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USAGE OF PROBABILITY DISTRIBUTIONS IN RISK MANAGEMENT

BINOMIAL DISTRIBUTION
Conditions: 1) The number of trials or occurrences are fixed there are only two possible outcomes (heads/tails or win/lose, for example) 2) All occurrences are independent of each other (tossing a head does not make it more or less likely you will get the same result next time)

BINOMIAL DISTRIBUTION
Binomial distribution is best applied in cases where the population size is at least 10 times the sample size, and not to simple random sample.

Example: Suppose you invest a fixed sum of your money in shares of five different companies. The probability that each share will yield profit tomorrow is 0.7. Find the probability that at least two shares earns the profit tomorrow?

EXPONENTIAL DISTRIBUTION
1) Exponential distribution is widely used for the determination of waiting time in any Poisson process. 2) Exponential distribution is also used for mortality of human life, primarily due to its shape.

EXPONENTIAL DISTRIBUTION
If S=x1+x2+....+xn, where all xi's follows exponential distribution with same parameters, then S will follow Gamma Distribution with parameters a=n and b=lambda

EXPONENTIAL DISTRIBUTION
Example For a certain population the time until death random variable T has an exponential distribution with mean 60 years, find the probability that a member of this population will die by age 50?

NORMAL DISTRIBUTION
The normal distribution is the most common type of distribution, and is often found in stock market analysis. Given enough observations within a sample size, it is reasonable to make the assumption that returns follow a normally distributed pattern, but this assumption can be disproved. As with any distribution, the distributions mean, skewness and kurtosis coefficients should be calculated in order to determine the type of distribution you may be dealing with.

NORMAL DISTRIBUTION
EXAMPLE An insurance company has 5000 policies which are independent with each other. Each policy is governed by the same distribution with a mean of Rs 495 and a variance of Rs 30000. What is the probability that the total claims for the year will be less than Rs. 2,500,000?

LOGNORMAL DISTRIBUTION
Log-normal distributions can model certain instances, such as the change in price distribution of a stock, or commodity positions. This is because the time series creates random variables. By taking the natural log of each of the random variables, the resulting set of numbers will be log-normally distributed. Other uses include survival rates of cancer patients or failure rates in product tests.

LOGNORMAL DISTRIBUTION
The shape of curve of lognormal make it suitable for insurance claim analysis. The value of a single stock at some future point in time is a random variable. Lognormal distribution is suitable for modeling it because exponential function is used to model continuous growth A(t)=A(0).exp(rt)

LOGNORMAL DISTRIBUTION
EXAMPLE A share of ABC company was purchased for Rs 100 in Feburary 2011. During one year it grows by 10%. What would be its value in August 2012?

PARETO DISTRIBUTION
Pareto distribution is appropriate for phenomena such as claim amounts It is appropriate in phenomena where heavy losses are expected to occur, the Pareto Principal establishes that the occurrence of large losses may be less however big sums would be paid for it.

PARETO DISTRIBUTION
EXAMPLE A comprehensive insurance policy on commercial vehicles has a deductible of Rs 500. The random variable for the loss amount on the claims files has a Pareto distribution with a failure rate of 3.5/x (x would be taken in monetary unit). Find the mean of loss amount?

WEIBULL DISTRIBUTION
Weibull distribution is applied in those models in which the vulnerability of loss increases with respect to time. In other words, we can say that there are variable failure rates, one typical example can be modeling of life table in which chances of mortality increases with respect to age.

WEIBULL DISTRIBUTION
EXAMPLE Suppose X be a random variable that follows Weibull distribution with a=2 and b=2.5 represents the lifetime in years of an insured automobile. Find the probability that it will last longer than one year.