Various parametric continuous probability models have been presented and discussed in this blog. The number of parameters in these models ranges from one to two, and in a small number of cases three. They are all potential candidates for models of severity in insurance applications and in other actuarial applications. This post highlights these models. The list presented here is not exhaustive; it is only a brief catalog. There are other models that are also suitable for actuarial applications but not accounted for here. However, the list is a good place to begin. This post also serves a navigation device (the table shown below contains links to the blog posts).
Many of the models highlighted here are related to gamma distribution either directly or indirectly. So the catalog starts with the gamma distribution at the top and then branches out to the other related models. Mathematically, the gamma distribution is a two-parameter continuous distribution defined using the gamma function. The gamma sub family includes the exponential distribution, Erlang distribution and chi-squared distribution. These are distributions that are gamma distributions with certain restrictions on the one or both of the gamma parameters. Other distributions are obtained by raising a distribution to a power. Others are obtained by mixing distributions.
Here’s a listing of the models. Click on the links to find out more about the distributions.
|Gamma sub families|
|Independent sum of gamma|
|Raising to a power||Raising exponential to a positive power|
|Raising exponential to a power|
|Raising gamma to a power|
|Raising Pareto to a power|
|Burr sub families|
The above table categorizes the distributions according to how they are mathematically derived. For example, the gamma distribution is derived from the gamma function. The Pareto distribution is mathematically an exponential-gamma mixture. The Burr distribution is a transformed Pareto distribution, i.e. obtained by raising a Pareto distribution to a positive power. Even though these distributions can be defined simply by giving the PDF and CDF, knowing how their mathematical origins informs us of the specific mathematical properties of the distributions. Organizing according to the mathematical origin gives us a concise summary of the models.
Further Comments on the Table
From a mathematical standpoint, the gamma distribution is defined using the gamma function.
In this above integral, the argument is a positive number. The expression in the integrand is always positive. The area in between the curve and the x-axis is . When this expression is normalized, i.e. divided by , it becomes a density function.
The above function is defined over all positive . The integral of over all positive is 1. Thus is a density function. It only has one parameter, the , which is the shape parameter. Adding the scale parameter making it a two-parameter distribution. The result is called the gamma distribution. The following is the density function.
Both parameters and are positive real numbers. The first parameter is the shape parameter and is the scale parameter.
As mentioned above, many of the distributions listed in the above table is related to the gamma distribution. Some of the distributions are sub families of gamma. For example, when are positive integers, the resulting distributions are called Erlang distribution (important in queuing theory). When , the results are the exponential distributions. When and where is a positive integer, the results are the chi-squared distributions (the parameter is referred to the degrees of freedom). The chi-squared distribution plays an important role in statistics.
Taking independent sum of independent and identically distributed exponential random variables produces the Erlang distribution, a sub gamma family of distribution. Taking independent sum of exponential random variables, with pairwise distinct means, produces the hypoexponential distributions. On the other hand, the mixture of independent exponential random variables produces the hyperexponential distribution.
The Pareto distribution (Pareto Type II Lomax) is the mixture of exponential distributions with gamma mixing weights. Despite the connection with the gamma distribution, the Pareto distribution is a heavy tailed distribution. Thus the Pareto distribution is suitable for modeling extreme losses, e.g. in modeling rare but potentially catastrophic losses.
As mentioned earlier, raising a Pareto distribution to a positive power generates the Burr distribution. Restricting the parameters in a Burr distribution in a certain way will produces the paralogistic distribution. The table indicates the relationships in a concise way. For details, go into the blog posts to get more information.
Another informative way to categorize the distributions listed in the table is through looking at the tail weight. At first glance, all the distributions may look similar. For example, the distributions in the table are right skewed distributions. Upon closer look, some of the distributions put more weights (probabilities) on the larger values. Hence some of the models are more suitable for models of phenomena with significantly higher probabilities of large or extreme values.
When a distribution significantly puts more probabilities on larger values, the distribution is said to be a heavy tailed distribution (or said to have a larger tail weight). In general tail weight is a relative concept. For example, we say model A has a larger tail weight than model B (or model A has a heavier tail than model B). However, there are several ways to check for tail weight of a given distribution. Here are the four criteria.
|Tail Weight Measure||What to Look for|
|1||Existence of moments||The existence of more positive moments indicates a lighter tailed distribution.|
|2||Hazard rate function||An increasing hazard rate function indicates a lighter tailed distribution.|
|3||Mean excess loss function||An increasing mean excess loss function indicates a heavier tailed distribution.|
|4||Speed of decay of survival function||A survival function that decays rapidly to zero (as compared to another distribution) indicates a lighter tailed distribution.|
Existence of moments
For a positive real number , the moment is defined by the integral where is the density function of the distribution in question. If the distribution puts significantly more probabilities in the larger values in the right tail, this integral may not exist (may not converge) for some . Thus the existence of moments for all positive is an indication that the distribution is a light tailed distribution.
