Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

10 April 2002 (pm)

Subject 103 — Stochastic Modelling

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.

ã Faculty of Actuaries
103—A2002 ã Institute of Actuaries
1 A stock price {St: t = 1, 2, ¼} is modelled as

æ t ö
St = S0 exp ç å X j ÷ ,
ç j =1 ÷
è ø

where X1, X2, ¼ is a sequence of independent Normal random variables, with

E(Xj) = mj, Var(Xj) = s2j .

In order to perform a martingale analysis it is necessary to find a sequence of

constants a1, a2, ¼ such that Yt = a t St is a martingale.

(i) Derive a recurrence equation satisfied by the constants {at: t = 1, 2, ¼}.

[You may use the fact that the moment generating function of N(m, s2) is
M(s) = exp(ms + ½s2s2).] [4]

(ii) State, with a brief explanation, whether the same answer would be obtained if
Xj had a non-normal distribution with mean mj, variance s2j . [1]
[Total 5]

2 An analyst wishes to use a model which is based on Brownian motion, but which does
not become too large and positive for large t. The model proposed is

Xt = Bt e-cBt ,

where Bt is standard Brownian motion, and c is a positive constant.

(i) Verify that there is an upper bound which X never exceeds. [2]

(ii) Use Itô’s Lemma to find dXt. [3]

(iii) State, with a brief explanation, whether the suggested model is appropriate for
a process which is asymptotically stationary. [1]
[Total 6]

103 A2002—2
3 (i) Explain briefly what is meant by a linear trend and by seasonal variation in
respect of a sequence of observed values {x1, x2, …, xn} forming a time series.
[2]

(ii) Describe an operation which can be applied to the data in order to remove
additive seasonal variation of period 2. [2]

(iii) Derive an appropriate operation to perform on the process

Xt = exp(a + bt + Zt),

where Z is I(1), in order to obtain a stationary process Yt. [2]

[Total 6]

4 Consider the second-order autoregressive process

Yt = -2aYt-1 + a2Yt-2 + Zt

where {Zt} is a zero-mean white noise process with Var(Zt) = s2.

(i) Determine the range of values of a for which the process Y can be stationary.
[3]

(ii) Derive the autocovariances γ1 and γ2 of Y in terms of a and s. [6]

[Total 9]

103 A2002—3 PLEASE TURN OVER

5 The ratio of claims to premium income is calculated annually by a division of a large
insurance company over a period of 30 years. The observed values are plotted against
time in Figure 1a, with the sample autocorrelation function (ACF) plotted in
Figure 1b; the dotted lines indicate the cutoff points for significance at the 5% level.

Figure 1a

Ratio of claims to premium income

1.200

1.100

1.000
Ratio

0.900

0.800

0.700
11
13
15
17
19

21
23
25
27
29
1
3

5
7
9

Year, t

Figure 1b

Autocorrelation Function for Ratio

0.6

0.4
Autocorrelation, r k

0.2

0
0 1 2 3 4 5 6 7
-0.2

-0.4

-0.6
Lag, k

(i) Explain which feature of the Figures indicates that differencing is not required
in order to obtain a stationary series. [1]

(ii) On the basis of the sample ACF, rk , the company’s analyst decides to fit a
first-order autoregressive model to the data. State, with reasons, whether you
consider this to be a reasonable decision and indicate what additional plot you
would require in order to make a firmer recommendation. [3]

103 A2002—4
 (iii) The model is fitted and the residuals calculated. The sample ACF of the
residuals is shown in Figure 1c. State what conclusions you would draw from
the plot. [1]

Figure 1c

Autocorrelation Function for Residuals

0.6

0.4
Autocorrelation, r k

0.2

0
0 1 2 3 4 5 6 7
-0.2

-0.4

-0.6
Lag, k

(iv) The fitted model is

Xt = 0.49541 + 0.5118Xt-1 + et .

(a) Derive forecasts xˆ30 (1) and xˆ30 (2) for the next two values in the
series.

(b) Comment on the reliability of the forecasts. [4]

[Total 9]

6 A disability benefit scheme is modelled in continuous time by a Markov jump process

with states A (active), T (temporarily disabled), P (permanently disabled) and
D (dead). The transition rates are as follows:

A ® T: 3l T ® A: 5l P ® D: 2a
A ® P: l T ® P: 2l
A ® D: a T ® D: a

(i) Write down the generator matrix of the process. [2]

(ii) Calculate the probability that, having started in state A, the process has visited
neither T nor P by time t. [3]

(iii) Write down the matrix form of the Kolmogorov backward differential
equations and use this to derive a differential equation for pPD(t), the
probability that a scheme member in state P at time 0 will be in state D at
time t. [2]

(iv) Solve the equation for pPD(t), the probability that a policyholder, initially
permanently disabled, is dead by t. [2]
[Total 9]

103 A2002—5 PLEASE TURN OVER

7 (i) Demonstrate that the random variable

X = -¼log(U)

has an exponential distribution with mean ¼ when U is uniformly distributed

over the range (0, 1). [2]

(ii) (a) Explain how the above can be used to simulate a path of the Poisson
process with intensity l = 4.

