Actmodels PDF

STT 455-6: Actuarial Models
Albert Cohen
Actuarial Sciences Program

Department of Mathematics
Department of Statistics and Probability
C336 Wells Hall
Michigan State University
East Lansing MI
48823
albert@math.msu.edu
acohen@stt.msu.edu
Albert Cohen (MSU) STT 455-6: Actuarial Models MSU 2013-14 1 / 324
Copyright Acknowledgement
Many examples and theorem proofs in these slides, and on in class exam
preparation slides, are taken from our textbook ”Actuarial Mathematics for
Life Contingent Risks” by Dickson,Hardy, and Waters.
Please note that Cambridge owns the copyright for that material.
No portion of the Cambridge textbook material may be reproduced
in any part or by any means without the permission of the
publisher. We are very thankful to the publisher for allowing posting
of these notes on our class website.
Also, we will from time-to-time look at problems from released
previous Exams MLC by the SOA. All such questions belong in
copyright to the Society of Actuaries, and we make no claim on
them. It is of course an honor to be able to present analysis of such
examples here.
Survival Models
An insurance policy is a contract where the policyholder pays a

premium to the insurer in return for a benefit or payment later.
The contract specifies what event the payment is contingent on. This
event may be random in nature
Assume that interest rates are deterministic, for now
Consider the case where an insurance company provides a benefit
upon death of the policyholder. This time is unknown, and so the
issuer requires, at least, a model of of human mortality
Survival Models
Define (x) as a human at age x. Also, define that person’s future lifetime
as the continuous random variable Tx . This means that x + Tx represents
that person’s age at death.
Define the lifetime distribution
Fx (t) = P[Tx ≤ t] (1)

the probabiliity that (x) does not survive beyond age x + t years, and it’s
complement, the survival function Sx (t) = 1 − Fx (t).
Conditional Equivalence
We have an important conditional relationship
P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]
P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]

P[x < T0 ≤ x + t] (2)
=
P[T0 > x]
and so
F0 (x + t) − F0 (x)
Fx (t) =
1 − F0 (x)
P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]

P[x < T0 ≤ x + t] (2)
=
P[T0 > x]
and so
F0 (x + t) − F0 (x)
Fx (t) =
1 − F0 (x)
(3)
S0 (x + t)
Sx (t) =
S0 (x)
In general we can extend this to
Sx (t + u) = Sx (t)Sx+t (u) (4)
Conditions and Assumptions
Conditions on Sx (t)
Sx (0) = 1
limt→∞ Sx (t) = 0 for all x ≥ 0
Sx (t1 ) ≥ Sx (t2 ) for all t1 ≤ t2 and x ≥ 0
Assumptions on Sx (t)
d
dt Sx (t) exists ∀t ∈ R+
limt→∞ t · Sx (t) = 0 for all x ≥ 0
limt→∞ t 2 · Sx (t) = 0 for all x ≥ 0
The last two conditions ensure that E[Tx ] and E[Tx2 ] exist, respectively.
Example 2.1
t
1
Assume that F0 (t) = 1 − 1 − 120
6
for 0 ≤ t ≤ 120. Calculate the
probability that
(0) survives beyond age 30
(30) dies before age 50
Example 2.1
t
1
Assume that F0 (t) = 1 − 1 − 120
6
for 0 ≤ t ≤ 120. Calculate the
probability that
(30) dies before age 50
P[(0) survives beyond age 30] = S0 (30) = 1 − F0 (30)

1
30 6
= 1− = 0.9532
120
P[(30) dies before age 50] = F30 (20) (5)
F0 (50) − F0 (30)
= = 0.0410
1 − F0 (30)
S0 (65)
P[(40) survives beyond age 65] = S40 (25) = = 0.9395
S0 (40)
The Force of Mortality
Recall from basic probability that the density of Fx (t) is defined as

d
fx (t) := dt Fx (t).
Recall from basic probability that the density of Fx (t) is defined as

d
fx (t) := dt Fx (t).
It follows that
d F0 (x + dx) − F0 (x)
f0 (x) := F0 (x) = lim +
dx dx→0 dx
(6)
P[x < T0 ≤ x + dx]
= lim +
dx→0 dx
However, we can find the conditional density, also known as the Force of
Mortality via
P[x < T0 ≤ x + dx | T0 > x]

µx = lim +
dx→0 dx
P[Tx ≤ dx] 1 − Sx (dx)
= lim + = lim +
dx→0 dx dx→0 dx
1 − Sx (dx)
= lim + (7)
dx→0 dx
S0 (x+dx)
1− S0 (x) 1 S0 (x) − S0 (x + dx)
= lim + = lim +
dx→0 dx S0 (x) dx→0 dx
1 d f0 (x)
=− S0 (x) =
S0 (x) dx S0 (x)
In general, we can show
1 d fx (t)
µx+t = − Sx (t) = (8)
Sx (t) dt Sx (t)
and integration of this relation leads to
S0 (x + t)
Sx (t) =
S0 (x)
R x+t
e− 0 µs ds
= Rx
(9)
e −R 0 µs ds
x+t
= e− x µs ds
Rt
= e− 0 µx+s ds
Example 2.2
t
1
Assume that F0 (t) = 1 − 1 − 120
6
for 0 ≤ t ≤ 120. Calculate µx
Example 2.2
t
1
Assume that F0 (t) = 1 − 1 − for 0 ≤ t ≤ 120. Calculate µx
120
6
x − 56

d 1 1
S0 (x) = · 1 − · −
dx 6 120 120
x − 56

1 1 1
∴ µx = − 1 · 6 · 1 − 120 · − (10)
1− x 6 120
120
1
=
720 − 6x
Gompertz’ Law / Makehams’s Law
One model of human mortality, postulated by Gompertz, is µx = Bc x ,

where (B, c) ∈ (0, 1) × (1, ∞). This is based on the assumption that
mortality is age dependent, and that the growth rate for mortality is
proportional to it’s own value. Makeham proposed that there should also
be an age independent component, and so Makeham’s Law is
µx = A + Bc x (11)
Of course, when A = 0, this reduces back to Gompertz’ Law.
Of course, when A = 0, this reduces back to Gompertz’ Law.

By definition,
R x+t R x+t
(A+Bc s )ds
Sx (t) = e − x µs ds
= e− x
B x (c t −1)
(12)
= e −At− ln c c
Keep in mind that this is a multivariable function of (x, t) ∈ R2+
Some online resources:

CDC National Vital Statistics report, Dec. 2002 .
Comparison with US Gov’t data
Actuarial Notation
Actuaries make the notational conventions
t px = P[Tx > t] = Sx (t)

t qx = P[Tx ≤ t] = Fx (t) (13)
u|t qx = P[u < Tx ≤ u + t] = Sx (u) − Sx (u + t)
u|t qx , also known as the deferred mortality probability, is the probability
that (x) survives u years, and then dies in the subsequent t years.
Another convention is that px := 1 px and qx := 1 qx .
Actuarial Notation-Relationships
Consequently,
t px + t qx = 1
u|t qx = u px − u+t px
t+u px = t px · u px+t (14)
−1 d
µx = (x p0 )
x p0 dx
Similarly,
−1 d d
µx+t = t px ⇒ t px = µx+t · t px
t px dt dt
fx (t) (15)
µx+t = ⇒ fx (t) = µx+t · t px
Sx (t)
Rt
t px = e− 0 µx+s ds
Rt
Also, since Fx (t) = 0 fx (s)ds, we have as a linear approximation
Z t
t qx = s px · µx+s ds
0
Rt
Also, since Fx (t) = 0 fx (s)ds, we have as a linear approximation
Z t
t qx = s px · µx+s ds
0
Z 1
qx = s px · µx+s ds
0
Z 1 Rs
(16)
= e− 0 µx+v dv
· µx+s ds
0
Z 1
≈ µx+s ds
0
≈ µx+ 1
2
Mean and Standard Deviation of Tx
Actuaries make the notational definition e̊x := E[Tx ], also known as the
d
complete expectation of life. Recall fx (t) = t px · µx+t = − dt t px , and
Z ∞
e̊x = t · fx (t)dt
Z0 ∞
= t · t px · µx+t dt
Z0 ∞
d
= t · − t px dt
0 dt
d
Z ∞
Z0 ∞
Z0 ∞
d
= t · − t px dt
dt
Z0 ∞
= t px dt
0
d
Z ∞
Z0 ∞
Z0 ∞
d
= t · − t px dt
dt
Z0 ∞
= t px dt
0
Z ∞ Z ∞
2 2
E[Tx ] = t · fx (t)dt = 2t · t px dt
0 0
d
Z ∞
Z0 ∞
Z0 ∞
d
= t · − t px dt
dt (17)
Z0 ∞
= t px dt
0
Z ∞ Z ∞
2 2
E[Tx ] = t · fx (t)dt = 2t · t px dt
0 0
V [Tx ] := E[Tx2 ] − (e̊x ) 2
Example 2.6
x
1
Assume that F0 (x) = 1 − 1 − 120
6
for 0 ≤ x ≤ 120. Calculate e̊x , V [Tx ]
for a.)x = 30 and b.)x = 80.
Example 2.6
x
1
Assume that F0 (x) = 1 − 1 − 120 6
for 0 ≤ x ≤ 120. Calculate e̊x , V [Tx ]
for a.)x = 30 and b.)x = 80.
x
1
Since S0 (x) = 1 − 120 6
, it follows that in keeping with the model where
survival is constrained to be les than 120,

1
6
S0 (x + t)  1 − t : x + t ≤ 120
t px = = 120−x
S0 (x)  0 : x + t > 120
Example 2.6
So,
Z 120−x 1
t 6 6
e̊x = 1− dt = · (120 − x)
0 120 − x 7
Z 120−x 1
t 6
(18)
E[Tx2 ] = 2t · 1 − dt
120 − x
0
6 6
= − · 2(120 − x)2
7 13
and
(e̊30 ,e̊80 ) = (77.143, 34.286)

(19)
(V [T30 ], V [T80 ]) = (21.396)2 , (9.509)2

Exam MLC Spring 2007: Q8
Kevin and Kira excel at the newest video game at the local arcade,
Reversion. The arcade has only one station for it. Kevin is playing. Kira is
next in line. You are given:
(i) Kevin will play until his parents call him to come home.
(ii) Kira will leave when her parents call her. She will start playing as
soon as Kevin leaves if he is called first.
(iii) Each child is subject to a constant force of being called: 0.7 per
hour for Kevin; 0.6 per hour for Kira.
(iv) Calls are independent.
(v) If Kira gets to play, she will score points at a rate of 100,000 per
hour.
Calculate the expected number of points Kira will score before she leaves.
(A) 77,000
(B) 80,000
(C) 84,000
(D) 87,000
(E) 90,000
Define
t px = P [Kevin still there]

(20)
t py = P [Kira still there]
and so
Z ∞
E [Kira’s playing time] = (1 − t px ) · t py dt
Z0 ∞
1 − e −0.7t · e −0.6t dt

=
Z0 ∞ (21)
−0.6t −1.3t

= e −e dt
0
1 1
= − = 0.89744 hrs.
0.6 1.3
It follows that
$
E [Kira’s winnings] = 100000 · E [Kira’s playing time]
hr (22)
= $89744.
Hence, we choose (E ).
Numerical Considerations for Tx
In general, computations for the mean and SD for Tx will require
numerical integration. For example,
Table: 2.1: Gompertz Model Statistics: (B, c) = (0.0003, 1.07)
x e̊x SD[Tx ] x + e̊x

0 71.938 18.074 71.938
10 62.223 17.579 72.223
20 52.703 16.857 72.703
30 43.492 15.841 73.492
40 34.252 14.477 74.752
50 26.691 12.746 76.691
60 19.550 10.693 79.550
70 13.555 8.449 83.555
80 8.848 6.224 88.848
90 5.433 4.246 95.433
100 3.152 2.682 103.152
Curtate Future Lifetime
Define
Kx := bTx c (23)
and so
P [Kx = k] = P [k ≤ Tx < k + 1]
= k| qx
= k px − k+1 px (24)
= k px − k px · px+k
= k px · qx+k
∞
X
E [Kx ] := ex = k · P [Kx = k]
k=0
∞
X
= k · (k px − k+1 px )
k=0
X∞
= k px by telescoping series..
k=1
∞
X
E [Kx ] := ex = k · P [Kx = k]
k=0
∞
X
= k · (k px − k+1 px )
k=0
X∞
= k px by telescoping series..
k=1
∞ (25)
X
Kx2 2

E = k · P [Kx = k]
k=0
∞
X ∞
X
=2· k · k px − k px
k=1 k=1
X∞
=2· k · k px − ex
k=1
Relationship between e̊x and ex
Recall
Z ∞ ∞ Z
X j+1
e̊x = t px dt = t px dt (26)
0 j=0 j
By
R j+1trapezoid rule for numerical integration, we obtain
1
j t px dt ≈ 2 (j px + j+1 px ), and so
∞
X 1
e̊x ≈ (j px + j+1 px )
2
j=0
∞ (27)
1 X 1
= + j px = + ex
2 2
j=1
As with all numerical schemes, this approximation can be refined when

necessary.
Comparison of e̊x and ex
Approximation matches well for small values of x
Table: 2.2: Gompertz Model Statistics: (B, c) = (0.0003, 1.07)
x ex e̊x
0 71.438 71.938
10 61.723 62.223
20 52.203 52.703
30 42.992 43.492
40 34.252 34.752
50 26.192 26.691
60 19.052 19.550
70 13.058 13.55
80 8.354 8.848
90 4.944 5.433
100 2.673 3.152
Notes
An extension of Gompertz - Makeham Laws is the GM(r , s) formula

2
µx = hr1 (x) + e hs (x) , where hr1 (x), hs2 (x) are polynomials of degree r
and s, respectively.
Hazard rate in survival analysis and failure rate in reliability theory is
the same as what actuaries call force of mortality.
Homework Questions
HW: 2.1, 2.2, 2.5, 2.6, 2.10, 2.13, 2.14, 2.15
Life Tables
Define for a model with maximum age ω and initial age x0 the radix lx0 ,
where
lx0 +t = lx0 · t px0 (28)
Life Tables
It follows that
lx+t = lx0 · x+t−x0 px0

= lx0 · x−x0 px0 · t px
= lx · t px
Life Tables
It follows that
lx+t = lx0 · x+t−x0 px0

= lx0 · x−x0 px0 · t px
= lx · t px (29)
lx+t
t px =
lx
We assume a binomial model where Lt is the number of survivors to age
x + t.
Life Tables
So, if there are lx independent individuals aged x with probability t px of

survival to age x + t, then we interpret lx+t as the expected number of
survivors to age x + t out of lx independent individuals aged x.
Symbolically,
E[Lt | L0 = lx ] = lx+t = lx · t px (30)
Life Tables
So, if there are lx independent individuals aged x with probability t px of

survival to age x + t, then we interpret lx+t as the expected number of
survivors to age x + t out of lx independent individuals aged x.
Symbolically,
E[Lt | L0 = lx ] = lx+t = lx · t px (30)

