ACST152 Introduction to Actuarial Studies

Tutorial Solutions : More Reinsurance and Cost-Benefit Analysis

Question 1. Quota share reinsurance and stop-loss reinsurance.
Insurance company ABC sells 1000 bicycle insurance policies. The policy will pay $200 towards the cost of a
new bicycle if the customers bicycle is stolen during the year.
In a few cases, a customer might make 2 or more claims during the year (e.g. if his bicycle is stolen, he makes a
claim, he buys a replacement bicycle, and then the SECOND bicycle is also stolen). The insurer will pay $200
for EACH stolen bicycle.
The insurance company has decided that the number of claims for each customer is a random variable which
follows the Poisson distribution with parameter = 0.003. Since the customers are assumed to have
independent and identically distributed claims, the total number of claims for the entire group of 1000
customers will follow a Poisson distribution with parameter 1000*0.003 = 3. Poisson probabilities are given in
the table below.
n
0
1
2
3
4
5
6
7
8
9
10

Pr(N=
n)
0.049
79
0.149
36
0.224
04
0.224
04
0.168
03
0.100
82
0.050
41
0.021
60
0.008
10
0.002
70
0.000
81

Pr(N<
=n)
0.0497
9
0.1991
5
0.4231
9
0.6472
3
0.8152
6
0.9160
8
0.9664
9
0.9881
0
0.9962
0
0.9989
0
0.9997
1

You may ignore expenses.

(a) What is the risk premium for this policy? [Ignore interest, i.e. assume the interest rate is 0%]
Risk Premium = present value of expected claims costs
Expected claims cost = Expected number of claims per policy * expected size of each claim

= 0.003 * 200
= 0.60
Since we are assuming a 0% interest rate, Risk Premium = 60 cents per policy
(b) If the insurer charges $1 per policy, what is the expected profit for the group of policies?
Profit = Premium Income Claims
= 1 * 1000 200 * N

where N is a Poisson(3) random variable

Expected Profit = 1000 200 * E(N)

= 1000 200 * 3
= 400
(c) If the insurer has no capital, what is the probability of ruin?
The insurer will be ruined if the claims cost exceeds the amount available to pay claims
Pr(ruin) = Pr(Claims Cost > Capital + Premium Income + Investment Income Expenses)
In this case we are ignoring expenses and investment income is assumed to be 0,
And we have been told that the company has no capital,
Pr(ruin) = Pr(Claims Cost > Premium Income)
Pr(ruin) = Pr(200N > 1000)
= Pr(N>5)
= 1 Pr(N<=5)
= 1 0.91608
= 8.392%
(d) How much capital would the insurer need to have a probability of ruin which is below 1/2 %?
Looking at the cumulative probabilities in the table above, Pr(N<=8) = 0.99620
If the insurer had enough to cover 8 claims, then he would have a 99.6% probability of sufficiency.
The amount needed to cover 8 claims is 200*8 = 1600
He has $1000 in premium income, so he would need an additional $600 in capital.
(e) Suppose that the insurer has capital of just $200 and buys quota share reinsurance. He will give the
reinsurer x% of the premium and the reinsurer will pay x% of each claim.
(i)
If x% is 30%, what is the new probability of ruin and the new expected profit for the
insurer?
(ii)
What is the expected profit for the reinsurer? What is the probability that the reinsurer
will make a loss on this policy?
The amount of money which the insurer has available to pay claims is the capital plus the NET premium
income (where NET premium income = total premium income less the amount paid to the reinsurer as a
reinsurance premium).
NET Amount available to pay claims = 200 + 1000 30% * 1000 = 900
The insurer will be ruined if the NET claims exceed the amount available to pay claims. The NET
claims = total claims amount received from the insurer for his share of the claims. In this case the NET
claims cost is 70% of the total claims cost, i.e. $140 per claim

NET claims cost = 140 * N

Pr(Ruin) = Pr(Net claims cost > Net Amount Available to pay claims)
= Pr(140N > 900)
= Pr(N > 6.428)
= 1-Pr(N<=6)
= 1-0.96649
= 3.35%
From the reinsurers perspective, he will receive 30% of the premium income, i.e. $300.
He will have to pay 30% of each claim, i.e. $60 per claim.
Profit for reinsurer = 300 60N
Expected profit = 300 60 * E(N)
= 300 60*3
= 120
The reinsurer will make a loss if the profits are less than 0.
Pr(Reinsurer loss) = Pr(Profit < 0)
= Pr(300-60N< 0)
= Pr(N > 5)
= 8.392%
Reinsurers usually have reinsurance deals with many many direct insurers, so they can diversify their
risk.
(f) Suppose that the insurer has capital of just $200 and buys stop-loss reinsurance. He will give the
reinsurer a reinsurance premium of $300 and the reinsurer will pay each claim after the 4th claim.
Insurance Company ABC will only pay a maximum of 4 claims in the year
i.
ii.