(b) Derive a method for simulating a Poisson random variable with

mean 4. [4]

(iii) Describe an alternative method for generating a Poisson random variable with
mean 4 based on the cumulative distribution function. [2]

(iv) State, giving reasons, which of the two methods in (ii) and (iii) would be more
efficient if a simulation calls for a large number of Poisson random variables
with mean 4. [2]
[Total 10]

8 A company is studying the health records of its longest serving employee in order to
improve its provision for health insurance. Let X(t) = H if the employee is healthy at
time t, X(t) = S otherwise. The available information includes the value of X(t) for all
0 £ t £ T.

(i) Explain the principal stages in the formulation and verification of a stochastic
model for this process. [3]

(ii) The company chooses to model X as a two-state time-homogeneous Markov

jump process with transition rates sHS = s, sSH = r.

(a) State the distribution of a typical holding time in state H and of a

typical holding time in state S assuming the model is valid.

(b) Write down estimates for the parameters s and r of the model in terms
of quantities which may be derived from the available data.

(c) Indicate one test which could be used to determine whether the data
support the assumption that the Markov jump process model is
suitable. [4]

103 A2002—6
 (iii) Having fitted the model the company discovers that the observed distribution
of holding times in state H does not fit the predictions of the time-
homogeneous Markov model; in particular, the mean holding time in state H
between visits to state S appears to be decreasing with t.

(a) Describe the principal difference between a time-inhomogeneous

model and a time-homogeneous one and indicate whether a time-
inhomogeneous model might provide a better fit to the observations.

(b) Explain why the original model could still be used if the company is
large and has a roughly constant age profile. [4]
[Total 11]

103 A2002—7 PLEASE TURN OVER

9 A motor insurer operates a no claims discount system that has five levels. The
percentage of the basic premium paid by the insured in each level is as follows:

Level % premium charged

5 100
4 90
3 80
2 70
1 60

Insured motorists move between levels depending on the number of claims in the
previous year. For each policyholder, the number of claims per year follows a
Poisson distribution with mean 0.25.

For those in Levels 2, 3, 4 and 5 at the start of the previous year:

· if no claims are made during the previous year, the insured moves down one
level (e.g. from Level 4 to Level 3)

· if one claim is made during the previous year, the insured moves up one level
(except those in Level 5 at the start of the previous year, who will remain in
Level 5)

· if two claims are made during the previous year, the insured moves up two
levels (except those in Level 5 at the start of the previous year, who will
remain in Level 5 and those in Level 4, who will move to Level 5)

· if three or more claims are made during the previous year, the insured moves
to Level 5

For those in Level 1 at the start of the start of the previous year, a no claims discount
protection policy applies whereby they remain in Level 1 if they make one claim. If
they make two claims, they move to Level 2. If they make three or more claims, they
move to Level 5. If they make no claims, they remain in Level 1.

(i) Determine the transition matrix for the no claims discount system (assuming
that all motorists continue their policies). [3]

(ii) A policyholder is in Level 3 for the first year of the policy. Assuming that the
policy is maintained, calculate the probability that at the start of the third year
the policyholder will be (a) in Level 1, (b) in Level 3. [3]

(iii) (a) State conditions under which the probability of being in a particular
state after n years converges as n ® ¥ to some limit which is
independent of the initial state.

(b) Verify that the conditions are satisfied in this instance.

(c) Determine the ultimate probability that the insured will be in Level 1.
[8]

103 A2002—8
 (iv) The insurer suspects that the model used for its calculations may be too
simplistic. Given annual data listing numbers of claims per policy, broken
down by discount level, state which test would be most appropriate to test the
assumption that the distribution of the number of claims per policy per year is
Poisson with mean 0.25. [1]
[Total 15]

103 A2002—9 PLEASE TURN OVER

10 (i) State the Lévy decomposition theorem which describes the constituent parts of
a Lévy process. [3]

(ii) Let Mt = exp(-2ab + 2bBt - 2b2t), where Bt is standard Brownian motion and
where a and b are positive constants. Define T as the first time that Mt = 1,
with the definition T = ¥ if M never hits the point 1. You may assume that
Mt ® 0 as t ® ¥, so that

ì if M hits 1
MT = í1
î0 if M never hits 1

(a) Show that M is a martingale and that 0 £ Mt £ 1 for all 0 £ t £ T.

(b) State the optional stopping theorem and use it to prove that the
probability that the Brownian motion Bt ever hits the line a + bt is
e-2ab. [6]

(iii) An insurance company earns premium income at a constant rate c per unit
time. Claims arrive according to a Poisson process with rate l; each claim
may be assumed to be of fixed size k. Let Xt denote the total value of all
claims received up until time t and denote by St the company’s surplus at
time t,

St = s0 + ct - Xt,

where s0 is a positive constant. Show that {St: t ³ 0} is a Lévy process and

identify the components of the Lévy decomposition of S. [2]

(iv) Calculate the expectation and variance of St. [2]

(v) The company is interested in the probability of ruin, defined as the probability
that St ever goes below 0. An investigator proposes using a Brownian model

St* = s0 + mt + sBt,

where Bt is a standard Brownian motion, as an approximation to the surplus

process St.

(a) Calculate the appropriate values of m and s.

(b) State the significance of the condition c > kl in this situation.

(c) Write down the probability that the approximating process S* ever hits
0 assuming that c > kl.

(d) Outline the principal difference between S and S* and state whether
you consider that the probability obtained in (c) would be an
acceptable approximation to the probability of ruin. [7]
[Total 20]

103 A2002—10