Also, define the expected number of deaths from year x to year x + 1 as

lx+1
dx := lx − lx+1 = lx · 1 − = lx · (1 − px ) = lx qx (31)
lx
Example 3.1
Table: 3.1: Extract from a life table

x lx dx
30 10000.00 34.78
31 9965.22 38.10
32 9927.12 41.76
33 9885.35 45.81
34 9839.55 50.26
35 9789.29 55.17
36 9734.12 60.56
37 9673.56 66.49
38 9607.07 72.99
39 9534.08 80.11
Example 3.1
Calculate:
a.) l40
b.) 10 p30
c.) q35
d.) 5 q30
e.) P [(30) dies between age 35 and 36]
Example 3.1
Calculate:
a.) l40 = l39 − d39 = 9453.97
Example 3.1
Calculate:
a.) l40 = l39 − d39 = 9453.97
l40
b.) 10 p30 = l30 = 0.94540
Example 3.1
Calculate:
a.) l40 = l39 − d39 = 9453.97
l40
b.) 10 p30 = l30 = 0.94540
d35
c.) q35 = l35 = 0.00564
Example 3.1
Calculate:
a.) l40 = l39 − d39 = 9453.97
l40
b.) 10 p30 = l30 = 0.94540
c.) q35 = dl3535 = 0.00564
l30 −l35
d.) 5 q30 = l30 = 0.02107
Example 3.1
Calculate:
a.) l40 = l39 − d39 = 9453.97
l40
b.) 10 p30 = l30 = 0.94540
c.) q35 = dl3535 = 0.00564
l30 −l35
d.) 5 q30 = l30 = 0.02107
l35 −l36
e.) P [(30) dies between age 35 and 36] = l30 = 0.00552
Fractional Age Assumptions
So far, the life table approach has mirrored the survival distribution
method we encountered in the previous lecture. However, in detailing the
life table, no information is presented on the cohort in between whole
years. To account for this, we must make some fractional age
assumptions. The following are equivalent:
Fractional Age Assumptions
So far, the life table approach has mirrored the survival distribution
method we encountered in the previous lecture. However, in detailing the
life table, no information is presented on the cohort in between whole
years. To account for this, we must make some fractional age
assumptions. The following are equivalent:
UDD1 For all (x, s) ∈ N × [0, 1), we assume that s qx = s · qx
UDD2 For all x ∈ N, we assume
Rx := Tx − Kx ∼ U(0, 1)
Rx is independent of Kx .
Proof of Equivalence
Proof:
UDD1 ⇒ UDD2: Assume for all (x, s) ∈ N × [0, 1), we assume that
s qx = s · qx . Then
∞
X
P [Rx ≤ s] = P [Rx ≤ s, Kx = k]
k=0
X∞
= P [k ≤ Tx ≤ k + s]
k=0
∞ ∞ (32)
X X
= k px · s qx+k = k px · s · qx+k
k=0 k=0
∞
X ∞
X
=s· k px · qx+k = s · P [Kx = k] = s
k=0 k=0
and so Rx ∼ U(0, 1).

Proof of Equivalence
To show independence of Rx and Kx ,
P [Rx ≤ s, Kx = k] = P [k ≤ Tx ≤ k + s]
= k px · s qx+k
(33)
= s · k px · qx+k
= P[Rx ≤ s] · P[Kx = k]
UDD2 ⇒ UDD1: Assuming UDD2 is true, then for (x, s) ∈ N × [0, 1)
we have
s qx = P [Tx ≤ s]
= P [Kx = 0, Rx ≤ s]
(34)
= P[Rx ≤ s] · P[Kx = 0]
= s · qx
QED
Corollary
lx −lx+s
Recall that s qx = lx . It follows now that
dx lx − lx+s
s qx = sqx = s =
lx lx
Corollary
lx −lx+s
dx lx − lx+s
s qx = sqx = s =
lx lx
lx+s = lx − s · dx
which is a linear decreasing function of s ∈ [0, 1)
Corollary
lx −lx+s
dx lx − lx+s
s qx = sqx = s =
lx lx
lx+s = lx − s · dx
(35)
which is a linear decreasing function of s ∈ [0, 1)
d
qx = [s qx ] = fx (s) = s px · µx+s
ds
But, since qx is constant in s, we have fx (s) is constant for s ∈ [0, 1).
Read over Examples 3.2 − 3.5
Constant Force of Mortality for Fractional Age
For all (x, s) ∈ N × [0, 1), we assume that µx+s does not depend on s, and
we denote µx+s := µ∗x . It follows that
R1 ∗
px = e − 0 µx+s ds
= e −µx
Rs
µ∗x du ∗
s px = e− 0 = e −µx s = (px )s
Rs
µ∗x du
s px+t = e− 0 = (px )s when t + s < 1
(36)
∞
−µ∗x
X (−1)k+1 (µ∗x )k
qx = 1 − e = ≈ µ∗x
k!
k=1
−µ∗x ·t
s qx =1−e ≈ µ∗x · t,
where the last two lines assume µ∗x 1.
Read Examples 3.6, 3.7 and Sections 3.4, 3.5, 3.6.
Homework Questions
HW: 3.1, 3.2, 3.4, 3.7, 3.8, 3.9, 3.10
Contingent Events
We have spent the previous two lectures on modeling human mortality.

The need for such models in insurance pricing arises when designing
contracts that are event-contingent. Such events include reaching
retirement before the end of the underlying life (x) .
However, one can also write contracts that are dependent on a life (x)
0
being admitted to college (planning for school), and also on (x) s external
portfolios maintaining a minimal value over a time-interval (insuring
external investments.)
Contingent Events: General Case
Consider a probability space (Ω, F, P) and an event A ∈ F.

If we are working with a force of interest δs (ω) and the time of event W
as τW , then we have under the stated probability measure P the Expected
Present Value of a payoff K (ω) contingent upon W
R τW
EPV = E[K (ω)e − 0 δs (ω)ds
] (37)
Actuarial Encounters of the Third Kind !!
Some Initial Simplifying Assumptions
K (ω) = 1 for all ω ∈ Ω (a.s.)

δs (ω) = δ for all ω ∈ Ω (a.s.)
W := {event that (x) dies} ⇒ τW := Tx
P is obtained via historical observation and is thus a physical
measure. Specifically, we use t px obtained from life tables or via
models of human mortality
We do not assume now that a unique risk-neutral pricing measure P̃
exists.
Standard Ultimate Survival Model with assumes Makeham’s law
with (A, B, c) = (0.00022, 2.7 × 10−6 , 1.124)
Recall...
The equivalent interest rate i := e δ − 1 per year

The discount factor v := 1
1+i = e −δ per year
1

The nominal interest rate i (p) = p · (1 + i) p − 1 compounded p
times per year
The effective rate of discount d := 1 − v = i · v = 1 − e −δ per year
1

The nominal rate of discount d (p) := p · 1 − v p compounded p
times per year
Whole Life Insurance: Continuous Case
Consider now the random variable
Z = v Tx = e −δTx (38)
which represents the present value of a dollar upon death of (x). We are
interested in statistical measures of this quantity:
Z ∞
E[Z ] = Āx := E[e −δTx ] = e −δt t px µx+t dt
0
E[Z 2 ] = 2 Āx := E[e −2δTx ]
Z ∞
= e −2δt t px µx+t dt (39)
0
2
Var (Z ) = 2 Āx − Āx

− ln (z)
P[Z ≤ z] = P Tx ≥
δ
Whole Life Insurance: Yearly Case
Assuming payments are made at the end of the death year, our random
variable is now Z = v Kx +1 = e −δKx −δ and so
∞
X
Kx +1
E[Z ] = Ax := E[v ]= v k+1 P[Kx = k]
k=0
∞
X
= v k+1 k| qx
k=0
X∞ (40)
E[Z 2 ] = v 2k+2 k| qx
k=0
Var (Z ) = 2
Ax − (Ax )2

−δ − ln (z)
P[Z ≤ z] = P Kx ≥
δ
1 thly
Whole Life Insurance: m Case
Instead of only paying at the end of the last whole year lived, an insurance
contract might specify payment upon the end of the last period lived. In
this case, if we split a year into m periods, and define
(m) 1
Kx = bmTx c (41)
m
For example, if Kx = 19.78, then

 19 m=1
1

19 2 = 19.5 m=2

(m)
Kx = 3

 19 4 = 19.75 m=4
9
19 12 = 19.75 m = 12

1 thly
It follows that we need ∀r ∈ 0, m1 , m2 , ..., m−1 m+1

m , 1, m , ...

h
(m)
i 1
P Kx = r = P r ≤ Tx < r + = r | 1 qx (42)
m m
to compute statistics for our random variable

(m) 1
Z = v Kx +m
(43)
1 thly
∞
(m) 1 k+1
(m)
X
Kx +m
E[Z ] = Ax := E[v ]= v m k 1
| qx
m m
k=0
∞
2k+2
2 (m)
X
2
E[Z ] = Ax = v m k 1
| qx
m m
k=0 (44)
2
(m) (m)
Var (Z ) = 2 Ax − Ax

(m) ln (z) 1
P[Z ≤ z] = P Kx ≥ − −
δ m
Recursion Method
One of the computational tools we share directly with quantitative finance

is the method of backwards-pricing. In option pricing, we assume the
contract has a finite term. Here, we assume a finite lifetime maximum of
ω < ∞. It follows that
h i
Aω−1 = E v Kω−1 +1 = E v 1 = v

(45)
Recursion Method
One of the computational tools we share directly with quantitative finance

is the method of backwards-pricing. In option pricing, we assume the
contract has a finite term. Here, we assume a finite lifetime maximum of
ω < ∞. It follows that
h i
Aω−1 = E v Kω−1 +1 = E v 1 = v

(45)
At age ω − 2, we have P[Kω−2 = 0] = qω−2 and so

h i
Aω−2 = E v Kω−2 +1
h i
= qω−2 · v + pω−2 · E v (1+Kω−1 )+1
h i (46)
= qω−2 · v + pω−2 · v · E v Kω−1 +1
= qω−2 · v + pω−2 · v 2
Recursion Method
In general, we have the recursion equation for a life (x) that satisfies
Ax = vqx + vpx Ax+1

(47)
Aω−1 = v
in the whole life case, and
(m) 1 1 (m)
Ax = v m 1 qx + v m 1 px Ax+ 1
m m m
(m) 1
(48)
Aω− 1 = v m
m
1 thly
in the m case.
Recursion Method
Recall that for Makeham’s law we have, respectively

x
1
A
−m − lnBc(c) c m −1
1 px = e
m
x
(49)
−A− lnBc(c) (c−1)
1 px =e
a
and for the power law of survival, S0 (x) = 1 − ωx for some a, ω > 0
!a
ω − x − m1
1 px =
m ω−x
(50)
ω−x −1 a

1 px =
ω−x
Recursion Method
For any positive integer m, it follows that for Makeham’s law:

x
1
A
(m) 1 −m − lnBc(c) c m −1
Ax = v m 1−e
x
1
A
1 −m − lnBc(c) c m −1 (m) (51)
+ v me Ax+ 1
m
(m) 1
Aω− 1 = v m
m
Recursion Method
For any positive integer m, it follows that for Power law:

!a !
(m) 1 ω − x − m1
Ax = v m 1 −
ω−x
!a
1 ω − x − m1 (m) (52)
+vm Ax+ 1
ω−x m
(m) 1
Aω− 1 = v m
m
3
HW Project: For Power law with a = 5 and ω = 101
Generate a spreadsheet like Table 4.1 in the text, including values for
2 A(m)
x
Repeat Example 4.3 with the Power law model
Term Insurance: Continuous Case
Consider now the case where payment is made in the continuous case, and
death benefit is payable to the policyholder only if Tx ≤ n. Then, we are
interested in the random variable
Z = e −δTx 1{Tx ≤n} (53)

and so
Z n
1
Āx:n = E[Z ] = e −δt t px µx+t dt
0
Z n (54)
2 1 2
e −2δt t px µx+t dt

Āx:n =E Z =
0
1 thly
Term Insurance: m Case
Consider again the case where the death benefit is payable at the end of
thly
the m1 period in the death year to the policyholder only if
(m) 1
Kx + m ≤ n. Then, we are interested in the random variable
(m) 1
Z = e −δ(Kx +m ) n
1 Kx
(m) 1
+m ≤n
o (55)
and so
mn−1
X k+1
A(m)1x:n = E[Z ] = v m k 1
| qx
m m
k=0
(56)
mn−1
X 2k+2
2 (m)1 2

A x:n =E Z = v m k 1
| qx
m m
k=0
Pure Endowment
Pure endowment benefits depend on the survival policyholder (x) until at

least age x + n. In such a contract, a fixed benefit of 1 is paid at time n.
This is expressed via
Z = e −δn 1{Tx ≥n}

Ax:n1 = E[Z ] = v n n px (57)
−δn
=e n px
Endowment Insurance
Endowment insurance is a combination of term insurance and pure

endowment. In such a policy, the amount is paid upon death if it occurs
with a fixed term n. However, if (x) survives beyond n years, the sum
insured is payable at the end of the nth year. The corresponding present
value random variable is
Z = e −δ min{Tx ,n}
E[Z ] = Āx:n
Z n
= e −δt t px µx+t dt + e −δn n px
0
1
= Āx:n + Ax:n1
Endowment Insurance

E[Z ] = Āx:n
Z n
0 (58)
1
= Āx:n + Ax:n1
Z = e −δ min{Kx +1,n}
1
⇒ Ax:n = Ax:n + Ax:n1 .
Endowment Insurance

E[Z ] = Āx:n
Z n
0 (58)
1
= Āx:n + Ax:n1
Z = e −δ min{Kx +1,n}
1
⇒ Ax:n = Ax:n + Ax:n1 .
1 thly
This can also be extended to the m case and for E[Z 2 ]
Deferred Insurance Benefits
Suppose policyholder on a life (x) receives benefit 1 if u ≤ Tx < u + n.

