Actuarial Science
by
Sant Kumar
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Syllabus
Unit I
Time of value of money, Present Value, Accumulated Value, Valuing Multiple Regular
Payments, Equations of Value, Application in Spreadsheets.
Unit II
Two State Model (Active/Dead), Calculating Probabilities using Two State Model.
Unit III
Introduction to the Life Table, Calculating Probabilities using the Life Table, Expected
Present Value, Accumulated Value and Uncertainty.
Unit IV
The life Insurance Company Scenario, Single Projection, Simulations, Analysing the
Simulation Output, Adjustment to Reserves, Additional Scenarios.
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Unit II
1. Two-State Model / Dead-Alive Model / Binary Model
In actuarial science, a two-state model is a simplified framework used to analyze and
predict the future outcomes of a random process that can be in one of two possible states
at any given time. These two states are typically referred to as "alive" and "dead" or
"working" and "retired," depending on the specific application.
The two-state model is commonly used in life insurance and pension fund modelling,
where it is used to describe the transition of individuals or policies between two states
over time. The primary purpose of this model is to estimate probabilities of transitioning
from one state to another, typically with a focus on the probability of death or
retirement.
For example, in a life insurance context, the two-state model might be used to analyze
the likelihood of policyholders transitioning from the "alive" state (actively paying
premiums) to the "dead" state (experiencing a death benefit payout). In a pension fund
context, it might be used to model the transition of employees from the "working" state
(actively contributing to the pension fund) to the "retired" state (receiving pension
benefits).
Actuaries use mathematical techniques and historical data to estimate transition
probabilities, which are essential for pricing insurance policies, calculating reserves,
and assessing the financial health of pension funds. These models can become more
complex when additional states or factors are considered, but the basic two-state model
provides a foundation for understanding and analyzing these important financial
processes.
Let us consider a simplified example of a two-state model in the context of life
insurance. In this example, we will focus on a term life insurance policy, where
individuals are either "alive" or "dead."
Alive State (A): Policyholders are in the "alive" state as long as they are paying their
insurance premiums.
Dead State (D): When a policyholder passes away, they transition from the "alive" state
to the "dead" state, and the insurance company pays out a death benefit to the
beneficiary.
Now, let us assume we have a group of 1,000 policyholders who have purchased this
term life insurance policy. We want to estimate the probabilities of transitioning
between these two states over the next year. Based on historical data and actuarial
analysis, we might come up with the following transition probabilities:
Probability of staying alive for one year (P(A → A)): 0.95
This means that 95% of policyholders who are alive at the beginning of the year will
remain alive at the end of the year.
Probability of transitioning from alive to dead (P(A→D)): 0.05
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This means that 5% of policyholders who are alive at the beginning of the year will
pass away during the year, triggering a death benefit payout.
Probability of staying dead for one year (P(D → D)): 1
Once policyholders are in the "dead" state, they remain there.
2. Calculating Probabilities using Two State Model.
In actuarial science, a two-state model is commonly used to analyze the probability of
transitions between two states or outcomes over time. This type of model is often
applied to insurance and risk assessment, where there are typically two states of interest,
such as "alive" and "dead" for a life insurance policy or "working" and "broken" for a
machine reliability study. The key concept in a two-state model is the transition
probability.
Let us break down the calculation of probabilities in a two-state model using a simple
numerical example:
Example: Consider a life insurance policy for a 40-year-old individual. The two states
of interest are "alive" and "dead." We want to calculate the probability that the
individual will be alive at age 60.
In this scenario, we can define the following variables:
Age at the beginning of the policy: 40 years (Let us denote this as Age 40)
Age at which we want to calculate the probability: 60 years (Let us denote this as Age
60)
Transition probability from "alive" to "dead" per year: 0.02 (2% annual mortality rate)
To calculate the probability of being alive at age 60, we can use the complementary
probability approach. We calculate the probability of being "dead" at age 60 and then
subtract that from 1 to find the probability of being "alive" at age 60.
Calculate the probability of being "dead" at age 60:
P(Dead at Age 60) = 1 - P(Alive at Age 60)
To calculate P(Alive at Age 60), we need to consider the probabilities of being alive at
each year from age 40 to age 60 and then multiply them together.
P(Alive at Age 60) = P(Alive at Age 40) × P(Alive at Age 41) × ... × P(Alive at Age 59)
Each year, the probability of staying alive is (1 - mortality rate per year), which is 1 -
0.02 = 0.98.
P(Alive at Age 60) = (0.98)(60 - 40) = 0.9820 = 0.667
Now, calculate the probability of being "dead" at age 60:
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P(Dead at Age 60) = 1 - P(Alive at Age 60) = 1 - 0.667 = 0.333
So, the probability of being alive at age 60, given a 2% annual mortality rate, is
approximately 66.7%. The complementary probability, the probability of being dead at
age 60, is approximately 33.3%.
This is a basic example of how probabilities are calculated in a two-state model in
actuarial science, where you use transition probabilities and the complementary
probability approach to determine the likelihood of different states at a future point in
time. In practice, more complex models and additional factors may be considered for a
more accurate analysis.
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Theory Questions
1. What do you mean by Dead-Alive Model? Explain with an example.
2. How can probabilities be calculated under the Dead-Alive Model?
3. Explain some examples where two-state model can be used to estimate the
probabilities.
Practical Questions
1. A 35-year-old individual purchases a life insurance policy with an annual
mortality rate of 0.03 (3%). What is the probability that the individual will be
alive at age 70?
Answer: 0.3443
2. A machine has an annual probability of failure (P(Failure)) of 0.05. What is the
probability that the machine will be "working" at the end of 7 years?
Answer: 0.6983
3. A company sells electronic devices, and the probability of a device failing
within the warranty period is 0.08. If the warranty period is 2 years, what is the
probability that a device will not fail within the warranty period?
Answer: 0.92
4. A bank has issued a loan to a customer, and there's a 5% annual probability that
the customer will default on the loan. What is the probability that the customer
will not default on the loan for the first 4 years?
Answer: 0.8145
5. A piece of equipment has a 0.10 annual probability of malfunction. What is the
probability that the equipment will malfunction within the first 3 years?
Answer: 0.271
