risk process with investment 141
6.2 Risk process with investment
We continue with the Cramer-Lundberg model. Suppose the insurance

company invests part of its surplus in a riskless bond, say a bank deposit,
and the remaining part in a risky asset, say a stock. Let ( 2: 0 denote the
force of interest (Le. interest rate operating continuously). We assurne
that the price Z (.) of one unit of the risky asset is given by the classical
Samuelson model in terms of a geometrie Brownian motion, viz.
dZ(t) = bZ(t) dt + a Z(t) dB(t), t > 0 (6.31)
with initial value Z(O) = Zo > 0, where a, b > 0 are constants, and
{ B (t) : t 2: O} is a standard one dimensional Brownian motion inde-
pendent of the total claim amount process SC). Let A(x) denote the
amount invested in the risky asset when the surplus is x; so A(R(t))
would represent the amount invested in the risky asset at time t. The
remaining amount R( t) - A( R( t)) is invested in the bond. (If we ass urne
A(x) :S x that would be a budget constraint.) The function A(·) will be
treated as a control; it will be assumed to be a reasonably weH behaved
function. We will write R(A) (.) to denote the riskjsurplus process when
investment is made according to A(·) as above.
The two (random) "observables" of the system are the total claim
amount S(·), and the unit price ZU of the risky asset. We assume that
the processes {S (s) : s 2: O} and {Z (t) : t 2: O} are independent; this
means that the sub a-algebras a{S(s) : s 2: O} and a{Z(t) : t 2: O} are
independent.
Note that (6.31) stands for the stochastic integral equation
J J
t t
Z(t) = Zo +b Z(s) ds +a Z(s) dB(s), t 2: 0

o 0
where the last term on the r.h.s. is an Ito integral. The "dispersion" or
"volatility" factor a > 0 is indicative of fiuctuations in the price of the
risky asset; the "drift" factor b > 0 indicates the rate at which the risky
asset would appreciate in the absence of any volatility.
It is intuitively clear that the SDE for the current surplus R(A) (.)
corresponding to the control AC) can be written as (see Exercise 6.2.2)]
dR(A)(t) = c dt - dS(t) + A(R(A)(t-))[b dt + a dB(t)]

+ (. [R(A)(t) - A(R(A)(t-))] dt. (6.32)
142 6. Lundberg risk proces$ with investment
Note that dS(t) is meaningful as sampIe paths of S(·) are piecewise

constant. Since O"{N(s) : 0 ::; s < t} 0:/: O"{N(s) : 0 ::; s ::; t}, observe
that knowledge of {S( s) : 0 ::; s < t} does not help predict if there
would be a claim at time t. So A (R( A) (t - )) indicates that investment
decision at time t can depend only on information available before t (see
[H], [HP1, HP2]). However we know that the process N(·), and hence
the processes S(·) and R(A)(.), can have only finitely many jumps in
any finite time interval. So by continuity of Brownian paths and non-
atomicity of dt measure, it follows that the SDE (6.32) is the same (with
probability one) as the SDE
dR(A)(t) = c dt - dS(t) + A(R(A)(t)) [b dt + 0" dB(t)]

+ (. [R(A)(t) - A(R(A)(t))] dt. (6.33)
In (6.33) it is apparent how "drift" and "dispersion" are defined only

for x 2: 0, that is, when surplus is nonnegative. We need, however, to
specify these coefficients for all x to have a meaningful framework. A
natural way of doing this in our context is given below.
Let A : [0, (Xl) - t IR be a nice function. Define
O"(A) (x) = {O"A(X), x 2: 0 (6.34)

O"(A)(O), x < 0
b(A)( ) _ { c + bA(x) + (x - (A(x), x 2: 0

x - b(A)(O), x< 0 (6.35)
where c, b, 0" > 0, (2: o. The functions O"(A) , b(A) are respectively the
dispersion and drift coefficients corresponding to the control A ( .). The
stochastic process R(A) (.) is required to satisfy the SDE
R(A)(t) = R(A) (0) + J t

O"(A) (R(A)(s)) dB(s)
o
J
t
+ b(A) (R(A)(s)) ds - S(t), t 2: o. (6.36)

o
Let {B(r) : r 2: O}, {S(r) : r 2: O}, R(A) (0) be independent denoting

respectively a standard one dimensional Brownian motion, a compound
6.2. Risk pracess with investment 143
Poisson process (total claim amount process), areal valued random vari-
able. We assurne that {gt : t 2': O} is a right continuous filtration such
that o-{R(A) (0), Z(s), S(r) : 0::; s, r ::; t} ~ gt, t 2': o. We also assurne
that for each t 2': 0, {B(t+r) - B(t), S(t+a) - S(t) : r, a 2': O} is indepen-
dent of gt. Here 'right continuous filtration' means that gt is a nünde-
creasing family of sub o--algebras with the property gt = gt+h!3:. gt+hn
h>O
for each t 2': O. This is an important technical assumption making argu-
ments involving stopping times simpler; see [KS] and references therein
für details and nuances. By a strong solution to the SDE (6.36) we
mean a {gd-adapted process {R(A)(t) : t 2': O} with r.c.l.l. sampie paths
satisfying the equation (6.36) with probability one.
Note that the corresponding continuous diffusion with drift b(A) and
dispersion o-(A) is the solution to the Brownian driven SDE
J
t
y(A)(O) + o-(A)(R(A)(s)) dB(s)

o
J
t
+ b(A)(R(A)(s)) ds, t 2': o. (6.37)
o
It is weIl known that a unique strong solution of (6.37) exists when
o-(A), b(A) are Lipschitz continuous. Moreover the process y(A) (.) is a
strong Marküv process with continuous sampie paths. See [KS], [lW] for
more details and information; see also Appendix A.4.
~ 6.12 Let A : [0,(0) ----t lR be a Lipschitz continuous function;

that is, there is a con'stant K > 0 such that IA(x) - A(y)1 ::; Klx - Yl
for all x, Y 2': O. Define o-(A), b(A) respectively by (6.34), (6.35). Let
R(A)(O) be a mndom variable independent of the pracesses ZC), SC).
Then there exists a unique strang solution to the SDE (6.36).
Proof: We essentially follow the approach in [lW], which can be con-

sulted for more general results. (Thanks to Mrinal Ghosh for pointing
this out, replacing an, earlier long winded argument.)
Clearly o-(A) , b(A) are also Lipschitz continuous and satisfy a linear
growth condition. Note that discontinuities in R(A)C) occur only from
S(·). Let {Td denote the stopping times (w.r.t. the filtration generated
by S(·), and hence W.r.t. {gd) at which jumps of SC) occur; these are
Tn i 00 a.s.
°
the claim arrival times. We know that < Tl < T2 < ... < Tn < ... and
On the random interval [0, Td our (6.36) is just the Brownian driven
SDE (6.37) with y(A)(O) = R(A)(O); so y(A)C) is weH defined. Now put
R(A)(t) ={ ~) ) 0::; t < Tl

y( )(Tl-)-X l , ift=Tl
where Xl is the jump at Tl; note that Xl is the claim size for the
first claim. Clearly the above is the unique solution on [0, Tl]. By the
strang Markov property of B(·), SO note that R(A)(Td is independent
of {B (Tl + s) - B (Tt), S (Tl + r) - S (Td : s, r 2: O}; see [lW], [KS] for
detailed discussion on strang Markov property; abrief account is given
in Appendix A.4. So, with R(A)(Td playing the role of R(A)(O), repeat
the above procedure on h , T2) , using Brownian driven SDE on h ,T2)
to get R(A)(t) for Tl ::; t < T2 (and hence for t E [0, T2)). Then put
R(A)(T2) = R(A)(T2-) - X 2. This determines the solution uniquely on
[0,T2].
Praceed inductively to get the unique strang solution on [0, T n ] for
each n. As T n i 00 we are done. 0
A useful comparison result, which may be of independent interest, is
given next. Note that no moment conditions on claim sizes are assumed
Theorem 6.13 (Comparison result): Let the notation and hypotheses

be as in the preceding theorem.
(i) If R(A)(O) ::; y(A)(O) a.s. then
p(R(A)(t) ::; y(A)(t) for all 0::; t < (0) = 1.
(ii) Let 6,6 be random variables independent of B(·), SC) such that
6 ::; 6 o..s. Let R(i) be the solution to the SDE (6.36) with initial value
°
~ i = 1,2. Then P(R(1)(t) ::; R(2)(t) for alt 0::; t < (0) = 1.
(iii) Let R(A) (0) ::; yCA) (0). Then for any T > there exist constants
°
Cl, C2 > such that
for all °: ; t ::; T.

Proof: (i) On [0, Td both R(A), y(A) are one dimensional Brow-
nian driven SDE's. So by the comparison result on pp. 293-294 of
[KS], R(A)(t) ::; y(A)(t) for 0 ::; t < Tl a.s. Therefore, as Xl ~ 0

and y(A) is continuous, R(A)(Tl) = R(A)(Tl-) - Xl::; y(A)(Td. Next,
on (Tl, T2) again R(A)(.), y(A)(-) are one dimensional Brownian driven
SDE's. So invoking the comparison result from [KS] as before we get
R(A)(-) ::; y(A)(.) on [0,T2)' Proceed thus, and as Tn i 00 a.s., the re-
quired conclusion follows.
(ii) Similar to (i).
(iii) By part (i), note that I[o,oo)(R(A)(t)) . R(A)(t) ::; I[O,oo)(y(A)(t)) .
y(A) (t) ::; IY(A) (t) I. The assertion now follows by standard results on
Brownian driven SDE's; see p.289 of [KS]. 0
One of our objectives is to establish the Markov property and the
strong Markov property of the stochastic process R(A)(.), as weIl as to
identify the associated infinitesimal generator.
We shall write Ex [J(R(A) (t))] ~ E[f(R(A) (t))IR(A) (0) = x] to denote
expectation of f(R(A)(t)) when the initial value R(A)(O) = x.
The following result giving the FeIler property of the process R(A) (.)
is an important continuity property.
Theorem 6.14 (Feller property): Let A, a(A), b(A) be as in Theorem

6.12.
(i) Let Xn --) Xo. For n == 0,1,2, . . , let R(n) (.) denote the solution to
the SDE (6.36) with initial value Xn . Then for any T > 0
(6.38)
(ii) Let R(A) (.) be as in Theorem 6.12. For any bounded continuous
function f on IR, t > 0 the function x ~ Ex [J(R(A) (t))] is bounded
continuous.
Proof: (i) We first claim that for T >0
J
T
E la(A)(R(n)(s))1 2 ds < 00, n = 0, 1,2, ...

o
Indeed, denoting by y(n) the solution to the Brownian driven SDE (6.37)
with initial value X n , and using Theorem 6.13 (iii), we have
J
T
E la(A)(R(n)(s))1 2 ds
o
J
T
la(A)(0)1 2 E 1(_oo,o)(R(n)(s)) ds
o
J
T
+E 1[o,oo)(R(n)(s)) ·la(A)(R(n)(s))1 2 ds
o
J
T
< la(A)(0)1 2 T + 2K?E 1[0,00) (R(n) (s)) [1 + IR(n)(s)1 2 j ds

o
J
T
< (la(A)(0)1 2 + 2K?)T + 2K?C1 (1 + EIY(n)(0)1 2 ) e C2t dt

o
< 00
where K 1 > 0 is such that la(A)(y)1 ~ KIll + lylJ, Y ~ O.

t
By the claim J a(A)(R(n)(s)) dB(s), t ~ 0 is a continuous square
o
integrable martingale for n = 0, 1, 2, . . .. I t also follows that R( n) ( t) -
R(O)(t) , t ~ 0 is a continuous square integrable process, for n = 1, 2, ....
(Note that the above hold, though the claim sizes Xi may not even be
integrable. )
Now fix T > 0, and write
<Pn(t) = E [sup IR(n)(s) - R(0)(S)1 2 ] , tE [0, Tl, n = 1,2, ...

~ ~
By Doob's maximal inequality, Schwartz inequality and the Lipschitz

condition we get
tpn(t) ::; 31x n - xol 2 + 12E J t
la(A)(R(n)(r)) - a(A)(R(O)(r))1 2 dr
o
J
t
+3t E Ib(A)(R(n)(r)) - b(A)(R(O)(r))1 2 dr

o
J
t
< 31xn - xol 2 + (12 + 3T)K 2 tpn(s) ds.

o
So by Gronwall's inequality (see [0], [KS]) we get
tpn(t) ::; 31x n - xol 2 exp[(12 + 3T)K 2 t], 0::; t ::; T
whence (6.38) follows.

(ii) Let X n --7 Xo. We need to prove that
where t > 0, ja bounded continuous function. By (i), RCn)(t) --7 R(O)(t)

in probability. So there is a subsequence {nd such that R(nk)(t) --7
RCO)(t) a.s. and hence j(R(nk)(t)) --7 j(R(O)(t)) a.s. Apply the domi-
nated convergence theorem to conclude that
E[j(RCnk)(t))] --7 E[j(R(O)(t))]. This argument, in fact, shows that
for any subsequence {x nk } of {x n } there is a further sequence {Yp} such
that E[j(R(p)(t))] --7 E[j(R(O)(t))]. So the required conclusion follows.
o
Next we look at the Markov property of the process R(A)e).
Fix s > 0; let ~ be a random variable independent of
{B(t) - B(s) : t 2: s} and {S(t) - 8(s) : t 2: s}. Denote Qt
~ ) - B(s), 8(r) - 8(s) : s ::; r ::; t}, t 2: s. Consider the
SDE
dR(t) = a(A)(R(t)) dB(t) + b(A)(R(t)) dt - d8(t), t 2: s (6.39)
with initial value R(s) ~ By an easy adaptation of Theorem 6.12,

existence of a unique {Qt}-adapted strong solution to (6.39) can be
established; see Exercise 6.2.3. Consequently {R(A) (t) : t 2: s} is the
unique solution to (6.39) with R(s) = R(A)(s). Hence for t 2: s, R(A)(t)
is measurable w.r.t. a{RCA)(s), B(r) - B(s), 8(r) - 8(s) : s ::; r ::; t}.
Let t ~ 0 be fixed. Take A = (it, 8 = IJ"{R(A)(t)}, C = IJ"{B(r) -

B(t), S(r) - Set) : r ~ t}. Then 8 ~ A, and A and C are independent.
Put [t = IJ"{R(A)(r) : r ~ t}. By the preceding paragraph [t ~ (8 V
C). Using Lemma 6.1, and proceeding as in Propositions 6.2, 6.3 the
following result can be proved.
Theorem 6.15 (Markov property): Let A, {R(A) (t)}, {9d be as in

Theorem 6.12. Fix t ~ 0 and let A, 8, C be as above. Then jor any
(8 V C)-measurable, integrable random variable V
E(V I 9t) = E(V I R(A)(t)) a.s. (6.40)
In particular, jor k ~ 1, 0 :::; SI < S2 < ... < Sk and any bounded
measurable junction j on IR k
E[J(R(A)(t + sd, ... , R(A)(t + Sk)) I 9t]

