THE UNIVERSITY OF NEW SOUTH WALES

MONTH OF EXAMINATION - NOVE:MBER 2008

Final Examination

ACTL2003
STOCHASTIC MODELS FOR ACTUARIAL APPLICATIONS

INSTRUCTIONS:
1. TIME ALLOWED - 3 HOURS.

2. TOTAL NUMBER OF QUESTIONS - 9.

3. TOTAL MARKS - 100.
4. THERE ARE 2 SECTIONS. EACH SECTION SHOULD BE ANSWERED IN
A SEPARATE EXAMINATION BOOK.
5. SECTION I HAS FIVE (5) QUESTIONS. USE A SEPARATE EXAMINATION
BOOK AND INDICATE THE SECTION NUMBER ON THE FRONT PAGE. ANSWER EACH QUESTION STARTING ON A NEW PAGE.
6. SECTION 11 HAS FOUR (4) QUESTIONS. USE A SEPARATE EXAMINATION BOOK AND INDICATE THE SECTION NUMBER ON THE FRONT PAGE.
ANSWER EACH QUESTION STARTING ON A NEW PAGE.

7. QUESTIONS ARE NOT OF EQUAL VALUE.

8. CANDIDATES MAY BRING THE "FORMULAE AND TABLES FOR ACTUARIAL
EXAMINATIONS" BOOK (ANY EDITION) INTO THE EXAMINATION. IT MUST
BE WHOLLY UNANNOTATED.
9. CANDIDATES MAY BRING THEIR OWN CALCULATORS PROVIDED THEY
DO NOT HAVE A "QWERTY" KEYBOARD.
ALL ANSWERS MUST BE WRITTEN IN INK. EXCEPT WHERE THEY
ARE EXPRESSLY REQUIRED, PENCILS MAY BE USED ONLY FOR DRAWING, SKETCHING OR GRAPHICAL WORK.
Answer each question starting on a new page
1

\)

.~

SECTION I [50 MARKS]

START A NEW EXAMINATION BOOK. ANSWER ALL QUESTIONS. START EACH
QUESTION ON A NEW PAGE.
Question 1 (10 marks)
a) Consider a Markov chain {Xn , n = 0,1,' .. } with state space {I, 2, ... ,5}. Suppose
its probability transition matrix is given as below:
1

0 0 0 54
1
1
"3 "3 0 "3 0
0 0 21 0 "21
1
1
0 1 0
i 0"2 1. 04 0
"2
2
~

i) Classify the states, and determine whether they are recurrent or transient [1
marks].
ii) Find the expected number of visits in each transient state starting in any transient
state. [2 marks]
iii) Given that X o is equally likely to be in any state, calculate the probability that
two steps later, the process is in state 3. [2 marks]

b) Consider a matrix

x I _ y2 )
( I-x
Y
i) Find all the possible values of x and y such that the above matrix is a probability
transition matrix? [2 marks]
ii) Show in detail when the above matrix will be a probability transition matrix of a
Markov chain whose limiting probabilities exist, and when it will not. [3 marks]

Question 2 (14 marks)

A no claims discount system for car insurance has 3 discount levels: 0%, 20% and 30%.
The number of claims made by a policyholder follows a Poisson process with rate 2 per
year. The size of a claim is independent of the other claims, and it follows an exponential
distribution with mean 250. A claim is referred to as a small claim if its size is strictly less
than the mean, and a large claim otherwise..
At the end of each year, the insurance company will adjust the discount level of each policyholder. If a policyholder makes no claims in a year, then next year they move to the next
higher discount level or remains at the highest level. If they only make one small claim in a
year, then next year they will stay at the same discount level. If strictly more than 1 claim
or at least one large claim are made, they will move to the next lower discount level or stay
at the lowest level.
a) Set out the appropriate Markov chain to analyse this NCD system (with 3 states) and
give the probability transition matrix. [5 marks]
b) Assume that the full premium the insurance company will charge a policyholder is
$1,000 for a year. Determine the long-run average premium a policyholder will expect
to pay per year. [7 marks]
c) For each discount level, determine the expected number of years until the policyholder
returns to the same discount level and comment on the ability of this NCD system to
differentiate between good and bad risks. [2 marks]

Question 3 (6 marks)

a) A casino has a game that makes payouts according to a Poisson process with rate 5 per
hour. The payout amounts are 1,2,3, ... without limit, and the probability that any
given payout is equal to i is
Payouts are independent. Calculate the probability
that there are only payouts with amounts 1 or 4 in a given 10 minutes period. [2

it.

marks]
b) The time elapsed between arrivals of customers is modeled such that Vk represents the
time elapsed between the arrivals of the (k - 1)th and kth customer. (VI =the time the
first customer arrives). Suppose that: i) Vi, "'2, '" are mutually independent; ii) The
pdf of each Vk is f(t) = O.le- Olt , t > 0, where t is measured in minutes.
Determine the probability that at least two customers arrive in a ten-minute period.