In the above table, the only distributions for which all positive moments exist are gamma (including all gamma sub families such as exponential), Weibull, lognormal, hyperexponential, hypoexponential and beta. Such distributions are considered light tailed distributions.
The existence of positive moments exists only up to a certain value of a positive integer is an indication that the distribution has a heavy right tail. All the other distributions in the table are considered heavy tailed distribution as compared to gamma, Weibull and lognormal. Consider a Pareto distribution with shape parameter and scale parameter . Note that the existence of the Pareto higher moments is capped by the shape parameter . If the Pareto distribution is to model a random loss, and if the mean is infinite (when ), the risk is uninsurable! On the other hand, when , the Pareto variance does not exist. This shows that for a heavy tailed distribution, the variance may not be a good measure of risk.
Hazard rate function
The hazard rate function of a random variable is defined as the ratio of the density function and the survival function.
The hazard rate is called the force of mortality in a life contingency context and can be interpreted as the rate that a person aged will die in the next instant. The hazard rate is called the failure rate in reliability theory and can be interpreted as the rate that a machine will fail at the next instant given that it has been functioning for units of time.
Another indication of heavy tail weight is that the distribution has a decreasing hazard rate function. On the other hand, a distribution with an increasing hazard rate function has a light tailed distribution. If the hazard rate function is decreasing (over time if the random variable is a time variable), then the population die off at a decreasing rate, hence a heavier tail for the distribution in question.
The Pareto distribution is a heavy tailed distribution since the hazard rate is (Pareto Type I) and (Pareto Type II Lomax). Both hazard rates are decreasing function.
The Weibull distribution is a flexible model in that when its shape parameter is , the Weibull hazard rate is decreasing and when , the hazard rate is increasing. When , Weibull is the exponential distribution, which has a constant hazard rate.
The point about decreasing hazard rate as an indication of a heavy tailed distribution has a connection with the fourth criterion. The idea is that a decreasing hazard rate means that the survival function decays to zero slowly. This point is due to the fact that the hazard rate function generates the survival function through the following.
Thus if the hazard rate function is decreasing in , then the survival function will decay more slowly to zero. To see this, let , which is called the cumulative hazard rate function. As indicated above, . If is decreasing in , has a lower rate of increase and consequently has a slower rate of decrease to zero.
In contrast, the exponential distribution has a constant hazard rate function, making it a medium tailed distribution. As explained above, any distribution having an increasing hazard rate function is a light tailed distribution.
The mean excess loss function
The mean excess loss is the conditional expectation . If the random variable represents insurance losses, mean excess loss is the expected loss in excess of a threshold conditional on the event that the threshold has been exceeded. Suppose that the threshold is an ordinary deductible that is part of an insurance coverage. Then is the expected payment made by the insurer in the event that the loss exceeds the deductible.
Whenever is an increasing function of the deductible , the loss is a heavy tailed distribution. If the mean excess loss function is a decreasing function of , then the loss is a lighter tailed distribution.
The Pareto distribution can also be classified as a heavy tailed distribution based on an increasing mean excess loss function. For a Pareto distribution (Type I) with shape parameter and scale parameter , the mean excess loss is , which is increasing. The mean excess loss for Pareto Type II Lomax is , which is also decreasing. They are both increasing functions of the deductible ! This means that the larger the deductible, the larger the expected claim if such a large loss occurs! If the underlying distribution for a random loss is Pareto, it is a catastrophic risk situation.
In general, an increasing mean excess loss function is an indication of a heavy tailed distribution. On the other hand, a decreasing mean excess loss function indicates a light tailed distribution. The exponential distribution has a constant mean excess loss function and is considered a medium tailed distribution.
Speed of decay of the survival function to zero
The survival function captures the probability of the tail of a distribution. If a distribution whose survival function decays slowly to zero (equivalently the cdf goes slowly to one), it is another indication that the distribution is heavy tailed. This point is touched on when discussing hazard rate function.
The following is a comparison of a Pareto Type II survival function and an exponential survival function. The Pareto survival function has parameters ( and ). The two survival functions are set to have the same 75th percentile, which is . The following table is a comparison of the two survival functions.
Note that at the large values, the Pareto right tails retain much more probabilities. This is also confirmed by the ratio of the two survival functions, with the ratio approaching infinity. Using an exponential distribution to model a Pareto random phenomenon would be a severe modeling error even though the exponential distribution may be a good model for describing the loss up to the 75th percentile (in the above comparison). It is the large right tail that is problematic (and catastrophic)!
