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ACTL3002 Life Insurance and Superannuation Models

Model Solutions to Tutorial 9 - held in Week 10


See Dickson, et al. Solutions Manual for assigned problems.
In class exercises and presentations.
1. Denote by P the vector of one-year transition probabilities:

0.92 0.05 0.03


P = 0.00 0.76 0.24
0.00 0.00 1.00
(a) Let (t) denote the row vector of state probabilities at time t so that
(t) = (t 1) P
where (0) = (1, 0, 0) since the policyholder

0.92
(1) = (1, 0, 0) 0.00
0.00

is active/healthy at issue. Therefore, we have

0.05 0.03
0.76 0.24 = (0.92, 0.05, 0.03)
0.00 1.00

and similarly,

0.92
(2) = (0.92, 0.05, 0.03) 0.00
0.00

0.05
0.76
0.00

0.92
(3) = (0.8464, 0.0840, 0.0696) 0.00
0.00

0.03
0.24 = (0.8464, 0.0840, 0.0696)
1.00

0.05
0.76
0.00

0.03
0.24 = (0.7787, 0.1062, 0.1152) .
1.00

(b) Let P be the required gross premium. We summarize below all the possible states that might
happen by maturity and take the net present value of premiums, benefits and expenses under
each state:
possible states
0 1 2 3 probabilities net present value
H D
0.03000
(0.6P 200) 60000v
H H D
0.02760
(0.6P 200 + P v) 40v 60000v 2

H H H H 0.77869
0.6P 200 + P v + P v 2  40v + 40v 2

H H H D 0.02539
0.6P 200 + P v + P v 2  40v + 40v 2 + 60000v 3 
3
H H H C 0.04232
0.6P 200 + P v + P v 2 40v + 40v 2 + 40000v

H H C D 0.01104
(0.6P 200 + P v) 40v + 40040v 2 + 35000v 3
2
H H C C 0.03496
(0.6P 200 + P v) 40v + 40040v

H C D
0.01200
(0.6P 200) 40040v + 35000v 2

H C C D 0.00912
(0.6P 200) 40040v + 40v 2 + 35000v 3
H C C C 0.02888
(0.6P 200) 40040v + 40v 2
Then multiplying each net present value by the appropriate probabilities to get the actuarial
present value of premiums, benefits and expenses, and then equate this to zero, by the equivalence
principle. Solving for the gross annual premium, we get
P = 4, 740.40.
[Here we assumed that the renewal expense of $40 in years 1 and 2 is NOT payable upon death only if healthy or sick.]

2. Let P be the annual premium payable for this insurance. We summarize below all the possible states
that might happen by maturity and take the net present value of premiums and benefits (no expenses)
under each state:
possible states
0 1 2
probabilities net present value
H
H
H
H
H
H
H

D
H
H
H
S
S
S

D
H
S
D
H
S

P 20000v
(P + P v) 20000v 2
P + Pv
(P + P v) 3000v 2 
P 3000v + 30000v 2
P 3000v

P 3000v + 3000v 2

0.10
0.08
0.64
0.08
0.02
0.01
0.07

Then multiplying each net present value by the appropriate probabilities to get the actuarial present
value of premiums, benefits and expenses, and then equate this to zero, by the equivalence principle.
Solving for the annual premium, we get
P = 2, 607.50.
3. Let P be the net premium per annum. We summarize below all the possible states that might happen
by maturity and take the net present value of premiums and benefits under each state:
possible states
0 1 2

probabilities

net present value

1
1
1
1
1
1
1
1
1

0.9261
0.0192
0.0096
0.0096
0.0196
0.0004
0.0096
0.0004
0.0100

P
P
P
P
P
P
P
P
P

1
1
1
1
2
2
3
3
4

1
2
3
4
2
4
3
4

+ Pv
+ Pv
+ Pv
+ P v 100, 000v 2
+ Pv
+ P v 100, 000v 2
+ Pv
+ P v 100, 000v 2
100, 000v

[Here, we assumed that premiums are payable so long as at least one of the lives is alive.]
(a) Then multiplying each net present value by the appropriate probabilities to get the actuarial
present value of premiums, benefits and expenses, and then equate this to zero, by the equivalence
principle. Solving for the net annual premium, we get
P = 975.72.
(b) The standard deviation can be obtained by taking the square root of
X
2
(net present value) probabilities.
One can easily verify that this is equal to
13, 206.58.
4. There is only sickness benefits in the policy and there is only one single premium. The probability of
being sick at time t = 1 is given by
pHS
50 = 0.10.
The probability of being sick at time t = 2 is given by
HS
HS
SS
pHH
50 p51 + p50 p51 = 0.85 0.10 + 0.10 0.05 = 0.09.

