THE UNIVERSITY OF NEW SOUTH WALES

MONTH OF EXAMINATION - NOVEI\1BER 2007

Final Examination
ACTL2003
STOCHASTIC MODELS FOR ACTUARIAL APPLICATIONS

INSTRUCTIONS:
1. TIME ALLOWED - 3 HOURS.

2. TOTAL NUMBER OF QUESTIONS - 8.

3. TOTAL MARKS - 100.
4. THERE ARE 2 SECTIONS. EACH SECTION SHOULD BE ANSWERED IN
A SEPARATE EXAMINATION BOOK.
5. SECTION I HAS 6 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 2 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" BOOKLET INTO THE EXAMINATION.
9. CANDIDATES MAY BRING THEIR OWN CALCULATORS OR HAND HELD
COMPUTERS.
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

SECTIOX I [73 MARKS]

START A NEW EXAMIl\ATIO~ BOOK. ANSWER ALL QUESTIONS. START EACH
QUESTION ON A NEW PAGE.
Question 1 (6 marks)

(a) Specify the classes of the following Markov chains, and determine whether they
are transient or recurrent:

0 "21 "21
1
1
"2 0 "2
1
1
"2 "2 0

P2

0 "21 0
1
1
"2 '4 0
0 21 0
0 0 0 "21
0 0 0 "21
"2
1
'4
1
"2

0
0
0

0 0 0
0 0 0
1
1
"2 "2 0
0 0 1

1
1
0
0

.:i

0 0 0
"2 "2 0 0 0
0 0 1 0 0
0 0 31 32 0
1 0 0 0 0
4

P4

"2

[2 marks]
(b) Let the transition probability matrix of a two-state Markov chain be given by
p =

III ~

1;

11

Show that

Hint: Use mathematical induction. [4 marks]

Question 2 (10 marks)

An insurance company is modelling its motor insurance claims. It has determined that the
probability of a claim depends on the number of claims in the previous two years. If a motor
insurance policyholder has had claims in both of the previous two years the probability of
a claim in the current year is 0.25, if they had claims in only one of the previous two years
then the probability of a claim in the current year is 0.15 and if they had no claims in the
previous two years then the probability of a claim in the current year is 0.05.
(a) Describe the claims process as a Markov chain taking into account the previous
two years claims, specifying the states of the process and the transition matrix.
[2 marks]
(b) Explain the requirements for this process to have a long run stationary distribution
and show that the Markov chain satisfies these requirements. [2 marks]
(c) Determine the long proportion of policyholders making at least one claim in a
year. [6 marks]
Question 3 (15 marks)
An insurance company checks policyholder claims to determine if they are fraudulent or
not. Initially every claim is checked until there are i consecutive genuine claims. Once
i genuine claims have been processed, the company then checks only one in r claims by
random sampling. If a fraudulent claim is detected then the company returns to checking
every claim until i consecutive genuine claims are processed. The probability that any claim
is fraudulent is p. Consider the stochastic process {Xn : n = 1,2, ... } where X n is the state
of the checking system at the nth claim. This checking system can be modelled as a Markov
chain using i + 1 states. State 0 is the detection of a fraudulent claim, states k = 1, ... , i - I
are the states when the checking system has processed k consecutive genuine claims, and
state i is the state when random sampling for one in r claims is being used for checking.
(a) Write down the probability transition matrix for the chain and justify your answer.
Hint: you should have i + 1 states. [3 marks]
(b) Using your transition matrix in (a), derive expressions for the long run probabilities for each of the states, showing all your working. [8 marks]
(c) A student has suggested that from general reasoning the long run proportion of
undetected fraudulent claims will be equal to

Do you agree or disagree with this, and explain your answer. [4 marks]

Question 4 (14 marks)

A retirement home has separate accommodation for healthy residents and a nursing facility
for ill residents. Residents who get ill may spend time in the nursing facility on a temporary
basis if they recover. Residents may leave the retirement home because of death or because
they move elsewhere. Consider a continuous time Markov chain model of the retirement
home residents with the following states:

State
1
Healthy - Separate Accommodation
III - Nursing Facility
2
3
Dead
4
Withdrawn from Retirement Home
Transition rates between the states are denoted by

(Jij.