Since the Pareto survival function and the exponential survival function have closed forms, We can also look at their ratio.
In the above ratio, the numerator has an exponential function with a positive quantity in the exponent, while the denominator has a polynomial in . This ratio goes to infinity as .
In general, whenever the ratio of two survival functions diverges to infinity, it is an indication that the distribution in the numerator of the ratio has a heavier tail. When the ratio goes to infinity, the survival function in the numerator is said to decay slowly to zero as compared to the denominator.
It is important to examine the tail behavior of a distribution when considering it as a candidate for a model. The four criteria discussed here provide a crucial way to classify parametric models according to the tail weight.
This post continues with the discussion on the exponential distribution. The previous posts on the exponential distribution are an introduction, a post on the relation with the Poisson process and a post on more properties. This post discusses the hyperexponential distribution and the hypoexponential distribution.
Suppose are independent exponential random variables. If they are identically distributed where the common mean is (the common rate is ), then the sum follows the gamma distribution with shape parameter and rate parameter . Since the shape parameter in this case is an integer , the gamma distribution is also called the Erlang distribution, a sub family of the gamma family.
What if the exponential are not identically distributed? Suppose that the rate parameter of is such that for . Then the sum is said to follow a hypoexponential distribution.
To contrast, a hyperexponential distribution is also a “sum” of independent exponential random variables . The notion of “sum” is not the arithmetic sum but rather is the notion of a mixture. The random variable can be one of the independent exponential random variables such that is with probability with . Such a random variable is said to follow a hyperexponential distribution.
The Erlang distribution, the hypoexponential distribution and the hyperexponential distribution are special cases of phase-type distributions that are useful in queuing theory. These distributions are models for interarrival times or service times in queuing systems. They are obtained by breaking down the total time into a number of phases, each having an exponential distribution, where the parameters of the exponential distributions may be identical or may be different. Furthermore, the phases may be in series or in parallel (or both). The phases are in series means that the phases are run sequentially, one at a time. The Erlang distribution is one example of a phase-type distribution where the phases are in series and that the phases have the same parameter for the expoenential distributions. The hypoexponential distribution is an example of a phase-type distribution where the phases are in series and that the phases have distinct exponential parameters. The hyperexponential distribution is an example of a phase-type distribution where the phases are in parallel, which means that the system randomly selects one of the phases to process each time according to specified probabilities.
The Erlang distribution is a special case of the gamma distribution. For basic properties of the Erlang distribution, see the previous posts on the gamma distribution, starting with this post. The remainder of the post focuses on some basic properties of the hyper and hypo exponential distributions.
The Hyperexponential Distribution
The hyperexponential distribution is the mixture of a set of independent exponential distributions. To generate a hyperexponential distribution, let be independent exponential random variables with rates parameters , and with weights , respectively. Then is a hyperexponential random variable if is with probability . Thus the hyperexponential distribution has a variable number of parameters. There are many parameters, for the exponential rate parameters and for their respective weights. We use the same notations in the discussion of the hyperexponential distribution that follows.
Basic facts about mixture distributions can give a great deal of information on the hyperexponential distribution. For example, many distributional quantities of a mixture distribution are obtained by taking weighted averages of the corresponding quantities of the individual components. Specifically, the density function, the cumulative distribution function (CDF), the survival function, along with the mean, the higher moments can all be obtained by taking weighted averages. However, the the variance of a mixture is not the weighted average of the individual variances. The following shows the probability density function , the survival function and the cumulative distribution function of the hyperexponential distribution.
The above three distributional quantities are the weighted averages of the corresponding quantities of the individual exponential distributions. The hyperexponential distribution is sometimes called a finite mixture since there are a finite number of components in the weighted average. The raw moments of the hyperexponential distribution are also weighted averages of the corresponding exponential raw moments. The following shows the mean and the higher moments where is any positive integer.
Interestingly, the hyperexponential variance is not the weighted average of the individual variances.
The following gives the correct variance of the hyperexponential distribution.
It is instructive to rearrange the above variance as follows:
Compare with the right hand side of . The difference is the content within the squared brackets in , which represents the added uncertainty in a mixture. Note that the content within the squared brackets is a positive value and is the variance of the random variable that has value with probability . In other words, the content inside the squared brackets is the variance of the conditional exponential means (see the random variable described below).
The derivation in shows that the hyperexponential variance is more than the weighted average of the individual exponential variances. This is because the mixing of the exponential random variables has added uncertainty. There are two levels of uncertainty in a mixture – the uncertain in each component (e.g. in each exponential distribution) and the uncertainty in not knowing which component will be realized, which is the added uncertainty. The content inside the squared brackets quantifies the added uncertainty. See here for a more detailed discussion on the variance of a mixture.