E[j(R(A)(t + sd, ... , R(A)(t + Sk)) I R(A)(t)]
h(R(A)(t)) a.8. (6.41)
where h is the measurable junction on IR defined by
h(y) ~ Ey[J(R(A)(sd, ... , R(A)(Sk))]

.- E[j(R(A)(sd, ... , R(A)(Sk)) I R(A)(O) = y]. (6.42)
o
In fact, a stronger property holds, which is also very useful. Recall
that a random variable T taking values in [0, ooJ ~ [0,00) U {+oo} is
called a stopping time w.r.t. {9d if {T :::; t} E 9t for all t ~ o. Define
the pre-T IJ"-algebra
97 = {E E F : E n {T :::; t} E 9t for all t ~ O}.
Then 97 is a IJ"-algebra that can be considered as the repository of all in-

formation about the process R(A) upto time T. (See [KS], [SV2].) It can
be proved that T and R(A)(T) are 97-measurable; here the random vari-
able R(A)(T) is defined only on {T < oo} by R(A)(T)(W) = R(A)(T(W),W).
(See Exercise 6.2.5.)
Now let T be a finite stopping time w.r.t. {9t}. Using conditional
characteristic functions, it can be shown that {iJ (s) ~ B (T + s) - B (T) :
S ~ O} is a standard Brownian motion independent of 97. Similarly it
6.2. Risk pracess with investment 149
can be shown that {S(s) ~ S(T + s) - S(T) : S 2: O} is a compound

Poisson process independent of gT' and that the processes SO and S ( .)
are identical in law. See [KS]. Of course B(.), SO are independent
processes. We have already used these facts in the proof of Theorem
6.12. Observe that
R(Al(T + t) = R(Al(T) + J T+t

a(Al(R(Al(r)) dB(r)
T
J
T+t
+ b(Al(R(Al(r)) dr - (S(T + t) - S(T))
T
R(Al(T) + J t
a(Al(R(Al(T + r)) dB(r)

o
J
t
+ b(Al(R(Al(T + r)) dr - S(t).

o
So by uniqueness of solutions to SDE's ofthe form (6.36) w.r.t. BO, SO,
it follows that for any k 2: 1, 0 :S SI < S2 < ... < Sk < 00 the
k-dimensional random variable (R(Al(T + sd, ... , R(Al(T + Sk)) is mea-
- -
surable w.r.t. a{T,R (Al (T),B(r),S(r): r 2: O}.
Theorem 6.16 (Strang Markov praperty): Let A, R(Al, {gd be as in

Theorem 6.12. Let T be a finite stopping time w.r.t. {gd. Let 8 =
a{T, R(Al(T)}, C = a{B(T + r) - B(T), S(T + r) - S(T) : r 2: O}. Then
for any (8 V C)-measurable integrable random variable V
E[V I gT] = E[V I a{T,R(Al(T)}] a.s. (6.43)
In particular, for any k 2: 1, 0 :S SI < ... < Sk < 00 and any bounded
measurable function f on jRk
E[j(R(Al(T+Sl), ... ,R(Al(T+Sk)) I gT]

h(R(Al(T)) a.s. (6.44)
where h is given by (6.42).
Proof: Clearly B <;:; gT' and gT and C are independent. So, in

view of the discussion preceding the theorem, (6.43) follows by Lemma
6.1. As O"{R(A)(T + r) : r ~ O} ~ (8 V C), from (6.43) it is clear that

l.h.s. of (6.44) is O"{T, R(A) (T)}-measurable. Hence there is a measurable
function 9 : [0,00) x IR ----t IR such that l.h.s. of (6.44) = g(T, R(A)(T)) a.s.
Since O"(A) , b(A) do not depend on the time variable, and since B(·), SO
have stationary increments, time homogeneity now implies
= E[j(R(A)(t + SI), ... , R(A)(t + Sk)) I R(A)(t) = y]

g(t, y)
E[j(R(A)(sd, ... , R(A)(Sk)) I R(A)(O) = y] = h(y) (6.45)
completing the proof. 0

Remark: ActuaIly, it can be proved that any Markov process with
r.c.l.l. sample paths having the FeIler property is strong Markov.
As in Section 6.1 we want to investigate the connection between the
ruin probability of the Markov process R(A) and the generator. Fix A
satisfying the hypothesis of Theorem 6.12. It will transpire that we need
to impose additional conditions on the way. For t ~ 0 and measurable
function j on IR define
whenever r.h.s. makes sense. If j is bounded measurable, clearly Tt(A) j

is weIl defined, ~ = Tt(A) (T1 A)f) = T1 A) (Tt(A) f), and sup ITt(A) f(x)1 ~
x
sup Ij(x)l. Thus {Tt(A) : t ~ O} is a contraction semigroup of linear op-
x
erators on the space of bounded measurable functions (under the "sup"
norm). A function space suitable for our purposes is given below.
Definition 6.17 We shall denote by VI the collection of all functions

j : IR ----t IR such that the following hold:
(i) jE V; (that is, (i) - (iii) of Definition 6.5 hold);
(ii) the function f" is weIl defined, bounded and right continuous, with
o as the only possible discontinuity point, where
d2 f
dx'!(x), x>O
{
j'!( x) = ~ ~ j (x)) , x=O (6.47)
0, x< O.
Note that f"(0) is the right derivative of the right derivative of j at
x =0.
o
We know that the continuous process y(A) defined by (6.37) is the

one dimensional diffusion with drift b(A) (-) and dispersion o-(A) (.). By
!to's formula, for 9 E ~ )
g(y(A)(t)) - g(y(A)(O)) - J~ t
) )) ds
o
a continuous martingale, (6.48)
where
(6.49)
The martingale on r.h.s. of (6.48) is an Ito integral W.r.t. Brownian

motion. Consequently for 9 E ~ ~) x E IR.
lim ~ E[g(y(A)(t)) - g(y(A)(O)) I y(A)(O) = x]

tlO t
~ g(x). (6.50)
In particular, the second order differential operator ~ is the infinites-

imal generator of the diffusion y(A). For proofs of these assertions and
detailed discussions ab out the nuances see [KS], [BW], [Du] and refer-
ences therein.
Define the ruin time of the controlled risk process R(A) (.) by
(6.51)
Remark 6.18 Suppose o-(A)(-) is nondegenerate at 0; that is,

(o-(A)(0))2 > O. Assume that R(A)(O) = 0, which means that the ini-
tial capital is O. By continuity inf{(o-(A)(y))2 : y E K} > 0 for some
compact neighbourhood of O. Since the first jump time (= arrival time
of first claim) Tl > 0 a.s., the behaviour of R(A)(t) for small t is like
y(A)(t), which in turn is like the Brownian motion due to nondegener-
acy at O. Then by the "smudging effect" of Brownian motion it follows
that Ta A)= 0 a.s.; see Exercise 6.2.6. This is not a desirable situation
as we will explain now. If A == 0, that is, there is no investment in
risky asset, our process is basically like the Lundberg risk process R( ·).
For such a process starting at 0, we know that the ruin time is strictly
positive, and that the ruin probability is strictly less than one at least
when the net profit condition hold; see (5.30). See Exercise 6.2.7. So,
having a nondegnerate investment plan at 0 increases the ruin probabil-
ity. This is contrary to our objective, and hence nondegeneracy at 0 is
not desirable.
Lemma 6.19 Assume A(x) 2: 0 for x 2: 0, A(O) = 0, and b 2: (. Let

(J(A)(.), b(A)(-), y(A)(.) be as in (6.37). Let y(A)(O) 2: 0, and 1'0 =
inf{ t 2: 0 : y(A) (t) < O} = first hitting time of (-00,0) by the diffusion
y(A). Then P( 1'0 = (0) = 1 or equivalently
p(y(A)(t) 2: 0 for all t 2: 0 I y(A)(O) 2: 0) = 1.
Proof: By continuity of sample paths of y(A), it is enough to con-

sider the case y(A)(O) == O. Let p(Yo(A))-l denote the distribution ofthe
process y(A) starting at 0; this is a probability measure on the function
space Co [0, (0). Denote
H: = {h: [0, (0) --+ lR : h solves the ODE
J J
t t
h(t) = 0 + b(A)(h(s)) ds + ) h ))~ ) ds
o 0
for some cp E C oo (lR) }.
By the support theorem of Stroock and Varadhan (see [SVI]), support of
p(Yo(A))-l = closure of Hin Co [0, (0). As (J(A)(O) = 0, b(A)(-) 2: c > 0
and y(A)(O) = 0, any hE H will satisfy h(t) > 0 for all sufficiently small
t > O. So for any W in the support of p(yo(A))-l we have w(t) 2: 0 for
all sufficiently small t 2: O. Hence P( 1'0 > 0) = 1.
Next suppose P( 1'0 < (0) > O. By continuity of sample paths
y(A)(To(w)) = 0 for any w with TO(w) < 00. Then by the strong
Markov property of y(A) and the preceding paragraph, it follows that
y(A)(To(w) + t) 2: 0 for all sufficiently small t 2: 0 for a.e.w. This would
contradict the definition of To(w). Hence P(To = (0) = 1. 0
Proposition 6.20 Let A, (J(A) , b(A) satisfy the hypotheses of Theorem

6.12 and Lemma 6.19. Let the ruin time rJA) of R(A) be defined by
(6.51). If R(A)(O) 2: 0 then ruin can occur only at a jump time. Mo re-
over R(A) (rJA)) < 0 tL.S. on {rJA) < oo} for any starting point.
Proof: We need to consider only R(A)(O) 2: O. Suppose rJA)(w) <

00. The three possibilities are:
(i) TJA)(w) is a continuity point of R(A)(.,w);

(ii) TJA)(w) is a point of discontinuity and R(A)(TJA)(w)) = 0;
(iii) TJA)(w) is a discontinuity point and R(A)(TJA)(w)) < O.
In the first two cases R(A)(TJA)(w)) = o. As the claims arrive ac-
cording to a Poisson process, note that r](A) > TJA) where r](A) denotes
the next jump time after TJA) of R(A). Also, as TJA) is a stopping time,
by the strong Markov property, on [TJA) , r](A)) the process R(A) behaves
like y(A)(.) starting at R(A)(TJA)). Therefore by strong Markov property
and Lemma 6.19,
P (R(A)(t) < 0for some t E (TJA),r](A)) IR(A) (TJA)) = 0)

P (R(A)(t) < 0 for some 0 < t < TIIR(A)(O) = 0)
 0 ly(A)(O) = 0) = o.
Thus the first two cases can occur only with probability zero. 0
The next result identifies the infinitesimal generator of the Markov
process R(A)(.).
Theorem 6.21 Let A, a(A), b(A) satisfy the hypotheses of Theorem

6.12 and Lemma 6.19. Assume that i. i. d. claim sizes Xi are continuous
random variables. Let the semigroup {Tt(A)} be given by (6.46). Then
for fE VI
lim ~ [T(A) f(x) - f(x)] := L(A) f(x)

tlO t t
~ ~ (a(A)(x))2 1"(x) + b(A)(x) j'(x)
+A J [f(x - z) - f(x)] dFx(z), x E IR (6.52)

[0,00)
where Fx is the distribution function of claim size, and f', 1" are as in
Definitions 6.5, 6.17.
We need two lemmas.
Lemma 6.22 To prove Theorem 6.21 it is enough to consider f E VI

such that :3 K > 0 with f(y) = 0 for all y ~ K,
Proof: See Exercise 6.2.8. D
Lemma 6.23 Let the hypotheses of Theorem 6.21 hold. Let f E VI

be as in Lemma 6.22. Let Tl denote the arrival time of the first claim.
Then:3 a constant C independent of y, t such that
Proof: By independence of y(A)(.) and N(·) note that for any y E

IR, t?:' °
Ey [{ f (R(A)(t)) - f(y)} . I{rI>t}]
E y [{f (y(A)(t)) - f(y)}· I{Tl>t}]
e- At E y [f (y(A)(t)) - f(y)] .
So it is enough to prove that
(6.54)
where C is independent of y, t.
Let y ::::: O. Then by Lemma 6.19, y(A)(t) ::::: 0 for all t. By our
assumption on f, note that ~ ) f is bounded. Hence, as f is C 2 on
[0, (0), by (6.48) we get (extending f to a C;-function on IR ifnecessary),
whence (6.54) follows for y ?:' 0.

Next let y < 0, and rJ = inf{ s ?:' °:
y(A) (s) ?:' o}. Since f is constant
on (-00,0), y(A)(rJ) = 0, by strong Markov property of y(A) we have,
using (6.55)
E y [f (y(A)(t)) - f(y)]
Ey ~ . Eo [f (y(A)(t - rJ)) - f(O)]]
E y [I{"gj Eo [ ~~ f (yCA)(r)) drlJ· (6.56)

Boundedness of ~ f, and t - 'Tl ::; t now imply that (6.54) holds for
y< 0.
o
Proof of Theorem 6.21: We may assume that f is as in Lemma
6.22; and by Exercise 6.2.9 it is enough to consider x 2: 0. Fix x 2: 0.
Note that for t 2: 0,
Tt(A) f(x) - f(x) = Ex [{ f (R(A)(t)) - f(x)} . I{N(t)=O}]

+Ex [{ f (R(A)(t)) - f(x)} . I{N(t)=l}]
+Ex [{ f (R(A)(t)) - f(x)} . I{N(t)2 2 }]

Jo(t) + Jl(t) + h(t), say. (6.57)
°
Clearly h(t) = o(t), t 1 as f is bounded and P(N(t) 2: 2) = o(t), t 1 0.
On {N(t) = O}, we know that R(A)(s) = y(A)(s) 2: 0, 5(s) = 0, °: ;
s ::; t. So as (in the derivation of (6.55)) in the proof of Lemma 6.23,
using (6.48) and independence of y(A) and N we get
lim ~ Jo(t) = lim ~ Ex [f (y(A)(t)) - f(x)] . e- At

tlo t tlO t
~ ~ e- At Ex ~ f (yCA)(rl) dr]
~~) f(x) = ~ ((T(A) (x)f f"(x) + b(A)(x) f'(x). (6.58)
Here we have used the fact that ~ fis a bounded continuous function
when restricted to [0,00), because f is as in Lemma 6.22.
Next, on the set {N(t) = I} clearly 5(t) = Xl, the first claim size.
Therefore
Jl(t) E x [{f (R(A)(t)) - f(x)}, I{Tl::;t}' Ih>t}]
Ex [{ f (R(A)(t-fj - f (R(A)(TI))} . ~ . Ih>t}]

+Ex [{f (R(A)(Tr)) - f(x - Xr)}. ~ I{T2>t}]
+Ex [{f(x - Xr) - f(x)}· ~ . Ih>t}]
J l1 (t) + J 12 (t) + J I3(t), say. (6.59)
As Xl and N (.) are independent we now obtain

