ACMT 302: ACTUARIAL MATHEMATICS II
Topic 1: Multiple state models
So far we have considered contingencies where a life is exposed to death only.
If we suppose that a life is subject to more than one transition, then the transitions are referred to as a set
of competing risks. For example, a member of a pension scheme can, in order for the associated pension
scheme benefits to be valued, be regarded as exposed to the competing risks of retirement and death.
In a similar way, a person with a health insurance policy who is in good health, can be
considered as exposed to the competing risks of becoming sick and dying.
Multiple state models are well suited to valuing cashflows that are dependent on multiple transitions, such
as of health insurance contracts. The model will be chosen to include the relevant states,and transitions
between states, that are necessary to replicate the required cashflows for the contract concerned.
Multiple state models consist of a finite set of states with arrows indicating possible movements
between some, but not necessarily all, pairs of states. Each state represents the status of an
individual or a set of individuals.
Simple examples
Basic survival model/alive- dead models
The withdrawal-death model
The permanent disability model
The HIV-AIDS progression model
Try the covid one???
Health insurance contracts
In the same way as insurance contracts exist that pay benefits contingent upon death or survival, so
contracts also exist that pay benefits contingent upon the state of health of a person. In this case a
policyholder can be considered to be subject to the competing risks of death and of becoming sick.
An income protection insurance contract pays an income to the policyholder while that policyholder is
deemed as being “sick” (with the definition of sickness being carefully specified in the policy conditions).
If the policyholder recovers, the cover under the policy usually continues, so that subsequent bouts of
qualifying sickness would merit further benefit payments.
Such policies are usually subject to a deferred period (eg 3 months) of continuous sickness that has to
have elapsed before any benefits start to be paid, and during which no benefit is payable.
Premiums for these policies would normally be regular (eg monthly) and would typically be waived
during periods of qualifying sickness. This means that premiums would not be paid at the same time as
benefits are payable.
There are many varieties of insurance contracts that can be based on health-dependent contingencies.
Other examples include:
critical illness insurance, which normally pays a lump sum on diagnosis of a defined
“critical” illness (such as cancer)
long-term care insurance, which pays an income contingent upon the policyholder
requiring long-term care, and hence supports the costs of receiving that care.
The transition intensity from sick to dead is represented by (nu, the 13th letter of the Greek
alphabet), not v (the 22nd letter of the English alphabet).
The alive–dead model above captures all the survival/mortality information for an individual that
is necessary for calculating insurance premiums and reserves for policies where payments –
premiums, benefits and expenses – depend only on whether the individual is alive or dead at any
given age, or example a term insurance or a whole life annuity. More complicated forms of
insurance require more complicated models
Important notations
The alive–dead model
Our individual is, at any time, in one of two states, ‘Alive’ and ‘Dead’. For convenience we
label these states ‘0’ and ‘1’, respectively. Transition from state 0 to state 1 is allowed, as
indicated by the direction of the arrow, but transitions in the opposite direction cannot occur.
This is an example of a multiple state model with two states.
The disability income insurance model.
x
H = healthy S = sick
x
x x
D = dead
Notation
Other Important notations:
For states i and j in a multiple state model and for x, t ≥ 0, we define
In terms of the alive–dead model represented earlier(0 is alive,1 is dead), we can make
the following observations.
In Actuarial mathematics it is assumed that:
State space
Numerical evaluation of probabilities
Example
Solution
Multiple decrement models
Multiple decrement models are special types of multiple state models.
A multiple decrement model is characterized by having a single starting state and several exit
states with a possible transition from the starting state to any of the exit states, but no further
transitions.
A multiple decrement model is a multiple state model which has:
one active state, and
one or more absorbing exit states
Moreover, there can be no return to the active state from an exit state and we will typically
ignore transitions between exit states in our analysis (i.e. we treat them as absorbing states,
though in practice typically such transitions between exit states would exist)
Many practical situations involving competing risks can be modelled adequately
using this simplified model structure.
Example
We begin with the general healthy-sick-dead multiple state model described earlier
