Financial Mathematics: Jonathan Ziveyi

Financial Mathematics
Jonathan Ziveyi1
1 University of New South Wales
Actuarial Studies, Australian School of Business
j.ziveyi@unsw.edu.au
Module 2 Topic Notes
1/28
Plan
Module 2: Valuation of Contingent Cash Flows

Introduction
A Continuous Model for Survival Analysis
A Discrete Model for Survival Analysis
Expected Present Value of Basic Life Insurance Products
2/28
Introduction
Plan

Introduction
3/28
Introduction
Contingent Cash Flows
a contingent cash flow is a cash flow that happens if. . .
Contingent cash flows happen in a variety of situations:

depending on an event that will happen, and only once
depending on other securities: derivatives
use probability model or replicating portfolio (arbitrage-free)

another module of this course
depending on an event that may not happen at all, or indeed

several times, and for random claim amounts
3/28
related to life insurance mathematics (death is such an event)

a probability model is necessary for that event
we can calculate standard expected present values
this module
this is the case of any GI insurance product

pricing techniques are discussed in other courses
Introduction
History of life insurance mathematics Several steps to get to life

insurance mathematics
Simon Stevin (1548-1620), a Dutch mathematician, developed

the first compound interest tables
Blaise Pascal (1623-1662), a French mathematician and

philosopher, gives birth to probability calculus
Edmund Halley (1656-1742), a British mathematician and

astronomer, builds the first mortality table
James Dodson (1705-1757), a British mathematician, was the
first to put all components together. In a 1756 lecture, he
showed how
a life insurance plan should be set up

premium rates should be calculated
reserves would build up
The discipline of life insurance mathematics was born!

4/28
Introduction
Plan of this module

1. Introduction
2. A Continuous Model for Survival Analysis
3. A Discrete Model for Survival Analysis
4. Expected Present Value of Basic Life Insurance Products
5/28
Plan

Introduction
6/28
Survival Probabilities Let an individuals age-at-death, Z , be a

continuous r.v. with distribution function
FZ (z) = Pr(Z z),
x 0.
Its complement, the survival function S(x), is defined as

S(x) = 1 FZ (x)
= Pr(Z > x),
x 0,
where S(x) is seen to be the probability that a newborn will attain

age x.
6/28
Probabilities of dying (surviving) over the next t years Convention:
a life aged x will be denoted by (x)
x for men, y for women
The future lifetime

T (x) = Z x|Z > x
of (x) is a random variable with distribution function
t qx
= 1 t px
= Pr(Z x t | Z > x)
FZ (x + t) FZ (x)
=
1 FZ (x)
S(x) S(x + t)
=
S(x)
7/28
Probability of dying over the next t years, in s years The probability

(x) will die between ages x + s and x + s + t is
s|t q x
= Pr(s < T (x) s + t)

= Pr(s < Z x s + t | Z > x)
= Pr(x + s < Z x + s + t | Z > x)
S(x + s) S(x + s + t)
.
=
S(x)
8/28
Force of mortality Let s = 0 and t be infinitesimal (a dt):

dt q x
is the probability that (x) will die in the next instant
this is equal to the pdf of T (x) at s = 0, times dt
We have
dt q x
S(x) S(x + dt)

S(x + dt) S(x) dt
S (x)
=
=
dt.
S(x)
dt
S(x)
S(x)
The coefficient of dt is called the force of mortality, and represents

the likelihood for the individual (x) to die in the next instant dt:
x =
S (x)
fZ (x)
fZ (x)
= [ln S(x)] =
=
.
S(x)
S(x)
1 FZ (x)
Note that
S(x) = e
9/28
Rx
0
t dt
One more step to obtain the pdf of T (x) What if s > 0?
we have to account for the probability of surviving s years,

before dying between s and s + dt
We have then
s|dt q x
S(x + s) S(x + s + dt) S(x + s)

dt = s p x x+s dt
S(x)
S(x + s)dt
This integrates to 1. We can now calculate the expected future

lifetime of (x):
Z
ex = E [T (x)] =
t t p x x+t dt.
0
Note that
t px
10/28
= e
Rt
0
x +s ds
Example The lifetime of a light bulb is sometimes modeled using an

exponential distribution:
fZ (z) = e z .
Find
1. the probability that the bulb will fail before x hours of usage;
2. the probability that it will function more than x hours;
3. its failure rate;
4. its expected lifetime;
5. the probability that it will function for another t years if it has
already functioned for x hours.
11/28
Example
12/28
Analytical distributions of T (x) de Moivre (1724):
maximum age
T (x) is uniformly distributed between 0 and x