1 1
t J13(t) =t Ex [{J(x - Xt} - f(x)} IN(t) = 1] At e-,\t
Ae-,\t Ex[f(x - Xt} - f(x)]
-+ A J [f(x - z) - f(x)] dFx(z), as t 1 o. (6.60)
[0,00)
In view of (6.57) - (6.60), to complete the proof of the theorem we just

need to establish
. 1 . 1
11m - Jn(t) = 0, and hm - J 12(t) = O. (6.61)
tlO t tlO t
With t ~ 0 fixed, for 0 :S s :S t, Y E IR denote
Then by Lemma 6.23 there is a constant C independent of y, s, t such

that 1<p(s,y)1 :S C(t - s) . Therefore using the strong Markov property
of R(A) we get
IJll(t)1
= lEx [E [ {f (R(A)(t)) - f (R(A)( Tl)) } h~ h 1 1]]
97 I
lEx [Ih9} <p (Tl, R(A) (Tl) )] I

< CEx [(t - Tt} h~ :S Ct (1- e-,\t)
t
and hence Jn(t) -+ 0 as t 1 o.
We know, by Proposition 2.7, that the conditional distribution of Tl
given N(t) = 1 is the uniform distribution over (0, t). Consequently
1
- 1t2(t)
t
~ Ex [{f (R(A)(Tl)) - f(x - Xt}}1 N(t) = 1] At e-,\t
Ae-,\t Ex [ {f (y(A)(Tt} - Xl) - f(x - Xl) } I N(t) = 1]
J
t
Ae-,\t Ex [f (y(A)(s) - Xl) - f(x - Xt}] ~ ds.

o
Note that P(X I = x) = O. Since J is continuous except possibly at 0

it follows that J(y(A)(s) - Xd -> J(x - Xl) a.e Px as s 1 o. As J is
bounded we now have Ex[J(y(A)(s) - Xd - J(x - XdJ -> 0 as s 1 o.
t
Hence from the above it follows that JI2(t) -> 0 as t 1 o. Thus both
the assertions in (6.61) are now established, completing the proof. 0
Corollary 6.24 Hypotheses as in Theorem 6.21. Let J E VI. Then

(i) L(A) J is a right continuous function with 0 as the only possible
discontinuity point, (ii) L(A) J(x) = 0, x < 0, and (iii) IL(A) J(x)1 ~
C(1 + x 2 ), x 2:: 0 where C is a constant. In addition, if J'(O) = 0 then
L(A) J is continuous. 0
Proposition 6.25 Let hypotheses oJ Theorem 6.21 hold.. Let 9 be a

right continuous Junction with 0 as the only possible discontinuity point,
g(x) = go, a constant, for x < 0, and Ig(x)1 ~ K[1 + x 2 J, x 2:: O.
Then (i) Tt(A) g(x) is well defined for t 2:: 0, x E lR; also for to > 0,
there exist constants Cl, C 2 such that ITt(A)g(x) I ~ Cl + C 2 (x V 0)2,
Jor aU x E lR, 0 ~ t ~ to; (ii) lim Tt(A) g(x) = g(x), x E lR; (iii)
tl°
for fixed x E lR, tl--> Tt(A)g(x) is right continuous on [0,(0); (iv) for
fixed t 2:: 0, X I--> Tt(A) g( x) is a right continuous function. In particular,
putting 9 = L(A) J, with J E VI, we see that Tt(A) L(A) J(x) has the above
properties.
Proof: (i) We will prove the estimate in (i); weIl definedness will be
evident on the way. Let to > 0 be fixed. For any event U we denote
Px(U) ~ P(U I R(A)(O) = x). Consider first x 2:: O. By our hypotheses
on g, Theorem 6.13 and known estimates concerning Brownian driven
SDE's we get for 0 ~ t ~ to
ITt(A)g(X) I ~ IgO·Px(R(A)(t) <0)1

+ lEx [1[0,00) (R(A)(t)) . 9 (R(A)(t))] I
< Igol + KEx [1[0,00) (R(A)(t)) {I + (R(A)(t)f}]
< Igol + K + K Ex ~~f ly(A)(t)n
(6.62)
where Cl, C 2 are constants depending only on to, K, the Lipschitz and
growth constants of a, b.
Next let x < 0, and 1] = inf{t 2': 0 : RCA)(t) 2': O}. Since jumps are
negative it is clear that RCA) (1]) = 0 on {1] < oo}. Therefore by tlle
strong Markov property (Theorem 6.16) we obtain for 0 ::; t ::; to
ITtCA )g(x) I = IgOPx (1] > t) + Ex [I{1]::;t}g (RCA)(t))] I

IgOPx (1] > t) + Ex [I{7)::;t}ER (A)C7)) (g (RCA)(t -1])))] I
< Igol +C1 · (6.63)
In the last step we have used (6.62) with 0 as the starting point. Thus
part (i) follows from (6.62) and (6.63).
(ii) Let x < O. As aCA)(y) = 0, bCA)(y) = C > 0 for y < 0, it is
clear that RCA)(t) < 0 and hence g(RCA)(t)) = g(x) if t < ~ So the
required conclusion is evident.
Next let x 2': O. By right continuity of S(·) and continuity of Ito
integrals in t, we see that RCA)(t) -- x a.s. as t 1 o. At any x > 0, 9
is continuous and hence g(RCA)(t)) -- g(x) as t 1 0 for x > O. Suppose
x = O. Since Tl > 0 a.s., note that RCA)(t,w) = yCA)(t,w) for small t,
a.e.w. So by Lemma 6.19, R(A)(t,w) 2': 0 for small t, for a.e.w. Hence
right continuity of 9 at x = 0 now implies g(RCA)(t)) -- g(O) a.e. Thus
g(R(A)(t)) __ g(x) a.s. as t 1 0, for any x 2': o. Now the quadratic
growth condition on 9 and the comparison result (Theorem 6.13) imply
for all 0 ::; t ::; 1; cf. (6.62). As the r.h.s. of the above is known
to be integrable, an application of the dominated convergence theorem
completes the proof of (ii).
(iii) See Exercise 6.2.11.
(iv) Let t > 0 be fixed; (for t = 0 there is nothing to prove). Let
X n 1 xo. For n = 0,1,2, ... let RCn)(.) denote the solution to the SDE
(6.36) with initial value x n . Let y > 0 be such that Xo ::; Xn < Y for
all n. Let Y (.) be the solution to the Brownian driven SDE (6.37) with
initial value y. By the comparison result (Theorem 6.13) we have
RCO)(t) ::; RCn)(t) ::; Y(t) a.s. for all n. (6.64)
By Theorem 6.14 (i) we have RCn)(t) -- RCO)(t) in probability. So, for
any subsequence {x n' } of {x n } there is a further subsequence {x n" } such
that R(n") ----+ R(O)(t) a.s. As 9 is right continuous, (6.64) now implies
that g(R(n")(t)) ----+ g(R(O) (t)) a.s. By our hypothesis on 9 and (6.64) we
see that
Ig(R(n")(t))1 SC1 +C2 IY(t)1 2 , foralln".
Since Y (t) is square integrable, by dominated convergence theorem
E[g(R(n") (t))] ----+ E[g(R(O) (t))] as n" ----+ 00. So any subsequence has a
further subsequence converging to E[g( R(O) (t))]. Therefore
E[g(R(n)(t))] ----+ E[g(R(O) (t))] as n ----+ 00; that is Tt(A) g(x n ) ----+ Tt(A) g(x)
whenever X n 1 xo. Hence Tt(A) g(.) is right continuous, completing the
proof. D
Lemma 6.26 Let the hypotheses of Theorem 6.21 hold. For fE 1)1, xE
lR, t 1-+ Tt(A) f(x) is a continuous function on [0,00).
Proof: Though we need to prove only left continuity at t > 0, our
proof will also give continuity at t > O. We follow the approach in [Dy] ,
VoLl, p.35; we just sketch the proof.
Let 0 < a < b < t, 0 < s < t - h, s < t, h small. As ~ ) : r ~ O}
is a contraction semigroup,
.- sup ~~f ) - Tt(A) f(x)1

