The Use of Phase-Type Models For Disability Insurance Calculations

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The use of phase-type models for

disability insurance calculations
a b b
Amin Hassan Zadeh , Bruce L. Jones & David A. Stanford
a
Department of statistics, Shahid Beheshti University, Tehran,
Iran.
b
Department of Statistical and Actuarial Sciences, University of
Western Ontario, London, Canada.
Published online: 18 Mar 2013.
To cite this article: Amin Hassan Zadeh, Bruce L. Jones & David A. Stanford (2014) The use of
phase-type models for disability insurance calculations, Scandinavian Actuarial Journal, 2014:8,
714-728, DOI: 10.1080/03461238.2012.761645
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Scandinavian Actuarial Journal, 2014
Vol. 2014, No. 8, 714–728, http://dx.doi.org/10.1080/03461238.2012.761645
Original Article
The use of phase-type models for disability insurance

calculations
AMIN HASSAN ZADEH∗ †, BRUCE L. JONES‡ and DAVID A. STANFORD‡
Department of statistics,Shahid Beheshti University,Tehran, Iran
Department of Statistical and Actuarial Sciences, University of Western Ontario, London, Canada
Downloaded by [Simon Fraser University] at 04:23 16 November 2014
(Accepted December 2012)
This paper explores the use of phase-type models in actuarial calculations for disability insurance. We
demonstrate that the changes in status of disability insureds can be appropriately captured by a phase-type
model. Our model represents the aging process as the passage through a number of phases of decreasing vitality.
When disabled, individuals additionally pass through several stages that represent duration of disability.
Recovery and mortality rates from the earlier stages are greater than those in later stages. Using such a model,
explicit and easily calculable expressions are obtained for relevant probabilities and actuarial present values.
This facilitates the calculation of premiums and reserves.
Keywords: actuarial present value; aggregate Markov chain; continuous-time Markov chain; disability
insurance; phase-type distribution
1. Introduction
Various types of disability benefits are provided by a variety of different kinds of insurance
policies. The commonality is that covered individuals may at any time be in one of two statuses:
active (not disabled), or disabled. The definition of disability is based on the individual’s inability
to perform occupational duties. Benefits are typically payable periodically while the individual
is in the disabled status, after a waiting period.
Actuarial calculations for disability coverages present challenges because of the possibility of
repeat visits to the disabled status. Traditional approaches involve the use of disability incidence
rates and termination rates (see e.g. Bowers et al. 1997, p. 359). The incidence rates depend
on age, and the termination rates depend on duration of disability and age. These sets of rates
allow insurers to calculate the probability that a disability begins in a given year and continues
for a given period of time. Often the termination rates do not distinguish recoveries from
deaths, and, therefore, calculations may only contemplate one spell of disability. Allowance for
additional spells of disability can be made through conservatism in the incidence and termination
rates.
∗ Corresponding author. E-mail: am_hassanzadeh@sbu.ac.ir
© 2013 Taylor & Francis

Scandinavian Actuarial Journal 715
More recently multi-state models have been used for disability insurance (see, e.g. Haberman
and Pitacco 1999). These models allow for repeat visits to the disabled status. When such models
are semi-Markov, the rates of transition between the two statuses as well as mortality and lapse
rates may depend on both age and duration in the status. While these models are very realistic,
the price of this realism is that actuarial calculations are difficult, often requiring simulation or
numerical methods.
The type of model presented in this paper allows one to retain the realism of a semi-
Markov model while achieving the computational ease of simpler models. We achieve this
by introducing additional model states, while imposing the condition that the rates of transition
between states are constant as a function of time. This enables us to make use of matrix-analytic
methods, which are commonly used in working with so-called phase-type distributions (PH ).
In fact, under our model, the durations of sojourns in the active and disabled states follow PH
distributions.
Section 2 provides an introduction to PH distributions as well as the notational convention
that will be used in describing our disability model. In Section 3, we describe the structure of our
disability model and how relevant probabilities can be calculated. What we feel is particularly
noteworthy in this regard is how explicit expressions can be obtained for very complicated
conditional probabilities. The calculations are demonstrated for a simple example. Using this
example, we illustrate the calculation of some basic probabilities associated with the model.
Financial calculations for disability insurance are then discussed and some annual premiums are
presented in Section 4. Section 5 closes the paper with some concluding remarks and a brief
discussion of future research directions.
2. PH distributions
A continuous random variable is said to follow a PH distribution if it can be viewed as the time
to absorption in a continuous-time Markov chain with a finite number of transient states (say,
{1, . . . , n}) and a single absorbing state (say, 0). The term ‘phase’ reflects the fact that the time
to absorption comprises a succession of sojourns or ‘phases’ in various transient states prior to
absorption.
Since they were made widely known by Neuts (1994) in 1981, PH distributions have been
used in a wide range of stochastic modelling applications in areas as diverse as telecommu-
nications, biostatistics, queueing theory, risk theory, reliability theory and survival analysis.
This is in large measure because PH distributions have very nice properties which make them
tractable and attractive for applications. The most fundamental of these is the fact that they
are completely characterized by a row-vector of probabilities β of starting in the various
underlying states, and a matrix S that describes the instantaneous rates of transition among
the states. For this reason, it is common to say that a random variable is ‘phase-distributed
with representation (β , S)’. (Throughout the paper, α is used to represent the transpose of a
vector α.) The infinitesimal generator matrix Q for such a Markov chain can be written as:
716 A. Hassan Zadeh et al.