(the remaining years)
1
x+t =
x t
Gompertz (1824)
the force of mortality grows exponentially

x+t = Bc x+t
Makeham (1860)
generalises Gompertz
x+t = A + Bc x+t
13/28
Analytical distributions of T (x) Lee-Carter (1992):
one of the models that are most used now (several

modifications were (and still are) developed to improve it)
x,t = e x +x t + x,t = Ax Bxt + x,t
where
x,t is the force of mortality of (x) at time t
x and x depend on x
t depends on t
x,t are iid N(0, 2 ) random variables
This is the continuous model for longitudinal or generation life

tables, that relate to the generation of persons born at time t x.
14/28
Plan

Introduction
15/28
Curtate Future Lifetime Let K (x) T (x) be the random number

of completed years lived by (x), or the curtate future lifetime of
(x). This is a discrete random variable.
Pr[K (x) = k] = Pr[k < T (x) k + 1]
=
k|1 q x
FZ (x + k + 1) FZ (x + k)
1 FZ (x)
1 FZ (x + k) FZ (x + k + 1) FZ (x + k)
=
1 FZ (x)
1 FZ (x + k)
S(x + k) S(x + k) S(x + k + 1)
=
S(x)
S(x + k)
= k px qx+k
=
15/28
Expected life in discrete time The expected curtate future lifetime

of (x) is denoted by
1
E [K (x)] = ex
ex .
2
It can be calculated as
ex =
k k px qx+k
k=1
or
ex =
X
k=1
16/28
Pr[K k] =
X
k=1
k px .
Numerical Example For a newborn (0):

t
0
1
2
3
4
5
6
17/28
qt
0.3
0.1
0.2
0.5
0.7
0.9
1.0
1 qt = pt
0.7
0.9
0.8
0.5
0.3
0.1
0.0
S(t) = t p 0
1.00000
0.70000
0.63000
0.50400
0.25200
0.07560
0.00756
e0 = 2.16916
Pr[K (0) = t]
0.30000
0.07000
0.12600
0.25200
0.17640
0.06804
0.00756
1.00000
Numerical Example For (2):

t
0
1
2
3
4
5
6
18/28
qt
0.3
0.1
0.2
0.5
0.7
0.9
1.0
1 qt = pt
0.7
0.9
0.8
0.5
0.3
0.1
0.0
t q2
0.000
0.200
0.600
0.880
0.988
1.000
t p2
1.000
0.800
0.400
0.120
0.012
0.000
Pr[K (2) = t]
0.200
0.400
0.280
0.108
0.012
0.000
e2 = 1.332
1.000
Plan

Introduction
19/28
Insurance products: conventions
historically (and practically) priced in discrete time
premiums are paid at the beginning of the year, benefits at the

end of the year
(have you ever wondered why all insurance premiums had to
be paid in advance?)
the net single premium, or actuarial present value, or risk

premium of the policy is the expected present value of future
benefits.
the actual premium paid by the customer is loaded; this is not

discussed here
let i be the technical rate of interest
In life insurance, benefit payments are contingent on the death

and/or survival of the person insured.
19/28
How to interpret this section Some standard EPV related to an

event that will happen only once:
an annuity until it happens
an annuity until it happens, but for a maximum of n years
a capital when it happens
a capital when it happens, if it happens before n years
a capital after n years, if it hasnt happened yet

a capital
20/28
when it happens if it happens before n years

after n years if it hasnt happened yet
Insurance in case of death Life insurance
single payment, the sum insured
net single premium is paid at time 0, for a sum insured of 1
the benefit is
B = v K (x)+1 ,
a random variable with distribution
Pr[v K (x)+1 = v k+1 ] = Pr[K (x) = k],
=
21/28
k px
qx+k , k = 0, 1, . . . .
Insurance in case of death Whole life insurance
h
i X
Ax = E [B] = E v K (x)+1 =
v k+1 k p x qx+k ,
k=0
and
Var (B) = 2 Ax (Ax )2
where
2
Ax

= E B2
h
i
= E v 2(K (x)+1)
i
h
K (x)+1
= E vj
where j = (1 + i)2 1, i.e.,

the effective two yearly rate of interest.
22/28
Insurance in case of death Term insurance

1
Ax:n
=
n1
X
v k+1 k px qx+k .
k=0
In continuous time
If B = v T (x) , then
x
A
1
x:n
A
23/28
=
=
Z
Z
0
n
0
v t t p x x+t dt, and
v t t p x x+t dt.
Insurance in case of survival Pure endowment