Assume the following transition rates per year

= 0.4,
(J13 = 0.1,
(J14 = 0.2
(J21 = 0.5,
(J23 = 0.4,
(J24 = 0.3
all other (J ij = 0
(J12

Justifying the formulae that you use, determine

(a) the probability that a healthy resident will remain healthy for at least 5 years.
[2 marks]
(b) the probability that a healthy resident will withdraw from the retirement home
over the next year. [3 marks]
(c) the probability that a resident entering the nursing facility will recover within 2
years. [3 marks]
(d) the probability that a healthy resident will become ill, enter the nursing facility
and remain in the nursing home until the end of the year. [6 marks]
You may use the following results in your answers without derivation:
Chapman-Kolmogorov equations

Pij (s, t)

I: Pik (s, u) Pkj (u, t)

for all u, s < u < t

Kolmogorov's forward equations in integrated form

Pij (s, t)

I: I
kfj

t
-

Pids, t - w)

:k g~ :j Aj (t J

w) e- fLw Aj(u)dudw for i =1= j

Question 5 (12 marks)

Consider the standard Brownian motion (B (t), t

(a) Show that B (t) +- B (5),

[2 marks]

5 ::;

0) .

t is normal with mean zero and variance 35

+ t.

(b) The solution to the SDE dX(t) = )"(fJ-X(t)) + adBt is given by X(t)
X (0) e- At + fJ (1 - e- At ) + ae- At J~ eAsdB s ' State, with reasons, the distribution
of X (t) and derive expressions for the mean and variance of X (t) . [4 marks]
(c) A share price Y (t) follows a geometric Brownian motion process with Y (t) =
exp (0.2B (t) + O.lt). Consider a contract where the payment to be made at time
t = 20 is given by exp [In Y(10 l ;ln Y(20)] . Showing all your working, determine the
mean and the variance of the payment at time t = 20. Briefly explain how you
would check your answers for reasonableness. [6 marks]
Question 6 (16 marks)
Consider the following procedure for generating simulated random variates.

Step 1 Let n

= 1.p

and .(3

= --p
1
1

Step 2 Set k = 0
Step 3 Generate a uniform (0,1) random variate U
Step 4 If k = n, stop. Otherwise k = k
Step 5 If U ::; p set X k = 1 and reset U
Return to Step 4.

+1

= nU.

If U > P set X k

= 0 and

reset U

= (3 (U -

p).

(a) Explain how this procedure works and how it can be used to generate binomial
random variates. In your answer explain why, and how, you would modify the
procedure if n is large. [3 marks]
(b) Describe another procedure that could be used to simulate a binomial random
variate. [2 marks]
(c) Explain how you could use either of these processes to simulate normal random
variates with mean fJ and variance a 2 . [3 marks]
(d) You wish to simulate the value of X (5) for s > t where the stochastic differential
equation (SDE) of the process is dX (t) = (fJ - X (t)) dt + aX (t) dB (t) and B (t)
is a standard Brownian motion.
1. Give an algorithm for the steps you would use to simulate this (SDE) in order
to generate paths for X (t) . [3 marks]

2. Describe the properties you should observe for the paths and also the distribution of your simulated values for X (s) for increasing values of s. Consider
separately the cases where (J is large compared to f..L and where (J is small
compared to f..L.
[5 marks]

SECTION II [27 MARKS]

START A NEW EXAMINATION BOOK. A:\'SWER ALL QUESTIONS. START EACH
QUESTIOl\ ON A NEW PAGE.
Question 7 (15 marks)

(a) Show that the two MA(l) processes

X t = Zt + ezt- 1,
-

1";; = Zt
where

{Zd '"'-' WN(O, ()2)

1-

{Zt} '"'-' WN (0, ()2 e2 ) ,

+ eZt-1,

< lel < 1, have the same autocovariance functions. [2 marks]

(b) Show that the value at lag 2 of the partial ACF of the MA(l) process

Xt=Zt+eZt-l,

t=O,l, ... ,

where {Zd '"'-' WN(O, ()2), is

[4 marks]
(c) Suppose that {Xt} is the noninvertible MA(l) process

where

lel > 1.

Define a new process {Wt} as

00

2::::( -e)-j X t - j

Wt =

j=O

1. Express ()~v in terms of

e and

()2

and show that {Wd '"'-' WN(O, ()~).