What is the new probability of ruin and the new expected profit for the insurer?
What is the expected profit for the reinsurer? What is the probability that the reinsurer
will make a loss on this policy?

For the insurer, the amount available to pay claims is the capital plus the NET premium income
Amount available to pay claims = 200 + 1000 300 = 900
The insurer might have to pay 0,1,2,3, or 4 claims, but he will never have to pay more than 4 claims. So
the amount payable will never exceed $800. Since he has $900 available to pay claims, there is no risk
of ruin. The probability of ruin is 0.
The expected profit is harder to work out. The easiest way is to set out the expected claims cost in a
table. Then the expected profit is the premium income less the expected claims cost

Then the expected profit is the net premium income less the expected claims cost
Expected profit = 700 536.13 = $163.87
In order to find out the expected claims cost for the insurer, the easiest method is usually by subtraction.
Reinsurers expected claims costs = Total expected claims cost Insurers expected claims cost
= 3*200 536.13
= 63.87
The reinsurer is receiving a premium of $300, and will pay any claims after the 4th claim. The reinsurer
will make a profit is he has to pay 0 or 1 claims, but will make a loss if he has to pay 2 or more claims.
So in this case:
* the reinsurer will make a profit if there are 5 claims in total (the reinsurer pays just one claim
of $200)
* the reinsurer will make a loss if there are 6 or more claims in total (the reinsurer pays 2 or more
claims of $200 each)
So the probability of a loss for the reinsurer is Pr(N>=6) = 1 Pr (N < =5) = 8.39%

Question 2 Profit share

A superannuation fund has 1000 members. The probability of death is 0.002 for each member of the fund. You
may assume that the number of deaths D is Binomial with n = 1000 and q = 0.002.
The insurer offers to insure each member for a sum insured of $100,000. The premium rate will be $310 for
each person.
Ignore expenses and investment income.
(a) What is the expected profit and what is the probability that the insurer will suffer a loss on this group
policy?
Expected profit = Premium Income Expected Claims Cost
= 310 * 1000 100000 * E(D)
= 310,000 200,000
= 110,000
Pr(Loss) = Pr(Claims Costs > Premium Income)
= Pr(100,000 D > 310,000)
= Pr(D > 3.10)
= 1 Pr(D <=3)
= 1 BINOMDIST(3,1000,2,1)
= 14.27%
(b) Now suppose that the insurer charges a premium of $500 per person but offers a profit share of 70% of
the profits to the superannuation fund (only if profits are positive). What is the expected profit and what
is the probability that the insurer will suffer a loss on this group policy?
Start by working out the expected value of the profit share payable to the superannuation fund

Number
of claims
0
1
2
3
4
5

Probability
0.135064
522
0.270670
386
0.270941
598
0.180627
732
0.090223
371
0.036017
025

Gross
Profit

Profit
Share

500000

350000

400000

280000

300000

210000

200000

140000

100000

70000

Expected Value of Profit Share

211,561.
55

The NET expected profit for the insurer is the premium income less the expected claims less the
expected profit share payment to the superannuation fund
= 500,000 100,000 * E(D) 211,561.55
= 88,438.45
The insurer received $500,000 in premiums and will suffer a loss on this policy if there are more than 5
claims.
Pr(Loss for the insurer) = Pr(D>5)
= 1 Pr(D<=5)
= 1- BINOMDIST(5,1000,0.02,1)
= 1.65%
So there is a much lower probability of suffering a loss on the policy but also lower expected profits.
From the perspective of the superannuation fund, they are paying a much higher premium rate at the
start of the year. If things go well, they will receive a large profit share payment at the end of the year.
But if things go badly (a lot of deaths) they will receive no profit share payment at all. So this creates
more uncertainty for the superannuation fund.