xEIR
~~~ ITi A) ~~ f ) - ~f ) 1
< II T(A)
t-h-s f - T(A)fll·
t-s (6.65)
Integrating the above w.r.t. s from (t - b) to (t - a),
J
t-a
(b - a) ~~f - Tt(A) fll s ~~ - ~f ds

t-b
J11
b
~~ - ~ )) fll dr. (6.66)

a
Since r 1-+ ~ ) fll is integrable over [0, t + 1], by Exercise 6.1.6, r.h.s.
of (6.66) tends to 0 as h ----+ O. In fact we have proved t 1-+ Tt(A) f is
continuous in the 'sup' norm. D
In the proof above, note that f', 1" do not enter the picture; only
boundedness of f is used. This leads to the next lemma
Lemma 6.27 In addition to the hypotheses of Theorem 6.21, let A(·)

be bounded. Then t f--t Tt(A) L(A) f is cantinuous on [0,00) in the sup
norm, for any f E VI .
Proof: Note that L(A) f is bounded in this case. So the proof of

preceding lemma applies to L(A) f. D
Proposition 6.28 Assurne the hypotheses of Theorem 6.21. For any

f E VI, x E ~ the function t f--t ~ ) f(x) has right derivative at any
t ~ 0, and ~ T/ A ) f(x) = Tt(A) L(A) f(x)j also the right derivative is
right continuous on [0,00). Moreover for :s: s :S: t°
Tt(A) f(x) - T1 A ) f(x) = J~ ) t
L(A) f(x) dr. (6.67)
s
Proof: By the semigroup property and Theorem 6.21
~ f ) - Tt(A) f(x)
h
Tt(A) {* ~ ) f(x) - f(X)]}
-> Tt(A) L(A) f(x), as h 1 ° (6.68)
proving the first assertion. As Tt(A) f(x) and T/ A )L(A) f(x) are respec-
tively continuous and right continuous functions of t (by Lemma 6.26
and Proposition 6.25), by Lemma 0.10 on p.237 of [Dy], vo1.2, (6.67)
and (6.68) are equivalent. D
The next result is the analogue of Theorem 6.8.
Theorem 6.29 Under the hypotheses of Theorem 6.21, for any fE VI,
any nonnegative square integrable R(A)(O),
Mt)(t) = f (R(A)(t)) - f (R(A) (0))
-J
t
L(A)f (R(A)(s)) ds, t ~ ° (6.69)

o
is a martingale w.r.t. {gd.

Proof: By Corollary 6.24 and Theorem 6.13, for 0 :::; s :::; t we have
IL(A)f(R(A)(S))1 < I[O,oo)(R(A)(s)) IL(A)f(R(A)(s))1
< K 1[0,00) (R(A)(s)) [1 + IR(A)(s)n

< K[1+ly(A)(s)n
< ~~~ ly(A)(r)n
where y(A)(O) = R(A)(O). It follows that L(A) f(R(A)(s)), 0:::; s :::; t and
MY) (t) are integrable. In view of the preceding proposition, imitating
the proof of Theorem 6.8 the required result can now be established. 0
Next, define the ruin probability of the process R(A)(.) by
'lj!(A) (x) ~ Px (T6 A) < (0) = P (T6 A) < ooIR(A)(O) = x) ,x ~ 0

1, x <0 (6.70)
and the survival probability by
(6.71)
A connection between survival prob ability and the infinitesimal genera-

tor is indicated below
Theorem 6.30 In addition to the hypotheses of Theorem 6.21, assurne

that for any x E IR
Px (R(A)(t) ~ +00 as t i (0)

P ~~ R(A)(t) = +ooIR(A)(O) = x) = 1. (6.72)
Let u E VI be such that
(i) L(A)U(X) = 0, if x ~ 0 }
(ii) u( x) = 0, if x < 0 and . (6.73)
(iii) lim u(x) = 1
x-oo
Then u(x) = 'P(A) (x), x E IR.

Proof: It is easily checked that LCA)u(x) = 0 for x < 0; thus

LCA)u(-) == 0 on JEt Now fix x 2: O. By Theorem 6.29 it follows that
u (RCA)(t)) - u(x) = Px - martingale W.r.t. Hit}.
So by the optional sampling theorem
u(x) = Ex [u (RCA) (T6 A) !\ t) )] for all t 2: O.
It may be noted that T6 A ) is a stopping time W.r.t. {gd as the filtration

is assumed to be right continuous. As RCA)(T6 A)) < 0 on {T6 A) < oo} by
Proposition 6.20, and u(·) = 0 on (-00,0) we now get
u(x) ~~ Ex [u(RCA) (T6 A) !\t))]
~~ Ex {[Icü,t) (T6 A)) . u (RCA) (T6 A)))]
+ [Irt,oo) (T6 A)) . u (RCA)(t))]}
~~ Ex [Irt,oo) (T6 A)) .u(RCA)(t))]. (6.74)
Now by (6.72), (iii) of (6.73) and (6.74) it follows that u(x) = Px (T6 A ) =
(0) = <p(A)(x). 0
The requirement (6.72) means that the process RCA)(.) wanders off
to +00 with probability one. Recall that the analogous property of
the Lundberg risk process R(·) played a key role earlier; the net profit
condition ensured this property for R(·) by Theorem 5.1 and Exercise
5.1.7. We want tü give a sufficient condition für (6.72) to hold. Für this
we need a lemma
Lemma 6.31 Assume the hypotheses of Theorem 6.21. In addition as-

sume that the net profit condition holds, that is,
(c - >. E(Xd) > 0; (in particular, it is assumed that the claim size
distribution has finite expectation E(XI)). Then ~ )) < 00 for any
r, x E IR, where ~ ) = inf{t 2: 0 : RCA)(t) 2: r}. Consequently the
process R(A) (.) hits [r, (0) in finite time with probability one.
Proof: The result holds trivially if x 2: r; so it is enough tü consider

x < r. Now take constant h 1 > 0 so that
h1(c - >'E(XI)) 2: 1. Put f(x) = hlX, X E JEt By Exercise 6.2.13,
t
f(R(A)(t)) - f(x) - J L(A) f(R(A)(s)) ds, t ?: 0 is a Px-martingale. Fix
°
!
r > O. Then for x < r, t > 0 by optional sampling theorem
Ex [,/;A) /\ tl < Ex [ "L(A) f (R(A)(s)) ds 1

Ex [f (R(A) ~) 1\ t))] - f(x) :s h 1(r - x).
In the above we have used ) ~ ) = r since the jumps are negative.

Letting t i 00 we have the desired result. 0
The next result is motivated by results concerning transience of con-
tinuous diffusions; proof follows that of Proposition 4.1 of [BR].
Theorem 6.32 Let the hypotheses of Theorem 6.21 and the net profit
condition (5.26) hold. Suppose there exist ro > 0, u E 1)1 such that
(i) u ?: 0 and non-increasing, (ii) u is strictly decreasing on [ro, 00), and
(iii) L(A)u(·):s 0 on [ro, 00). Then (6.72) holds.
Proof: Let r1 > ro be arbitrary; let T{A) = inf {t ?: 0 : R(A) (t) :s r1}.
We claim that Px (T{A) < 00) < 1 for all x > r1. Suppose not; then there
is x > rl with Px(T{A) < 00) = 1. By Theorem 6.29, option al sampling
theorem and (iii) above, for any t > 0
u(x) > Ex [u (R(A) (Ti A ) 1\ t))]

> Ex [I[O,t) (T{A») . u (R(A) (Ti A»))] .
Consequently
as R(A)(T{A») :s r1 and u nonincreasing. This contradicts assumption

(ii) of the theorem. Hence the claim holds.
Now let rl, r2 be arbitrary such that ro < rl < r2. By the above
paragraph and part (ii) of Theorem 6.13 it follows that
sup{Px (Ti A ) < 00) : x?: r 2} Pr2 (Ti A ) < 00)

~ 8< 1. (6.75)
Let x E IR. Define (1 = inf{t 2 0 : R(A)(t) 2 r2}, and inductively for

i = 1,2, ....
(2i inf {t > (2i-l : R(A)(t) :::; r l } ,
(2i+l inf {t > (2i : R(A)(t) 2 r2} .
By the strong Markov property, (6.75) and Lemma 6.31 we have for
i 2 1
Px (R(A)(t) :::; rl (0)

for a sequence of t's i
< Px ((2i < (0) = Ex [I{(2i_l<00} . ((2i-1l (Ti A) < (0)]
PR(A)
< 8P < (0) = 8 P

x ((2i-l < (0) : :; 8
x ((2i-2 i.
As 8 < 1 it now follows that
Px (liminf R(A)(t) > r l ) = 1.

t->oo
Since rl > ro is arbitrary, the required result now follows. o

Example 6.33 In addition to the hypotheses of Theorem 6.21, assume
the following
(i) A(O) = 0, A(x) > 0, x> 0, A(·) nondecreasing;
(ii) ( 20, b> (, and there exist constants 0"1 > 0, b1 > 0 such that
for all x 2 1, 0"2(A(x))2 :::; O"r and [(x + (b - ()A(x))] 2 bl ;
(iii) Claim sizes Xi, i 2 1 are i.i.d. random variables having expo-
nential distribution with parameter () > 0;
(iv) net profit condition (5.26) holds; so ~) > o.
Note that O"(A) (.) is bounded, while b(A) (.) will be bounded only if
(=0.
For suitable function f write for x > 0
~~ f ) = ~ 0"2(A(x))2 f"(x) + [(x + (b - ()A(x)]f'(x),
J
00
Ljumpf(x) cf' (x) +A (f(x - z) - f(x)) dFx(z),

o
so that
L(A) f(x) = ~~ f ) + Ljumpf(x), x> o.

Now choose a constant Ko such that
0< K o < mm
. {2bar' (), -;l () (
c- 7i).) } . (6.76)
Define
u(x) = { exp( -Kox), x2:0

1, x::;O
Then it can be shown that ~ ~ ) ::; 0, Ljumpu(x) ::; for x 2: 1; °

°
hence L(A)u(x) ::; for x 2: 1. Consequently by Theorem 6.32 it follows
that R(A) (t) ----+ +00 with probability one. See Exercise 6.2.14. D
Remark 6.34 We shall continue with the set up as in Example 6.33.

Suppose u E VI solves the problem (6.73); in such a case, by Theorem
6.30, u(x) = <p(A)(x), X E IR, the survival probability. As the claim size
has an exponential distribution, we shall try to mimic the approach in
Example 6.11. Put
E[u(x - X)] = E[<p(A) (x - X)]
J
00
<p(A) (x - z)() e- oz dz, xE R

o
Since <p(A) (y) = ° for y < 0, it is easily seen that
J
x
h(A)(x) = e- ox <p(A)(y) () eOYdy, x 2: 0. (6.77)

o
As u is continuous on [0, (0), by (6.77), h(A) is continuously differentiable
on [0,(0); here we mean right differentiability at x = 0. Hence
(h(A))' (x) = (J [<p(A) (x) - h(A)(X)] , x> 0. (6.78)
Since L(A)u(x) = L(A)<p(A) (x) = 0, x> ° we get
~ )) )) ) + [(x + (b - ()A(x)](<p(A))'(x)
+c(<p(A))'(x) +). h(A) (x) -). <p(A) (x) }

= 0, x> o. (6.79)
Now assume in addition that A(·) is continuously differentiable on [0, 00).

Then (6.78), (6.79) imply that ip(A) is thrice continuously differentiable
on (0,00). Differentiate (6.79), and use (6.78), (6.79) again to obtain
~ )) (ip(A))"'(x)
2
{ ~ ) + (/2 A(x) A'(x) } ( (A))"(x)

+ +(x + (b - ()A(x) + c ip
[( + (b - ()A'(x) - A]
{ +O[c+(x+(b-()A(x)] } (A)'
+ (ip ) (x)
0, x> O. (6.80)
Note that (6.80) is a third order ODE. However, if we put w(x) ==

w(A)(x) = (ip(A))'(x), x > 0, clearly (6.80) is a second order ODE for
w(·). We want a nonconstant solution to (6.80). In fact w(·) should
satisfy, as it is a density function on (0,00),
J
00
w(x) > 0, x> 0 and w(x) dx = 1 - ip(A)(O). (6.81)

o
Since A(O) = 0 note that x = 0 is a singular point for the ODE (6.80).
In general the singularity can be irregular; (see [CL] for a discussion
on singular points of ordinary differential equations). Even if A(x) rv
QX, X 1 0, the point x = 0 is not a regular singular point. It is not clear
how to handle the ODE (6.80) so that (6.81) is satisfied. 0
Further investigations concerning the process R(A)(.) and the oper-

ator L(A) (.) are needed to get sharper results. Even good examples will
be helpful.
Hipp and Plum have considered the problem of optimal investment
policy that minimizes the ruin probability; see [HP1], [HP2]. This is,
however, beyond the scope of this introductory text.
6.3 Assorted comments
In this section we briefly comment on some topics not (adequately)

discussed in the text.
Primary among them are insurance models based on finite state-
space Markov chains. Life insurance models, pension funds, bonus-malus
6.3. Assorted comments 167
models in motor insurance fall under this category. Time horizon in

such models may be much longer compared to collective risk theory;
moreover, there may be absorbing states. See [RSST], [KGDD] and
appropriate references therein.
Reinsurance, which concerns insuring insurance companies, has not
been touched upon. There are various types of reinsurance, like propor-
tional reinsurance, stop-loss reinsurance, excess-loss reinsurance, etc.
Usually reinsurance is very expensive so that the primary insurer is
discouraged from shifting the entire liability to the reinsurer. [RSST],
[EKM] , [M] are good starting points.
Ruin problems for renewal risk models continue to be investigated,
especially with interarrival times being Erlang distributions or phase-
type distributions, and claim sizes being heavy tailed. Finite time ruin
probability, deficit at ruin, surplus just before ruin are useful quantities.
Semi-Markov models are also studied. For example see [As], [AB].
Heavy tailed distributions, especially subexponential distributions,
attract attention for their own sake. [MN], [DDS] are recent examples.
Methods from optimization theory play significant role in insurance
modelling. Strong suggestions to such an interplay were given forty years
back by Borch in his seminal paper [Bc]; however, only recently some of
these are being realized. As discussed in Section 6.2, insurance models
with possibility of investment are being considered only now even for the
Cramer-Lundberg framework. Amount invested in risky asset can be
considered as a control, and one may seek to minimize ruin probability
or maximize dividend payment. This naturally brings in ideas from
control theory. See [T], [H], [HP1], [HP2]. Another instance of such
an interaction concerns reinsurance involving two or more interacting
companies with each trying to get an optimal deal. Ideas from game
theory can not be far away; see [Aa], [Ra].
For multidimensional risk models see [BG], [Ra] and references therein.
There is more to insurance besides mathematical modelling. There
are statistical quest ions like estimation of various parameters in the
models, fitting appropriate claim size (or loss) distributions, etc. Some
of these are addressed in [Bd]. Certain underpinning ideas from eco-
nomics and finance have been indicated respectively in Sections 3.4.1
and 6.2; see [Bc], [Aa] for more of the former, and [H], [T] and refer-
ences therein for more of the latter. Many practical issues are discussed
in [BCHJKPR]. Of late, many methods from insurance are being applied
to advantage in risk management involving banking and other financial
institutions; an authoritative account is given in [MFE].
6.4 Exercises
6.1.1. For t 2: 0 let Et be as in the proof of Proposition 6.2. For any

Et-measurable integrable random variable Y show that
E(Y 1Ft ) = E(Y I R(t)) a.s.
This is, in fact, equivalent to (6.1).

6.1.2. Let A E F t , CE Et . Show that
P(A n C I R(t)) = P(A I R(t)) . P(C I R(t)) a.s.
(Hint: E[IA1c I R(t)] = E[E[IA1C I F t ] I R(t)] a.s.). We know that

F t can be regarded as the repository of all information concerning the
"past", Et as that of the "future", and a(R(t)) as the "present". So
the exercise means that conditional on the "present" (that is, given the
"present"), the "past" and the "future" are independent. In fact this
not ion can be shown to be equivalent to the Markov property.
6.1.3. Let Tt , t 2: 0 be defined by (6.10); j, JI, 12 below denote
bounded measurable functions.
(i) Show that Td is well defined, bounded and
Td(x) = J j(z) P(O, x; t, dz), xE R

lR
(ii) Show that Tt(fl + 12) = Tdl + Tth·

(iii) (Semigroup property:) For t, s 2: 0 show that
(iv) Show that sup ITd(x)1 ~ sup Ij(x)l.

xElR xElR
6.1.4. For j E D show that Lj(x) = 0, x < 0 and Lj(O) = cj'(O).
(Hint: Recall that Xi > 0 a.s.)
6.1.5. Show that (6.12) holds also for any bounded continuously
differentiable function j on IR.
6.4. Exercises 169
6.1.6. Let 0: : [to, tI] -t IR be an integrable function. For any

[so, SI] C (to, td show that
J
SI
lim Io:(s + h) - o:(s )Ids = O.

h-+O
So
In particular the assertion holds for any bounded measurable function.
(Rint: Result holds for continuous functions. For any closed set A C