[6 marks]
2. Show that {Xd has the invertible representation (in terms of {Wt }),

[3 marks]

Question 8 (12 marks)

Charts showing the natural logarithm of the index, the ACF and PACF for the natural
logarithm of the index as well as the ACF and PACF for the first differences of the natural
logarithm of the index for a monthly index of Sydney residential property prices over the
period January 1979 to April 2007 are given below.
Chart 1: Linear trend fitted to the Logarithm of the Sydney Property Price Index
Trend Analysis Plot for In(Index)
Unear Trend Model

Yt

= 0.248127 + 0.00696689*t
Variable
- . - Actual
E
Fits
Accuracy t~easures
MAPE
13.0268
MAD
0.0823
MSD
0.0099

34

68

102

136

170

204

238

272

306

340

Index

Chart 2: ACF for the Logarithm of the Sydney Property Price Index
ACF In Index
1.0
0.8
0.6

..
...
..=
c

0.4

.!i

0.2

.2
41

0
v
0

0.0
-0.2

cc -0.4
-0.6
-0.8
-1.0
5

10

15

20

25

30

35

40

Lag

45

50

55

60

Chart 3: PACF for the Logarithm of the Sydney Property Price Index
PACF In Index
1.0
0.8
c

0.6

..

0.4

...
..!lI
.2

GI

0.2

0
0

... 0.0
= -0.2

er:

....

]j

Co

-0.4
-0.6
-0.8
-1.0
1

15

10

20

25

30

35

40

45

55

50

60

Lag

Chart 4: ACF for differences of the Logarithm of the Sydney Property Price Index
ACF of Residuals for Diff(lnindex)
(with 5% significance limits for the autocorrelations)

1.0
0.8
0.6
c

0.4

..

0.2

...=

-0.2

...
..!lI

.2

GI

u
0

0.0

Cl: -0.4

-0.6
-0.8
-1.0
6

12

18

24

30

36

42

Lag

48

54

60

Chart 5: PACF for differences of the Logarithm of the Sydney Property Price Index
PACF of Residuals for Diff(lnindex)
(with 5% significance limits for the partial autocorrelations)

1.0
0.8

..
c
.S!

0.6

.
...

0.4

..!!i!
ClJ

..
0
0

::J

Cl:

0.2
0.0
-0.2

t= -0.4
ca

a. -0.6
-0.8
-1.0
6

12

18

24

30

36

48

42

54

60

Lag

(a) Based on these charts explain, giving reasons, the form of the time series model
you would propose to use to model the series. In your answer clearly identify each
of the different components required in the model. [5 marks]
(b) A seasonal ARIMA model has been fitted. The following Charts give the parameter estimates as well as the ACF and PACF for the residuals of the fitted
model.
1. Write down an expression for the fitted model explaining all the terms used
as well as specifying the parameter values. [3 marks]
2. Discuss whether or not the model is a suitable model based on the Charts
provided and mention any additional analysis you would undertake to finalise
the model. [4 marks]

10

Chart 6: Parameter estimates for Seasonal ARlyIA model

Type
AR
SAR
MA

1
12
1

Coef

SE Coef

0.9668
0.3758
0.7913

0.0214
0.0530
0.0457

45.10
7.09
17.32

0.000
0.000
0.000

Differencing: 1 regular difference

Number of observations: Original series 340, after differencing 339
Residuals:
SS = 0.0385921 (backforecasts excluded)
MS = 0.0001149 DF = 336
Modified Box-Pierce (LJung-Box) Chi-Square st.atis::ic
Lag
Chi-Square
DF
P-Value

12
32.4
9
0.000

24
62.8
21
0.000

36
74.1
33
0.000

48
89.5
45
0.000

Chart 7: ACF for residuals of seasonal ARL'v1A model

ACF of Residuals for In(Index)
(with 5% significance limits for the autocorrelations)

1.0
0.8
0.6

c
.Si!
~

0.4

0.2
0.0 +r.LLJLoJ..........................,.--...I.y--n~ ...~-'--.-.-''-rT....-'LL-ry.'-r'-"-T.L....,..........r-i

~ -0.2

<

-0.4

-0.6
-0.8
-1.0
6

12

18

24

30

36

42

48

Lag

11

54

60

Chart 8: PACF for residuals of seasonal ARIMA model

PACF of Residuals for In(Index)
(with 5% significance limits for the partial autocorrelations)

1.0

0.8
c
.Si!

0.6

:s

0.4

0.2

III

:I

BD'0 +,-.LLl..L.L.J'-rr-.---."TT"1.-J----r.......,,-'-L........-r-J~rr"rn.-l-'_'_r_ ..........

._r""r_''_rr........,,__I

:::I

cl:

-0.2

:; -0.4

~ -0.6
-0.8
-1.0
6

12

18

24

30

36

42

48

54

60

Lag

END OF EXAMINATION

12