0 0
Q= , (2.1)
s0 S
where the matrix S = (si j ) is n × n, s0 = (s j0 ) is an n-dimensional column vector, and 0 is

an n-dimensional column vector of zeros. These elements satisfy the conditions sii < 0, for
i = 1, . . . , n, si j ≥ 0, for i = j, and S 1 + s0 = 0, where 1 is an n-dimensional column vector
of ones. States 1, . . . , n are transient if and only if S is non-singular; (see Neuts 1994). In this
paper, we assume that the probability of starting in the absorbing state is zero, however this is
not required.
If Y follows a PH distribution, the event Y > y implies that the process started in a transient
state, and it has not reached the absorbing state by time y. Thus, the distribution function of Y is
FY (y | β, S) = 1 − P(Y > y)
= 1 − (0, β ) eQy (0, 1 )
= 1 − β eSy 1 , y ≥ 0, (2.2)
where in the foregoing, the exponential of a square matrix A is defined by
∞
Ak
eA = . (2.3)
k!
k=0
Taking derivatives of (2.2), the probability density function of Y is given by
f Y (y | β, S) = −β eSy S 1
= β eSy s0 , y ≥ 0 . (2.4)
PH distributions are dense in the class of all distributions defined on the non-negative real
numbers in the sense that for any given desired level of precision, it is possible to construct a
PH distribution such that FY (y) as given by (2.2) is within that level of precision for all y. Not
only are there closed-form expressions for the distribution and density functions as per (2.2) and
(2.4), but this also applies to the Laplace–Stieltjes transform and all moments. In fact,
E(Y k ) = k! β (−S−1 )k 1, k = 1, 2, . . . . (2.5)
In addition, PH distributions provide a broad class for which straightforward, tractable algo-
rithms can be derived for quantities of interest. Notable among these is the fact that the waiting
time distribution in the M/G/1 queue with PH service is of PH (as shown first by Neuts 1994,
p. 57). This is likewise true of the maximum aggregate loss in the classical risk problem, due to
the equivalence of these processes. For a comprehensive review of PH distributions see Neuts
(1994).
Figure 1. The three-state disability model.
3. PH models for disability insurance

In modelling disability for disability insurance purposes, we begin by considering the set-up
shown in Figure 1. Insured individuals are in the active status when the policy is issued. At
any time thereafter, they may become disabled or die. Disabled individuals may recover or die.
As explained in Section 1, rates of transition from the active state depend on age, and rates of
transition from the disabled state depend on age and duration of disability. Therefore, if one
wants to treat active, disabled and deceased states to properly reflect these facts, the model must
be a semi-Markov model.
Instead of using a three-state semi-Markov model, we achieve the desired age and duration
dependence of rates of transition among the three statuses while retaining the computational
ease of a time-homogeneous Markov model by increasing the number of states. This modelling
strategy was explored by Fredkin and Rice (1986) and used by Xie et al. (2005) to model the
length of stay of elderly people in institutional long-term care.
Specifically, we propose a model involving aging phases and m disability stages, as shown
in Figure 2. Individuals may move from left to right in the figure as they age. Upon disability,
individuals move downward from the first row to the corresponding state in the second row. As
time evolves, disabled individuals may move further downward to the next stage of disability
or they may recover. The recovery rate will normally be lower for the later stages of disability.
Of course, individuals may die while in any state, as indicated by the arrows pointing up and to
the right in Figure 2.
In order to describe how probabilities and actuarial present values are calculated, we define
some notation for our model. For t ≥ 0, let X 30+t represent the state of an individual at age
30 + t. (We have arbitrarily chosen age 30 as the youngest age of interest.) Now, suppose that
there are n + 1 states, n alive states plus the deceased state. Denote the collection of n alive
states by E, and suppose this set can be partitioned into the set E A of n A active states and the
set E I of n I disabled (impaired) states. Therefore,
E A ∪ E I = E,
and
n A + n I = n.
Figure 2. The PH disability model.
We assume that {X 30+t , t ≥ 0} is a time-homogeneous Markov chain with (n + 1) × (n + 1)