(to, td, approximate JA pointwise by bounded continuous functions.)
6.1. 7. (a) Let 9 be a bounded right continuous function, and t 2 O.
Show that x f--t Ttg(x) is bounded and right continuous.
(b) Let 9 be as in (a). For any x E IR, show that t f--t Ttg(x) is
continuous on [0,00). (Rint: By semigroup property it is enough to
show that Ttg(x) - t g(x) as t 1 o. Condition w.r.t. N(t), and use (a).)
6.1.8. (a) For J E V show that LJ is a bounded right continuous
function on IR.
(b) Let J E V, x E IR. Show that t f--t TtLJ(x) is continuous on
[0,00).
6.1.9. If, for some J, the convergence in (6.12) is uniform over x,
show that t f--t Ttf (x) is differentiable for each x.
6.1.10. Show that R(TO) < 0 whenever TO < 00. (Rint: Suppose
that R(TO) = O. Then using right continuity of sampIe paths, and by
taking suitable subsequences, if necessary, there exists {td such that
tk 1 TO, R(tk) i O. As R(·) is strictly increasing in between jumps, this
means there is a jump in [tk+I, tk]' Arrive at a contradiction).
6.2.1. (i) Using stochastic calculus show that (see [KS]) Z(·) satis-
fying (6.31) is given by
Z (t) = Zo exp { (b - ~ 0'2 ) t + aB (t) }, t 2 O.
(ii) Show that the total claim amount SO and the unit price Z(·)
of the risky asset are independent as processes {:} {Xj , N (s) : j
1,2, ... ,s 2 O} and {B(t) : t 2 O} are independent.
(iii) For any t 2 0 show that O'{Z(u),S(r) : 0 ::; r,u ::; t}
O'{B(r), S(u) : 0::; r, u::; t}.
(iv) It will generally be assumed that b > (. Why is this a reasonable
assumption?
6.2.2. (i) Let (}(t) = number of units of the risky asset bought at
time t. So A(R(A)(t-)) = (}(t) Z(t) = amount invested in risky asset at
time. (Why?) Argue that R(A) is governed by the SDE
dR(A)(t) = c dt - dS(t) + (}(t) dZ(t)
+(. [R(A)(t) - (}(t) Z(t)] dt, t > O.
Using Exercise 6.2.1 (i), now obtain (6.32).
(ii) Show that the SDE's (6.32) and (6.33) are the same with prob-
ability one.
6.2.3. Formulate a suitable not ion of a strong solution to (6.39),
and establish the analogues of Theorems 6.12 - 6.14 for the SDE (6.39).
6.2.4. Work out the details of the proof of Theorem 6.15.
6.2.5. (i) Let T be a stopping time w.r.t {9d and 97 the associated
pre-T O"-algebra. Show that 97 is indeed a O"-algebra, and that T is 9 7-
measurable. (It can be shown that R(A) (T), defined on {T < oo}, is also
97-measurable; see p.9 of [KS].)
(ii) Show that the jump times Tn , n ~ 1 and the ruin time T6 A ) are
stopping times w.r.t. {9d; (for the second assertion you may need the
assumption that the filtration {9d is right continuous, that is, 9t =
9t+ ~ n
h>O
9tH for all t ~ 0).
6.2.6. The purpose of this exercise is to show that nondegeneracy
of the dispersion coefficient at x = 0 leads to immediate ruin of R(A).
Let A, O"(A) , b(A), R(A), y(A) be as in (6.36), (6.37). Let the ruin time
T6 A) of R(A) be defined by (6.51) and put 1'0 = inf{t ~ 0 : y(A)(t) <
O}. Assume that (0"(A)(0))2 > 0; so by continuity, inf{(0"(A)(y))2 : y E
[-xo, xo]} > 0 for some xo > o.
(i) To prove P(T6 A) = 0 [ R(A)(O) = 0) = 1 it is enough to prove that
P(To = 0 [ y(A)(O) = 0) = 1.
(ii) Show that one may assume without loss of generality that b(A) ==
O. (Hint: Enough to prove that P(ToI\T = 0 [ y(A)(O) = 0) = 0 V T > O.
Then use Girsanov's theorem for continuous diffusions; see p.202 of [Du]
or p.302 of [KS].)
t
(iii) Now we can take y(A)(t) = J O"(A)(y(A)(s)) dB(s), t ~ o.
o
Assume that inf (0"(A)(y))2 > O. Using Theorem 3.4.6, p.174 of [KS]
yElR
(or Theorem 4.4, Chap. 3, p.113 of [Du]) conclude that y(A) is a time-
changed Brownian motion. Then use Blumenthal's 0-11aw (p.14 of [Du]
or p.94 of [KS]) to conlcude that P( 1'0 = 0 [ y(A) (0) = 0) = 1.
6.4. Exercises 171
(iv) Remove the ad hoc assumption inf (a A )(y))2 > 0.

yE IR
6.2.7. Let A == 0, c > 0, ( ~ 0. Let Re, denote the corresponding
risk process; (this means that investment is made only in the riskless
bond). If Re,(O) ~ 0, show that the ruin time is strictly positive, and
that the ruin probability is strictly less than 1.
°
6.2.8. Give a proof of Lemma 6.22.
(Rint: Fix x E IR, f E 1)1; let K > which will be chosen suitably. Let
fK E 1)1 be such that x + K > 0, fK(Y) = f(y), Y :s: x + K, fK(Y) = 0,
Y ~ x + 2K, and IlfKlloo := sup IfK(y)1 :s: sup If(y)1 =: Ilflloo. By
comparison result Theorem 6.13 and Chebyshev's inequality, for all < °
t :s: 1,
~ Ex [f (R(A)(t)) - fK (R(A)(t))]
< ~ 211fll 00 Px (y(A)(t) - x ~ K)

< ;2t 211fll00 Ex (ly(A)(t) - x1 2 ) •
°
Using standard arguments for SDE's driven by Brownian motion, show
that for :s: t :s: 1, Ex(ly(A)(t) - x1 2 ) :s: ct where c is a constant
°
independent of t, x, K.)
6.2.9. For f E 1)1, X < show that both sides of (6.52) are zero.
°:
°: °
(Rint: As the jumps are negative, note that T/o ~ inf {t ~ R(A) (t) ~
O} = inf{t ~ R(A)(t) = O}. Since a(A)(-) = 0, b(A)(-) = c > on
(-00,0), clearly T/o ~ ~ lxi a.s. Px , for x < 0.)
°
6.2.10. Take A(x) = ax, x ~ in Lemma 6.19, where a > is a
constant. Show directly (without invoking the support theorem) that
°
the conclusion of the lemma holds.
6.2.11. (a) Let 9 be as in Proposition 6.25; (assume also the hy-
potheses and notation of Proposition 6.25). For h ~ set gh(Y) =°
~ ) ) ) Y E IR. By (ii) ofProposition 6.25, lim gh(Y) = 0, Y E IR.
hlO
Using (i) of Proposition 6.25 for t ~ 0, O:S: h :s: 1, show that
Igh (R(A)(t)) I :s: Cl + C2Iy(A)(t)12.

°
(b) Show that Tt(A)9h(X) --+ as h 1 0, for fixed t ~ 0, x E IR, to
prove part (iii) of Proposition 6.25.
6.2.12. Supply the details of the proof of Lemma 6.26. (Justify the
measurability and integrability assumptions.)
6.2.13. In addition to the hypotheses of Theorem 6.21, assume that

the i.i.d. claim sizes Xi have finite expectation. Let h be a constant and
f(x) = hx, xE R Show that for any x E .IR,
J
t
f (R(A)(t)) - f(x) - L(A) f (R(A)(s)) ds, t ~0
o
is a Px-martingale w.r.t. {gd. (Rint: Note that the given expression is

the same as
Now use the proof of Theorem 6.14 (i).)

6.2.14. Let the notation and hypotheses be as in Example 6.33.
(a) As K o < 2bI/O'i, using condition (ii) in Example 6.33 show that
~ u(x) ~ 0, x ~ 1.
(b) Verify that
J
00
[u(x - z) - u(x)] dFx(z) = (Ko1_ 0) AKo[e- Bx - e- Kox ], x> o.

o
Now using (6.76) and (NPC) show that L jump u(x) ~ 0 for x ~ 1.
Appendix
A.l Basic not ions
We review here some basic notions of probability theory. Detailed ac-

counts can be found in any text book on probability theory, for example,
[Bl2], [Bo], leT], [P2], [VI].
Let (0" F, P) be a probability space. Here 0, is a nonempty set, and
F is a nonempty collection of subsets of 0, satisfying the following:
(i) rjJ E F, 0, E F;
(ii) B E F =} the complement Be E F;
00
(iii) Bi E F; i = 1,2, ... =} U Bi E :F. The collection F is called a

i=1
a-algebm (or a a-field) of events. Pis a probability measure on (0" F);
that is, P : F - t [0, 1] such that
(a) P(rjJ) = 0, p(0,) = 1, and
(b) if Bi E F, i = 1,2, ... with Bi n B j rjJ whenever i i= j, then
P (gI Bi) = ~ P(Bi ).

A function X : 0, - t IR is called a (real valued) mndom variable
(abbreviated r.v.) if X- 1 (E) E F for any Borel set E in IR; so a random
variable is a Borel measurable function. This is equivalent to saying
X-I (G) E F for any open set G ~ IR. For areal valued random variable
X, define
Fx(x) ~ P(X- 1 ((-oo,x])) ~ P(X ~ x), x E IR. (A.1.I)
The function F x is called the distribution junction of the random vari-
°
able X. It can be easily proved that F x is a nondecreasing right contin-
uous function on IR with Fx(-oo) ~ lim Fx(x) = and Fx(+oo) ~
xl-oo
lim Fx(x) = 1. Also the set of discontinuity points of Fx can be at
xi+oo
174 Appendix
most countably infinite.

If there is a countable subset C = {Xl, X2, ... } of IR such that P(X E
C) = 1 then X is called a discrete random variable; in this case C is the
set of discontinuity points of Fx. For such a random variable put
x(x) ~ { P(X = xk) ~ Pk, if x = xk for some k, (A.1.2)

p 0, otherwlse
The function Px on IR is called the probability mass Iunction of the

discrete random variable X. Note that Pk 2': 0 V k and 2: Pk = 1. If
k
C = {O, 1, 2, ... } then X is a nonnegative integer valued r.v.
If Fx is a continuous function then X is said to be a continuous
random variable; in this case, for any fixed x E IR note that P(X = x) =
O.
If there is a nonnegative integrable function Ix on IR such that
J
x
Fx(x) = Ix(y) dy, x E IR (A.1.3)

-00
then X is said to be an absolutely continuous random variable; the func-

tion I X in (A.1.3) is called the probability density function (or p. d.J. for
short) of X. Note that J Ix(x) dx = 1.
IR
For areal valued random variable X one can define a probability
measure Vx on the real li ne by Vx (B) = P(X-l(B)), for any Borel set
B ~ IR; this probability measure Vx may be called the distribution 01
X. Clearly Fx(x) = vx(( -00, x]), x E IR. If X represents the random
characteristic under study, all the relevant information is captured by
Fx or equivalently by Vx. Consequently the focus of attention can be
Fx or Vx.
For a Borel measurable function 9 on IR, if
J
IR
Ig(x)1 dFx(x) == J
IR
Ig(x)1 d vx(x) < 00
then we say that E(g(X)) exists; in such a case, we define
E(g(X)) ~ J g(x) dFx(x) == J g(x) dvx(x). (A.1.4)

IR IR
A.l. Basic notions 175
As F x is a monotone function, Stieltjes integral W.r.t. dFx (-) rnakes

sense and is the same as integral W.r.t. the rneasure dvx(-). If X is a
discrete r.v. then E(g(X)) = L g(Xk) Pk, provided the surn converges
k
absolutely. If X is an absolutely continuous randorn variable with p.dJ.
(Xl
fx then E(g(X)) = J g(x) fx(x) dx, provided the integral exists.

-(Xl
E(X k ) is called the k-th moment of X; E(X) is known as expectation

or mean of X. Variance of X is given by Var(X) ~ E[(X - E(X))2].
In a sirnilar fashion, an JRn-valued rneasurable function on a prob-
ability space is called an JRn-valued mndom variable. Such a randorn
variable can be represented as (Xl, X 2 , ... ,Xn ) where each Xi is areal
valued randorn variable. Also if Xi is areal valued randorn variable for
i =, 1,2, ... ,n then (Xl, X 2 , ... ,Xn ) is an JRn-valued randorn variable.
An JRn-valued r.v. (Xl,"" X n ) is said to be absolutely continuous if
there is a nonnegative integrable function f(Xl'''''X n ) on JRn such that
for any ai < bi , i = 1, ... ,n we have
P(al < Xl :S bl , a2 < X 2 :S b2,·.·, an < X n :S bn)
J... J J
bn b2 b1
f(Xl, ... ,Xn)(XI, X2,'" ,Xn) dXI ... dxn.

an a2 al
Here the function f(Xl, ... ,Xn) is also referred to as the joint probability
density function of Xl, X 2, ... , X n . We may also say that Xl, X2, ... , X n
are jointly distributed according to f(x 1 , ... ,Xn )·
Real valued randorn variables X I ,X2 , ... ,Xn are said to be indepen-
dent if for any Borel sets BI, B 2, ... ,Bn in JR
P(X I E BI, X 2 E B 2, ... ,Xn E B n)

P(X I E BI) . P(X2 E B 2)··· P(Xn E B n )·
If real valued absolutely continuous randorn variables X I, X 2 , ... , X n are

independent note that the JRn-valued randorn variable
(Xl, X 2 , ... , X n ) is also absolutely continuous and
(A.1.5)
for all (Xl, X2, ... ,x n ) E JRn.

Let Xl, X2,'" ,Xn have ajoint prob ability density function f(Xl, ... ,Xn )'
176 Appendix
For a Borel measurable function 9 on ]Rn we define
J... J
00 00
g(Xl,""Xn) f(Xl, ... ,Xn)(Xl, ... ,Xn) dXl···dx n

-00 -00
provided the integral exists. In particular let Xl, X 2 have joint p.dJ.
f(Xl,X2); let X l ,X2 have finite expectations ml,m2 respectively. One
can then define the covariance between Xl, X 2 by
JJ
00 00
(Xl - md(x2 - m2)f(Xl,X2)(Xl,X2) dXl dX2 (A.1.6)

-00 -00
whenever the integral on the r.h.s. exists. If Xl, X 2 are indepen-

dent r.v.'s having finite means, then E(X 1 X 2 ) = E(X l ) . E(X2) and
Cov(X l , X 2 ) = 0; the converse is not true. In general if E(Xf) <
00, E(Xi) < 00 then E(X l ), E(X 2 ), Cov (Xl, X 2 ) exist.
An important aspect of probability theory is the study of sums of
independent identically distributed random variables; these arise at least
as a first step of stochastic modelling in various situations.
Let X, Y be independent random variables with respective distribu-
tion functions Fx, Fy. Then the distribution function of X + Y is given
by
(Fx * Fy)(z) == (Fy * Fx )(z) ~ J Fx(z - y) dFy(y), z E IR. (A.1.7)

lR
Fx * Fy is called the convolution of Fx and Fy. Thus if X, Y are inde-

pendent then Fx + y = Fx * Fy. Let X, Y be independent r.v.'s having
a common distribution function F; in such a case the distribution of
X + Y is governed by F*(2) ~ F * F. In the same spirit if Xl, X 2, ... , X n
are independent identically distributed random variables (i.i.d.r.v. 's, for
short) then the distribution function of Xl + X2 + ... + X n is the n-fold
convolution F * ... * F = F*(n). In terms of distributions, (A.1. 7) can
be written as
(l/X * 1/y)(G) == (l/y * I/x)(G) ~ J

lR
I/x(G - y) dl/y(Y)
for any Borel set G ~ IR. So if Xl, X 2 , . .. ,Xn are i.i.d.r.v.'s with com-
mon distribution 1/, then the distribution of Xl + ... + X n is the n-fold
convolution 1/*(n) = 1/ * ... * 1/.
Various not ions of convergence are possible in the context of random
variables. Let X n , n 2': 1 and X be random variables. We say that
{Xn } converges to X almost surely (or with prabability one) if:J M E F
such that P(M) = 0 and Xn(w) ~ X(w) for w tJ. M; in other words
P(lim X n = X) = 1. This is often denoted X n ~ X a.s. or X n ~ X
w.p.1. We say that {Xn } converges to X in prabability if for any f > 0
lim P({w: IXn(w) - X(w)1 2': f}) = O.

n->oo
Almost sure convergence is stronger than convergence in probability.
Next, suppose F n , n 2': 1 and F denote the corresponding distribution
functions. We say that {X n } converges to X in distribution (or in law,
or weakly) if lim Fn(x) = F(x) whenever x is a continuity point of F;
n->=
this is equivalent to
lim
n->oo J
IR
g(z) dFn(z) = J
IR
g(z) dF(z)
for any bounded continuous function g, or in terms of the corresponding

distributions
~ J g(z) d1/n(z) = J g(z) d1/(z)
for any bounded continuous function g. This is denoted X n .!!:.. X, X n ~

X, X n =} X, Fn =} F or 1/n =} 1/. (Since this not ion depends only on
the distribution of the random variables, X n 's and X need not even be