Question 3 Risk Classification : Cost Benefit Analysis of Underwriting

Insurer ABC gets 1000 new customers per year, all aged 40 males, who buy one year term life policies. The
mortality rate is 0.002 for someone who does not have Disease X. Hence the risk premium for a $100,000
policy is $200 and they charge a 10% safety loading.
They are reviewing their underwriting procedures.
They can test every person for Disease X, and it costs $20 per test.
About 1% of the population have Disease X.
The test is not perfect it only detects 90% of people who have Disease X.
Anyone who has Disease X has a probability of dying which is 10 times the normal rate.
Assume that the insurer rejects any person who fails the test.
(a) If all customers buy insurance with sum insured $100,000, should they test ?
(b) If the sum insured is $500,000, would your answer be different ?
(c) What is the break-even sum insured (i.e. what is the sum insured which would mean that you have the
same profits whether you test or not).
(d) How would your answer to c) change if the cost of the test was only $15?
(e) Suppose you know that only people with blue eyes get this disease, and they account for just 10% of the
population. How would that change your answer?
SOLUTION: In each case, calculate the expected profits (i) with no testing and (ii) with testing. Choose
whichever alternative produces the higher profits
(a) If there is no testing, then you have 1000 customers, 990 who are healthy and 10 who are high risk.
The premium rate will be 200*1.10 = 220 per person, for 1000 people
The 990 healthy people will have expected claims = 990 * 0.002 * 100,000
The 10 high risk people will have expected claims = 10 * 0.020 * 100,000
So the total expected profit = 220 * 1000 990 * 0.002 * 100,000 10 * 0.020 * 100,000
= 2000
If there IS testing, then the test will identify 90% of the high risk people.
That is, 9 out of the 10 high risk people will be excluded.
That will leave 990 healthy customers plus 1 high risk customer
Premium income = 991 * 220
The 990 healthy people will have expected claims = 990 * 0.002 * 100,000 (as before)
The 1 remaining high risk person will have expected claims = 1 * 0.020 * 100,000
We will pay $20 * 1000 to test everyone
So expected profits = 991 * 220 - 990 * 0.002 * 100,000 - 1 * 0.020 * 100,000 20 * 1000
= -1980

If we test, we will make a loss of 1980 instead of a profit of 2000, so it is better NOT to test.
The cost of testing outweighs the benefits
(b) Repeat the same analysis, but with sum insured $500,000
If the sum insured is $500,000, then the risk premium is 0.002 * 500,000 = 1000
And the premium including a 10% safety loading is 1100
With no testing, expected profits = 1100 * 1000 -990 * 0.002 * 500,000 10 * 0.020 * 500,000
= 10,000
With testing, expected profits = 991 * 1100 - 990 * 0.002 * 500,000 - 1 * 0.020 * 500,000 20 * 1000
=70100
Expected profits increase if we test, so we would go ahead with testing.
Note that as the sum insured increases, the benefit of testing also increases
(c) We have seen that it is not worthwhile to test if the sum insured is 100,000 and it IS worthwhile to test of the
sum insured is 500,000. There must be some sum insured, between 100,000 and 500,000, where the costs of
testing are exactly equal to the benefits of testing.
Let S be this breakeven sum insured. S is the value where the expected profits WITH testing equal the expected
profits without testing.
Expected profits without testing = 1.10*S*0.002 * 1000 -990 * 0.002 * S 10 * 0.020 * S
Expected profits with testing = 991 * 1.10S*0.002 - 990 * 0.002 * S - 1 * 0.020 * S 20 * 1000
Setting these equal and solving for S gives S = 124,844
So the insurer would not bother to test people with sums insured below this limit, but would test people above
this limit (To prevent arbitrage, you would check to see whether people applied for 2 policies of 100,000 each in
order to avoid testing).
(d) If the cost of the test goes down, then you would be more likely to test. The breakeven sum insured would
go down to S = 93,633
(e) If you can narrow down the group which needs testing, then it becomes more feasible to test. You could
eliminate 9 out of the 10 high risk people by testing just the blue-eyed people, so the test cost would be only
$20 * 100 people= 2000. The breakeven sum insured falls to below $10,000, so it practice you would test all the
blue eyed customers (not many people buy sums insured below $10,000 anyway).
To give a more realistic example, insurers are unlikely to test everyone for harmful genetic mutations, since
many of these mutations are uncommon and the cost of testing is currently quite high. But they might decide to
test people who have a family history of a particular disease (such as breast cancer), because they are much
more likely to carry the harmful mutation.