infinitesimal generator matrix:

0 0
Q= ,
s0 S
where s0 is an n-dimensional column vector containing the rate of death from each of the n alive
states, and S is the n × n sub-generator matrix with off-diagonal elements si j representing the
rate of transition from state i to state j. Furthermore, suppose that the alive states are ordered
so that the active states precede the disabled states. Then, the matrix S can be expressed as:

SA S AI
S= .
SI A SI
Clearly, the matrix S AI contains the rates of transition from an active state to a disabled
state, and S I A contains the rates of transition from a disabled state to an active state. Also, S A
is the sub-generator (with non-zero main and upper diagonal elements) matrix for the Markov
chain describing a sojourn in E A , and S I is the sub-generator (with non-zero main and upper
diagonal elements) matrix for the Markov chain describing a sojourn in E I . Finally, let β. be an
n-dimensional column vector providing the initial (age 30) state probabilities.
In constructing expressions for probabilities, we make use of identity matrices and related
matrices. Let Iq be the q-dimensional identity matrix. Also, let I E,E A be the n × n A matrix with
(i, i) entry equal to 1 for i = 1, . . . , n A and all other entries equal to 0, and let I E,E I be the
n × n I matrix with (n A + i, i) entry equal to 1 for i = 1, . . . , n I and all other entries equal to 0.
We also require certain vectors containing zeros and ones. Let 1 be an n-dimensional column
vector with all components equal to 1, let 1 A be an n-dimensional column vector with the first
n A components equal to 1 and the remaining n I components equal to 0, and let 1 I = 1 − 1 A . We
are now able to state expressions for a variety of useful probabilities. As a particular example,
we find that
P(X 50+t ∈ E A |X 50 ∈ E A ) = β 50,A etS 1 A , (3.1)
where the initial probability vector β 50,A is given by
β e20S I E,E A IE,E A

β e20S 1 A
One can, of course, prove that equation (3.1) is correct. However, it is easily justified in-
tuitively. We begin with the initial vector β 50,A . Multiplication of the initial state vector by
e20S gives the probability of being in each of the n alive states at age 50. Post-multiplication
by 1 A sums the probabilities corresponding to the active states resulting in P(X 50 ∈ E A ). In
the numerator, multiplying the row-vector of probabilities of being in the n alive states by
I E,E A IE,E A produces an n-dimensional row-vector where the probabilities corresponding to the
disabled states have been replaced by zeroes, and the probabilities corresponding to the active
states have been retained. Multiplication of this vector by etS results in the joint probabilities
of being in an active state at age 50 and each alive state at age 50 + t. Finally, multiplying this
row-vector by 1 A gives P(X 50 ∈ E A , X 50+t ∈ E A ).
The following probabilities can be justified by similar arguments.
P(X 50+t ∈ E I |X 50 ∈ E A ) = β 50,I etS 1 I , (3.2)
where the initial probability vector β 50,I is given by
β e20S I E,E A IE,E A

.
β e20S 1 A
β e20S I E,E A IE,E A etS I E,E I ewS I IE,E I 1 I

P(X 50+t+u ∈ E I ∀ u ∈ [0, w]|X 50 ∈ E A ) = .
β e20S 1 A
(3.3)
P(X 50+t+u ∈ E I ∀ u ∈ [0, v]|X 50− ∈ E A , X 50+r ∈ E I ∀ r ∈ [0, t])