Then
Z = e −δTx 1{u≤Tx <u+n}

1
E[Z ] = u| Āx:n
Z u+n
= e −δt t px µx+t dt
Zu n
= e −δ(s+u) s+u px µx+s+u ds (59)
0
Z n
−δu
=e e −δs u px · s px+u µx+s+u ds
0
−δu 1
=e u px Āx+u:n
1 1
= Āx:u+n − Āx:u
Relationships
By definition, we have
1
Ax = Ax:n + n| Ax
1
(60)
= Ax:n + v n n px Ax+n
Relationships
By definition, we have
1
Ax = Ax:n + n| Ax
1
(60)
= Ax:n + v n n px Ax+n
What about relationship between Āx and Ax ?
Employing UDD: Āx vs Ax
If expected values are computed via information derived from life tables,
then certainly Āx must be approximated using techniques from previous
lecture.
If expected values are computed via information derived from life tables,
then certainly Āx must be approximated using techniques from previous
lecture.
Recall that by the definition of s px and the UDD, we have
s px µx+s = fx (s)
d
= P[Tx ≤ s]
ds (61)
d d
= (s qx ) = (s · qx )
ds ds
= qx
It follows that using the UDD approximation leads to
Z ∞ ∞ Z
X k+1
−δt
Āx = e t px µx+t dt = e −δt t px µx+t dt
0 k=0 k
∞
X Z 1
= k px v
k+1
· e δ e −δs s px+k µx+k+s ds
k=0 0
X∞ Z 1
≈ k px v
k+1
qx+k · e δ e −δs ds
k=0 0
X∞ Z 1 Z 1
δ −δs
= v k+1
P[Kx = k] · e e ds = Ax · e δ e −δs ds
k=0 0 0
i
= Ax ·
δ
It follows that using the UDD approximation leads to
Z ∞ ∞ Z
X k+1
−δt
Āx = e t px µx+t dt = e −δt t px µx+t dt
0 k=0 k
∞
X Z 1
= k px v
k+1
· e δ e −δs s px+k µx+k+s ds
k=0 0
X∞ Z 1
≈ k px v
k+1
qx+k · e δ e −δs ds
0
k=0 (62)
X∞ Z 1 Z 1
= v k+1 P[Kx = k] · e δ e −δs ds = Ax · e δ e −δs ds
k=0 0 0
i
= Ax ·
δ
(m) i i
Ax ≈ Ax = 1
· Ax
i (m) m · (1 + i) m − 1
(m)
Claims Acceleration Approach : Ax vs Ax
thly
Consider now a policy that pays the holder at the end of the m1 period
of death. In this case, the benefit is paid at one of the times r where

1 2 m
r ∈ Kx + , Kx + , ..., Kx + (63)
m m m
and so under the UDD,
m
X 1 j m+1
E [Tpayment | Kx = k] = · k+ =k+ (64)
m m 2m
j=1
(m)
Claims Acceleration Approach : Ax vs Ax
Once again, it follows using the UDD aproximation

∞
(m) 1 k+1
(m)
X
Kx +m
Ax = E[v ]= v m k 1
| qx
m m
k=0
∞
X
≈ v E[Tpayment |Kx =k] P [Kx = k]
k=0 (65)
∞ ∞
X m+1 m−1 X
= v k+ 2m
k| qx = (1 + i) 2m · v k+1 k| qx
k=0 k=0
m−1 1
= (1 + i) 2m · Ax → (1 + i) · Ax 2
(m)
Āx Ax
as m → ∞. Note that using the UDD approximation, both Ax and Ax
are independent of x.
Variable Insurance Benefits
Upon death, we have considered policies that pay the holder a fixed
amount. What varied was the method and time of payment. If, however,
the actual payoff amount depended on the time Tx of death for (x), then
we term such a contract a Variable Insurance Contract.
Specifically, if the payoff amount dependent on Tx is h(Tx ), then
Z = h(Tx )e −δTx
Z ∞
E[Z ] = h(t)e −δt t px µx+t dt
0
Z ∞
(66)
te −δt t px µx+t dt

Ī Ā x :=
Z0 n
te −δt t px µx+t dt
1
Ī Ā x:n :=
0
Example 4.8
Consider an n−year term insurance issued to (x) under which the death
benefit is paid at the end of the year of death. The death benefit if death
occurs between ages x + k and x + k + 1 is valued at (1 + j)k . Hence,
using the definition i ∗ := 1+j
1+i
− 1,
Z = v Kx +1 (1 + j)Kx
n−1
X
E[Z ] = v k+1 (1 + j)k k| qx
k=0
n−1
1 X (67)
= · v k+1 (1 + j)k+1 k| qx
1+j
k=0
n−1
1 k| qx 1
X
1
= · k+1 = · Ax:n
1+j 1+j

k=0 1+i
1+j
Homework Questions
HW: 4.1, 4.2, 4.3, 4.7, 4.9, 4.11, 4.12, 4.14, 4.15, 4.16, 4.17, 4.18
Life Annuities
A Life Annuity refers to a series of payments to or from an individual as

long as that person is still alive. For a fixed rate i and term n , we recall
the deterministic pricing theory:
1 − vn
än i = 1 + v + ... + v n−1 =
d
1 − vn
an i = v + ... + v n = än i − 1 + v n =
Z n i
t 1 − vn
ān i = v dt = (68)
0 δ
1 1 1
1 − vn
(m)
än i = · 1 + v m + ... + v n− m = (m)
m d
1 1 1
1 − vn
(m) n− n
an i = · v m + ... + v m + v = (m)
m i
Whole Life Annuity Due
Consider the case where 1 is paid out at the beginning of every period
until death. Our present random variable is now
1 − v Kx +1
Y := äKx +1 = (69)
d
and so
1 − v Kx +1

1 − Ax
äx = E[Y ] = E = (70)
d d
1 − v Kx +1

1 1
V [Y ] = V = 2 V [1] + 2 V [v Kx +1 ]
d d d
(71)
2 A − A2
x x
=0+
d2
Whole Life Annuity Due
The present value random variable can also be represented as

∞
X
Y = v k 1{Tx >k} (72)
k=0
As P[Tx > k] = t px , we have the alternate expression for äx

"∞ #
X
k
äx = E[Y ] = E v 1{Tx >k}
k=0
∞
X
= E[v k 1{Tx >k} ] (73)
k=0
∞
X ∞
X
= v k k px = k| qx äk+1
k=0 k=0
Term Annuity Due
Define the present value random variable

äKx +1 : Kx ∈ {0, 1, 2, ..., n − 1}
Y =
än : Kx ∈ {n, n + 1, n + 2, ...}
Another expression is
1 − v min{Kx +1,n}
Y = ämin{Kx +1,n} = (74)
d
and so
1 − E v min{Kx +1,n}

äx:n = E[Y ] =
d
1 − Ax:n
= (75)
d
n−1
X n−1
X
t
= v t px = k| qx äk+1 + n px än
t=0 k=0
Whole Life and Term Immediate Annuity
Define Y ∗ = ∞ k
P
k=1 v 1{Tx >k} . Then we have an annuity immediate that
begins payment one unit of time from now. It follows that
ax = äx − 1
(76)
V [Y ∗ ] = V [Y ]
Also, if we define Y = amin{Kx ,n} , then
n
X
ax:n = v t t px = äx:n − 1 + v n n px (77)
t=1
Whole Life Continuous Annuity
Define
Z ∞
1 − v Tx
Y = āTx = = e −δt 1{Tx >t} dt
δ 0
Z ∞ (78)
1 − Āx
āx = E[Y ] = = e −δt t px dt
δ 0
Note that if δ = 0, then āx = e̊x
Term Continuous Annuity
Define Y = āmin{Tx ,n} .

Then
1 − v min{Tx ,n}
Y =
δ
1 − Āx:n
āx:n = E [Y ] = (79)
δ
Z n
= e −δt t px dt
0
Deferred Annuity
Consider now the case of an annuity for (x) that will pay 1 at the end of
each year, beginning at age x + u and will continue until death age
x + Tx . We define u| äx to be the Expected Present Value of this policy. It
should be apparent that
u| äx = äx − äx:u

X∞
= v t t px
t=u
∞ (80)
X
= v u u px · v t t px+u
t=0
u
=v u px äx+u
holds in the discrete case, and similarly in the continuous case,
u| āx = āx − āx:u (81)
Term Deferred Annuity
For the cases of an annuity for (x) that will pay 1 at the end of each year,
beginning at age x + u and will continue until death age x + Tx up to a
thly
term of length n, or annuity-due payable m1 . Then
u| ax:n = v u u px ax+u:n
(m) (m)
(82)
u| äx = v u u px äx+u
respectively.
These combine with the previous slide to reveal the useful formulae:
äx:n = äx − v n n px äx+n

(m) (m) (m)
(83)
Linearly Increasing Annuities
Define an annuity where the payments increase linearly at times

t = 0, 1, 2, .. provided that (x) is alive at time t
∞
X
(I ä)x = (t + 1) · v t t px
t=0
n−1
(84)
X
(I ä)x:n = (t + 1) · v t t px
t=0
Linearly Increasing Annuities
If then the annuity is payable continuously, with payments increasing by 1

at each year end and the rate of payment in the t th year constant and
equal to t for t ∈ {1, 2, ..m, .., n}, then h(t) = (m + 1)1{m≤t<m+1} , and
the EPV is
n−1
X
(I ā)x:n = (m + 1)m| āx:1 (85)
m=0
If h(t) = t, then
Z n
(Ī ā)x:n = te −δt t px dt. (86)
0
Evaluating Annuities Using Recursion
By recursion, we observe
äx = 1 + vpx + v 2 2 px + v 3 3 px + ....

= 1 + vpx 1 + vpx+1 + v 2 2 px+1 + v 3 3 px+1 + ....

= 1 + vpx äx+1
äx = 1 + vpx + v 2 2 px + v 3 3 px + ....

= 1 + vpx 1 + vpx+1 + v 2 2 px+1 + v 3 3 px+1 + ....

= 1 + vpx äx+1 (87)

(m) 1 1 (m)
äx = + v m 1 px äx+ 1
m m m
äx = 1 + vpx + v 2 2 px + v 3 3 px + ....

= 1 + vpx 1 + vpx+1 + v 2 2 px+1 + v 3 3 px+1 + ....

= 1 + vpx äx+1 (87)

(m) 1 1 (m)
äx = + v m 1 px äx+ 1
m m m
Consider the case where there is a maximum age in the model, and so
äω−1 = 1
(m) 1 (88)
äω− 1 =
m m
Evaluating Annuities Using UDD
Recall that under the UDD assumption,
(m) i
Ax = Ax
i (m) (89)
i
Āx = Ax
δ
and by definition,
1 − Ax
äx =
d
(m)
(m) 1 − Ax (90)
äx =
d (m)
1 − Āx
āx =
δ
It follows that
(m)
(m) 1 − Ax
äx =
d (m)
i
1 − i (m) Ax
= (m)
d
i (m) − iAx
= (m) (m)
i d
i (m) − i(1 − däx ) (91)
=
i (m) d (m)
id i − i (m)
= (m) (m) äx − (m) (m)
i d i d
:= α(m)äx − β(m)
id i −δ
āx = 2 äx − 2
δ δ
For term annuities, we have

(m) (m) (m)
= α(m)äx − β(m) − v n n px · (α(m)äx+n − β(m))

(m)
= α(m) · äx − v n n px äx+n − β(m) · (1 − v n n px ) (92)
n
= α(m) · äx:n − β(m) · (1 − v n px )
m−1
≈ äx:n − · (1 − v n n px )
2m
Guaranteed Annuities
There are instances where an age (x) wishes to buy a policy where
payments are guaranteed to continue upon death to a beneficiary. In this
case, define the present random variable as Y = än + Y1 , where

0 : Kx ∈ {0, 1, 2, ..., n − 1}
Y1 =
äKx +1 − än : Kx ∈ {n, n + 1, n + 2, ...}
and so
h i
E[Y1 ] = E äKx +1 − än 1{Kx ≥n}
= n| äx = v n n px äx+n
Guaranteed Annuities
There are instances where an age (x) wishes to buy a policy where
payments are guaranteed to continue upon death to a beneficiary. In this
case, define the present random variable as Y = än + Y1 , where

0 : Kx ∈ {0, 1, 2, ..., n − 1}
Y1 =
äKx +1 − än : Kx ∈ {n, n + 1, n + 2, ...}
and so
h i
E[Y1 ] = E äKx +1 − än 1{Kx ≥n}
= n| äx = v n n px äx+n
(93)
E[Y ] := äx:n = än + v n n px äx+n
(m) (m) (m)
and E[Y (m) ] := äx:n = än + v n n px äx+n
Example 5.4
A pension plan member is entitled to a benefit of 1000 per month, in

advance, for life from age 65, with no guarantee. She can opt to take a
lower benefit with a 10−year guarantee. The revised benefit is calculated
to have equal EPV at age 65 to the original benefit. Calculate the revised
benefit using the Standard Ultimate Survival Model, with interest at 5%
per year.
Example 5.4
Let B denote the revised monthly benefit. Then the two options are
12000 per year, paid per month with Present Value Y1
12B per year, paid per month with Present Value Y2
Hence E[Y1 − Y2 ] = 0 implies
(12) (12)
12000ä65 = 12Bä
65:10

(12) (12)
= 12B · ä10 + v 10 10 p65 ä75
Example 5.4
(12) (12)
12000ä65 = 12Bä
65:10

(12) (12)
= 12B · ä10 + v 10 10 p65 ä75
(12)
ä65
∴ B = 1000 · (12) (12)
ä10 + v 10 10 p65 ä75
13.0870
= 1000 · = 978.17
13.3791
Example 5.4
(12) (12)
12000ä65 = 12Bä
65:10

(12) (12)
= 12B · ä10 + v 10 10 p65 ä75
(12)
ä65
∴ B = 1000 · (12) (12)
(94)
ä10 + v 10 10 p65 ä75
13.0870
= 1000 · = 978.17
13.3791
V [Y1 − Y2 ] = 0?
Woolhouse’s Formula
Consider a function g : R+ → R such that limt→∞ g (t) = 0, then
∞ ∞
h2 h4 00
Z X h
g (t)dt = h · g (kh) − g (0) + g 0 (0) − g (0) + ... (95)
0 2 12 720
k=0
Define
g (t) = v t t px
∴ g 0 (t) = −t px δe −δt − v t t px µx+t (96)
0
∴ g (0) = −δ − µx
and so for h = 1,
∞
X 1 1
āx ≈ g (k) − + g 0 (0)
2 12
k=0
∞
X 1 1 (97)
= v k k px − − (δ + µx )
2 12
k=0
1 1
= äx − − (δ + µx )
2 12
1
Correspondingly, for h = m,
∞
1 X k 1 1
āx ≈ g − + g 0 (0)
m m 2m 12m2
k=0
∞
X k 1 1 (98)
= v m k px − − (δ + µx )
m 2m 12m2
k=0
(m) 1 1
= äx − − (δ + µx )
2m 12m2
Equating the previous two approximations for āx , we obtain
(m) m − 1 m2 − 1
äx ≈ äx − − (δ + µx ) (99)
2m 12m2
For term annuities, we obtain the approximation
(m) m−1 m2 − 1
äx:n ≈ äx:n − (1−v n n px )− (δ+µx −v n n px (δ+µx+n )) (100)
2m 12m2
Letting m → ∞, we get
1 1
āx ≈ äx − − (δ + µx )
2 12 (101)
1 1
āx:n ≈ äx:n − (1 − v n n px ) − (δ + µx − v n n px (δ + µx+n ))
2 12
For āx with δ = 0, the approximation above reduces further to
1 1
e̊x ≈ (ex + 1) − − µx (102)
2 12
NB: For life tables, we can compute these quantities using the
approximation µx ≈ − 12 [ln (px ) + ln (px+1 )]
Select and Ultimate Survival Models
Notation:
Aggregate Survival Models: Models for a large population, where
t px depends only on the current age x.
Select (and Ultimate) Survival Models: Models for a select group
of individuals that depend on the current age x and
Future survival probabilities for an individual in the group depend on
the individual’s current age and on the age at which the individual
joined the group
∃d > 0 such that if an individual joined the group more than d years
ago, future survival probabilities depend only on current age. So, after
d years, the person is considered to be back in the aggregate
population.
Ultimately, a select survival model includes another event upon which
probabilities are conditional on.
Select and Ultimate Survival Models
Notation:
d is the select period
The mortality applicable to lives after the select period is over is
known as the ultimate mortality.
A select group should have a different mortality rate, as they have been
offered (selected for) life insurance. A question, of course, is the effect on
mortality by maintaining proper health insurance.
Example 3.8
Consider men who need to undergo surgery because they are suffering
from a particular disease. The surgery is complicated and
P[survive one year after surgery] = 0.5