Question 4 (old exam question 2010 exam) [20 marks]

Insurer ABC gets 1000 new customers per year, all aged 60 males, who buy one year term life
policies. The mortality rate is 0.02 for someone who does not have Disease X.
The company charges a premium rate of $2,500 per $100,000 sum insured.
They are reviewing their underwriting procedures. You are the actuary advising the company.
About 5% of the population have Disease X. Anyone who has Disease X has a probability of dying
which is double the normal mortality rate. They can test every person for Disease X, and it costs
$30 per test. The test is perfect it accurately identifies each person with Disease X.
Assume that the insurer rejects any person who fails the test.
(a)If all the customers all buy policies with sum insured $100,000, should they test all of
them ? [6 marks]

Normal mortality rate

Disease X mortality rate
Premium rate per
$100,000
Sum insured
Proportion with Disease X
Cost of test
Percentage detected

0.02
0.04
$

2500
100,000.00
0.05
$30
1

Without testing
Premium Income
Claims cost
Disease
X
Healthy
Profit

2,500,000.00

$
$

200,000.00
1,900,000.00

400,000.00

$
$

950.00
2,375,000.00

$
$

With testing
Number of customers
Premium Income
Claims cost
Disease
X
Healthy
Test
cost
Profit

$
$

1,900,000.00
30,000.00
445,000.00

The profit is higher with testing, so test everyone.

(b)Suppose that the customers all buy policies with different sums insured. You have decided
that you will test all customers who want to buy a policy with sum insured exceeding $S (S
is called the break-even level). What is the value of S which will maximise your profits ?
[5.5 marks]

Answer
Let the break even sum insured be S
If there is no testing, then the companys profit will be calculated as follows
We will sell 1000 policies. If the sum insured is S for a $100,000 policy, then the
premium for a sum insured of S is 2500 * S / 100000.
The premium income will be 1000 * 2500/100000 * S = 25S
The death claims for the 950 normal lives will be 0.02*S*950 = 19S
The death claims for the 50 people with disease X will be 0.04*S*50 = 2S
Total death claims will be 21S
So profits will be 4S
If there IS testing, and we reject all the Disease X people
We will sell 950 policies at the same premium rate, i.e. premium income is 23.75S
The number of death claims will be 19S
The total testing costs will be 30*1000 = 30000
Hence profit = 4.75S - 30000
The break even cost occurs when these two profits are equal, i.e.
4S = 4.75S 30000
0.75S = 30000
S = 40000

(c) Under each of the following conditions, would the value of the break-even level S go up or
down ? You are NOT required to recalculate S, just state whether it would go up or down,
and explain your reasoning. [1.5 marks each = 4.5 marks]
(i)

The cost of the test increases by $5;

(ii)

The proportion of people with Disease X increases from 5% to 8%;

(iii)

The accuracy of the test is reduced , so that it only detects 80% of people who have
Disease X.

Answer
(i)

If the cost of the test increases, then we are less likely to test. The value
of S goes UP.

(ii)

As the proportion of people with disease X increases, we are more likely to

test. The value of S goes DOWN.

(iii)

If the accuracy of the test is reduced, the value of S goes UP.

Question 5 (2013 Exam Question)

A car insurance company currently has 1000 customers.
For each customer, the number of claims is a Poisson random variable. However the value of the Poisson
parameter is different for different customers.
For good drivers, the Poisson parameter is 0.10
For bad drivers, the Poisson parameter is 0.20
The number of bad drivers is estimated to be 15% of all customers, but at present the insurer has no way of
identifying the bad drivers, so it charges everyone the same premium of $600.
The average claim size is $5000 per claim, and is the same for both good and bad drivers.
(a) Calculate the expected profits for the next year.