β e20S I E,E A S AI e(t+v)S I IE,E I 1 I
= . (3.4)
β e20S I E,E A S AI etS I IE,E I 1 I
The probability in Equation (3.3) is useful in determining premiums and active life reserves
for disability insurance involving a waiting period w. Note that the matrix S I appears on the
right-hand side of Equation (3.3) because the individual must remain in the disabled states
continuously for at least w time units. The probability in Equation (3.4) is useful in determining
disabled life reserves.
Figure 3. Forces of transition: True (solid) and fitted with 10 (dotted) and 30 (dashed) aging phases. In the lower two
graphs, disability is assumed to occur at age 30.
Example 1
To illustrate the computation of the above probabilities, a simple PH model was constructed.
Our starting point was a collection of four force of transition functions intended to represent the
‘true’ instantaneous rates of transition between the three statuses Active (A), Disabled (I ) and
Deceased (D). These functions were not estimated from data, but rather were chosen to roughly
approximate the behaviour we expect. The force of mortality from the active status is given
by Gompertz’s law, which is known to represent mortality well over the age range of interest.
Specifically, let
μ30+t
AD
= 0.0001(1.1)30+t , t > 0. (3.5)
The force of disability incidence is greater than the force of mortality, but we expect the
two functions to increase in a similar manner. We, therefore, assume that these functions are
proportional and let
μ30+t
AI
= 0.0002(1.1)30+t , t > 0. (3.6)
Table 1. The aging parameters in Example 2.
a0 a1 b c
1e-14 1e-3 5.5376 e-6 2.6895
The force of recovery should generally decrease with duration of disability and we assume it
decreases exponentially from 1 toward 0.1. Let
μ[30+t]+r
IA
= 0.1 + 0.9(0.1)r , t, r > 0, (3.7)
where the ‘select’ notation [30 + t] + r denotes an individual of attained age 30 + t + r who
became disabled at age 30 + t. Finally, the force of mortality for disabled lives is assumed to
increase with age in the same way as that for active lives, and to decrease with disability duration.
This recognizes extra mortality that arises due to the disability, but wears off over time. Let
μ[30+t]+r
ID
= 0.0001(1.1)30+t + 0.01(0.01)r , t, r > 0. (3.8)
We next specified the structure of our PH model. We used a model with m = 2 disability
stages and = 10 aging phases (see Figure 2). This model was fit to the true model given
by Equations (3.5)–(3.8) using a least squares approach. Some assumptions were made about
relationships among the rates in our PH model in order to reduce the number of parameters. The
mortality rates are given by
s0 = (s1,0 , . . . , s30,0 ),
where for i = 1, . . . , 10,
si,0 = s20+i,0 = a + b i c ,
s10+i,0 = 0.01 + a + b i c ,
with a = 0.0010, b = 1.3323 × 10−6 and c = 4.8830. We observe that these mortality rates are
constrained to increase with the aging phase. (The same form for the mortality rate as a function
of aging phase was used by Lin and Liu (1999) in modelling mortality using PH distributions.)
Note that the rates are higher by 0.01 in the first stage of disability, which ensures the duration
dependence assumed in Equation (3.8). The sub-generator matrix with off-diagonal elements
giving the transition rates is given by
S = (si, j ), i, j = 1, . . . , 30,
where the rates of transition from one aging phase to the next are given by
si,i+1 = 0.2472, i = 1, . . . , 9, 11, . . . , 19, 21, . . . , 29.
The disability incidence rates, again proportional to the mortality rates, are given by
si,i+10 = 2[a + b i c ], i = 1, . . . , 10,

Table 2. Disability income insurance premium rates per 1000 of annual benefit for various ages, waiting periods and
interest rates; premiums and benefits payable continuously.
Waiting period
Age 0 months 3 months 6 months
Force of interest δ = 3%
30 62.33 58.58 55.30
40 99.67 93.47 88.08
50 140.63 131.05 122.77
60 109.18 97.91 88.444
30 44.25 41.42 38.96
40 82.46 76.94 72.15
50 128.83 119.33 111.15
60 106.41 94.81 85.11
30 31.32 29.19 27.35
40 68.09 63.19 58.97

50 117.82 108.47 100.45
60 103.66 91.77 81.87
and the rates of transition from disability stage 1 to disability stage 2 are
si,i+10 = 4.0300, i = 11, . . . , 20.
The rates of recovery from disability are given by
si,i−10 = 1, i = 11, . . . , 20,
and
si,i−20 = 0.1, i = 21, . . . , 30,
which allows us to achieve the desired decrease with disability duration, as assumed in (3.7).
All other entries of S are zero except the diagonal entries which are:

30
si,i = − si, j , i = 1, . . . , 30.
j=0
j=i
Finally, it was assumed that individuals age 30 are in aging phase 1 and active. That is,
β = (1, 0, . . . , 0).
Figure 3 shows the forces of transition among the three statuses that result from our fitted
model as well as the true forces of transition. We also show the results of fitting the model using
30 aging phases to illustrate that we can easily improve the fit by increasing the number of states.
However, for simplicity, we have retained 10 aging phases in our illustrations.
Figures 4–6 show plots of probabilities that were calculated using this PH disability model.
In Figure 4, we display the probabilities that the individual is active at various times after age
50 given that the individual was active at age 50 and given that the individual was disabled at
age 50. We show only 15 years on the horizontal axis, because we assume that the disability
Figure 4. Probability that an individual is active given active (solid) or disabled (dashed) at age 50.
insurance is no longer in force after age 65. Given active at age 50, the probability of being active
decreases from 1 as the probability of being disabled or deceased increases. Assuming one is
disabled at age 50, the probability of being active increases from 0 initially as the probability of
being recovered increases, but the probability decreases later, as the probability of being disabled
again or deceased increases.
Figure 5 shows the probabilities that an individual is disabled, and disabled for at least six
months, given that the individual was active at age 50. As expected, both curves increase, and
the probability that the individual is disabled for at least six months is lower than the probability
that the insured is disabled.
Figure 6 displays probabilities of the same events as in Figure 5, but conditions on the event
that the individual has been disabled for exactly six months when he/she attains age 50. Again,
the probability of being disabled for at least six months is lower, since the event that the insured
is disabled at a given time includes outcomes involving a subsequent spell of disability that has
lasted less than six months at that time.
Example 2
This example uses real data for the rates of disability incidence and death of active lives
and the rates of death and recovery of disabled lives. We assume that the rates of death and
disability incidence are proportional to the death rates of females in the CIA9704 Mortality
Tables (see Canadian Institute of Actuaries (2010) and that the recovery rate is constant. The
overall observed experience is captured by the following assumptions:
Figure 5. Probability that an individual is disabled (solid) or disabled for at least six months (dashed) given active at
age 50.
Figure 6. Probability that an individual is disabled (solid) or disabled for at least six months (dashed) given disabled
for exactly 6 months at age 50.
• The rate of death of active lives is 0.87 of the CIA Female Combined;
• The rate of disability of active lives is 0.60 of the CIA Female Combined;
• The rate of death of disabled lives is 4.3 of the CIA Female Combined;
• The overall rate of recovery from disability is 0.018.
To fit the model we set m = 1 and l = 25. To model early recovery and death rates of disabled
lives, further investigation of the data for disabled lives is required.
The elements of the mortality rates vector s0 is given as follows:

0.89(a0 + a1 + b i c ), for i = 1, . . . , 20
si,0 = , (3.9)
0.89(a1 + b i c ), for i = 21, . . . , 25
and

4.3(a0 + a1 + b i c ), for i = 1, . . . , 20
si+25,0 = , (3.10)
4.3(a1 + b i c ), for i = 21, . . . , 25
where the parameters are given in Table 1. The rates of transition from one aging phase to the
next are given by
si,i+1 = λ, i = 1, . . . , 24, 26, . . . , 49,
where λ is estimated as 0.7499. The rates of disability of active lives are

0.60(a0 + a1 + b i c ), for i = 1, . . . , 20,
si,i+25 = . (3.11)
0.60(a1 + b i c ), for i = 21, . . . , 25,
And finally, the rate of recovery from disability is
si+25,i = 0.018 i = 1, . . . , 25.
All the remaining elements of the sub-intensity matrix S are 0. The graph of rates of transitions
are given in Figure 7.
4. Present values of disability insurance premiums and benefits
In this section, we discuss the computation of actuarial present values that are useful in premium
and reserve calculations. We begin by considering a simplified disability income insurance policy
for which premiums are payable continuously while the insured is active, and a benefit of one
per year is payable continuously while the insured is disabled, but no benefits are payable after
age 65. Hence, the policy terminates at age 65. The insurer uses a force of interest δ to discount
payments, and v = e−δ . Then, the actuarial present value of future benefits payable to an active
Figure 7. Forces of transition: True (solid) and fitted with 25 (dotted) aging phases. In the lower two graphs, disability
is assumed to occur at age 30.
life now age 50 is