(103)
(d, l60 , l61 , l70 ) = (1, 89777, 89015, 77946)
Calculate P[A], P[B], P[C ], where
A = {(60),about to have surgery, will be alive at age 70}
B = {(60),had surgery at age 59, will be alive at age 70}
C = {(60),had surgery at age 58, will be alive at age 70}
Example 3.8
l70
P[A] = P[(60),about to have surgery, alive at age 61] ·
l61
77946
= 0.5 · = 0.4378
89015
(104)
l70
P[B] = = 0.8682
l60
l70
P[C ] = = 0.8682
l60
Select Survival Models
S[x]+s (t) = P[(x + s) selected at (x),survives to(x + s + t)]

t q[x]+s = P[(x + s) selected at (x),dies before(x + s + t)]
µ[x]+s = force of mortality at (x + s) for select at (x)
1 − S[x]+s (h)

(105)
= lim+
h→0 h
t p[x]+s = 1 − t q[x]+s = S[x]+s (t)
Rt
= e− 0 µ[x]+s+u du
For t < d, we refer to to the above as part of the select model. For
t ≥ d, they are part of the ultimate model. Please read through section
on Select Life Tables.
Select Life Tables
Sometimes, we wish to compute values from life tables. Consider again a

model where x ≥ x0 , where x0 is the initial age, and 0 ≤ t ≤ d. Then
lx+d = d−t p[x]+t · l[x]+t (106)
Example 3.9
Theorem
Consider y ≥ x + d > x + s > x + t ≥ x ≥ x0 . Then
ly
y −x−t p[x]+t =
l[x]+t
(107)
l[x]+s
s−t p[x]+t =
l[x]+t
Example 3.9
Proof.
y −x−t p[x]+t = y −x−d p[x]+d · d−t p[x]+t
= y −x−d px+d · d−t p[x]+t
ly lx+d
=
lx+d l[x]+t
ly
=
l[x]+t
(108)
d−t p[x]+t
s−t p[x]+t =
d−s p[x]+s
lx+d l[x]+s
=
l[x]+t lx+d
l[x]+s
=
l[x]+t
Example 3.11
A select survival model has a select period of three years. Its ultimate
mortality is equivalent to the US Life Tables, 2002 Females of which an
extract is shown below. Information given is that for all x ≥ 65,

p[x] , p[x−1]+1 , p[x−2]+2 = (0.999, 0.998, 0.997). (109)
Table: 3.5: Extract from US LIfe Tables, 2002 Females

x lx
70 80556
71 79026
72 77410
73 75666
74 73802
75 71800
Example 3.11
Calculate the probability that a woman currently aged 70 will survive to

age 75 given that
1 she was select at age 67:
2 she was select at age 68
Example 3.11
l75
5 p[70−3]+3 = 5 p70 = = 0.8913
l70
l[68]+2+5 l75
5 p[70−2]+2 = =
l[68]+2 l[68]+2
l75 l75 (110)
= l = · 1 p[68]+2
[68]+3 l71
1 p[68]+2
= 4 p71 · 1 p[68]+2
71800
= · 0.997 = 0.9058
79026
Example 3.11
l[69]+1+5 l75
5 p[70−1]+1 = =
l[69]+1 l[69]+1
l75
= l[69]+3
(1 p[69]+1 )·(1 p[69]+2 )
l75
= · (1 p[69]+1 ) · (1 p[69]+2 )
l72 (111)
71800
= · 0.997 · 0.998 = 0.9229
77410
l75
5 p[70] = · (1 p[70] ) · (1 p[70]+1 ) · (1 p[70]+2 )
l73
71800
= · 0.997 · 0.998 · 0.999 = 0.9432
75666
Example 3.12
Given a table of values for q[x] , q[x−1]+1 , qx and the knowledge that the
model incorporates a 2−year selct period, compute
4 p[70]
3 q[60]+1
Example 3.12
4 p[70]
3 q[60]+1
4 p[70] = p[70] p[70]+1 p[70]+2 p[70]+3 = p[70] p[70]+1 p72 p73

= 1 − q[70] · 1 − q[70]+1 · (1 − q72 ) · (1 − q73 )
Example 3.12
4 p[70]
3 q[60]+1
4 p[70] = p[70] p[70]+1 p[70]+2 p[70]+3 = p[70] p[70]+1 p72 p73

= 1 − q[70] · 1 − q[70]+1 · (1 − q72 ) · (1 − q73 )
3 q[60]+1 = q[60]+1 + p[60]+1 q62 + p[60]+1 p62 q63 (112)

= q[60]+1 + 1 − q[60]+1 · q62

+ 1 − q[60]+1 · (1 − q62 ) · q63
Example 3.13
A select survival model has a two-year select period and is specified as

follows. The ultimate part of the model follows Makeham’s law, where
(A, B, c) = (0.00022, 2.7 × 10−6 , 1.124):
µx = 0.00022 + (2.7 × 10−6 ) · (1.124)x (113)

The select part of the model is such that for 0 ≤ s ≤ 2,
µ[x]+s = 0.92−s µx+s (114)

and so for 0 ≤ t ≤ 2,
" !#
−
Rt
µ[x]+s ds 2−t 1 − 0.9t c t − 0.9t
t p[x] =e 0 = exp 0.9 + (115)
ln 0.9

ln (0.9) c
Example 3.13
It follows that given an initial cohort at age x0 , that is given lx0 , we can
compute the entries of a select life table via
lx = px−1 lx−1
lx+2
l[x]+1 =
p[x]+1 (116)
lx+2
l[x] =
2 p[x]
Homework Questions
HW: 3.1, 3.2, 3.4, 3.7, 3.8, 3.9, 3.10, 5.1, 5.3, 5.5, 5.6, 5.11, 5.14
What is a Premium?
When entering into a contract, the financial obligations of all parties must
be specified. In an insurance contract, the insurance company agrees to
pay the policyholder benefits in return for premium payments. The
premiums secure the benefits as well as pay the company for expenses
attached to the administation of the policy
Premium Types
A Net Premium does not explicitly allow for company’s expenses, while a
Office or Gross Premium does. There may be a Single Premium or or a
series of payments that could even match with the policyholder’s salary
freequency.
It is important to note that premiums are paid as soon as the contract is
signed, otherwise the policyholder would attain coverage before paying for
it with the first premium. This could be seen as an arbitrage opportunity -
non-zero probability of gain with no money up front.
Premium Types
Premiums cease upon death of the policyholder. The premium paying

term is the maximum length of time that premiums are required.
Certainly, premium term can be fixed so that upon retirement, say, no
more payments are required.
Also, the benefits can be secured in the future (deferred) by a single
premium payment up front. For example, pay now to secure annuity
payments upon retirement until death.
Assumptions
Recall the life model used in Example 3.13 : The select survival model has
a two-year select period and is specified as follows. The ultimate part of
the model follows Makeham’s law, where
(A, B, c) = (0.00022, 2.7 × 10−6 , 1.124):
µx = 0.00022 + (2.7 × 10−6 ) · (1.124)x (117)

The select part of the model is such that for 0 ≤ s ≤ 2,
µ[x]+s = 0.92−s µx+s (118)

and so for 0 ≤ t ≤ 2,
" !#
−
Rt
µ[x]+s ds 2−t 1 − 0.9t c t − 0.9t
t p[x] =e 0 = exp 0.9 + (119)
ln 0.9

ln (0.9) c
Assumptions
Furthermore, we can extend the recursion principle when using a select life
model to obtain
äx = 1 + vpx äx+1

ä[x]+1 = 1 + vp[x]+1 äx+2 (120)
ä[x] = 1 + vp[x] ä[x]+1
Basic Model
In general, an insurance company can expect to have a total benefit paid

out, along with expense loading and other related costs. We represent this
total benefit as Z . Similarly, to fund Z , the company can expect the
policyholder to make a single payment, or stream of payments, that has
present value P · Y . Here, P represents the level premium P and Y
represents the present value associated to a unit payment or payment
stream.
Future Loss Random Variable
For life contingent contracts, there is an outflow and inflow of money

during the term of the agreement. The premium income is certain, but
since the benefits are life contingent, the term and total income may not
be certain up front. To account for this, we define the Net Future Loss
Ln0 (which includes expenses) and the Gross Future Loss Lg0 (which does
not includes expenses) as
Ln0 = PV [benefit outgo] − PV [net premium income]

Lg0 = PV [benefit outgo] + PV [expenses] (121)
− PV [gross premium income]
Example 6.2
An insurer issues a whole life insurance to [60], with sum insured S

payable immediately upon death. Premiums are payable annually in
advance, ceasing at 80 or on earlier death. The net annual premium is P.
What is the net future loss random variable Ln0 for this contract in terms of
lifetime random variables for [60]?
Example 6.2
An insurer issues a whole life insurance to [60], with sum insured S

payable immediately upon death. Premiums are payable annually in
advance, ceasing at 80 or on earlier death. The net annual premium is P.
What is the net future loss random variable Ln0 for this contract in terms of
lifetime random variables for [60]?
Ln0 = Sv T[60] − Pä (122)

min{K[60] +1,20}
Equivalence Principle
Absent a risk-neutral type pricing measure, insurers price these

event-contingent contracts by setting the average value of the loss to be
zero. Symbolically, this is simply (for net premiums) find P such that
E [Ln0 ] = 0 (123)
Note that this value P does not necessarily set Var [Ln0 ] = 0
Returning to our general set-up, we see that the equivalence pricing
principle can be summarized as
E[Z ]
P= (124)
E[Y ]
As an introductory example, consider λ > 0 and a contract where (under

no selection)
Z = v Tx
Y = āTx (125)
−λt
t px =e
As an introductory example, consider λ > 0 and a contract where (under

no selection)
Z = v Tx
Y = āTx (125)
−λt
t px =e
Hence, we have a unit whole-life insurance payable immediately upon death
of (x), where mortality is modeled to be exponential with parameter λ.
We obtain
E v Tx

Ā Āx
P̄x = h i = x =δ
E āTx āx 1 − Āx
R ∞ −δt −λt
e λe dt
= δ 0R ∞ −δt −λt (126)
1 − 0 e λe dt
λ
λ+δ
=δ λ
=λ
1 − λ+δ
We obtain
E v Tx

Ā Āx
P̄x = h i = x =δ
E āTx āx 1 − Āx
R ∞ −δt −λt
e λe dt
= δ 0R ∞ −δt −λt (126)
1 − 0 e λe dt
λ
λ+δ
=δ λ
=λ
1 − λ+δ
ω−x
HW: repeat the above calculation if S0 (x) = ω for a finite lifetime
model with maximal age ω.
If we repeat the previous example, but now for the case of of a unit
whole-life insurance contract with level annual premium payment and
benefit paid at the end of the death year, then
Z = v Kx +1
Y = äKx +1 (127)
−λt
t px =e
It follows that
P∞ −δ(k+1)
Ax k=0 e · (k px − k+1 px )
Px = d =d
1 − Ax 1− ∞ −δ(k+1) · ( p −
P
k=0 e k x k+1 px )
∞
(1 − e −λ ) · k=0 e −δ(k+1) e −λk
P
=d
1 − (1 − e −λ ) · ∞ −δt e −λk
P
k=0 e (128)
(1 − e −λ ) · e −δ · 1
1−e −(δ+λ)
=d 1
1 − (1 − e −λ ) · e −δ · 1−e −(δ+λ)
= (1 − e −λ ) · e −δ
”Deterministic” Insurance
Consider an endowment insurance with sum insured 100000 issued to an

age (x) where 20 premiums are paid in return for the benefit 100000 paid
1
at the end of year 20. Assume v = 1.05 . Then
Z = 100000v 20
1 − v 20
Y = ä20 =
1−v
”Deterministic” Insurance
Consider an endowment insurance with sum insured 100000 issued to an

age (x) where 20 premiums are paid in return for the benefit 100000 paid
1
at the end of year 20. Assume v = 1.05 . Then
Z = 100000v 20
1 − v 20
Y = ä20 =
1−v
100000v 20
⇒ Pd = 20
(129)
1−v
1−v
v 20
= (1 − v ) × 100000 ×
1 − v 20
≈ 2880.25.
Example 6.5
Now, consider an endowment insurance with sum insured 100000 issued to

a select life aged [45] with term 20 years under which the death benefit is
payable at the end of of the year of death. Using the Standard Select
Survival Model with interest at 5% per year, calculate the total amount of
net premium payable in a year if premiums are payable annually.
Example 6.5
1
By the EPP, the fact that d = 1 − 1.05 , and tables 6.1 and 3.7, we have
100000 · A[45]:20 = P · ä[45]:20

A[45]:20 100000 · 1 − dä[45]:20
⇒ P = 100000 · =
ä[45]:20 ä[45]:20
(130)

l65
1 − d ä[45] − l[45] v 20 ä65
= 100000 · l65 20
ä[45] − l[45] v ä65
0.383766
= 100000 · = 2965.52
12.94092
Is it reasonable that P = 2965.52 > 2880.25 = Pd ?
New Business Strain
Starting up an insurance company requires start-up capital like most other

companies. Agents are charged with drumming up new business in the
form of finding and issuing new life insurance contracts. This helps to
diversify risk in the case of a large loss on one contract (more on this
later.)
However, new contracts can incur larger losses up front in the first few
years even without a benefit payout. This is due to initial commision
payments to agents as well as contract preparation costs. Periodic
maintenance costs can also factor into the premium calculation.
An Example..
Consider offering an n−year endowment policy to an age (x) in the

aggregate population where the benefit B is paid at the end of the year of
death or on maturity. There are periodic renewal expenses of r per policy.
An Example..

death or on maturity. There are periodic renewal expenses of r per policy.
Then the premium P is calculated via the EPP as
Päx:n = B · Ax:n + r äx:n

Ax:n (131)
⇒P=B· +r
äx:n
and we see that periodic expenses are simply passed on to the consumer!
Another Example..

death or on maturity. There are periodic renewal expenses of r per policy
and an inital preparation expense of z per contract.
Another Example..

death or on maturity. There are periodic renewal expenses of r per policy
and an inital preparation expense of z per contract.
Then the premium P is calculated via
Ax:n z
P=B· +r + (132)
äx:n äx:n
and so the initial preparation expense is amortized over the lifetime of the
contract.
Example 6.6
An insurer issues a 25−year annual premium endowment insurance with

sum insured 100000 to a select life aged [30]. The insurer incurs initial
expenses of 2000 plus 50% of the first premium and renewable expenses of
2.5% of each subsequent premium. The death benefit is payable
immediately upon death. What is the annual premium P?
Example 6.6
We can see that
Lg0 = 100000v min{T[30] ,25} + 2000 + 0.475P

+ 0.025Pä − Pä
min{K[30] +1,25}
min{K[30] +1,25}
h i
100000 · E v min{T[30] ,25} + 2000
⇒P=
0.975 · E ä − 0.475
min{K[30] +1,25} (133)
100000 · Ā[30]:25 + 2000
=
0.975 · ä[30]:25 − 0.475
100000 · (0.298732) + 2000
=
0.975 · (14.73113) − 0.475
= 2295.04.
Some more worked examples
Consider the following net loss random variables:
Ln0 = v Tx − Pāmin{Tx ,t}

Ln0 = v min{Tx ,n} − Pāmin{Tx ,t}

Ln0 = v min{Tx ,n} − Pāmin{Tx ,t} (134)
Ln0 = v Kx +1 − Pämin{Kx +1,t}
What are the fair premiums under the EPP?

