Principle of Actuarial Modelling

BY CA SWATI GUPTA
• Actuarial Science applies mathematical and statistical methods to
finance and insurance, particularly to risk assessment. Actuaries are
professionals who are qualified in this field through examinations and
experience.
• Principles of Actuarial modeling deals with the modeling techniques used
by actuaries when trying to assess uncertainty and risk. Some of the key
areas in the Principles of Actuarial Modeling are stochastic processes,
survival models, markov chains, markov jump processes, graduation of
data and estimating lifetime distributions. 
 Stochastic Process in Insurance sector
• Insurance mathematics today is considered a part of applied probability
theory, and a major portion of it is described in terms of continuous time
stochastic processes.
• A reasonable mathematical theory of insurance can possibly provide a
scientific basis for the trust between the insured and the company.
• The main objectives are modelling of claims that arrive in an insurance
business, and decide how premiums are to be charged to avoid ruin of the
insurance company.
 What is Markov Model?
• In probability theory, a Markov model is a stochastic model used
to model randomly changing systems where it is assumed that future
states depend only on the present state and not on the sequence of
events that preceded it (that is, it assumes the Markov property).
Generally, this assumption enables reasoning and computation with
the
model that would otherwise be intractable.
• If the system moves from state i during one period to state j during
the next period, we call that a transition from i to j has occurred.

• Some Examples are:

– Snake & ladder game
– Weather system
.
 Markov Process
Simple Example
Weather: 40% rain tomorrow
• raining today 60% no rain tomorrow

• not raining today 20% rain tomorrow

80% no rain tomorrow

The transition matrix:

Rain No rain
Rain
 0.4 0.6 
P 
No rain  0.2 
 Markov
Coke vs.Process
Pepsi Example

•Given that a person’s last cola purchase was Coke,

there is a 90% chance that his next cola purchase will
also be Coke.
•If a person’s last cola purchase was Pepsi, there is
an 80% chance that his next cola purchase will also be
Pepsi.

transition matrix? 0.9 0.1

0.8

coke pepsi

0.2
 transition matrix: 0.9 0.1
0.8

coke coke pepsi

coke
pepsi
0.9
0.2 0.1
0.8 0.2

pepsi
P
 
 Markov Process
Coke vs. Pepsi Example (cont)

coke
coke
0.9
pepsi 0.1
0.2 0.8
pepsi
P
 
•Given that a person is currently a Coke purchaser, what is the probability that he
will purchase Coke two purchases from now?
•Pr[Coke ?Coke ] =
•Pr[Coke CokeCoke ] + Pr[Coke  Pepsi Coke ] =
• 0.9 * 0.9 + 0.1 * 0.2 = 0.83
 Markov Process
Coke vs. Pepsi Example (cont)

•Given that a person is currently a Coke purchaser, what is the

probability that he will purchase Pepsi two purchases from
now?
•Pr[Coke ? Pepsi ] =
•Pr[Coke Coke Pepsi ] + Pr[Coke  Pepsi  Pepsi ] =
• 0.9 * 0.1 + 0.1 * 0.8 = 0.17

11
 Markov Process
Coke vs. Pepsi Example (cont)

•Given that a person is currently a Pepsi purchaser, what is the

probability that he will purchase Coke two purchases from
now?
•Pr[ Pepsi?Coke ] =
•Pr[ PepsiCokeCoke ] + Pr[ Pepsi Pepsi Coke ] =
• 0.2 * 0.9 + 0.8 * 0.2 = 0.34

12
 Markov Process
Coke vs. Pepsi Example (cont)

•Given that a person is currently a Pepsi purchaser, what is the

probability that he will purchase Pepsi two purchases from
now?
•Pr[ Pepsi? Pepsi ] =
•Pr[ PepsiCoke Pepsi ] + Pr[ Pepsi Pepsi  Pepsi ] =
• 0.2 * 0.1 + 0.8 * 0.8 = 0.66

13
• Find P X P = P2 Using Multiplication of two matrix
FOR THE ABOVE QUESTION and u will get same
answer.
 Life Table

• Life table is a mathematical sample which gives a view of death in a country

and is the basis for measuring the average life expectancy in a society. It
tells about the probability of a person dying at a certain age, or living upto a
definite age.
• According to Bogue, “The life table is a mathematical model that portrays
mortality condition at a particular time among a population and provides a
basis for measuring longevity. lt is based on age specific mortality rates
observed for a population for a particular year.”
• Life tables represent a well-known basic tool of actuarial mathematics,
which is efficiently applicable in other branches, as well. They contain the
age specified probabilities of dying and express the subsequent dying out
of the hypothetical population cohort. The key elements of the tables, the
probabilities of dying, are estimated from the empirical statistical data.
x will be given
fx or dx will be given FORMULAS
Age is x in years
No. of persons living at an specified age is fx
No. of persons among fx persons who die before
reaching f(x+1)ie. Number of deaths is dx (is given)=
fx-f(x+1)
Probability of death per person qx = dx/fx
Probaility of surviving per person px = 1-qx or
f(x+1)/fx
Number of people lived on an average Lx = {fx +
f(x+1)}/2 or fx -dx/2
PRACTICE SUM
Time series

Sums in excel

Self study