defined on the same prob ability space.)
We now state two basic limit theorems of probability theory.
Theorem A.1.1 (strang law of large numbers): Let Xl, X 2 , ... be a

sequence of independent identically distributed random variables with
finite expectation m. Then
1
- (Xl + X2 + ... + X n ) ~ m a.s. as n ~ 00. (A.1.8)
n
1f {Xd are i.i.d nonnegative random variables then (A.l.B) holds even
ifm = +00. 0
178 Appendix
The preceding theorem forms the philosophical basis for taking av-
erages in many situations.
Theorem A.1.2 (Lindeberg-Levy form of central limit theorem): Let

{Xn } be a sequence of i.i.d. random variables with finite nonzero vari-
ance. Put Sn = Xl + ... + X n , Zn = ~ ) , n 2: 1. Then for any
n ar(Xl)
aS:b
J~
b
~~ P(a< Zn S: b) = ~ dx. (A.1.9)

a
D
The above classical centrallimit theorem provides the mathematical

basis for bulk of statistics, and explains the prevalence of the Gaussian
(or normal) distribution in diverse disciplines.
Some issues related to the central limit problem are briefly outlined
in Appendix A.2.
Some important one dimensional distributions are given below.
1. Discrete Uniform distribution: Let Xl, ... , X K be distinct points

in lR, where K is a fixed integer. The probability mass function
in this case is PX(Xi) = -k,
1 S: i S: K and px(x) = 0 if X 1= Xi
for any i. In this case E(X) is just the average of the numbers
Xl,··· ,XK·
2. Binomial distribution: Let n 2: 1 be an integer and 0 < p < 1.

Let px(-) be given by
px(k) = ~) pk(l-pt- k , k=O,l, ... ,n
and px(x) = 0 if X rf- {O, 1, ... , n}. This is the binomial distri-
bution with parameters n and p. In this case E(X) = np and
Var(X) = np(l - p).
3. Poisson distribution: Let A > O. Here the discrete random

variable X takes value in {O, 1, 2, ... } with probabilities
An
px(n) = P(X = n) = e- A -" n = 0,1,2, ....
n.
This is the Poisson distribution with parameter A; and E(X) = A,
Var (X) = A.
4. Geometrie distribution: Let 0 < P < 1, X take value in

{0,1,2, ... }and
px(j) = P(X =j) =p(l-p)i, j = 0,1, ....
The discrete distributions (1) - (4) above have finite moments of

any order. Let 0 < p < 1 be fixed, and Xl, ... , X k be inde-
pendent random variables; if Xi has a binomial distribution with
parameters ni and p for 1 ::; i ::; k then Xl + X 2 + ... X k has a
binomial distribution with parameters nl + ... + nk and p. Simi-
larly, if Xl, X 2, ... ,Xn are independent random variables with Xi
having a Poisson distribution with parameter Ai, 1 ::; i ::; n, then
Xl + X 2 + ... + X n has a Poisson distribution with parameter
Al + ... + An.
Next we list so me absolutely continuous distributions.
5. Uniform distribution U(a, b): Here a < band the probability

density function is
1
fx(x) = (b _ a) I(a ,b) (x).
6. Exponential distribution EXp(A): Here A > 0 and the p.d.f. of

the exponential distribution with parameter A is given by
fx(x) = { Ae->'x, x>O

0, otherwise.
It is easily seen that E(X) = ±' Var(X) = -b.

7. Normal distribution N(J-L , a 2): Let J-L E IR, a 2 > 0 be constants
and
fx(x) = _1_ ~ exp { __l_(X - J-L)2} , x E IR.

~ a 2a 2
The above f x is called the p.d.f. of the normal distribution with
mean J-L and variance a 2. When J-L = 0, a 2 = 1 the distribution
is called the standard normal distribution. If Xi has N(J-Li,
distribution for 1 ::; i ::; k, and Xl, ... ,Xk are independent then
an
Xl + X 2 + '" + Xk has N(J-LI + ... + J-Lk, ai
+ ~ + ... + ~)
distribution. Observe that Theorem A.1.2 basically says that
d
Zn --+ N(O, 1).
180 Appendix
8. Gamma distribution r(a, A): Let a > 0, A > 0 be constants,

and let the p.d.f. be
),''' a-l -AX x >0

fx(x) = { real x e ,
0, otherwise.
If Xl, X 2 are independent random variables having respectively

r(al, A), r(a2, A) distributions then Xl + X 2 has r(al + a2, A)
distribution. Note that r(l, A) = Exp (A).
All the distributions (1) - (8) are light-tailed.
A.2 On the central limit problem
The classical central limit theorem says that if {Xi} is an Li.d. se-
quence with finite nonzero variance, then ~ ) is asymptotically
Vn ar(xI)
standard normal (in the sense of convergence in distribution), where
Sn = (Xl + X 2 + ... + X n ), n 2: 1 denotes the sequence of partial sums.
So, if variance exists then the partial sum Sn is approximately normal (or
Gaussian) for large n; this approach has proved to be extremely useful.
There are also very interestingjsignificant extensions giving asymptotic
normality.
However, when second moments do not exist the above result is of
limited use, as it does happen in actuarial context involving heavy tailed
distributions. Still, a discussion of the centrallimit problem gives a good
perspective regarding motivation for the various definitions encountered
in the sequel. It may be mentioned that the central limit problem was
investigated purely as a mathematical curiosity, and many outstanding
results were obtained by Levy, Doeblin, Kolmogorov, Khinchin, FeIler
and others.
Motivated by the CLT, the following quest ion is meaningful.
Question: What are the possible nondegenerate limit distributions for
partial sums Sn (of Li.d.'s) when suitably centered and normalized?
This is related to the following definition.
Definition A.2.1 Let G be a distribution function on IR such that J1c #

<Sx for any x E IR. A distribution function F is said to belong to the
domain of attraction of C if there exist constants an > 0, bn E IR, n =
1,2, ... such that ~ ~ C, where Sn = Xl + ... + X n , n 2: 1 with
{Xd being a sequence of i.i.d. 's with distribution function F.
A.2. On the central limit problem 181
In view of the above definition, if G has a domain of attraction the

following property is not surprising.
Definition A.2.2 A distribution R is stable if for each n > 1 there

exist constants Cn > 0, In E IR such that
where Yl , Y 2 , ..• ,Yn are i.i.d. 's with Ras distribution function, and Y
also has R as its distribution function.
It is clear that the normal distribution is stable.

This definition immediately implies that a stable distribution is a
limit law.
Proposition A.2.3 R is stable {:} for any real numbers Cl, C2 and Y,
Yl , Y 2 independent random variables with common distribution function
R, there exist constants C i= 0, I such that Cl Yl + c2 Y 2 :1:. cY + I' Thus
the class of stable distributions coincides with the class of distributions
closed under convolutions and multiplication with real numbers, upto
changes of location and scale. 0
The connection between our quest ion and the definitions above is
the following
Theorem A.2.4 A nondegenerate distribution G is a limit law of par-

tial sums of i.i.ds. 's
{:} G is a nondegenerate stable distribution
{:} G is nondegenerate and has a domain of attraction. 0
Note: Degenerate distributions are excluded because any sequence of

partial sums Sn of LLd.'s can be made to converge to zero after suitable
scaling. Indeed let {Xd be i.i.d.'s. Put Sn = lXII + ... + IXn I, n 2: 1.
Let {an} be a sequence of positive numbers such that P(ISnl > Fn) =
P(Sn > y'a n ) < ~ n 2: 1, and an ---> 00. Then it can be shown that
~ °
an ---> in probability. Therefore ß..
an ---> ° in probability, and hence
in distribution. This is not an interesting situation because the scaling
factor an is too large to detect any pattern in the bahaviour of Sn.
182 Appendix
In fact one can say more than the preceding theorem. A major role
is played in the analysis by the function
V(x) = J y2 dP(y), x> 0, (A.2.1)

[-x,x]
where P is the common distribution function of the i.i.d. summands.

Also the following property proves critical.
Definition A.2.5 A positive measurable function L on (0,00) is said

to be slowly varying at 00 if
. L(tx)
11m - (-)
x--->oo L x
= 1, for any t > O. (A.2.2)
This is a concept introduced in classical analysis by Karamata in the

context of Tauberian theorems. See [BGT].
Theorem A.2.6 (a) P belongs to the domain of attraction of the nor-

mal distribution if and only if V is slowly varying at 00. (This is the
case whenever second moment exists.)
(b) P belongs to the domain of attraction of a nonnormal stable
distribution if and only if
V(x) rv x 2-O: L(x), as x --; 00, (A.2.3)
and
1 - P(x) P(-x)
-1---P-(-x)-+--'---'-P-(--x-) --; p, 1 _ P(x) + P( -x) --; (1 - p), as x --; 00,
(A.2.4)
where 0: E (0,2), L is slowly varying, 0 :S p :S l.
(b)' (equivalent form of (b)): P belongs to the domain of attraction
of a non normal stable distribution if and only if
1 - F(x) = Cl + 0(1) L(x), F( -x) = C2 + 0(1) L(x), as x --; 00

xO: xO:
(A.2.5)
where 0 < 0: < 2, L(.) is slowly varying at 00, Cl ::::: 0, c2 ~ 0 are
constants such that Cl + C2 > O.
Note: (1 - F(x)) is the right tail of the distribution while P( -x) is

the left tail.
A.2. On the centml limit problem 183
Remark A.2.7 As can be discerned from the theorem ab ove , the pa-
rameter a E (0,2] plays a dominant role in the description of a stable
distribution. To give an idea of this, let X be a random variable with
distribution function F. Suppose the eorresponding Fourier transform
(or eharaeteristie funetion) is given by
(A.2.6)
°
where e > 0, < a :S 2 are eonstants, and i = A. Then F is a stable
distribution. Note that a = 2 eorresponds to the Gaussian ease. In this
ease the random variable X is symmetrie about the origin, and henee is
°
also ealled the symmetrie a-stable distribution. For < a < 2 it ean be
shown that X has finite moments only of order < a. A representation
for the eharaeteristie function/Fourier transform of a nonnormal stable
distribution ean be given, with a E (0,2) onee again determining tail
behaviour and existenee of moments. See [Fe], [EKM], [L], ... In fact,
for studying stable distributions, Fourier transforms seem to be most
amenable to analysis. 0
Suppose F belongs to the domain of attraetion of C, where ILc is non-

degenerate. Then there exist constants an > 0, bn such that ~ !!:. G.
How ean an > 0, bn be chosen?
Remark A.2.8 (i) If F has finite non zero variance (]"2, then we know
from classical CLT that bn = n E(XI), an = y'n (]".
(ii) Let G denote symmetrie a-stable distribution. Let {Xi} be an
i.i.d. sequence distributed aeeording to C. Let Sn = Xl + ... + X n , n :2:
1. As Xi 's are symmetrie about 0, it is natural to take bn = as the °
centering faetor. Now Sn ~ anX I by definition of stable distribution for
some an > 0. So by (A.2.6), for t E IR
'PS n (t) = 'Pan X! (t) = E[eitanX!]

'PX! (ant) = exp( -e I ant IQ) = exp( -c ~ I t IQ)· (A.2.7)
As Sn = Xl + ... + X n , again by (A.2.6), for t E IR
(A.2.8)
Prom (A.2.7), (A.2.8) it is clear that an = n l / Q is the natural ehoice.

184 Appendix
In general the following choices can be made. If E xl = 00 and

0: = 2, or
0: E (0,2) then an = nl/aL(n) where L is an appropriate
slowly varying function. If 0: E (1,2] then bn = n E(Xd. If 0: E (0,1)
then bn = O.
The above considerations lead to the following definition and the
subsequent theorem.
Definition A.2.9 We say that F belongs to the domain of normal at-

traction of an o:-stable distribution G, if F belongs to the domain of
attraction of G and if the normalization an = c n l / a , where C > 0 is a
constant, can be chosen.
Theorem A.2.10 (a) F belongs to the domain of normal attraction of

Gaussian distribution {:} F has finite variance.
(b) Let 0: E (0,2). Then F belongs to the domain of normal attrac-
tion of an o:-stable distribution {:}
(A.2.9)
for constants Cl ::::: 0, c2 ::::: 0 with Cl + c2 > O.
Remark A.2.11 Even though it can be proved that stable distributions

have probability density functions, closed form express ions are known
only when 0: = 2 (Gaussian), 0: = 1 and symmetrie (Cauchy), and
0: = !and one sided (inverse Gaussian). This could be one reason why
stable laws might not have received the attention they deserve. On the
other hand for F to belong to the domain of attraction of an o:-stable
distribution, as seen from the above discussion, the tail (especially the
right tail in the actuarial context) should be like apower law modified
by a slowly varying function. In fact for F to belong to the domain
of normal attraction of a stable distribution, by (A.2.9), tail behaviour
should be a Pareto-like power law.
Thus there are very good probabilistic reasons, not just aesthetic
ones, why power laws (especially Pareto distributions) form an impor-
ta'nt class among the heavy tailed distributions.
For proofs of the various results discussed above, extensions/ gen-
eralizations, and for more insight and applications, one may see [Fe],
[EKM], [Lj, [ST], etc.
A.3. Martingales 185
A.3 Martingales
Martingale theory has become a very powerful tool in recent decades.

We shall, however, recall only those aspects having a direct bearing for
our purposes. For more information one may look up Chapter 1 of [K8],
[VI], [V2], [CT], [BW] and the references therein.
We first need the not ion of conditional expectation. Let (0, F, P) be
a prob ability space and A ~ F a sub O"-algebra. Let X be an integrable
random variable. The conditional expectation of X given A is defined
to be the A-measurable random variable Y such that
J
A
X(w) dP(w) = J
A
Y(w) dP(w), for all A E A. (A.3.1)
It is uniquely determined up to sets of measure 0 and is denoted E(X I

A). Existence of conditional expectation is an important consequence
of the Radon-Nikodym theorem. Important properties of conditional
expectation are summarised in the following proposition; all the random
variables are assumed to be integrable; A, Al, A2 are sub O"-algebra.'3 of
F.
Proposition A.3.1 (i) E(X I A) is integrable and E(E(X I A)) =

E(X).
(ii) X ~ 0 a.s. ~ E(X I A) ~ 0 a.s .. Hence Xl S; X 2 a.s. ~ E(XI I
A) :::; E(X 2 I A) a.s.
(iii) E(aIX I + a2X2 I A) = aIE(X I I A) + a2 E (X 2 I A) a.s. where
al, a2 E IR,. so conditional expectation is a linear operation.
(iv) 1f X is A-measurable then E(X I A) = X a.s.
(v) 1fY is a bounded A-measurable random variable then E(YX I A) =
Y E(X I A) a.s.
(vi) If X n ---t X in probability and IXnl S; U a.s. for all n, where U is
integrable then
E(X I A) = E(lim X n I A) = lim E(Xn I A) a.s.

n ~
Thus dominated convergence theorem holds for conditional expectation.