Āx
P=
āx:t

Āx
P=
āx:t
Āx:n
P=
āx:t

Āx
P=
āx:t
Āx:n
P= (135)
āx:t
Ax
P=
äx:t
Refunded Deferred Annual Whole-Life Annuity Due
Consider the case where a n−year deferred annual whole-life annuity due
of 1 on a life (x) where if the death occurs during the deferral period, the
single benefit premium is refunded without interest at the end of the
year of death. What is this single benefit premium P?
The net loss random variable is
Ln0 = Pv Kx +1 · 1{Kx +1≤n} + v n 1{Kx +1>n} · äKx +1−n − P (136)

and by the EPP we have
1
0 = PAx:n + n| äx − P (137)
The net loss random variable is
Ln0 = Pv Kx +1 · 1{Kx +1≤n} + v n 1{Kx +1>n} · äKx +1−n − P (136)

and by the EPP we have
1
0 = PAx:n + n| äx − P (137)
This implies that
n| äx
P= 1
1 − Ax:n
1 (138)
Ax:n − Ax:n
= 1
· äx+n
1 − Ax:n
Profit
Consider a 1−year term insurance contract issued to a select life [x], with
sum insured S = 1000, interest rate i = 0.05, and mortality
q[x] = P[T[x] ≤ 1] = 0.01
It follows that L0 , the future loss random variable calculated at the time of
issuance, is
L0 = 1000v 1 1{T[x] ≤1} − P
Profit
Consider a 1−year term insurance contract issued to a select life [x], with
sum insured S = 1000, interest rate i = 0.05, and mortality
q[x] = P[T[x] ≤ 1] = 0.01
It follows that L0 , the future loss random variable calculated at the time of
issuance, is
L0 = 1000v 1 1{T[x] ≤1} − P

⇒ P = E[1000v 1 1{T[x] ≤1} ] = 1000v · P[T[x] ≤ 1] (139)
(1000)(0.01)
= = 9.52
1.05
Profit
Consider that the company has issued a lot of these contracts, say N 1,
to independent select lives [x]. Let D[x] be the random variable
representing the number of deaths in a year of this population, and assume
D[x] ∼ Bin(N, q[x] ) (140)
Profit
In general, we have the event

that the insurer
turns a profit on this group
of policies is {Profit} = D[x] ≤ N · q[x] , and so as N → ∞,
P[Profit] = P[D[x] ≤ N · q[x] ]

= P[D[x] ≤ E[D[x] ]]
 
D[x] − E[D[x] ] (141)
= P q ≤0


Var D[x]
1
→ Φ(0) = by the CLT.
2
HW: Compute

E Profit | D[x] ≤ N · q[x]
(142)
N ·P
Profit
Consider now a whole-life contract issued to [x] with sum insured S and
annual premium P. Then
P[Profit] = P[L0 < 0] = P[Sv K[x] +1 − PäK[x] +1 < 0]

1 − v K[x] +1
= P[Sv K[x] +1 < P · ]
d
P
= P v K[x] +1 <
P +d ·S
(143)
1 P
= P K[x] + 1 > ln
δ P +d ·S

1 P
= P K[x] > b ln c
δ P +d ·S
= b 1 ln ( P )c p[x]
δ P+d·S
Conditional Sums
Define L0 (k) = PV [Loss | K[x] = k]. For a contract with a term n, it

follows that
"n−1 #
X
E[L0 ] = E[PV [Loss]] = E PV [Loss | K[x] = k] · 1{K[x] =k }
k=0
h i
+ E PV [Loss | K[x] ≥ n] · 1{K[x] ≥n}
n−1
X
= PV [Loss | K[x] = k] · P[K[x] = k] + L0 (n) · P[K[x] ≥ n]
k=0
n−1
X
= L0 (k) · k| q[x] + L0 (n)n p[x]
k=0
(144)
Q: Can we use this for the case n = ∞ ?
Example 6.9
A life insurer is about to issue a 25−year endowment insurance with a

basic sum insured S = 250000 to a select life aged exactly [30]. Premiums
are payable annually throughout the term of the policy. Initial expenses are
1200 plus 40% of the first premium and renewal expenses are 1% of the
second and subsequent premiums. The insurer allows for a compound
reversionary bonus of 2.5% of the basic sum insured, vesting on each
policy anniversary (including the last.) The death benefit is payable at the
end of the year of death. Assume the Standard Select Survival Model with
interest rate 5% per year.
Example 6.9
In this case, we have the reversionary bonus exponentially grow the sum
insured:
L0 = B0 (K[x] ) + E0 − P0 (K[x] )
B0 (k) = 250000 · 1.025k v k+1 for k ∈ {0, 1, 2, ..., 24}
B0 (25) = 250000 · 1.02525 v 25 (145)
E0 = 1200 + 0.39P
P0 (k) = 0.99Pämin {k+1,25}
Example 6.9
1+i
For 1 + j = 1.025 , we have j = 0.02439 and so
E[L0 ] = E[B0 (K[x] )] + E0 − E[P0 (K[x] )]

24
X
= B0 (k)k| q[30] + B0 (25)25 p[30] + E0 − 0.99Pä[30]:25
k=0
24
X 250000 · (1.025)k (146)
= k| q[30] + B0 (25)25 p[30]
(1.05)k+1
k=0
+ E0 − 0.99Pä[30]:25
250000 1
= A + B0 (25) · 25 p[30] + 1200 + 0.39P − 14.5838P
1.025 [30]25 j
Under the EPP, we have P = 9764.44.
Example 6.9
1+i
For 1 + j = 1.025 , we have j = 0.02439 and so
E[L0 ] = E[B0 (K[x] )] + E0 − E[P0 (K[x] )]

24
X
= B0 (k)k| q[30] + B0 (25)25 p[30] + E0 − 0.99Pä[30]:25
k=0
24
X 250000 · (1.025)k (146)
= k| q[30] + B0 (25)25 p[30]
(1.05)k+1
k=0
+ E0 − 0.99Pä[30]:25
250000 1
= A + B0 (25) · 25 p[30] + 1200 + 0.39P − 14.5838P
1.025 [30]25 j
Under the EPP, we have P = 9764.44.
HW: Replicate Table 6.3 in the text by using a spreadsheet program.
Compare this example with Example 6.10.
Portfolio Percentile Premium Principle
Assume once again that a company is about to issue insurance to N

independent lives [x], each with loss L0,i for i ∈ {1, 2, .., N} . In this case
N
X
L0 = L0,i
i=1
" N # N
X X (147)
E[L0 ] = E L0,i = E [L0,i ] = N · E [L0,1 ]
i=1 i=1
Var [L0 ] = N · Var [L0,1 ]
Portfolio Percentile Premium Principle
If we require P such that P[L0 < 0] = α, we can use CLT once again to
show
α = P[L0 < 0]
" #
L0 − E[L0 ] E[L0 ]
=P p < −p
Var [L0 ] Var [L0 ] (148)
!
E[L0 ]
→ Φ −p as N → ∞
Var [L0 ]
For an individual present value of loss, stated wlog as L0,1 , we recover the
EPP as N → ∞
Φ−1 (α) Var [L0,1 ]

p
E[L0,1 ] ≈ − √ →0 (149)
N
Example 6.11
An insurer issues whole life insurance policies to select lives aged [30]. The
sum insured S = 100000 is paid at the end of the month of death and
level monthly premiums are payable throughout the term of the policy.
Initial expenses, incurred at the issue of the policy, are 15% of the total of
the first year’s premiums. Renewal expenses are 4% of every premium,
including those in the first year. Assume the SSSM with interest at 5% per
year.
Calculate the monthly premium P using the EPP and
Calculate the monthly premium P using the PPPP such that
α = 0.95 and N = 10000.
Example 6.11
For the EPP calculation, we have

(12)
E[PV (Premiums)] = 12Pä[30] = 227.065P
(12)
E[PV (Benefits)] = 100000A[30] = 7866.18
(12)
E[PV (Expenses)] = (0.15)(12P) + (0.04)(12Pä[30] )
= 10.8826P
Example 6.11
For the EPP calculation, we have

(12)
E[PV (Premiums)] = 12Pä[30] = 227.065P
(12)
E[PV (Benefits)] = 100000A[30] = 7866.18
(12)
E[PV (Expenses)] = (0.15)(12P) + (0.04)(12Pä[30] ) (150)
= 10.8826P
E[PV (Premiums)] = E[PV (Benefits)] + E[PV (Expenses)]
⇒ P = 36.39
Example 6.11
For all i ∈ {1, 2, .., N}, we have the i.i.d. PV(Loss) random variables
(12) 1
K[30] + 12
L0,i = 100000v + (0.15)(12P)
!
(12)
− (0.96) 12Pä (12) 1
K[30] + 12 (151)
(12) (12)
E[L0,i ] = 100000A[30] + (0.15)(12P) − (0.96)(12Pä[30] )
= 7866.18 − 216.18P
Example 6.11
To find the variance, we rewrite
(12)
(0.96)(12P) 1
K[30] + 12
L0,i = 100000 + v
d (12)
(0.96)(12P)
+ (0.15)(12P) −
d (12) (152)
(0.96)(12P) 2

(12) 2

2 (12)
Var [L0,i ] = 100000 + · A[30] − A[30]
d (12)
= (100000 + 236.59P)2 · (0.0053515)
Example 6.11
Collecting our results, we now have
0.95 = α = P[L0 < 0]

!
E[L0 ]
≈ Φ −p
Var [L0 ]
!
√ E[L0,1 ] (153)
=Φ − N·p
Var [L0,1 ]
√

216.18P − 7866.18
=Φ 10000 · √
(100000 + 236.59P) · 0.0053515
Example 6.11
It follows that
1.645 = Φ−1 (0.95)

√ 216.18P − 7866.18
≈ 10000 · √ (154)
(100000 + 236.59P) · 0.0053515
⇒ P = 36.99
For general N, we have
216.18P − 7866.18 1.645

√ = √ (155)
(100000 + 236.59P) · 0.0053515 N
and as N → ∞, we have P → 36.39, recovering the EPP premium as
expected.
Independent Exponential RV’s
Imagine that a fully continuous whole life insurance is offered to N

(i)
individuals aged [x] with T[x] ∼ exp(λ) for all i ∈ {1, .., N}. For each
insured, the i.i.d. loss random variables are
(i)
T[x] δS + P −δT[x]
(i) P
L0,i = Sv − Pā (i) = e − (156)
T[x] δ δ
PN
and so for L0 = i=1 L0,i ,
the PPPP seeks to determine P such that
" N #
X δS + P −δT (i) P
P e [x] − <0 =α (157)
δ δ
i=1
In this case, we can rewrite this as

N
" #
1 X −δT[x] (i) P
P e < =α (158)
N P + δS
i=1
(i)
−δT[x]
In this case, foreach i if wedefine Yi := e , then we know that
(i)
−δT[x] λ
P [Yi > y ] = P e > y = 1−yδ.
In this case, we can rewrite this as

N
" #
1 X −δT[x] (i) P
P e < =α (158)
N P + δS
i=1
(i)
−δT[x]
In this case, foreach i if wedefine Yi := e , then we know that
(i)
−δT[x] λ
P [Yi > y ] = P e > y = 1−yδ.
HW Using convolution techniques, find the above probability

N
" #
1 X P
P Yi < = α. (159)
N P + δS
i=1
Are there any ergodic theory results that we can use?
Capped Maximal Loss
Another principle is to find P such that for any α ∈ (0, 1), the probability
δ
that any contract suffers a loss of β < Sα λN < S is set to α for a set of
(i)
i.i.d. exponentially distributed times T[x] :

δS + P −δT[x]
(i) P
P max e − <β =α (160)
i=1..N δ δ
We rewrite this as
Capped Maximal Loss
δ
(i)

δS + P −δT[x] (i) P
P max e − <β =α (160)
i=1..N δ δ
We rewrite this as

n
(i)
o 1 P + δβ
α = P min T[x] > − ln
i=1..N δ P +δ
N λN

−λ[− δ1 ln ( P+δβ )] P + δβ δ
= e P+δ =
P + δS
Capped Maximal Loss
δ
(i)

δS + P −δT[x] (i) P
P max e − <β =α (160)
i=1..N δ δ
We rewrite this as

n
(i)
o 1 P + δβ
α = P min T[x] > − ln
i=1..N δ P +δ
N λN

−λ[− δ1 ln ( P+δβ )] P + δβ δ
= e P+δ = (161)
P + δS
δ
Sα λN − β
P =δ· δ → ∞ as N → ∞
1 − α λN
For this risk measure, is there a number of policy holders N that is too
high?
Comments on PPPP
Notice that the PPPP only guarantees that the probability of a loss is
1 − α.
It says nothing about the size of what that loss could be if it
arises.
This is a big problem if the loss is extremely large and bankrupts the
insurer. It may seem very unlikely, but recent economic events have
shown otherwise.
Further improvements to this model can be seen in the ERM for
Strategic Management (Status Report) by Gary Venter, posted on
the SOA.org website
Also, there is a close link, perhaps to be explored in a project, with
VAR in the financial world. Click here for an informative article in the
NY Times TM for an article on VAR and the recent financial crisis.
Homework Questions
HW: 6.1, 6.2, 6.5, 6.7, 6.8, 6.12, 6.14, 6.15
Policy Value Basis
When entering into a contract, the financial obligations of all parties

should be specified at the time the agreement is signed. This includes
disclosure of health status, age, and premium payments expected to fund
benefits and expenses associated with the contract.
The Policy Value t V is the expected value of the future loss random
variable Lt at time t:
tV = E[Lt ] = E[ Loss | T[x] > t] (162)
Policy Value Basis
Definition
The gross premium policy value for a policy in force at duration
t ≥ 0 years after it was purchased is the expected value at that time
of the gross future loss random variable on a specified basis. The
premiums used in the calculation are the actual premiums payable
under the contract.
The net premium policy value for a policy in force at duration
t ≥ 0 years after it was purchased is the expected value at that time
of the net future loss random variable on a specified basis (which
makes no allowance for expenses.) The premiums used in the
calculation are the net premiums calculated on the policy value basis
using the equivalence principle, not the actual premiums payable
It is important to note that usual practice dictates that when calculating
t V , premiums and premium-related expenses due at t are regarded as
future payments and any insurance benefits and related expenses as past
payments.
Recursion
Define
Pt as the premium payable at time t
et as the premium-related expense payable at time t
St+1 as the sum insured payable at time t + 1
Et+1 as the expense of paying the sum insured at time t + 1
t+1 V as the gross premium policy value for a policy in force at time
t +1
Lt as the gross future loss random variable at time t
it as the interest rate from time t to time t + 1.
Recursion
Then, using recursion, we obtain
St+1 + Et+1 t+1 V

tV = et − Pt + q[x]+t · + p[x]+t · . (163)
1 + it 1 + it
Notice that if there is a fixed term to the contract, such as an endowment
or term insurance, then we have the boundary condition
nV =0 (164)
Also, if the premium is calculated using the EPP and the policy basis is
the same as the premium basis, then
0V = E[L0 ] = 0 (165)
BC : Endowment
For an endowment insurance contract with sum insured S, however, we

have the pair of boundary conditions
n− V = lim+ n− V = S
→0 (166)
nV =0
In calculating n−1 V , we actually use n− V instead of n V . See next example!
Example 7.7
Consider a zero-expense, 20 year endowment policy purchased by a life

aged 50. Level premiums of 23500 per year are payable annually
throughout the term of the policy. A sum insured of 700000 is payable at
the end of the term if the life survives to age 70. On death before age 70,
a sum insured is payable at the end of the year of death equal to the policy
value at the start of the year in which the policyholder dies. Assuming the
SSSM with interest at 3.5% per year, calculate 15 V , the policy value in
force at the start of the 16th year.
Example 7.7
It follows that
St+1 = t V
et = 0 = Et
S = 700000 (167)
Pt = 23500
tV t+1 V
tV = −23500 + q[50]+t + p[50]+t
1.035 1.035
Example 7.7
Combining with our boundary value, we obtain the difference equation
p[50]+t · t+1 V − 24322.50

tV =
p[50]+t + 0.035 (168)
20− V = 700000.
Example 7.7
p[50]+t · t+1 V − 24322.50

tV =
p[50]+t + 0.035 (168)
20− V = 700000.
Our initial iteration actually uses 20− V to obtain
p69 · (20− V ) − 24322.50