15
APV of future benefits = v t P(X 50+t ∈ E I |X 50 ∈ E A ) dt
0
15 β e20S I E,E A IE,E A etS 1 I
= vt dt
0 β e20S 1 A
15 β e20S I E,E A IE,E A et (S−δIn ) 1 I
= dt
0 β e20S 1 A
β e20S I E,E A IE,E A (S − δIn )−1 (e15(S−δIn ) − In ) 1 I
= .
β e20S 1 A
Similarly, the annuity factor used to discount future premiums is

15
Premium factor = v t P(X 50+t ∈ E A |X 50 ∈ E A ) dt
0
β e20S I E,E A IE,E A (S − δIn )−1 (e15(S−δIn ) − In ) 1 A

= .
β e20S 1 A
If π is the premium rate obtained using the equivalence principle, then
APV of future benefits

π= . (4.12)
Premium factor
The situation is more complicated when our insurance policy involves a waiting period.
Nonetheless, we still obtain explicit expressions that are easy to compute.
Consider a disability income insurance policy that pays a benefit of one per year continuously
while the insured is disabled, but only after a waiting period w. Therefore, no benefit is paid if
the spell of disability lasts less than w. We also assume that no benefits are payable after age 65.
Premiums are payable continuously while the insured is active and continue during the waiting
period if the insured becomes disabled. However, if the insured is still disabled at the end of the
waiting period and benefits begin, then premiums stop and those paid during the waiting period
are refunded. Thus, we assume no premiums are paid during the waiting period of disabilities
that last longer than the waiting period. In this case, the actuarial present value of future benefits
for an insured who is active at age 50 is
APV of future benefits

15−w
= v t+w P(X 50+t+u ∈ E I ∀ u ∈ [0, w]|X 50 ∈ E A ) dt
0
e−δw β e20S I E,E A IE,E A (S − δIn )−1 (e(15−w)(S−δIn ) − In ) I E,E I ewS I IE,E I 1 I
= .
β e20S 1 A
The annuity factor used to discount future premiums is

15−w
Premium factor = v t P(X 50+t ∈ E A |X 50 ∈ E A ) dt (4.13)
0
15−w w
+ vt āz| P(X 50+t−dt ∈ E A , X 50+t+s ∈ E I ∀s ∈ [0, z −dz), X 50+t+z ∈
/ E I |X 50 ∈ E A )
t=0 z=0
β e20S I E,E A IE,E A (S − δIn )−1 (e(15−w)(S−δIn ) − In ) 1 A

=
β e20S 1 A

15−w w β e20S I E,E A IE,E A etS I E,E A S AI e zS I (S I A IE,E A 1 A + IE,E I s0 )
+ vt āz| dz dt
0 0 β e20S 1 A
β e20S I E,E A IE,E A (S − δIn )−1 (e15(S−δIn ) − In )