Finally, the probability of being sick at time t = 3 is given by


HH
HS
HH
HS
SS
HS
SS
SS
HS
SH
HS
pHH
50 p51 p52 + p50 p51 p52 + p50 p51 p52 + p50 p51 p52

0.85 0.85 0.1 + 0.85 0.1 0.05 + 0.1 0.05 0.05 + 0.1 0.8 0.1

0.08475.

Therefore,P can be solved from


P = 0.05P + 10, 000 0.1v + 0.09v 2 + 0.08475v 2

and this implies that


P = 2, 585.23.
5. There are a total of 7 possible outcomes by the end of the policy.
(a) These outcomes are listed below, together with their associated cash flows:
HD: 6000, -16000
HHH: 6000, 0, 0
HHS: 6000, 0, -8000
HHD: 6000, 0, -16000
HSH: 6000, -8000, 0
HSS: 6000, -8000, -8000
HSD: 6000, -8000, -16000

(b) The probabilities of each of these outcomes are given below:


P (H D)

0.08

P (H H H)

0.8 0.8 = 0.64

P (H H S)

0.8 0.12 = 0.096

P (H H D)

0.8 0.08 = 0.064

P (H S H)

0.12 0.75 = 0.09

P (H S S)

0.12 0.1 = 0.012

P (H S D)

0.12 0.15 = 0.018

One can easily verify that the sum of all these probabilities equals to 1.
(c) The NPV of the profit at time 0 arising from each outcome:
H

D = 6000 16000v = 8814.81

H H = 6000 + 0v + 0v 2 = 6000

H S = 6000 + 0v 8000v 2 = 858.71

H D = 6000 + 0v 16000v 2 = 7717.42

S H = 6000 8000v + 0v 2 = 1407.41

S S = 6000 8000v 8000v 2 = 8266.12

S D = 6000 8000v 16000v 2 = 15124.83

(d) The expected value of the NPV of profits at time 0 is therefore given by
(8814.81 0.08) + (6000 0.64) + (858.71 0.096) + (7717.42 0.064)
+ (1407.41 0.09) + (8266.12 0.012) + (15124.83 0.018)
=

2060.36.

The variance of the net present value of profits at time 0 is



 

2
2
(8814.81 2060.36) 0.08 + (6000 2060.36) 0.64 +


2
+ (15124.83 2060.36) 0.018
=

34, 009, 449.78.

So that the standard deviation is


SD =

p
34, 009, 449.78 = 5, 831.76.

6. With no recovery to the healthy state, premiums are payable only until the first claim, or death
(whichever occurs first). The Actuarial Present Value of premiums is therefore
APV (Premiums) = P

00
k px

=P

k=0

v k (0.87) = P

k=0

1
= 5.57894P.
1 0.87v

Now valuing the benefits from the point when the first claim arises (that is, conditional on the first
claim), we get the following probabilities:
the first claim payment will be at claim level 1, with probability 1;
the second claim payment will be at claim level 1, with probability 0.6 and at claim level 2 with probability 0.3;
the third claim payment will be at claim level 1, with probability 0.62 = 0.36, and at claim level 2,
with probability 0.6 0.3 + 0.3 0.6 = 0.36;
the fourth claim payment will be at claim level 1, with probability 0.63 = 0.216, and at claim level 2,
with probability 0.6 0.3 0.6 + 0.6 0.6 0.3 + 0.3 0.6 0.6 = 0.324.
If the first claim is in k years, the expected present value of any level 1 claim benefits will be
50000 0.6 1.06k v k .
But with v at 6%, this is 30,000 for all k. Similarly, the expected present value of any level 2 claim
benefits will be 50,000, so we can ignore interest in valuing claims.
The APV of all claims from the point of the first claim payment arising is therefore
30, 000 (1 + 0.6 + 0.36 + 0.216) + 50, 000 (0 + 0.3 + 0.36 + 0.324) = 114, 480.
Finally, the probability that the first claim occurs at the end of year 1 is 0.1, at the end of year 2
is 0.87 0.1, at the end of year 3 is 0.872 0.1, and so on, which in general at the end of year k is
0.87k1 0.1.
The probability of a claim is therefore

0.1 1 + 0.87 + 0.872 + =

0.1
= 0.76923.
1 0.87

The APV of all claims is therefore


APV (Claims) = 114, 480 0.76923 = 88, 061.45.
With 7.5% of each premium for expenses, the equivalence principle leads us to the equation of value:
(1 0.075) 5.57894P = 88, 061.45
so that
P =

88, 061.45
= 17, 064.43.
(1 0.075) 5.57894

- End of Tutorial 9 model solutions -