Ax:n1 = v n n p x .
Whole life annuity-due
The present value of benefits is
B = 1 + v + v 2 + + v K (x) = aK (x)+1
with pmf
Pr[B = ak+1 ] = Pr[K (x) = k] = k p x qx+k .
We have then
ax
=
=
X
k=0
X
k=0
24/28
ak+1 k p x qx+k
v k k px .
Insurance in case of survival Whole life annuity-immediate

This is simply
ax = ax 1.
Temporary life annuity-due for n years

aK (x)+1 K (x) = 0, 1, 2, . . . , n 1
B=
an
K (x) = n, n + 1, n + 2, . . .
We have then
ax:n
n1
X
k=0
n1
X
k=0
25/28
ak+1 k p x qx+k + an n p x
v k k px .
Insurance in case of death and survival Endowment

Payment of 1
if death before n, or
after n years if survival.

K (x)+1
v
K (x) = 0, 1, 2, . . . , n 1
B=
vn
K (x) = n, n + 1, n + 2, . . .
with present value
1
Ax:n = Ax:n
+ Ax:n1 .
26/28
Numerical example (continued), for (2) and n = 3

Whole life insurance
A2 = 0.9132,
A2 = 0.8351,
and thus the variance is (0.0339)2
Endowment = Term insurance + Pure endowment

A2:3 = A12:3 + A2:31
0.9177 = 0.8110 + 0.1067
Life annuities
a2 = 2.2560
a2 = 1.2560
Temporary life annuity-due

a2:3 = 2.1391
27/28
Note: the technical rate of interest is 4%
Important relations There are many.... Here are two important ones:
dax + Ax = 1,
for whole life insurance and
dax:n + Ax:n = 1,
for term insurance.
Both are similar to
dan + v n = 1.
28/28

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Financial Mathematics

Module 2 Topic Notes

Module 2: Valuation of Contingent Cash Flows

Module 2: Valuation of Contingent Cash Flows

Contingent Cash Flows

a contingent cash flow is a cash flow that happens if. . .

Contingent cash flows happen in a variety of situations:

depending on other securities: derivatives

use probability model or replicating portfolio (arbitrage-free)

depending on an event that may not happen at all, or indeed

related to life insurance mathematics (death is such an event)

this is the case of any GI insurance product

History of life insurance mathematics Several steps to get to life

Simon Stevin (1548-1620), a Dutch mathematician, developed

Blaise Pascal (1623-1662), a French mathematician and

Edmund Halley (1656-1742), a British mathematician and

a life insurance plan should be set up

The discipline of life insurance mathematics was born!

Plan of this module

Module 2: Valuation of Contingent Cash Flows

Survival Probabilities Let an individuals age-at-death, Z , be a

Its complement, the survival function S(x), is defined as

where S(x) is seen to be the probability that a newborn will attain

Probabilities of dying (surviving) over the next t years Convention:

a life aged x will be denoted by (x)

x for men, y for women

The future lifetime

Probability of dying over the next t years, in s years The probability

= Pr(s < T (x) s + t)

Force of mortality Let s = 0 and t be infinitesimal (a dt):

is the probability that (x) will die in the next instant

this is equal to the pdf of T (x) at s = 0, times dt

S(x) S(x + dt)

The coefficient of dt is called the force of mortality, and represents

One more step to obtain the pdf of T (x) What if s > 0?

we have to account for the probability of surviving s years,

S(x + s) S(x + s + dt) S(x + s)

This integrates to 1. We can now calculate the expected future

Example The lifetime of a light bulb is sometimes modeled using an

Analytical distributions of T (x) de Moivre (1724):

T (x) is uniformly distributed between 0 and x

the force of mortality grows exponentially

Analytical distributions of T (x) Lee-Carter (1992):

one of the models that are most used now (several

x,t is the force of mortality of (x) at time t

x,t are iid N(0, 2 ) random variables

This is the continuous model for longitudinal or generation life

Module 2: Valuation of Contingent Cash Flows

Curtate Future Lifetime Let K (x) T (x) be the random number

Expected life in discrete time The expected curtate future lifetime

Numerical Example For a newborn (0):

Numerical Example For (2):

Module 2: Valuation of Contingent Cash Flows

Insurance products: conventions

historically (and practically) priced in discrete time

premiums are paid at the beginning of the year, benefits at the

the net single premium, or actuarial present value, or risk

the actual premium paid by the customer is loaded; this is not

let i be the technical rate of interest

In life insurance, benefit payments are contingent on the death

How to interpret this section Some standard EPV related to an

an annuity until it happens