(vii) 1f Al C A2 then E(E(X I At) I A2) = E(X I Al) = E(E(X I
A 2 ) I At) a.s.
(viii) (Jensen's inequality): If'{J is a continuous convex function on IR
then E('{J(X) I A) ~ '{J(E(X I A)) a.s. 0
186 Appendix
Note: If X E L 2 (O, F, P), that is, if X is square integrable then

E(X I A) turns out to be the projection of X onto the closed subspace
L 2 (O,A,P).
Note: Let G E F, A C:;;;:F. The conditional probability of G given A
is defined by P(G I A) ~ E[le I Al· (Note that P(G I A) may not be
defined on a set of measure zero, which may depend on G. In general
these null sets can accumulate and blow up as G varies. However, in our
contexts such a problem will not arise.) In particular, if X is a random
variableand B c:;;; lR is a Borel set then P(X E B I A) ~ E[lB(X) I Al =
E[lx- 1 (B) I Al·
Discrete parameter martingales will be taken up first. Let {Fn : n =
1,2, ... } be a sequence of sub a-algebras such that F n c:;;; F n+1 c:;;; F for
all n 2 1. Let {Xn : n 2 I} be a sequence of random variables satisfying
the following:
(i) X n is integrable, and measurable with respect to F n for n = 1,2, ...
(i.e., {Xn } is {Fn}-adapted and integraple);
(ii) for each n 2 1, E(Xn+1 I F n ) = X n a.s. Then we say {Xn } is a
discrete parameter martingale w.r.t. {Fn }, or simply {(Xn , F n ) : n 2 I}
is a martingale.
If the equality in (ii) above is replaced by E(Xn+l I F n ) ::; X n a.s.
for n = 1,2, ... then {(Xn , F n ) : n 2 I} is called a supermartingale.
Likewise, if in (ii) we have E(Xn+1 I F n ) 2 X n a.s. then {(Xn , F n ) :
n 2 1) is a submartingale.
Examples: 1) Let {Yi} be a sequence of independent random vari-
ables with mean o. Set Sn = Y1 + ... + Y n , F n = a{Yl, ... , Y n }, n 2 1.
Then {(Sn, F n ) : n 2 I} is a martingale.
2) Let X be an integrable random variable. Let F n c:;;; Fn+l c:;;;
F, n 2 1 be an increasing sequence of sub a-algebras. Define X n =
E(X I F n ), n 2 1. Then {(Xn,Fn ) : n 2 I} is a martingale.
An immediate consequence of Jensen's inequality for conditional ex-
pectations is
Lemma A.3.2 If {(Xn , F n ) : n 2 I} is a martingale and'P is a convex

function such that 'P(Xn ) is integrable for each n, then {'P(Xn ) : n 2 I}
is a submartingale w. r. t. {Fn }; in particular, for p 2 1, {IXn IP : n 2 I}
is a sub martingale provided E(IXnIP) < 00.
o
Most of the results we present here are due to Doob. We write
E[Y : Cl ~ f Y dP.
c
A.3. Martingales 187
Theorem A.3.3 (Doob's inequalities) Let {Xn : n ?': I} be a martin-

gale w.r.t. {Fn }. Let Mn(w) = sup IXi(w)l. Then
~ ~
(i) for any A > 0
1
< ~ E[lXnl : {IXni?': A}]
1
< ~ E[IXnl]; (A.3.2)
(ii) for any p > 1
(A.3.3)
If {Xn } is a martingale, we know that {IXni} is a submartingale. So

the above theorem is basically about nonnegative submartingales.
In the context of martingales, an important role is played by stopping
times. Let {Fn : n ?': O} be an increasing sequence of sub O"-algebras. A
measurable function T : n -+ {O, 1,2, ... } U {oo} is said to be a stopping
time w.r.t. {Fn } if {w : T(W) ~ n} E F n for each n?': o. For a stopping
time T w.r.t. {Fn } define
Fr = {A : A E Fand An {w : T(W) ~ n} E Fn for all n} .
It can be shown that Fr is a sub O"-algebra, and that T is Fr-measurable.

Fr can be thought of as the repository of all information up to time T.
If Tl, T2 are two stopping times w.r.t. {Fn } such that 0 ~ Tl ~ T2 then
Fr! ~ F r2 · Suppose {Yn } is a sequence of random variables such that
Yn is Fn-measurable for each n. If T is a stopping time, on the set
{w : T(W) < oo}, define Yr(w) ~ Yr(w) (w). It can be shown that Y r is
.rr-measurable.
A very useful theorem is
Theorem A.3.4 (Optional Stopping theorem or Optional Sampling the-

orem): Let {Xn} be a martingale w.r.t. {.rn}; let Tl, T2 be two stopping
times "W.T. t. {.rn} such that 0 ~ Tl ~ T2 ~ C where C is a constant.
Then
(A.3.4)
D
188 Appendix
Remark A.3.5 Let {Xn } be a martingale and 7 a stopping time, both

w.r.t. {Fn }; 7 need not be bounded. For any k, 7k ~ min{ 7, k} is
a bounded stopping time w.r.t. {Fn }. So by the optional stopping
theorem E(XTk ) = E(Xo) for any fixed k. If 7 < 00 a.s., then 7k i 7
and X Tk - t X T as k i 00 (because 7 takes value in the discrete set
{O, 1, 2, ... }). In addition if the dominated or monotone convergence
theorem are applicable to {X Tk } then we get E(XT ) = E(Xo). This is
one way the above theorem is used.
Remark A.3.6 Suppose {Xn } is a submartingale in Theorem A.3.4.

With 71,72 as in the theorem, the analogue of (A.3.4) is then obtained
as E[XT2 I F Tl ] ~ X Tl a.s. 0
Now we take a brief look at continuous parameter martingales and

associated stopping times.
Let (0, F, P) be a probability space. By a filtration we mean a
family {Ft : t ~ O} of sub O'-algebras such that F s ~ F t ~ F whenever
o ::; s ::; t. To avoid certain technical problems we shall make the
following assumptions:
(i) the filtration {Ft } is right continuous, that is, F t = Ft+ ~ n
F t +E
E>O
for any t 2': 0;
(ii) F o (and hence any Ft} contains all P-null sets.
Let {Ft : t ~ O} be a filtration satisfying the above assumptions. A
process {X(t) : t ~ O} is called a martingale w.r.t {Fd if the following
holds:
a) for almost all w, t r--+ X (t, w) is right continuous and has left limits;
that is, the process X has r.c.l.l. sampie paths;
b) for each t ~ 0, X(t) is Frmeasurable and integrable; (i.e. {X(t)} is
{Ft }-adapted and integrable);
c) for 0 ::; s ::; t, E(X(t) I F s ) = X(s) a.s.
If the above hold, we also say that {(X(t), F t ) : t ~ O} is a continuous
parameter martingale. As in the discrete parameter case, by replacing
the equality in (c) by appropriate inequality one can define continuous
parameter submartingale / supermartingale.
Analogues of Lemma A.3.2 and Theorem A.3.3 hold for continuous
parameter martingales.
Let {Ft : t ~ O} be a filtration as above. A random variable 7: 0 - t
[0,00 )U{ +oo} is called a stopping time w.r.t. {Ft } if {w : 7(W) ::; t} E F t
for all t ~ 0. As in the discrete parameter case, for a stopping time 7
A.4. Brownian motion and 1to integrals 189
set
FT = {A : A E Fand A n {T s; t} E F t for all t}.

As before the a--algebra F T is the repository of all information up to
time T.
In the continuous parameter case, a stopping time can take a con-
tinuum of values, and hence greater care is needed. Useful examples
of stopping times are the first time a process enters / hits an open / a
closed set. Technical assumptions (i), (ii) above are made to ensure that
these are stopping times w.r.t. {Ft}; see [KS].
For an {Ft }-adapted process {X (t)} and a stopping time T, de-
fine the random variable X T on the set {w : T(W) < oo} by XT(w) =
X(T(W),W). Then X T is FT-measurable.
Theorem A.3.7 Let {X (t) : t 2: O} be a submartingale w. r. t. {Ft }.

Let Tl, T2 be two stopping times w. r. t. {Ft } such that 0 S; Tl S; T2 S; C,
where C is a constant. Then
(A.3.5)
1f {X(t)} is a martingale, then equality holds in (A.S.S).
Corollary A.3.8 Let {X(t)} be a martingale w.r.t. {Ft} and T a stop-

ping time w. r. t. {Ft}. Then {XT/\t : t 2: O} is also a martingale w. r. t.
{Ft}. 0
A.4 Brownian motion and Ito integrals
Brownian motion is perhaps the most important stochastic process; and

Ito integral is a useful tool in stochastic analysis. We shall outline only
the one-dimensional case, which would suffice for our purposes. For
details, extensions and more information and insight see [BW], [lW],
[KS], [D], [V2].
The following definition has been abstracted from the study of the
physical phenomenon of Brownian motion. Let (n, F, P) be a proba-
bility space with a filtration {Ft : t 2: O}. Let {B(t) : t 2: O} be a
one-dimensional stochastic process satisfying the following:
1. For each fixed t 2: 0, B(t) is areal valued random variable which

is Frmeasurable.
190 Appendix
2. For a.e. w E 0, t 1-+ B(t,w) is continuous on [0,(0).

3. For 0 ::; s ::; t, the random variable B (t) - B (s) and the sub
a-algebra F s are independent; that is, B(t) - B(s) and any F s -
measurable random variable are independent. In particular {B (t) :
t 2:: O} is a process with independent increments.
4. For 0 ::; s ::; t the random variable B (t) - B (s) has Gaussian (nor-
mal) distribution with mean 0 and variance (t - s); Le., B(t) -
B(s) rv N(O, t - s). Then {B(t) : t 2:: O} is called an {Fd-
adapted one- dimensional Brawnian motion. If a process {B o(t)}
satisfies the above and Bo(O) == 0 a.s. then Bo is called stan-
dard Brownian motion. With Bo as ab ove , x E IR, the process
B (t) = x + B o(t), t 2:: 0 is the one-dimensional Brownian motion
starting at x.
Define for 0 ::; s < t, x, z E IR
p(s,x;t,z) = 1
y'27J"(t-s)
exp {It-s )(z-x)2} .
-2( (A.4.l)
Note that p(s, x; t, z) = p(s + h, x; t + h, z) = p(O, x; t - s, z) indicating

time homogeneity. An important fact is that the Brownian motion is a
Markov process so that for 0 ::; s < t, Borel set A ~ IR,
P(B(t) E A I F s ) = P(B(t) E A I a{B(s)}) = J

A
p(s,B(s);t,z)dz,
(A.4.2)
This is an easy consequence of the independent increments property.
Clearly with 0 ::; s < t, x E IR fixed, z 1-+ p(O, x; t-s, z) is the probability
density function of B(t - s) given B(O) = x; this is also the p.dJ. of
B(t) conditional on B(s) = x. Note that (A.4.2) holds even if B(O) is
random variable, of course, measurable w.r.t. Fo. It is not difficult to
prove that the distribution of B(O), called the initial distribution, and
the function p given by (A.4.l) determine the distribution of the process
{B(t) : t 2:: O}. The distribution of the Brownian motion process is
a probability measure on the space G[O, (0) of continuous functions on
[0, (0); this probability measure is referred to as Wiener measure.
In fact a stronger version of (A.4.2), called the strang Markov prap-
erly holds. Let T be a finite stopping time w.r.t. {Fd. Then the
stochastic process {B(t) = B(T + t) - B(T) : t 2:: O} is again distributed
A.4. Brownian motion and lto integrals 191
like a Brownian motion independent of Fr. In particular for any finite

stopping time T w.r.t. {Fd, any s ~ 0 and Borel set A C lR,
P(B(T+S) E AI O"{T,B(T)})
J p(O, B(T); s, z)dz. (A.4.3)
A
Another basic property of Brownian motion is that {B (t) : t ~ O}

and {B 2 (t) - t : t ~ O} are both martingales w.r.t. {Fd; this is easy to
prove.
Since p given by (A.4.1) is smooth in its arguments, simple differen-
tiation leads to
äp
äs
+ ~2 äx
ä 2p
2
_ 0 0 < s < t, x E lR
- ,
(A.4.4)
for fixed t > 0, z E lR, and
(A.4.5)
for fixed s ~ 0, x E R These are respectively the backward and the

forward heat equation or diffusion equation. In probability literature
the function p is called the transition probability density function of the
Brownian motion, because distributional properties of the process can
be got from p thanks to (A.4.2), (A.4.3). Because of (A.4.4) , (A.4.5)
and since solutions to initial value problems of heat equation can be
expressed in terms of the kernel p, in PDE literat ure the function p is
referred to as the fundamental solution to the heat equation. This forms
a basis for the fruitful interaction between prob ability theory and partial
differential equations. See [KS], [D], [V2].
Brownian motion is the prototype of a diffusion process. This led
Paul Levy to suggest that a diffusion process could perhaps be expressed
in terms of an integral w.r.t. Brownian motion together with a time inte-
gral. However, sampIe paths of Brownian motion are of infinite variation
over any bounded interval; so the technology of Stieltjes integration is
ruled out. This problem was elegantly solved by Kiyosi Ito. We now
briefly describe Ito integrals and some of its ramifications.
Fix T > O. Let f : [0, T] x n -+ lR be a simple function in the sense
that there exist 0 = to < tl < ... < tn-l < t n = T, and bounded
random variables Cl:i, i = 0,1, ... ,n - 1 such that Cl:i is Fti-measurable
192 Appendix
and f(t , w) = ai(W) if ti :S t < tHl , i = 0, 1, ... ,n - 1. In this case the

natural definition of integral w.r.t. Brownian motion is
J
t
It(f)(w) ~ f(s,w) dB(s,w)
o
n-l
A L ai(w)[B(tHl 1\ t, w) - B(ti 1\ t, w)l, O:S t :S T. (A.4.6)
i=O
Note that for each i, a i and [B(ti+l 1\ t) - B(ti 1\ t)] are independent .
Consequently it is easily proved that {It (f) : t E [0, T]} is a martingale
w.r.t. {Ft : t E [0, Tl}. With a little effort one can prove that
(A.4.7)
for °:Ss :S t :S T.
Next let 9 : [0, T] x n -+ IR be a measurable function satisfying
(i) for each t E [0, Tl, the map (s, w) 1---+ g(s, w), °
:S s :S t, wEn is
jointly measurable as a map from ([0, t] x n, B[O, t] x F t ) to the realline;
(that is, 9 is progressively measurable);
(ii) E (llf(S) 12 dS) < 00.

(Note that any simple function has the above properties). One can
T
find simple functions fn, n = 1, 2, ... such that E J Ifn(s)-g(s)J2ds -+ 0.
o
Using Doob's inequality for the martingales It(fn) and (A.4.7) one can
now show that
t
Now define It(g) == J g(s) dB(s) =
o
lim [t(fn) where limit is taken in
n--->oo
L 2 (P). It can be shown from the above that

A.4. Brownian motion and lto integrals 193
t
The process lt (g) = J g( s) dB (s), t ;::: 0 is called the lto integral of g; it is
o
clearly linear in g. The following properties of the process {It (g) : t ;::: O}
are not difficult to establish
i) progressive measurability w.r.t. {Fd, and continuity of sampie paths
with probability one;
ii) {It (g) : t ;::: O} is a martingale with respect to {Ft : t ;::: O}
iii) {(1t(g))2 -[lg(sW ds : t ;::: O} is also a martingale w.r.t. {Ft }.
t
With more effort one can define Ito integral J g(s) dB(s) for pro-
o
gressively measurable functions 9 satisfying
p {w, / jg(s,wlj2 ds < 00 Vt} ~ 1.

Importance of Ito integrals is mainly due to the following chain rule,
known as lto's lormula. Let u(·), v(·) be progressively measurable pro-
cesses such that
p {w , / ju(s,wljds < 00, / jv(s,wlj 2 ds < 00, V 0 :S t:S T } ~ 1.

Let
J J
t t
Y(t) = Y(O) + u(s) ds + v(s) dB(s), O:S t :S T (A.4.8)

o 0
where Y(O) is Fo-measurable. Let I : [0, Tl x IR ---+ IR be a continuous

function such that 10 ~ ~ 11 ~ ~~ 111 ~ ~ are also continuous on
[0, Tl x IR. Then with prob ability one, for 0 :S t :S T
I(t, Y(t)) - 1(0, Y(O))
J J
t t