19 V = = 652401 (169)
p69 + 0.035
Example 7.7
p[50]+t · t+1 V − 24322.50

tV =
p[50]+t + 0.035 (168)
20− V = 700000.
Our initial iteration actually uses 20− V to obtain
p69 · (20− V ) − 24322.50

19 V = = 652401 (169)
p69 + 0.035
Use tables or spreadsheet to calculate SSSM values and obtain
15 V = 478063.
Example 7.1
Consider a 20−year endowment policy purchased by a life aged 50. Level

premiums are payable annually throughout the term of the policy and the
sum insured, S = 500000, is payable at the end of the year of death or at
the end of the term, whichever is sooner. The basis used by the insurance
company for all calculations is under the SSSM with 5% per year interest
and no allowance for expenses. Calculate P under the EPPP and the
corresponding policy values
Example 7.1
Substituting the information contained in the problem formation, we obtain
500000 t+1 V
tV = −P + q[50]+t · + p[50]+t ·
1.05 1.05
t+1 V − 500000 500000
= p[50]+t + −P (170)
1.05 1.05
0 V = 0 = E[L0 ] = Pä[50]:20 − 500000A[50]:20
20− V = 500000
Solving for P, we obtain P = 15114.33. Iteration of the resulting
difference equation delivers the remaining policy values.
Example 7.4
A man aged 50 purchases a deferred annuity policy. The annuity will be

paid annually for life, with the first payment on his 60th birthday. Each
annuity payment will be 10000. Level premiums of 11900 are payable
annually for at most 10 years. On death before age 60, all premiums paid
will be returned, without interest, at the end of the year of death. The
insurer uses the following basis for calculation of policy values:
SSSM with 5% interest per year
Expenses of 10% of the first premium, 5% of subsequent premiums,
25 each time an annuity payment is paid, and 100 when a death claim
is paid.
Calculate t V for t ∈ {0, 1, ..., 9}
Example 7.4
Our initial policy value is

1 1
0V = P · (IA)50:10 + 100A[50]:10 + 10025v 10 10 p[50] ä60

− 0.95ä[50]:10 − 0.05 P (171)
= 485 > 0
This of course can now be used to forward iterate to find {t V }9t=1 . Since
0 V = 485 > 0, the premiums charged correspond to a valuation basis that
is more conservative than the premium basis.
Example 7.4
Our initial policy value is

1 1
0V = P · (IA)50:10 + 100A[50]:10 + 10025v 10 10 p[50] ä60

− 0.95ä[50]:10 − 0.05 P (171)
= 485 > 0
This of course can now be used to forward iterate to find {t V }9t=1 . Since
0 V = 485 > 0, the premiums charged correspond to a valuation basis that
is more conservative than the premium basis.
In general, we have for t ∈ {1, 2, ..., 9},
1 1
tV = P · (IA)50+t:10−t + (tP + 100)A[50]+t:10−t
(172)
+ 10025v 10−t 10−t p[50]+t ä60 − 0.95Pä[50]+t:10−t
Example 7.4
For 1 ≤ t ≤ 9, we can see our recursion equation is
(t + 1) · P + 100 t+1 V
tV = −0.95P + q[50]+t · + p[50]+t · (173)
1.05 1.05
For t ≥ 10, we have
t− V = 10025ä50+t
(174)
t+ V = 10025a50+t = t − V − 10025
Which do we use to find 9 V , 10− V or 10+ V ?
Notes
The previous example shows that sometimes we need to calculate the

initial value, given the information contained in the problem
statement, to iterate forward, especially if there is no term n and
corresponding boundary condition n V . Also, no annuity payments
have occured yet and this reflects in the expenses.
It is likely that DSAR := St+1 + Et+1 − t+1 V 6= 0. The Death Strain
At Risk, or DSAR, is the extra amount needed to increase the policy
value to the death benefit at time t + 1. This is a capital based risk
measure, as it is a direct measure of what the insurer may be at risk
of needing to close out a contract if a benefit must be paid. If the
DSAR is large enough, management may want to purchase
reinsurance in case a large DSAR (even with low probability) occurs.
Example 7.3
A woman aged 60 purchases a 20 year endowment insurance with a sum

insured S = 100000 payable at the end of the year of death or on survival
to age 80, whichever occurs first. An annual premium of 5200 is
payable for at most 10 years. The insurer uses the following basis for
calculation of policy values:
SSSM with 5% interest per year
Expenses of 10% of the first premium, 5% of subsequent premiums,
and 200 on payment of the sum insured.
Example 7.3
Our initial recursion equation is
100200 1V
0V = −0.9P + q[60] · + p[60] · . (175)
1.05 1.05
For 1 ≤ t ≤ 9, we have
100200 t+1 V
tV = −0.95P + q[60]+t · + p[60]+t · . (176)
1.05 1.05
For t = 10, we have
h i
10 V = E [L10 ] = E 100200v min{K70 +1,10}
(177)
= 100200A70:10 = 63703.
HW Compute 9 V and 12 V explicity.
Annual Profit - Example 7.8
An insurer issues a large number of policies identical to the policy in

Example 7.3 to women aged 60. Five years after they were issued, a total
of 100 of these policies were still in force. In the following year, one person
died (d5 = 1) and
expenses of 6% of each premium paid were incurred - i.e.
e5actual = 0.06P5
interest was earned at 6.5% on all assets - i.e. i5actual = 0.065
expenses of E6actual = 250 were incurred on the payment of the sum
insured for the policyholder who died.
Calculate a.) the profit or loss on the group of policies for this year and b.)
determine how much of this profit or loss is attributable to profit or loss
from mortality, from interest, and from expenses.
To solve, we compute the difference between the growth of assets from

t = 5 to t = 6 and subtract the total asset value at t = 6:
Profit = N · (5 V + P5 − 0.06P5 ) · (1 + i5 )1
− (d5 · (S + E6 ) + (N − d5 ) · 6 V )
= 100 · (5 V + (0.94)(5200)) · (1.065)1 (178)
− (1 · (S + E6 ) + 99 · 6 V )
= 106.5 · (5 V + 4888) − (100250 + 99 · 6 V )
Furthermore,
5V = E[L5 ] = 100200A65:15 − 0.95 · 5200ä65:5

= 29068
6V = E[L6 ] = 100200A66:14 − 0.95 · 5200ä66:4
= 35324
Furthermore,
5V = E[L5 ] = 100200A65:15 − 0.95 · 5200ä65:5

= 29068
6V = E[L6 ] = 100200A66:14 − 0.95 · 5200ä66:4
(179)
= 35324
∴ Profit = 106.5 · (29068 + 4888) − (100250 + (99)(35324))
= 18919
HW: Read the solution for part b.) in the textbook.
Define ASt as the share of the insurer’s assets attributable to each policy
in force at time t. Consider now a policy identical to the policy studied in
Example 7.4 and suppose that this policy has now been in force for five
years. Suppose that over the past five years, the insurer’s experience in
respect of similar policies has realized annual interest on investments as
(i1 , i2 , i3 , i4 , i5 ) = (0.048, 0.056, 0.052, 0.049, 0.047).
Furthermore,
Expenses at the start of the year in which a policy was issued were
15% of the premium
Expenses at the start of the year after the year in which a policy was
issued were 6% of the premium
The expense of paying a death claim was, on average, 120
The mortality rate q[50]+t ≈ 0.0015 for t ∈ {0, 1, 2, 3, 4}
Calculate ASt using the convention that ASt does not include the premium
and related expense due at time t. (This of course means that AS0 = 0.)
We calculate AS1 here and refer to Table 7.1 for the complete set of
calculations
At time 0, insurer receives premiums minus expenses of
0.85 · 11900N = 10115N.
At time 1, this accumulates to 10115N · (1 + i1 ) = 10601N.
A total of 0.0015N policy holders die in the first year and death
claims are 0.0015N · (11900 + 120) = 18N.
Therefore, the value of the fund at the end of the first year is
10601N − 18N = 10582N.
It follows that
Fund Value at time 1

AS1 =
Number of Policies in Force at time 1 (180)
10582N
= = 10598
0.9985N
Now, read Section 7.4 on computing Valuation between premium dates.
Policy Values - Cts Cash Flows
Recall that
St+1 + Et+1 t+1 V

tV = et − Pt + q[x]+t · + p[x]+t · . (181)
1 + it 1 + it
Now, consider that t is real-valued and define
Pt as the annual rate of premium payable at time t
et as the annual rate of premium-related expense payable at time t
St as the sum insured payable at time t if the policy holder dies
exactly at t
Et as the expense of paying the sum insured at time t
µ[x]+t as the force of mortality at age [x] + t
δt as the force of interest assumed at time t
tV as the ipolicy value at time t.
Now, as the force of interest varies, we have

Rt
v (t) = e − 0 δu du
v (t) Rt (182)
= e − s δu du
v (s)
and so
Z ∞
v (t + s)
tV = · [St+s + Et+s ] · s p[x]+t µ[x]+t+s ds
v (t)
Z 0∞ (183)
v (t + s)
− · [Pt+s − et+s ] · s p[x]+t ds
0 v (t)
Q: What happens if there is a finite term to contract?
By the product rule and the identities

r p[x]
r −t p[x]+t =
t p[x]
d (184)
t p[x] = −t p[x] µ[x]+t
dt
v 0 (t) = −δt v (t)
we obtain the ODE
d
(t V ) = δt · t V + Pt − et − (St + Et − t V ) µ[x]+t (185)
dt
Boundary Conditions:
For S sum insured, we have
lim t V = S for an endowment policy with term n years.

t→n−
lim t V = 0 for a term policy with term n years. (186)
t→n−
lim tV = S for a whole life policy with upper limit ω years.
t→ω −
Forward Euler:

t+h V = t V + h · δt · t V + Pt − et − (St + Et − t V ) µ[x]+t (187)
As an example, consider the case where for S sum insured, we have
St+s = S
et+s = 0 = Et+s
δt = δ (188)
µ[x]+t+s = λ
Pt+s = Pe −γ(t+s)
Then it follows that
Z ∞ Z ∞
−δs −λs
tV = Se · λe ds − e −δs · Pe −γ(t+s) e −λs ds
0 0
(189)
Sλ Pe −γt
= −
λ+δ λ+δ+γ
Policy Alterations
In many cases, policyholders may wish to change the terms of their

contract if it is still in effect. For example:
They may wish to stop making premiums, or to change the terms of
their benefit payout.
They may wish to cash out their position, or simply wish to shorten
the time remaining until payout.
Policy Alterations
In many cases, policyholders may wish to change the terms of their

contract if it is still in effect. For example:
They may wish to stop making premiums, or to change the terms of
their benefit payout.
They may wish to cash out their position, or simply wish to shorten
the time remaining until payout.
One may argue that the insurer is under no obligation to make such
changes if they are not written expressly into the initial contract. For
example:
The policyholder (but not insurer) may know something about their
health status that would make it better for them to cash out now.
By having to liquidate assets that cover the policy, the insurer may
have to take a loss to be able to settle the alteration, and this could
affect other policyholders adversely.
Policy Alterations
Because of these concerns, the lender may agree to alter the terms of the
contract, but only paying a Surrender (Cash) Value Ct of a fraction of
t V or ASt .
Policy Alterations
Because of these concerns, the lender may agree to alter the terms of the
contract, but only paying a Surrender (Cash) Value Ct of a fraction of
t V or ASt .
Ct = E [PVt (future benefits + expenses, altered contract)]

(190)
− E [PVt (future premiums, altered contract)]
In allowing the policy to lapse, the policy holder is cashing out a policy
and using the proceeds to enter into a new contract. If the period between
lapsing and entering into a new contract is too short, then the insurer may
suffer from not earning enough income to cover the new business strain of
writing the first contract. Hence, some countries including the US have
non-forfeiture laws that allow for zero cash values for early surrenders.
Policy Alterations: Example 7.13
Consider the policy discussed in Examples 7.4 and 7.9. Given the
experience of the insurer detailed in Example 7.9, at the start of the 6th
year but before paying the premium due, the policyholder requests that the
policy be altered in one of the following ways:
1 The policy is surrendered immediately

2 No more premiums are paid, and a reduced annuity is payable from
age 60. In this case, all premiums paid are refunded at the end of the
year of death if the policyholder dies before age 60.
3 Premiums continue to be paid, but the benefit is altered from an
annuity to a lump sum (pure endowment) payable on reaching age 60.
Expenses and benefits on death before age 60 follow the original
policy terms. There is an expense of 100 associated with paying the
sum insured at the new maturity date.
Calculate the surrender value, the reduced annuity, and sum insured
assuming the insurer uses
90% of the asset share less a charge of 200 or
95% of the policy value less a charge of 200
together with the assumptions in the policy value basis when calculating
revised benefits and premiums. Use the associated values
5V = 65470
(191)
AS5 = 63509
1
C5assetshare = 0.9 · AS5 − 200 = 56958
(192)
C5policyvalue = 0.9 · 5 V − 200 = 58723
1
C5assetshare = 0.9 · AS5 − 200 = 56958
(192)
C5policyvalue = 0.9 · 5 V − 200 = 58723
2
1 1
C5 = 5 · 11900A55:5 + 100A55:5
+ (X + 25) · v 5 5 p55 · ä60
(193)
X assetshare = 4859
X policyvalue = 5012
1
C5assetshare = 0.9 · AS5 − 200 = 56958
(192)
C5policyvalue = 0.9 · 5 V − 200 = 58723
2
1 1
C5 = 5 · 11900A55:5 + 100A55:5
+ (X + 25) · v 5 5 p55 · ä60
(193)
X assetshare = 4859
X policyvalue = 5012
3
1 1
C5 + 0.95 · 11900ä55:5 = 11900 (IA)55:5 + 5A55:5
1
+ 100A55:5 + v 5 5 p55 (S + 100)
(194)
S assetshare = 138314
S policyvalue = 140594
Related Project Topics
Over- or underestimated interest rates are only one risk factor for
actuarial reserving. Another very real factor is known as longevity
risk, which is due to the possibility that a pensioner may live longer
than expected. Hedging against such a possibility is extremely
important, Please consult the paper by Tsai, Tzeng, and Wang on
Hedging Longevity Risk When Interest Rates Are Uncertain
Related Project Topics
For those of you interested in more sophisitcated, cutting edge coding

methods for reserving, code.google.com has a site dedicated to
ChainLadder (google code name chainladder) that contains an R
package providing methods which are typically used in insurance
claims reserving. Links to slides explaining the method are also on the
site
An Introduction to R: Examples for Actuaries by Nigel de Silva is a
very nice primer on using R.
Homework Questions
HW: 7.1, 7.2, 7.4, 7.5, 7.8, 7.12, 7.14, 7.15
Two State Model: Alive or Dead
Recall that for the survival time Tx of an individual (x), we have
Sx (t) = 1 − Fx (t) = 1 − P[Tx ≤ t] (195)