=
β e20S 1 A

1 A +I E,E A S AI S−1 I (e wS I
−I nI )−(S I −δInI )−1 w(S I−δIn I )
(e −I nI ) (S I
1
I A E,E A A +I
E,E I 0 .
s )
The upper limit of the first two integrals in Equation (4.13) is 15 − w because an active insured
will not continue the policy beyond age 65 − w with no possibility of receiving benefits. Again,
the premium rate, obtained using the equivalence principle, is given by (4.12).
Table 2 shows the resulting annual premiums for different ages, waiting periods and interest
rates using the model presented in Example 1. These premiums behave the way we expect:
decreasing with interest rate and waiting period, and increasing with age, though we expect a
decrease as the insured gets close to age 65.
5. Conclusions
In this paper, we have presented a PH model for disability insurance. This type of model has two
main advantages over other modelling approaches. First, it allows one to accurately represent
the rates of change in status (active, disabled and deceased) of the insured. Second, it enables
one to determine explicit expressions for, and to compute, complicated conditional probabilities
and actuarial present values that are relevant in calculating disability insurance premiums and
reserves.
We observe that the same limitations that arise in using PH distributions exist for our PH
disability model. In the first instance, precisely because they possess all of their moments as per
(2.5); PH distributions are often unable to reflect heavy-tailed behaviour. However, this is not a
problem for the disability model, because all of the stages and phases we are modelling reflect
human aging phenomena, which are light-tailed. A second limitation is that it is generally the
case that several distinct PH representations can correspond to the same distribution, so that we
must consider problems associated with non-uniqueness of the PH parameter representation.
This can create difficulties for statistical inference with PH distributions, when there are diverse
ways to represent the same distribution, due to the non-uniqueness of the representation (see,
for instance, O’Cinneide (1989) and Asmussen et al. (1996)). Further work is needed to explore
the statistical issues in the context of our PH disability model.
References
Asmussen, S., Nerman, O. & Olsson, M. (1996). Fitting phase-type distributions via the EM algorithm. Scandinavian
Journal of Statistics 23, 419–441.
Bowers, N. L., Gerber, H. U., Hickman, J. C., Jones, D. A. & Nesbitt, C. J. (1997). Actuarial mathematics. Schaumberg,
IL: Society of Actuaries.
Canadian Institute of Actuaries (2010). Construction of CIA9704 mortality tables for Canadian individual insurance based
on data from 1997 to 2004, Document 210028.
Fredkin, D. R. & Rice, J. A. (1986). On aggregated Markov processes. Journal of Applied Probability 23, 208–214.
Haberman, S. & Pitacco, E. (1999). Actuarial models for disability insurance. Boca Raton, FL: Chapman and Hall/CRC.
Lin, X. S. & Liu, X. (2007). Markov aging process and phase-type law of mortality. North American Actuarial Journal
11, 92–109.
Neuts, M. F. (1994). Matrix-geometric solutions in Stochastic models: An algorithmic approach. Mineola, NY: Dover,
Corrected reprint of the 1981 original.
O’Cinneide, C. A. (1989). On non-uniqueness of representations of phase-type distributions. Communications in Statistics:
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This article was downloaded by: [Simon Fraser University]

On: 16 November 2014, At: 04:23

Scandinavian Actuarial Journal

The use of phase-type models for

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The use of phase-type models for disability insurance

(Accepted December 2012)

∗ Corresponding author. E-mail: am_hassanzadeh@sbu.ac.ir

© 2013 Taylor & Francis

where the matrix S = (si j ) is n × n, s0 = (s j0 ) is an n-dimensional column vector, and 0 is

where in the foregoing, the exponential of a square matrix A is defined by

Taking derivatives of (2.2), the probability density function of Y is given by

E(Y k ) = k! β (−S−1 )k 1, k = 1, 2, . . . . (2.5)

Figure 1. The three-state disability model.

3. PH models for disability insurance

Figure 2. The PH disability model.

We assume that {X 30+t , t ≥ 0} is a time-homogeneous Markov chain with (n + 1) × (n + 1)

β e20S I E,E A IE,E A

P(X 50+t ∈ E I |X 50 ∈ E A ) = β 50,I etS 1 I , (3.2)

where the initial probability vector β 50,I is given by

β e20S I E,E A IE,E A

β e20S I E,E A IE,E A etS I E,E I ewS I IE,E I 1 I

P(X 50+t+u ∈ E I ∀ u ∈ [0, v]|X 50− ∈ E A , X 50+r ∈ E I ∀ r ∈ [0, t])

Table 1. The aging parameters in Example 2.

1e-14 1e-3 5.5376 e-6 2.6895

si,i+1 = 0.2472, i = 1, . . . , 9, 11, . . . , 19, 21, . . . , 29.

si,i+10 = 2[a + b i c ], i = 1, . . . , 10,

40 68.09 63.19 58.97

si,i+10 = 4.0300, i = 11, . . . , 20.

The rates of recovery from disability are given by

si,i−10 = 1, i = 11, . . . , 20,

si,i+1 = λ, i = 1, . . . , 24, 26, . . . , 49,

where λ is estimated as 0.7499. The rates of disability of active lives are

And finally, the rate of recovery from disability is

si+25,i = 0.018 i = 1, . . . , 25.

4. Present values of disability insurance premiums and benefits

life now age 50 is

Similarly, the annuity factor used to discount future premiums is

β e20S I E,E A IE,E A (S − δIn )−1 (e15(S−δIn ) − In ) 1 A

If π is the premium rate obtained using the equivalence principle, then

APV of future benefits

APV of future benefits

The annuity factor used to discount future premiums is

β e20S I E,E A IE,E A (S − δIn )−1 (e(15−w)(S−δIn ) − In ) 1 A

β e20S I E,E A IE,E A (S − δIn )−1 (e15(S−δIn ) − In )

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