[2 marks]

(b) One of the managers has pointed out that the company is losing money by insuring bad drivers. He has
suggested that it would be simple to identify the bad drivers by looking at the past driving experience.
The company could simply refuse to renew the insurance policy for anyone who has had two or more
accidents in the previous year. Assess this suggestion: would it lead to improved profits in the next year?
Provide calculations to support your answer.
[4 marks]
(c) Another manager has heard of this new invention, the Telematics monitor. This can be installed in any
car, and it records information such as distance travelled, speed, proportion of time spent driving after
dark, etc. It costs $30 to install the monitor in each car and collect the data.
The Telematics system is not perfect, but it can be used to correctly identify x% of the bad drivers. (x is
the accuracy level)
Suppose the insurer installs the Telematics monitor in each customers car in 2014. At the end of the
year, the company will refuse to renew the policies of any customers who have been identified as
probable bad drivers by the Telematics system, i.e. these customers will not be allowed to buy a policy
in 2015.
However, they will only do this if a cost benefit analysis shows the benefits of doing so will exceed the
costs. (Ignore interest and the impact on profits in years after 2015; ignore the possibility that the
company will be able to gain new customers in 2015).
What is the minimum accuracy level (i.e. the minimum value of x) which would make it worthwhile for
the company to install Telematics monitors in all cars? Provide calculations to support your answer.
[5
marks]

Note that the same type of cost benefit analysis applies to general insurance (such as car insurance or home
insurance) as well as life insurance. The motor vehicle insurance market is very competitive so the insurers
devote a lot of energy to finding better methods of choosing rating factors (i.e. choosing factors which are used
to set premium rates).

SOLUTION FOR Q8 in 2013 Exam

(a) Calculate the expected profits for the next year.
There are 1000 customers and the premium charged is $600 per annum,
so premium income = $600,000.
There are 15% * 1000 = 150 bad drivers.
The expected claims cost for a bad driver is 0.20*5000 = 1000
So the expected claims cost for all the bad drivers = 150*1000 = 150,000
There are 85% * 1000 = 850 good drivers.
The expected claims cost for a good driver = 0.10 * 5000 = 500
So the expected claims cost for the all the good drivers = 850 * 500 = 425,000
So the expected profit = 600,000 - 150,000 - 425,000 = 25,000
(b)

How many bad drivers have had two or more claims in the year?
For a Poisson probability of 0.20,
Pr(0 claims) = exp(-0.20) (0.20)^0 / 0! = exp(-0.20)
Pr(1 claim) = exp(-0.20)*(0.20^1)/1! = 0.20 * exp(-0.20)
Pr(2 or more claims) = 1 - 0.982477 = 0.017523
Therefore we would eliminate 150*0.017523 = 2.6285 bad drivers
How many good drivers would be eliminated?
For a Poisson probability of 0.10,
Pr(0 claims) = exp(-0.10) (0.10)^0 / 0! = exp(-0.10)
Pr(1 claim) = exp(-0.10)*(0.10^1)/1! = 0.10 * exp(-0.10)
Pr(2 of more claims) = 1 - 1.10 exp(-0.10) = 1-0.99532= 0.00468
Therefore we would eliminate 850*0.00468 = 3.9770 good drivers
The number of customers would be (1000-2.6285-3.9770) = 993.3945
The expected claims for the bad drivers would be 0.982577*150,000 = 147,387
The expected claims for the good drivers would be 0.99532*425,000 = 423,011
This means that expected profits = 600*993.3945 - 147,387 - 423011 = 25,638
This is an increase in profits so it is a good idea.
{In practice you would just charge the people with 2 or more claims a higher premium, e.g. they would
lose their no-claim discount}

(c) If they do NOT install Telematics in any car, then the expected profits is as calculated in part b(i), i.e. 25,000
If they DO install Telematices, then they will exclude x% of the bad drivers.
Premium income will be 600*(850+(1-x%))*150) = 510,000 + 90000*(1-x%)
Expected Claims cost will be 425,000 for the good drivers and (1-x%)*150000 for the bad drivers.
Cost of testing is 30*1000 = 30,000
Expected profit will be = 510000+90000*(1-x%)-425000-150000*(1-x) - 30000
= 55,000 -60000*(1-x%)
We will choose this underwriting approach if the expected profits under this system are greater than our current
expected profits of 25000, i.e. when
55000 - 60000*(1-x%) > 25000
Solving for x:
55000 - 60000 - 25000 > - 60000*x%
-30000 > - 60000*x%
0.5 < x%
So we will choose this approach if x% is greater than 50%, i.e. if the Telematics machine can correctly identify
at least 50% of the bad drivers.