lo(s, Y(s)) ds + 11(S, Y(s)) u(s) ds

o 0
+J J111(S,
t t
l1(s, Y(s))v(s)dB(s) +~ Y(s))v 2(s)ds.(A.4.9)

o 0
194 Appendix
Presence of the "second order term" (the last term) on the r.h.s. of
(A.4.9) is the special feature of Ito's calculus. For a proof of Ito's formula
(A.4.9) and extensions, see [KS], [V2], [0], etc.
Now that Ito integrals are at our disposal we can talk ab out stochas-
tic integral equations. Let a : [0, Tl x IR ~ IR, b : [0, Tl x IR ~ IR be
functions, and X(O) an Fo-measurable random variable. Consider the
stochastic integral equation
J J
t t
X(t) = X(O) + a(s,X(s)) dB(s) + b(s,X(s)) ds,O::; t::; T.

o 0
(A.4.10)
By a strong solution to (A.4.10) we mean a continuous process
{X(t) : t E [0, Tl} progressively measurable w.r.t. {Ft} such that the
integrals in (A.4.1O) make sense and the equation (A.4.10) holds with
probability one. The above equation is formally written in differential
notation as
dX(t) = a(t,X(t)) dB(t) + (b(t,X(t)) dt (A.4.11)
and is referred to as a stochastic differential equation. As in the case

of ordinary differential equations, Picard's iteration can be applied. To
be more precise, assume that a, b satisfy a uniform Lipschitz condition
and a linear growth condition in x; that is, there is a constant K > 0
such that for all 0 ::; t ::; T, x, y E IR
la(t, x) - a(t, y)1 + Ib(t, x) - b(t, y)1 < Klx - yl,

la(t, 0)1 + Ib(t, 0)1 < K.
Assume also that X(O) is square integrable. Then it can be shown

that there is a unique strong solution {X(t)} to (A.4.10); moreover
T
E J IX(s)1 2 ds < 00. Furthermore it can be shown that {X(t) : t ~ O}
o
is a strong Markov process. In particular, for any finite stopping time T
w.r.t. {Ft}, s ~ 0 and A <;;;; IR
Therefore, the process {X (t) : t ~ O} is also called the one- dimensional

(continuous) diffusion process with drift band dispersion a.
A.4. Brownian motion and Ito integrals 195
Finally, note that Ito's formula is applicable to the diffusion XO as

it is in the form (A.4.8). So for any f E C 1,2([0, 00) x lR) we have
J
t
f(t,X(t)) - f(O,X(O)) = h(s,X(s)) O"(s,X(s)) dB(s)
o
J
t
+ {fo(s, X(s)) + Lf(s, X(s))} ds (A.4.12)
o
where
1 2 82 f 8f (s, x).
Lf(s, x) = -
2
0" (s, x) 8 2 (s, x)
x
+ b(s, x) -8
x
(A.4.13)
If 0" == 1, b == 0, observe that fo + Lf = + L) f = (ts

+~ ) f (ts
is just the backward heat operator encountered in (A.4.4). If f E
Ct,2([0,00) x lR) and 0", b are also bounded, then from (A.4.12) we
obtain
J
t
f(t, X(t)) - f(O, X(O)) - {fo(s, X(s)) + Lf(s, X(s))}ds
o
= a continuous martingale W.r.t. {Fd.
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Index
Additivity, 68 defective renewal equation, 118

adjustment coefficient, 113 delayed renewal function, 42
Almost sure convergence, 177 delayed renewal process, 42
arrival times, 29 delayed renewal sequence, 42
diffusion equation, 191
Binomial distribution, 178 diffusion process, 194
BlackweIl's renewal theorem, 44 directly Riemann integrable, 45
Brownian motion, 130, 141, 189 discounted sum, 21
distribution, 174
central limit theorem, 34, 178 distribution function, 173
Chapman-Kolmogorov equation, domain of attraction, 180
133 domain of normal attraction, 184
Choquet-Deny theorem, 50 Doob's inequalities, 186
claim arrival rate, 7
Elementary renewal theorem, 32
claim arrival times, 2, 10
Embrechts-Veraverbeke approx-
claim number process, 3
imation, 124
claim sizes, 2
equilibrium distribution, 43
compound geometric distribution,
Erlang distribution, 26
119
Esscher transform, 71
compound Poisson process, 21
expectation, 175
conditional expectation, 185
Expected value principle, 58
conditional probability, 185
Exponential distribution, 179
Consistency, 68 exponential distribution, 10
convergence in probability, 177 Exponential principle, 59
converges weakly, 44 exponential tilting, 71
convolution, 28, 176
coupling technique, 53 failure rate, 96
Cramer-Lundberg approximation, FeIler property, 145
120 filtration, 131, 188
Cramer-Lundberg condition, 120 filtration generated by the pro-
Cramer-Lundberg model, 21 cess, 24
INDEX 201
first entranee time, 109 long-tailed distribution, 93

fundamental solution to the heat Lundberg bound, 112
equation, 191 Lundberg eoeffieient, 113
Lundberg risk proeess, 107
Gamma distribution, 180
geometrie Brownian motion, 141 Markov property, 24, 131
Geometrie distribution, 179 martingale, 33, 186
moment generating funetion, 69
hazard rate, 96
heat equation, 191 Net or equivalenee prineiple, 58
heavy-tailed distribution, 72 net profit eondition (NPC), 111
heavy-tailed Weibull distribution, nonlattiee distribution, 44
106 Nonnegative loading, 68
Helly seleetion prineiple, 64 Normal distribution, 179
Homogeneity, 68
Optional Sampling theorem, 187
independent, 175 optional sampling theorem, 33
independent inerements, 6 Optional Stopping theorem, 187
infinitesimal generator, 136, 153 Order statisties, 17
integrated tail distribution, 43
integro-differential operator, 136 Pareto distribution, 82
interarrival times, 10, 29 partial maximum, 84
Ito integral, 141, 151, 189 partial sum, 84
Ito's formula, 151, 193 Poisson distribution, 178
Poisson proeess, 3
Jensen's inequality, 185 Poisson proeess with intensity (or
joint probability density funetion, rate) funetion, 8
175 Pollaezek-Khinehin formula, 118
premium rate, 67
Karamata representation theorem, prob ability density function, 174
75 probability mass funetion, 174
Key renewal theorem, 46 probability measure, 173
probability spaee, 173
ladder epoeh, 109
Laplaee-Stieltjes transform, 36 random variable, 173
large deviations, 111 random walk, 29
lattiee distribution, 44 Regularly varying functions and
Levy proeess, 21, 131 distributions, 72
Light-tailed distributions, 69 regularly varying with index, 76
loeally bounded, 40 regularly varying with tail index,
Lognormal distribution, 100 76
202 INDEX
renewal epoch, 29 strong law of large numbers, 177

renewal equation, 40 Strong Markov property, 149
renewal function, 36 strong Markov property, 190
rene wal measure, 39 strong solution, 143, 194
renewal model, 4 Subexponential distributions, 84
renewal process, 29 submartingale, 186
renewal risk process, 107 supermartingale, 186
renewal sequence, 29 support theorem, 152
residuallife, 16, 51 surplus process, 107
right continuous filtration, 143 survival probability, 116, 161
risk aversion factor, 59
Risk process with investment, 141 tail equivalent, 90
risk theory, 2 total claim amount process, 3
riskless bond, 141 transition probability density func-
risky asset, 141 tion, 191
ruin, 108 transition prob ability function, 133
ruin probability, 108, 161 Ttuncated standard normal, 71
Ruin Problems, 107
Uniform distribution, 179
ruin time, 108, 151
utility function, 60
safety loading factor, 58 utility theory, 59
Samuelson model, 141
Variance, 175
semigroup of operators, 134
Variance principle, 58
Semigroup property, 168
skeleton process, 108 waiting times, 10
SLLN for renewal process, 31 Wald's identity, 33
slowly varying, 182 Wiener measure, 190
slowly varying functions, 72
Sparre Andersen model, 54 zero utility premium, 61
stable distribution, 181
Standard deviation principle, 59
stationary excess distribution, 43
stationary increments, 6
stochastic differential equation,
194
stochastic differential equations,
130
stochastic integral equation, 141,
194
stopping time, 25, 187
Texts and Readings in Mathematics
1. R. B. Bapat: Linear Algebra and Linear Models (Seeond Edition)

2. Rajendra Bhatia: Fourier Se ries (Seeond Edition)
3. C. Musili: Representations of Finite Groups
4. H. Helson: Linear Algebra (Seeond Edition)
5. D. Sarason: Complex Funetion Theory (Seeond Edition)
6. M. G. Nadkarni: Basie Ergodie Theory (Seeond Edition)
7. H. Helson: Harmonie Analysis (Seeond Edition)
8. K. Chandrasekharan: A Course on Integration Theory
9. K. Chandrasekharan: A Course on Topologieal Groups
10. R. Bhatia (ed.): Analysis, Geometry and Probability
11. K. R. Davidson: C* - Aigebras by Example
12. M. Bhattaeharjee et al.: Notes on Infinite Permutation Groups
13. V. S. Sunder: Funetional Analysis - Speetral Theory
14. V. S. Varadarajan: Algebra in Aneient and Modern Times
15. M. G. Nadkarni: Speetral Theory of Dynamieal Systems
16. A. Borei: Semisimple Groups and Riemannian Symmetrie Spaees
17. M. Mareolli: Seiberg - Witten Gauge Theory
18. A. Botteher and S. M. Grudsky: Toeplitz Matriees, Asymptotie
Linear Algebra and Funetional Analysis
19. A. R. Rao and P. Bhimasankaram: Linear Algebra (Seeond Edition)
20. C. Musili: Aigebraie Geometry for Beginners
21. A. R. Rajwade: Convex Polyhedra with Regularity Conditions
and Hilbert's Third Problem
22. S. Kumaresan: A Course in Differential Geometry and Lie Groups
23. Stef Tijs: Introduetion to Game Theory
24. B. Sury: The Congruenee Subgroup Problem
25. R. Bhatia (ed.): Conneeted at Infinity
26. K. Mukherjea: Differential Caleulus in Normed Linear Spaees
(Seeond Edition)
27. Satya Deo: Aigebraie Topology: A Primer (Correeted Reprint)
28. S. Kesavan: Nonlinear Funetional Analysis: A First Course
29. S. Szab6: Topies in Faetorization of Abelian Groups
30. S. Kumaresan and G. Santhanam: An Expedition to Geometry
31. D. Mumford: Leetures on Curves on an Aigebraie Surfaee (Reprint)
32. J. W. Milnor and J. D. Stasheff: Charaeteristie Classes (Reprint)
33. K. R. Parthasarathy: Introduetion to Probability and Measure
(Correeted Reprint)
34. A. Mukherjee: Topies in Differential Topology
35. K. R. Parthasarathy: Mathematieal Foundations of Quantum
Meehanies
36. K. B. Athreya and S. N. Lahiri: Measure Theory
37. Terenee Tao: Analysis I (Seeond Edition)
38. Terenee Tao: Analysis 11 (Seeond Edition)
39. W. Decker and C. Lossen: Computing in Aigebraic Geometry
40. A. Goswami and B. V. Rao: A Course in Applied Stochastic
Processes
41. K. B. Athreya and S. N. Lahiri: Probability Theory
42. A. R. Rajwade and A. K. Bhandari: Surprises and Counterexamples
in Real Function Theory
43. G. H. Golub and C. F. Van Loan: Matrix Computations (Reprint of the
Third Edition)
44. Rajendra Bhatia: Positive Definite Matrices
45. K. R. Parthasarathy: Coding Theorems of Classical and Quantum
Information Theory
46. C. S. Seshadri: Introduction to the Theory of Standard Monomials
47. Alain Connes and Matilde Marcolli: Noncommutative Geometry,
Quantum Fields and Motives
48. Vivek S. Borkar: Stochastic Approximation: A Dynamical Systems
Viewpoint
49. B. J. Venkatachala: Inequalities: An Approach Through Problems
50. Rajendra Bhatia: Notes on Functional Analysis
51. A. Clebsch (ed.) Jacobi's Lectures on Dynamics
(Second Revised Edition)
52. S. Kesavan: Functional Analysis
53. V. Lakshmibai and Justin Brown: Flag Varieties: An Interplay of
Geometry, Combinatorics, and Representation Theory

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TEXTS AND READINGS

Hindustan Book Agency (India)

Copyright © 2009, Hindustan Book Agency (India)

No part of the material protected by this copyright notice may be

ISBN 978-81-85931-93-7 ISBN 978-93-86279-44-6 (eBook)

4 Claim size distributions 69

5 Ruin Problems 107

5.3 An integral equation in Cramer-Lundberg model . 115

6 Lundberg risk process with investment 130

This introductory book is an expanded version of aseries of lec-

contract) is at the core of the interaction. A reasonable mathemati-

1.1 Main assumptions

One of the objectives is modelling of claims that arrive in an insurance

2. The i th claim arriving at time Ti causes a payment Xi. The se-

The second assumption indicates a certain homogeneity of policies

N (t ) max {i 2: 0 : Ti ::; t},

Also define the total claim amount process by

S(t) = { 0, ~f N(t) = 0 (1.2)

with the renewal model. Renewal theorems, including BlackweIl's re-

the references therein. Our approach is sümewhat different. Für the

We first consider the claim number process {N (t) : t 2: O}. We assurne

P(N(h) 2: 2) = o(h), as h 1 o. (2.1)

• (N6): There exists >. > 0 such that

Pn(t) = P(N(t)) = n), t ;::: 0, n = 0,1,2 , .... (2.3)

Po(t + h) P(N(t) = 0, N(t + h) - N(t) = 0) (by (Nl),(N2))

By (NI), Po(O) = P(N(O) = 0) = 1. So the differential equation

Po(t) = P(N(t) = 0) = P(N(t + s) - N(s) = 0)

Pn(t + h) = P(N(t + h) = n) = h + 12 + Js,

h P(N(t) = n , N(t + h) - N(t) = 0),

Pn(t + h) = Pn (t)[l -)"h + o(h)] + Pn-I(t) [)"h + o(h)] + o(h).

Clearly Qo(·) == 1 by (2.5). So from (2.7) it follows that QI (t) = )..t + c

P(N(t + s) - N(s) = k) P(N(t) = k)

The assumptions (NI) - (N6) are qualitative, whereas the conclusion

Definition 2.2 Let)..(·) be a nonnegative measurable function on [0, CXl)

(i) (NI), (N2), (N3) are satisfied.

(ii) Far P - a.e. w E 0, the sample path N(·,w) is right continuous at

If A(.) == A > 0, a constant, then N is said to be a homogeneous P ois-

Proposition 2.3 Let A(') be a nonnegative measurable function on [0,00).

(i) {N(J.-L(t)) : t ~ O} is a Poisson process with rate junction A(')'

Proof: Left as an exercise. o

2.2 Interarrival and waiting time distributions

Let {N(t) : t 2: O} be a time homogeneous Poisson process with arrival

For any s > 0 note that {Tl> s} = {N(s) = O} Henee by (2.8)

P(A I > s) = P(TI > s) = P(N(s) = 0) = e- AS .

Therefore the random variable Al or Tl has exponential distribution

P(A I E (a, b)) = P(TI E (a, b))

e- AS ds, 0::; a < b < 00. (2.11)

With more effort one can prove the following

Theorem 2.4 Let {N(t) : t 2 O} be a time homogeneous Poisson pro-

( a) Fix n 2 1. Then the joint probability density function 0 f Tl, T 2, ... , T n

f(hh ... ,Tn ) (tl, ... , tn)

(b) {An: n = 1,2, ... } is a sequence of independent, identically dis-

Proof: (a) In view of the discussion preeeding the theorem (see

P((T" ... , Tn ) E I) ~ P (Ö{ai < Ti :0 b;})

[g P(N(a;) - N(bi-l) ~ 0)· P(N(bi ) - N(ai) ~ 1)]

= [rr e->.(ai-bi-1».,(bi - ai)e->.(bi-ai)]. e->.(a n-bn- d (l_ e->'(bn-an»)

~ (bi - ai )] "n(e- Aan _ e-Ab,,)

Since rectangles of the form I generate the Borel O"-algebra of G n , (2.12)

The linear transformation given by the (n x n) matrix in (2.14) has

f(A1, ... ,A n ) (al, a2, ... , an)

Proof: As Al has an exponential distribution, Al > 0 a.s. and

P(Tk :s; t) = j t 7::-_A_k--:-:- zk-Ie-Az dz

Consequently for n = 0,1,2, ...