The coefficient of variation of a probability distribution is the ratio of its standard deviation to its mean (we only consider the case where the mean is positive). It is sometimes called the relative standard deviation and is a standardized measure dispersion of a probability distribution. For the exponential distribution, the coefficient of variation is always one. For the hyperexponential distribution, the coefficient of variation is always more than one. To see why, consider the random variable as defined below (note that this is the same random variable that is used above to explain the added undertainty in a mixture).
The variance of is given by the following:
We now rearrange to show that the coefficient of variation of the hyperexponential distribution is more than one.
The variance is identical to the content within the squared brackets in . The above derivation shows that the variance of the hyperexponential distribution is always greater than the mean, hence making the coefficient of variation always more than one.
The following is the failure rate of the hyperexponential distribution.
The failure rate (also called the hazard rate) can be interpreted as the rate of failure at the instant right after the life has survived to age . If the lifetime of a system is modeled by an exponential distribution, then the failure rate is constant, which is another way to state the memoryless property of the exponential distribution. Since the exponential distribution is the only continuous distribution with the memoryless property, the failure rate in is obviously not constant. However, as the life goes up in age, the failure is approaching a constant failure rate as shown by the following:
where . That is, as the life (or system or process) goes up in age, the hyperexponential failure rate approaches that of the exponential component with the smallest failure rate (the longest lifetime). This makes intuitive sense. As the system or process survives to a high age, it is more likely the hyperexponential random variable is the exponential component that lasts the longest.
To see why is true, multiple both the numerator and the denominator in by . Then the terms with become (in the numerator) and (in the denominator). As , the terms with go to zero. As a result, the ratio goes to .
Though not discussed here, several distributional quantities that are based on moments can be calculated, properties such as skewness and kurtosis, using the moments obtained in .
The Hypoexponential Density Function
The remainder of the post discusses the basic properties of the hypoexponential distribution. We first examine the probability density function of a hypoexponential distribution. Since such a distribution is an independent sum, the concept of convolution can be used. The following example show how it is done for the hypoexponential distribution with 2 phases. It turns out that the density function in general has a nice form.
Suppose the rate parameters are and for the two independent exponential random variables and where . Determine the density function of the independent sum .
The integral for the density function is:
Note that the density appears to be a weighted average of the two individual exponential density functions, even though one of the weights is negative.
Suppose that the hypoexponential distribution has three phases. The parameters of the three phases are , and . Determine the density of the independent sum .
The idea is to apply the convolution of the density obtained in Example 1 and the exponential density . The convolution integral is:
The result of the integral is:
The density function also appears to be a weighted average of the individual exponential density functions with some of the weights being negative.
Now, the general form of the density function for a hypoexponential density function.
where the weight is defined as:
The density function in the general case of phases can be established by an induction proof.
More Hypoexponential Properties
As before, the hypoexponential random variable is the sum where are independent exponential random variables with being the rate parameter for . Since it is an independent sum, the mean and variance are easily obtained.
The coefficient of variation is the ratio of the standard deviation to the mean. For the exponential distribution, the coefficient of variation is always 1. For the hypoexponential distribution, the coefficient of variation is always less than 1. The following is the square of the coefficient of variation for a hypoexponential random variable.
Note that the quantity in the denominator in is always larger than the numerator, showing that . As a result, . In contrast, the coefficient of variation of the hyperexponential distribution is always greater than 1 (see ).
The survival function for the hypoexponential distribution has the following form:
where the weights are defined in . Then the CDF is . As an example, the survival function for the hypoexponential distribution in Example 1 is
With the density function in , several distributional quantities that are based on moments can be calculated, properties such as skewness and kurtosis.
The following is the failure rate of the hypoexponential distribution.
The hypoexponential failure rate is obviously not a constant rate since only the exponential distribution has constant failure rate. However, as the system reaches high ages, the failure rate approaches that of the smallest exponential rate parameters that define the hypoexponential distribution. The same observation is made above in , that is,
where . Suppose that the lifetime of a life or system is modeled by a hypoexponential distribution. Then when the system is in a high age, the failure rate is approximately the smallest rate parameter of the exponential distributions defining the hypoexponential lifetime. In other words, as the hypoexponentially distributed lifetime becomes large, the remaining lifetime of the system is approximately the exponential lifetime with a rate parameter equal to the smallest of the exponential rate parameters. The proof of is similar to the proof for . Simply multiply the numerator and denominator of by . Then the terms with become constants. As , the terms with go to zero and the ratio goes to .