Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

29 April 2004 (am)

Subject 106 Actuarial Mathematics 2

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. Enter all the candidate and examination details as requested on the front of your answer
booklet.

2. You must not start writing your answers in the booklet until instructed to do so by the
supervisor.

3. Mark allocations are shown in brackets.

4. Attempt all 10 questions, beginning your answer to each question on a separate sheet.

Graph paper is not required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this
question paper.

In addition to this paper you should have available Actuarial Tables and
your own electronic calculator.

Faculty of Actuaries
106 A2004 Institute of Actuaries
1 The loss severity distribution for a portfolio of household insurance policies is
assumed to be Pareto with parameters = 3.5, = 1,000.

Next year, losses are expected to increase by 5%, and the insurer has decided to
introduce a policyholder excess of £100.

Calculate the probability that a loss next year is borne entirely by the policyholder. [3]

2 The loss function under a decision problem is given by:

1 2 3

d1 120 97 131
d2 132 74 89
d3 117 141 37

(i) Determine the minimax solution to this problem. [2]

(ii) Given the probability distribution p( 1) = 0.3, p( 2) = 0.3, p( 3) = 0.4,

determine the Bayes criterion solution. [2]
[Total 4]

3 A risk consists of 5 policies. On each policy in one month there is exactly one claim
with probability and there is negligible probability of more than one claim in one
month. The prior distribution for is uniform on (0, 1). There are a total of 10
claims on this risk over a 12 month period.

(i) Derive the posterior distribution for . [2]

(ii) Determine the Bayesian estimate of under:

(a) quadratic loss

(b) all-or-nothing loss
[3]
[Total 5]

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4 A portfolio consists of two types of policies. For type 1, the number of claims in a
year has a Poisson distribution with mean 1.5 and the claim sizes are exponentially
distributed with mean 5. For type 2, the number of claims in a year has a Poisson
distribution with mean 2 and the claim sizes are exponentially distributed with
mean 4. Let S be the total amount claimed on the whole portfolio in one year. All
policies are assumed to be independent.

(i) Determine the mean and variance of S. [2]

(ii) Derive the moment generating function of S and show that S has a compound
Poisson distribution. [4]
[Total 6]

5 Claims arrive in a Poisson process rate and they are exponentially distributed with
mean . The premium loading factor is .

(i) Derive the formula for the adjustment coefficient, and state an upper bound on
the probability of ruin if the initial capital is u. [4]

(ii) Suppose = 1.

(a) Determine a value of such that the probability of ruin is at most 0.01
when the initial capital is 20.
(b) State how this value of changes if the initial capital is increased. [2]
[Total 6]

106 A2004 3 PLEASE TURN OVER

6 The reserving department of a general insurance company has obtained the following
incremental claims data (in £ 000s). You may assume that all claims are paid at the
end of the year.

Development Year
Accident Year 0 1 2 3
2000 210 95 40 10
2001 225 105 45
2002 215 95
2003 220

Underlying claims inflation rates over the twelve months to the middle of each year
were as follows:

2001 3.0%
2002 2.5%
2003 2.5%

Claims inflation from the middle of 2003 onwards is assumed to be 3.0% per annum.

(i) Calculate the outstanding claims reserve at 31 December 2003 using the
inflation adjusted chain ladder, without adjusting forecast claims for inflation.
[6]
(ii) State the assumptions made. [2]
[Total 8]

7 The total amount claimed for a particular risk in a portfolio is observed for each of 5
consecutive years.

(i) From past knowledge of similar portfolios, an insurer believes that the claims
are normally distributed with mean and variance 25, and that the prior
distribution of is normal with mean 125 and variance 36.

(a) Derive the Bayesian estimate for under quadratic loss, and show that
it can be written in the form of a credibility estimate combining the
mean observed claim size for this risk with the prior mean for .

(b) State the credibility factor, and calculate the credibility premium if the
mean claim size over the 5 years is 122.