We now extend the model to include multiple states, but first we define
the random variable Y (t) ∈ {0, 1} as the state of the individual (x). If (x)
is alive at time x + t, then Y (t) = 0. Otherwise, Y (t) = 1.
Hence, we can define
Tx = max {t | Y (t) = 0} (196)

and the model flow 0 → 1.
Accidental Death Model
We can also define

 0 if (x) is alive at time x + t
Y (t) = 1 if (x) is dead at time x + t of accidental cause
2 if (x) is dead at time x + t of other cause

0
>>
>>
>>
>>

1 2
Figure: ADM Flow Chart
There is a sum insured upon leaving state 0, but that sum is dependent on
entering state 1 or 2.
Permanent Disability Model
However, we can go even further and define

 0 if (x) is alive at time x + t
Y (t) = 1 if (x) is disabled at time x + t
2 if (x) is dead at time x + t

0 / 1
>>
>>
>>
>>

2
Figure: PDM Flow Chart
There is a lump sum paid upon entering state 1, an annuity paid while in
state 1, and a lump sum paid upon entering state 2.
Disability Income Insurance Model
However, we can go even further and define

 0 if (x) is alive and healthy at time x + t
Y (t) = 1 if (x) is alive and sick at time x + t
2 if (x) is dead at time x + t

0 o / 1
>>
>>
>>
>>

2
Figure: DIIM Flow Chart
Premium is paid while in state 0, is a lump sum paid upon entering state
1, an annuity paid while in state 1, and a lump sum paid upon entering
state 2.
Joint Life - Last Survivor
Define
Joint Life Annuity - annuity that pays until the first death among a
group of lives
Last Survivor Annuity - annuity that pays until the last death
among a group of lives
A common feature is payment rate decreases upon each death
Reversionary Annuity - life annuity that starts payment upon death
of a specified life, as long as another member of group is alive
Joint Life Insurance - life annuity that starts payment upon first
death of a member of group
Usually, group consists of two members, a husband and a wife
Joint Model
For example, consider a policy issued to a group (H, W ) of age (x, y ).
Then,


 0 if H is alive at x + t and W is alive at y + t
1 if H is alive at x + t and W is dead at y + t

Y (t) =

 2 if H is dead at x + t and W is alive at y + t
3 if H is dead at x + t and W is dead at y + t

0 / 1

2 / 3
Figure: Joint Model Flow Chart
Notation
Assuming that the group (which can consist of 1,2, or more individuals)
can be found in an of the the n + 1 states {0, 1, 2, ..., n − 1, n}, we define
the event
{Y (t) = i} (197)
to mean the group is in state i at time t.
It follows that {Y (t)}t≥0 is a discrete valued stochastic process.
Assumptions
We make the following assumptions and definitions about transitions

between states and their associated probabilities:
P[Y (x + t) = j | Y (x) = i] := t pxij (Markovity)
Assumptions


P[Y (x + s) = i for all s ∈ [0, t] | Y (x) = i] := t pxii
Assumptions


P[2 or more transitions in interval of length h]
lim =0
h→0 h
Assumptions


lim =0
h→0 h
ij
h px
lim+ := µijx
h→0 h
Assumptions


lim =0
h→0 h (198)
ij
h px
lim+ := µijx
h→0 h
d ij

t px exists for all t ≥ 0
dt
Note:
00
t px = t px
01
t px = t qx
10
t px =0
ij
0 px = 1{i=j}
µ01
x = µx
Note:
00
t px = t px
01
t px = t qx
10
t px =0
ij
0 px = 1{i=j} (199)
µ01
x = µx
ij
h px = h · µijx + o(h)
ii
t px ≤ t pxii
Note:
00
t px = t px
01
t px = t qx
10
t px =0
ij
0 px = 1{i=j} (199)
µ01
x = µx
ij
h px = h · µijx + o(h)
ii
t px ≤ t pxii
As an example, we can show that for the permanent disability model
Z u
01 00 01 11
u px = t px · µx+t · u−t px+t dt. (200)
0
P[Remaining in State i from age x to x + t]
Theorem
n
X
ii
h px = 1 − h · µijx + o(h)
j=0,j6=i
  (201)
Z t n
µijx+s ds 
X
ii
t px = exp −
0 j=0,j6=i
P[Remaining in State i from age x to x + t]
Proof.
P[(x, i) → (x + h, i)] = 1 − P[(x, i) 9 (x + h, i)]

X n
=1−h· µijx + o(h).
j=0,j6=i
n
µijx+t + o(h)
X
∴ t+h pxii = t pxii · h px+t
ii
= t pxii · 1 − h ·
j=0,j6=i
ii ii n
d ii t+h px − t px
µijx+t
X
⇒ t px = lim = −t pxii ·
dt h→0 h
j=0,j6=i
Rt P ij Rt P ij
⇒ t pxii = 0 pxii · e − 0 i6=j µx+s ds =e − 0 i6=j µx+s ds .
(202)
Kolmogorov Forward Equations
Using the vocabulary of probabilists, we define the Kolmogorov forward

equations for the evolution of the densities of the birth death Markov
process Y as
n n
d ij ik kj
µjk
X X
ij
tp = t px µx+t − t px (203)
dt x x+t
k=0,k6=j k=0,k6=j
In matrix notation, for a fixed x, define the matrices P(t), Q(t) such that
[P(t)]i,j = t pxij
In matrix notation, for a fixed x, define the matrices P(t), Q(t) such that
[P(t)]i,j = t pxij
 Pn
− k=1 µ0k 01 µ0n

x+t Pn µx+t ··· x+t
 µ10
x+t − 1k
k=0,k6=1 µx+t ··· µ1n
x+t
 (204)
Q(t) = 
 
.. .. .. .. 
 . . . . 
Pn−1 nk
µn0
x+t µn1
x+t ··· − k=0 µx+t
and the corresponding ODE system is
P 0 (t) = P(t)Q(t)
(205)
P(0) = I = Identity Matrix.
Here, Q is referred to as the transition intensity matrix. We can work

with off diagonal entries as the diagonal entries are dependent on them.
Also, a whole row of the matrix is filled by zeroes if there is no transition
out of the state corresponding to the row.
Consider the case where Q is time-independent. Also, consider the

diagonalization of Q via
Q = UDU −1
 
λ1 0 · · · 0
 0 λ2 · · · 0 (206)
D= .
 
.. . . .. 
 .. . . .
0 0 ··· λn
where {λ1 , λ2 , · · · , λn } are the eigenvalues of Q and U is the matrix
composed of the corresponding eigenvectors.
P∞ tk k
Then P(t) = e tQ P(0), where e tQ = k=0 k! Q .
If Q is diagonalizable, then
e tQ = Ue tD U −1
 tλ 
e 1 0 ··· 0
 0 e tλ2 ··· 0  (207)
e tD =  .
 
.. .. ..
 ..

. . . 
0 0 ··· e tλn
Question: What if Q is in fact time dependent?
0 → 1 transition matrix
For the regular alive-dead model with constant force of mortality µ, the
rate matrix is

−µ µ 1 1 −µ 0 1 −1
Q= = (208)
0 0 0 1 0 0 0 1
It follows that we retain
e −µt 1 − e −µt

tQ
P(t) = e = (209)
0 1
as in the previous sections.
Zombies!!
Consider a fun toy problem that remains in the 2 × 2 matrix setting:

A zombie population has the rate matrix
1 1

−1 1 −1 1 −3 0 −3 3
Q= = 2 1 (210)
2 −2 2 1 0 0 3 3
It follows that
−3t 1 1

−1 1 e 0 −3
P(t) = e tQ = 2
3
1 (211)
2 1 0 1 3 3
Zombies!!
Consider a fun toy problem that remains in the 2 × 2 matrix setting:

A zombie population has the rate matrix
1 1

−1 1 −1 1 −3 0 −3 3
Q= = 2 1 (210)
2 −2 2 1 0 0 3 3
It follows that
−3t 1 1

−1 1 e 0 −3
P(t) = e tQ = 2
3
1 (211)
2 1 0 1 3 3
Question As t → ∞, can you say anything about the percentage of

humans in the total population?
Zombies - the general case..
For a general zombie population constant rate matrix
b a b
1 − ba

−a a 0 0 a+b b a+b
Q= = b b (212)
b −b 1 1 0 −(a + b) − a+b a+b
b a b
1 − ba

−a a 0 0 a+b b a+b
Q= = b b (212)
b −b 1 1 0 −(a + b) − a+b a+b
It follows that
b a b
1 − ba

1 0 a+b b a+b
P(t) =
1 1 0 e −(a+b)t b
− a+b b
a+b
b a b
1 − ba

−a a 0 0 a+b b a+b
Q= = b b (212)
b −b 1 1 0 −(a + b) − a+b a+b
It follows that
b a b
1 − ba

1 0 a+b b a+b
P(t) =
1 1 0 e −(a+b)t b
− a+b b
a+b
−(a+b)t −(a+b)t
!
b+ae a−ae
= a+b a+b
b−be −(a+b)t a+be −(a+b)t
a+b a+b
b a b
1 − ba

−a a 0 0 a+b b a+b
Q= = b b (212)
b −b 1 1 0 −(a + b) − a+b a+b
It follows that
b a b
1 − ba

1 0 a+b b a+b
P(t) =
1 1 0 e −(a+b)t b
− a+b b
a+b
−(a+b)t −(a+b)t
!
b+ae a−ae
= a+b a+b (213)
b−be −(a+b)t a+be −(a+b)t
a+b a+b
b a
→ a+b a+b
b a
a+b a+b
Example 8.4
Suppose you are given the transition intensity matrix for the permanent
disability model as follows:
 00
µx µ01 µ02
  
x x −0.0508 0.0279 0.0229
µ10x µ11
x µ12
x
 =  0.0000 −0.0229 0.0229 (214)
20 21
µ x µx µx 22 0.0000 0.0000 0.0000
Then
R 10
00
10 p60
00
= 10 p60 = e − 0 (0.0279+0.0229)ds = 0.60170
Z 10
01 00 01 11
10 p60 = t p60 · µ60+t · 10−t p60+t dt
0 (215)
Z 10 R
t R 10−t
= e − 0 (0.0279+0.0229)ds · 0.0279 · e − 0 (0.0229)ds dt
0
= 0.19363
MLC Q12 / Nov 2012
A party of scientists arrives at a remote island. Unknown to them, a
hungry tyrannosaur lives on the island. You model the future lifetimes of
the scientists as a three-state model, where:
State 0: no scientists have been eaten.
State 1: exactly one scientist has been eaten.
State 2: at least two scientists have been eaten.
You are given:
(i) Until a scientist is eaten, they suspect nothing, so
µ01
t = 0.01 + 0.02 · 2
t
(ii) Until a scientist is eaten, they suspect nothing, so the tyrannosaur

may come across two together and eat both, with µ02 = 0.5 · µ01 t
(iii) After the first death, scientists become much more careful, so
µ12 = 0.01
Calculate the probability that no scientists are eaten in the first
year.
MLC Q12 / Nov 2012
This is essentially a Permanent Disability model, and so we can compute

the transition probabilities accordingly:
 
Z tX 2
00
t p0 = exp − µ0j
s ds

0 j=1
Z t (216)
t
= exp − 1.5(0.01 + 0.02 · 2 )ds
0
00
⇒ 1 p0 = 0.943.
HW Compute the other transition probabilities using both the integral
equation and the matrix exponential method.
Example 8.5 (Forward Euler Method)
Suppose you are given the transition intensity matrix for the disability
income insurance model as follows:
 00
µx µ01 µ02
  01
−µx − µ02 a1 + b1 e c1 x a2 + b2 e c2 x

x x x
µ10
x µ11
x µ12
x
 =  0.1 · µ01
x −µ10
x − µx
12 a + b e c2 x 
2 2 (217)
20 21
µx µx µx 22 0 0 0
for parameters
4 × 10−4 3.4674 × 10−6 0.138155

a1 b 1 c 1

= (218)
a2 b 2 c 2 5 × 10−4 7.5858 × 10−6 0.087498
Example 8.5
Then Forward Euler applied the Kolmogorov equations leads to

00 00 00 01 02

t+h p60 = t p60 − h · t p60 · µ60+t + µ60+t
01
+ h · t p60 · µ10
60+t + o(h)
01 01 01
(219)
· µ12 10

t+h p60 = t p60 − h · t p60 60+t + µ60+t
00
+ h · t p60 · µ01
60+t + o(h)
1
Ignoring the o(h) terms, we can iterate forward using, for example, h = 12 .
Example 8.5
In matrix-vector notation, we have

00
00
t+h p60 p
01 = [I − hA(t)] t 6001
t+h p60 t p60
Example 8.5

00
00
t+h p60 p
01 = [I − hA(t)] t 60 01
t+h p60 t p60

1 0
I= (220)
0 1
01
µ60+t + µ02 −µ10

A(t) = 60+t 60+t
−µ01
60+t µ12 10
60+t + µ60+t
Example 8.5

00
00
t+h p60 p
01 = [I − hA(t)] t 60 01
t+h p60 t p60

1 0
I= (220)
0 1
01
µ60+t + µ02 −µ10

A(t) = 60+t 60+t
−µ01
60+t µ12 10
60+t + µ60+t
Keep in mind that A is determined by the given transition intensity matrix.

