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You are on page 1of 4

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:

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

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

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.

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.

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

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

P (H D)

0.08

P (H H H)

P (H H S)

P (H H D)

P (H S H)

P (H S S)

P (H S D)

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

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

(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.

2

2

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

2

+ (15124.83 2060.36) 0.018

=

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

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

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