Univariate Distributions

The Pareto Distribution

Univariate Distributions

School of Risk & Actuarial Studies

UNSW Business School

Video lecture notes

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 Univariate Distributions
Pareto Distribution

Pareto Distribution

I Continuous distribution.
I Heavy tailed distribution (an extreme value distribution), also
known as Lomax distribution or Pareto Type II distribution.
I Heavy tailed distribution (an extreme value distribution).

I Often used for reinsurance purposes. The Pareto distribution

tapers away to zero much more slowly than LogNormal.
Hence, it is more appropriate for estimating reinsurance
premium in respect of very large claims.

I F&T book page 14–15. Used to model r.v. with very large
values with very low probabilities (e.g. incomes).

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 Univariate Distributions
Pareto Distribution

Pareto Distribution

I Cumulative distribution function (α > 0, λ > 0):

 α
λ
FX (x) = 1 − , x > 0.
λ+x

I Probability density function:

α · λα α
fX (x) = α+1
= .
(λ + x) λ · (1 + x/λ)α+1

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 Univariate Distributions
Pareto Distribution

Pareto Distribution
λ ↑ ⇒ p.d.f. shifts to right and α ↑ increases ⇒ p.d.f. shifts to left.
Pareto p.d.f. Pareto c.d.f.
2 1
α= 3, λ= 1
1.8 α= 3, λ= 2 0.9

1.6 α= 3, λ= 4 0.8

cumulative density function

α= 1, λ= 4
probability density function

1.4 0.7

1.2 0.6

1 0.5

0.8 0.4

0.6 0.3
α= 3, λ= 1
0.4 0.2 α= 3, λ= 2
0.2 0.1 α= 3, λ= 4
α= 1, λ= 4
0 0
0 1 2 3 4 5 0 1 2 3 4 5
x x
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 Univariate Distributions
Pareto Distribution

Pareto Distribution

I Moments do not always exist:

Γ (α − r ) · Γ (1 + r ) r
E [X r ] = ·λ ,
Γ (α)

for r = 1, 2 and 3, provided r < α.

I For example:

α · λ2
Var (X ) =
(α − 1)2 · (α − 2)

and only exists if α > 2.

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