(c) Comment on how the credibility factor and the credibility estimate
change if the variance of 25 is increased.
[6]

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 (ii) A second insurer does not believe that this is an appropriate prior distribution
for risks in this portfolio, and decides to use Empirical Bayes Credibility,
Model 1, where the credibility premium combines the mean for the particular
risk with the estimated value of E(m( )). Data from 3 risks in this portfolio
over 5 years are available. Let Xij be the claim for risk i in year j. The table
shows various summary statistics for the observed data.
5
Xi j 1
( X ij X i )2

Risk 1 (i = 1) 122 2,848

Risk 2 (i = 2) 164 1,628
Risk 3 (i = 3) 106 1,887

(a) Calculate the estimated credibility factor, and calculate the credibility
premium for risk 1.

(b) Compare your answer to that obtained in (i)(b).

[6]
[Total 12]

106 A2004 5 PLEASE TURN OVER

8 (i) Show that

2
d ½ m2 2 log d m
x m f ( x)dx = e m
0

2
1 1 log x
where f(x) = exp ½ [4]
x 2

(ii) The loss amount, X, from a portfolio of non-life insurance policies is assumed
to be independently distributed with mean £800 and standard deviation
£1,200.

Calculate the values of the parameters of a lognormal distribution with this

mean and standard deviation. [3]

(iii) The company is considering purchasing reinsurance cover, and has to decide
whether to purchase excess-of-loss or proportional reinsurance.

The amounts paid by the direct insurer and reinsurer respectively, are given by

X I(Prop) = (1 k) X
X R(Prop) = kX

and X I( XL ) = min{X, d}
X R( XL ) = max{0, X d}

where X denotes the loss amount.

Using the loss distribution from (ii), calculate the value of k such that

E[ X I(Prop) ] = 0.7E[X]

and show that if d = 1189.4, E[ X I( XL ) ] = 0.7E[X] [4]

(iv) Using the values of k and d from (iii), calculate the values of Var[ X I(Prop) ] and
Var[ X I( XL ) ] . [4]

(v) Comment on the results in (iii) and (iv). [2]

[Total 17]

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9 Let Yij be the number of accidents on a particular motorway in the jth quarter of year
i, i = 1, 2, 3, j = 1, , 4. Suppose that Yij has a Poisson distribution with mean ij.

(i) (a) Derive the log-likelihood function as a function of ij and determine

the maximum likelihood estimate of ij.

(b) If log( ij) = , determine the maximum likelihood estimate of .

(c) Define the scaled deviance, and derive an expression for the scaled
deviance for the model in (i)(b).
[8]

(ii) Three models are shown below.

Deviance Degrees of Freedom

Model 1 log( ij) = 266.35 11
Model 2 log( ij) = i 202.19 9
Model 3 log( ij) = i + j 10.68 6

(a) Interpret each of these models.

(b) Determine which model you would recommend, giving your reasons.
[7]

(iii) It is found that the model log( ij) = i+ j provides a reasonable fit to the
data, with the estimate of given as 0.34.

Interpret this model. [2]

[Total 17]

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10 A marine insurer offers policies to boat owners to protect against collision damage.
Cover is provided to coincide with the calendar year. For each policyholder the
probability of having an accident during the year is 0.2. The policy meets the cost of
repairs which, regardless of the timing of the accident, are always carried out at the
end of the year. The insurer operates a no claims discount system. In the event of a
claim free year, the policyholder moves to the next higher level of discount. In the
event of a claim during the year, the policyholder moves in the next year to the next
lower level of discount, unless the claim was as a result of drunken behaviour. In this
case, the policyholder moves in the next year to the lowest level of discount.

The discount levels are 0%, 20% and 50%. 25% of claims are due to drunken
behaviour.

The insurer charges a premium of £2,500 for policyholders at the 0% discount level.

A policyholder makes a claim following an accident if the cost of repairs is greater

than the additional premiums payable at the next two renewals, assuming no further
claims are made.

(i) Calculate the cost of a repair below which the policyholder will not claim, for
each level of discount. [7]

(ii) Assuming that the cost of each repair follows a lognormal distribution with
parameters = 6.5 and 2 = 3.5, calculate the probability that a policyholder
makes a claim in the event of an accident, at each level of discount. [6]

(iii) Write down the transition matrix. [5]

(iv) Derive the proportion of policyholders at each level of discount, once a steady
state has been reached. [4]
[Total 22]

END OF PAPER

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