[1 marks]
c) Lucky Jack finds coins on the way to work according to a Poisson process with a mean
of 22 coins per month.
5% of the time, Jack finds coins worth a total of 10.
15% of the time, Jack finds coins worth a total of 5.
80% of the time, Jack finds coins worth a total of 1.
The value of the coins he finds is independent of the number of coins.
the variance of the total amount he finds in a month. [3 marks]

Calculate

Question 4 (10 marks)

In a Continuing Care Retirement community, healthy residents live independently and will
become sick at rate 0.02 per year. A healthy resident will move to a Health Center immediately when he/she gets sick, and will recover to healthy at rate 2.0 per year, die at rate 0.1
per year, or leave treatment and therefore withdraw from the Health Center at rate 0.05.
A patient who leaves treatment will live independently with risk of death at a rate 1.0. A
patient may also recover to health at a rate 0.01 without treatment. Assume that illness is
the only cause of death.
Let 1, 2, 3, and 4 represent the four states - healthy, ill under treatment, ill without treatment, and dead, respectively.

a) Give the generator matrix for transitions between the four states. [2 marks]
b) Give the Kolmogorov backward equations for this model. [2 marks]
c) If a resident is in the Health Center currently, calculate the probability that he/she
will stay there for the next 2 years. [2 marks]
d) Determine the probability that a healthy resident at the beginning of Year 1 will remain
healthy for at least 2 years, then get sick and not leave the Health Center before the end
of year 5. Clearly explain the formula you use to determine your answer. [4 marks]

Question 5 (10 marks)

Let B t , t 2: 0 be a standard Brownian motion.

a) Show that exp(aBt -

;2 t ) is a martingale.

b) Define yt = cB fz' t 2:

o.

[2 marks]

Show that yt, t 2: 0 is a Brownian motion. [3 marks]

c) Let yt be defined as in (b). Determine the covariance Cov(Ys, yt). [2 marks]

d) For a constant c and

0:,

dX t

define X t = exp(ct + o:Bt ). Show that

=

(c + 2a )Xtdt + o:XtdBt .

[3 marks]

SECTION II [50 MARKS]

START A NEW EXAMINATION BOOK. ANSWER ALL QUESTIONS. START EACH
QUESTION ON A NEW PAGE.
Question 6 (14 marks)
(a) Outline the inverse transformation method for generating simulated values for a random variable X with continuous distribution function F.
[2 marks]
(b) A student has proposed to generate random variates from a Weibull distribution with
probability density function

f (x) = C/x1 - 1 exp [-ex 1 ]

for x 2: 0

using the following method:

1. Generate a uniform random variate u from U (0,1)

2. Determine the Weibull random variate using

X

= [-

In (1 - u)

]-1

Is this method and formulae correct? If not give a corrected method and formulae. [3
marks]
(c) Random variates are generated from a gamma distribution

Aa
f(x) = f(0:)xa-1e- AX , x> 0
Twenty values are generated for each sample and the mean and standard deviation of
each of the samples, to 2 decimal places, are as follows

Sample
Mean
Standard Deviation

12.01
6.15

11.79
4.73

3
13.43
6.42

14.01
7.02

5
11.44
4.30

6
11.19
3.90

7
11.24
3.84

8
12.42
4.35

9
12.91
3.59

i) Use all of the samples to estimate the mean and variance of the gamma distribution. Determine estimates of the parameters A and 0:. [5 marks]
ii) Determine the number of simulated values required in order for the estimate of
the mean of the distribution to be within 5% of the true value with (approximate)
probability 95%. [4 marks]
7

10
12.29
4.60

Question 7 (6 marks)
a) Find a filter of the form
that passes linear trends without distortion and that eliminates seasonal components
of period 2. [3 marks]
b) Show that the filter with coefficients

passes second degree polynomials and eliminates seasonal components with period 3.
[3 marks]

Question 8 (10 marks)

Consider the time series defined by

where X o = 0, /-l is a constant, and {Zt}

rv

WN(O, (72).

a) Find the relationship between Var(Xt ) and Var(Xt-d. Comment on the stationarity
of {Xd. [2 marks]
b) Find the mean of X t and explain why /-l is referred to as the "drift". [3 marks]
c) Find formulae for Var(Xt ) and Cov(Xt , X t +k ) in terms of

(72

and t. [5 marks]

Question 9 (20 marks)

a) Define the autocorrelation function for a stationary process. [2 marks]
b) For the process

Y; = "6Y;-1 - "6Y;-2
where {Zd

rv

+ Zt,

WN(O, a 2 ), show that the autocorrelation function is

[6 marks]
c) Give an expression for the general form of an ARlMA(p, d, q) process, defining and
explaining all of the terms in the expression. [3 marks]
d) For the ARlMA(p, d, q) process

x=
Zt

rv

0.6X-l + 0.3X-2 + 0.1Y;-3 + Zt - 0.25Zt -

N (0,1) i.i.d.

i) Determine the values of p, d and q. [3 marks]

ii) Determine if the process is stationary and the number of differences that must be
taken in order to obtain a stationary process. [2 marks]
iii) Explain the concept of a causal process and determine if {Y;} is causal. [2 marks]
iv) Explain the concept of an invertible process and determine if {Y;} is invertible.
[2 marks]

END OF EXAMINATION