HW Compute this vector over the interval t ∈ [0, 10] using a time step of
1
h = 12 . Use any numerical solver you like, but please have the values
computed into a pair of columns.
Permanent Disability Model
Upon finding the right diagonalization, one can show that for a PDM with
the rate matrix
 
−(a + b) a b
Q= 0 −c c  (221)
0 0 0
where a, b, c > 0, it follows that for a + b 6= c, P(t) =
e −(a+b)t a −ct − e −(a+b)t ) 1 − a −ct c−b

e −(a+b)t
 
a+b−c (e a+b−c e + a+b−c
 0 e −ct 1 − e −ct 
0 0 1
(222)
MLC Q16 / Nov 2012
Consider a Modified Disability Model where observed transition intensities

are (µ01 10 12
t , µt , µt ) = (0.02, 0.06, 0.10).
Using the Kolmogorov forward equations with step h = 0.5, calculate the
probability that a person currently disabled will be healthy at the end of
one year
MLC Q16 / Nov 2012
Recall that the Forward Euler method can be written explicitly as
f (t + h) ≈ f (t) + h · f 0 (t) (223)

and so for the Kolmorgorov Forward ODE system,
n
X n
ik kj
µjk
X
ij ij ij
t+h px = t px +h· t px µx+t − t px x+t . (224)
k=0,k6=j k=0,k6=j
MLC Q16 / Nov 2012
Again, wlog set x = 0 and fix i, j. For
f (t) := t p0ij
(225)
f (h) = f (0) + h · f 0 (0)
we have the system of equations

10 10 11 10 12 20 10 01 02
p
h 0 = p
0 0 + h · ( p
0 0 hµ + p
0 0 hµ ) − p
0 0 · (µ h + µ h )

11 11 10 01 12 21 11 10 12
p
h 0 = p
0 0 + h · ( p
0 0 hµ + p
0 0 hµ ) − p
0 0 · (µ h + µ h ) (226)

12 12 10 02 11 12 12 20 21
p
h 0 = p
0 0 + h · ( p
0 0 hµ + p
0 0 hµ ) − p
0 0 · (µ h + µ h ) .
MLC Q16 / Nov 2012
Using the above, and h = 0.5, we obtain for the first iterates:
10
h p0 = h · µ10
h = 0.03
12
h p0 = h · µ12
h = 0.03 (227)
11
h p0 =1−h· (µ10
h + µ12
h ) = 0.92.
Recursively, f (2h) = f (h) + h · f 0 (h) and so for f (2h) = 2h p0ij we obtain

10 10 11 10 12 20 10 01 02
p
2h 0 = p
h 0 + h · ( p µ
h 0 2h + p µ
h 0 2h ) − p
h 0 · (µ 2h + µ 2h )

= 0.03 + 0.5 · (0.92)(0.06) + 0 − (0.03)(0.02 + 0) (228)
= 0.0573.
MLC Q16 / Nov 2012
Note that
 
−0.02 0.02 0
Q =  0.06 −0.16 0.10
0 0 0
= UDU −1
MLC Q16 / Nov 2012
Note that
 
−0.02 0.02 0
Q =  0.06 −0.16 0.10
0 0 0
= UDU −1
 
−0.133827 0.92683 0.57735
where U =  0.991005 0.375482 0.57735
0 0 0.57735 (229)
 
−0.168102 0 0
D= 0 −0.0118975 0
0 0 0
 
−0.387597 0.956735 −0.569138
U −1 =  1.02298 0.138145 −1.16113 
0 0 1.73205
MLC Q16 / Nov 2012
It follows that
P(t) = Ue tD U −1
MLC Q16 / Nov 2012
It follows that
P(t) = Ue tD U −1
 
−0.133827 0.92683 0.57735
where U =  0.991005 0.375482 0.57735
0 0 0.57735
 −0.168102t 
e 0 0 (230)
e tD =  0 e −0.0118975t 0
0 0 1
 
−0.387597 0.956735 −0.569138
U −1 =  1.02298 0.138145 −1.16113 
0 0 1.73205
Compare these with your previously obtained Forward-Euler results.
Premiums
Consider an annuity issued to a life (x) that pays at rate 1 per year
continuously while the life is in state j. Then the EPV of this annuity at
force of interest δ per year is
Z ∞
ij −δt
āx = E e 1{Y (t)=j|Y (0)=i} dt
Z ∞0 Z ∞ (231)
−δt −δt ij

= e E 1{Y (t)=j|Y (0)=i} dt = e t px dt
0 0
If the annuity is payable at the start of each year from the current time,
based on the conditional event {Y (t) = j | Y (0) = i}, then the EPV is
∞
X
äxij = v k k pxij (232)
k=0
Premiums
If a unit benefit is payable to a life (x) on transition to state k, given that

it is currently in state i, then the EPV of this benefit is
Z ∞X
Āik
x = e −δt t pxij µjk
x+t dt (233)
0 j6=k
Example 8.6
An insurer issues a 10−year disability income insurance policy to a healthy

life aged 60. Use the model and parameters from i.) Example 8.5 and ii.)
Example 8.4. Assume an effective rate of 5% per year and no expenses.
Calculate the premiums for the following designs
(a) Premiums are payable continuously while in the healthy state. A
benefit of 20000 per year is payable continuously while in the disabled
state. A death benefit of 50000 is payable immediately upon death.
(b) Premiums are payable monthly in advance conditional on the life
being in the healthy state at the premium date. The sickness benefit
of 20000 per year is payable monthly in arrear, if the life is in the sick
state at the payment date. A death benefit of 50000 is payable
immediatlely upon death.
Example 8.6
For case a.), we have via the EPP principle that
01
20000ā60:10 + 50000Ā02
60:10
00
− Pā60:10 =0 (234)
and so
R 10
20000 0 e −δt t p60 01 dt
P= R 10
−δt p 00 dt
0 e t 60
R 10 −δt (235)
00 02 01 12

50000 0 e t p60 µ60+t + t p60 µ60+t dt
+ R 10 .
−δt p 00 dt
0 e t 60
1
For a time step of h = 12 (monthly), we can use the forward-Euler results
from the previous example to calculate P = 3254.65.
Example 8.6
For case b.), we have via the EPP principle that

(12)01 (12)00
20000ä60:10 + 50000Ā02
60:10
− Pä60:10 = 0 (236)
and so
k
20000 119 12 k p 01
P
k=0 v 12 60
P= P119 k
12 k p 00
k=0 v 12 60
R 10 −δt (237)
00 02 01 12

50000 0 e t p60 µ60+t + t p60 µ60+t dt
+ P119 k .
12 k p 00
k=0 v 60 12
n o(1,119)
0j
Again, we can use the previously computed values of k p60 to
12 (j,k)=(0,0)
calculate P = 3257.20.
Multiple Decrement Models
Consider the special case for transition matrix
 Pn
− k=1 µ0k 01 µ0n

x+t µx+t · · · x+t
 0 0 ··· 0 
Q(t) =  (238)
 
.. .. .. .. 
 . . . . 
0 0 ··· 0
Here, there are multiple exits from state 0, but no further transitions.
0 NN
>> NNN
>> NNN
>> NNN
>> NNN
> NN'
1 2 ··· n
Figure: Multiple Decrement Flow Chart
Multiple Decrement Models
n
" Z #
tX
00 00 0i
t px = t px = exp − µx+s ds
0 i=1
Z t (239)
0i 00 0i
t px = s px µx+s ds
0
ij
0 px = 1{i=j}
Note:
Premium is now different when compared to a policy that only allows
transition 0 → 1.
Pn
This is because µ00
x+t = −
0k 01 00
k=1 µx+t < −µx+t and so t px changes
accordingly.
See Example 8.8, where for example an insurer may allow for lower
premiums via lapse support.
Double Decrement Models
Consider the extra special case for transition matrix

 
−(a + b) a b
Q(t) =  0 0 0 (240)
0 0 0
Here, there are two possible exits from state 0, but no further transitions.

 
−(a + b) a b
Q(t) =  0 0 0 (240)
0 0 0
e −(a+b)t a
− e −(a+b)t ) b
− e −(a+b)t )
 
a+b (1 a+b (1
P(t) =  0 1 0  (241)
0 0 1

 
−(a + b) a b
Q(t) =  0 0 0 (240)
0 0 0
e −(a+b)t a
− e −(a+b)t ) b
− e −(a+b)t )
 
a+b (1 a+b (1
P(t) =  0 1 0  (241)
0 0 1
HW For this double decrement model, compute äx01 , äx02 as well as Ā01
x
and Ā02
x . What can you say about these financial instruments as b → 0?
Policy Values
Define
µijy as the transition intensity between states i and j at age y
δt as the force of interest per year at time t
(i)
Bt as the benefit payment rate while the policyholder is in state i
(ij)
St as the lump sum payment instantaneously at time t on transition
from state i to state j.
Assume the above are all members of C 0 [0, n]. Then ∀i ∈ {0, 1, · · · , n},
Thiele’s Differential Equation is
d i i (i)
X ij (ij)
j i

t V = δ ·
t t V − Bt − µ x+t St + t V − t V (242)
dt
j6=i
Joint Life - Last Survivor Benefits
µ01
0
x+t:y +t
/1
µ02
x+t:y +t µ13
x+t

2 /3
µ23
y +t
Figure: Joint Model Transition Rates
Define the joint transition matrix via the flow chart above.
Define
00
t pxy = t pxy = P[(x) and (y ) are both alive in t years]
01 02 03
t qxy = t pxy + t pxy + t pxy
= P[(x) and (y ) are not both alive in t years]
00 01 02 (243)
t pxy = t pxy + t pxy + t pxy
= P[ at least one of (x) and (y ) is alive in t years]
t qxy = 1 − t pxy
µx+t:y +t = µ01 02
x+t:y +t + µx+t:y +t
Also define
1
t qxy = P[(x) dies before (y ) and within t years]
Z t
00 02
= r pxy µx+r :y +r dr
0
02
6= t pxy (244)
2
t qxy = P[(x) dies after (y ) and within t years]
Z t
01 13
= r pxy µx+r dr
0
MLC Q1 / Nov 2012
For two lives, (80) and (90), with independent future lifetimes, you are
given
p80+k = 0.9 − 0.1k for k ∈ {0, 1, 2}

(245)
p90+k = 0.6 − 0.1k for k ∈ {0, 1, 2}
Calculate the probability that the last survivor will die in the third year.
MLC Q1 / Nov 2012
For two lives, (80) and (90), with independent future lifetimes, you are
given
p80+k = 0.9 − 0.1k for k ∈ {0, 1, 2}

(245)
p90+k = 0.6 − 0.1k for k ∈ {0, 1, 2}
Calculate the probability that the last survivor will die in the third year.
By definition,
00 01 02
t pxy = t pxy + t pxy + t pxy
(246)
= P[ at least one of (x) and (y ) is alive in t years]
is the probability we seek to compute.
MLC Q1 / Nov 2012
Using the assumption of independence of lives,
2 p80:90 − 3 p80:90 = P[ at least one of (80) and (90) is alive in 2 years]

− P[ at least one of (80) and (90) is alive in 3 years]
= P[ last survivor dies in the 3rd year]

= 2 p80 + 2 p90 − 2 p80:90 − 3 p80 + 3 p90 − 3 p80:90

= p80 p81 + p90 p91 − p80 p81 p90 p91

− p80 p81 p82 + p90 p91 p92 − p80 p81 p82 p90 p91 p92
= 0.24048.
(247)
Insurance Notation
00 , the Joint Life Annuity with continuous payment of 1 per
āxy = āxy
year while both husband and wife are alive.
Āxy the Joint Life Insurance with a unit payment immediately upon
first death.
1 , the Contingent Insurance, a unit payment immediately upon
Āxy
death of the husband given that he dies before his wife.
Insurance Notation
Āxy = Ā03
xy , the Last Survivor Insurance with unit payment
immediately upon second death.
02 the Reversionary Annuity with a continuous payment at
āx|y = āxy
unit rate per year while wife is alive given that husband has died..
00 + ā01 + ā02 , the Last Survivor Annuity, a continuous
āxy = āxy xy xy
payment at rate 1 per year while at least one person is alive.
It can be shown that
āxy = āx + āy − āxy

āx|y = āy − āxy
Āxy = Āx + Āy − Āxy (248)
1 − Āxy
āxy =
δ
HW
Prove this using explicit integral formulations.
Read over Examples 8.10 and 8.11.
MLC Q21 / Nov 2012
For a fully continuous whole life insurance issued on (x) and (y ), you are
given ∀t ≥ 0:
The death benefit of 100 is payable at the second death.
Premiums are payable until the first death.
The future lifetimes of (x) and (y) are dependent.
t pxy = λe −at + (1 − λ)e −bt for some λ ∈ [0, 1].
t px = e −at
t py = e −ct for some c < a < b.
The force of interest is constant at δ > 0.
Calculate the annual benefit premium rate P for this insurance
MLC Q21 / Nov 2012
The equation of value here, assuming the EPP, is
0 = 100Āxy − Pāxy
MLC Q21 / Nov 2012
The equation of value here, assuming the EPP, is
0 = 100Āxy − Pāxy
Āxy
⇒ P = 100
āxy
Āx + Āy − Āxy (249)
= 100
āxy
Āx + Āy − (1 − δāxy )
= 100
āxy
MLC Q21 / Nov 2012
However,
Z ∞
āxy = e −δt λe −at + (1 − λ)e −bt dt
0
λ 1−λ
= +
a +
Z ∞ δ b+δ
a
Āx = e −δt ae −at dt =
a + δ (250)
Z0 ∞
c
Āy = e −δt ce −ct dt =
0 c +δ

a c λ 1−λ
a+δ + c+δ − 1 + δ a+δ + b+δ
⇒ P = 100 λ 1−λ
a+δ + b+δ
Example: Joint Life Benefits
For a special whole life insurance policy on (x) and (y ) with dependent
future lifetimes, you are given:
A death benefit of 105, 000 is paid at the end of the year of death if
both (x) and (y ) die within the same year. No death benefits are
payable otherwise.
px+k = 0.85 for all k ∈ {0, 1, 2, ..}
py +k = 0.8 for all k ∈ {0, 1, 2, ..}
px+k:y +k = 0.75 for all k ∈ {0, 1, 2, ..}
The yearly interest rate used is r = 0.05.
Calculate the expected present value of the death benefit.
Example: Joint Life Benefits
First, notice that
1 px+k:y +k = px+k + py +k − px+k:y +k = 0.9

1 qx+k:y +k = 1 − 1 px+k:y +k = 0.1 (251)
k pxy = Πk−1
j=0 px+j:y +j = 0.75 . k
It follows that the

∞
X 1
EPV = 105000 k pxy 1 qx+k:y +k
(1 + r )k+1
k=0
∞
X 1
= 105000 (0.75k )(0.1) (252)
(1.05)k+1
k=0
10000
= = 35000.
1 − 57
Transitions at Specific Ages
Example 8.12 : The employees (0) of a large corporation can leave the
corporation in three ways: they can retire (1), they can withdraw from the
corporation (2), or they can die while they are still employees (3).
Consider the model
µ03 13 23
x ≡ µx ≡ µ x = µ x
(
µ02 , if x < 60 (253)
µ02
x =
0, if x ≥ 60
where retirement can only take place only on an employee’s
60th , 61st , 62nd , 63rd , 64th , or 65th birthday. Assume that 40% of
employees reaching exact age 60, 61, 62, 63 or 64 will retire at that age
and that 100% of all employees who reach age 65 retire immediately.
The corporation offers the following benefits to the employees:
For those employees who die while still employed, a lump sum of
200000 is payable immediately upon death.
For those employees who retire, a lump sum of 150000 is payable
immediately upon death after retirement.
Theorem
Assuming a constant force of interest of δ per year and the notation of Āx
and n Ex from single life computations based on a force of mortality µx , it
follows that the EPV of the Death after retirement benefit of an
employee currently aged 40 is
4
" # !
−20µ02
X
150000 · 20 E40 e 0.4 · 0.6k k| Ā60 + 0.65 · 5| Ā60 (254)
k=0
To begin our proof, we can compute
E(40) [PV(Benefit) | retire at age 60] = 150000e −20δ Ā60 (255)
Z 20
00 02 03

20− p40 = exp − µ + µ40+t dt
0
Z 20
02
= exp − (µ40+t ) dt e −20µ
0
−20µ02
= 20 p40 e (256)
00 −20µ02
P(40) [retire at age 60] = 0.4 · 20− p40 = 0.4 · 20 p40 e
00 00
20+ p40 = 0.6 · 20− p40
00 00
21− p40 = 20+ p40 · p60
02
00
21+ p40
00
= 0.6 · 21− p40 = 0.62 · 21 p40 e −20µ
Also,
P(40) [retire at age 61] = X1 X2 X3 X4

X1 = P(40) [survive in employment to age 60− ] = 20− p40
00
X2 = P(40) [will not retire at age 60] = 0.6

(257)
X3 = P(40) [(60+ ) will survive to age 61− ] = 1 p60
X4 = P(40) [will retire at age 61] = 0.4
E(40) [PV(Benefit) | retire at age 61] = 150000e −21δ Ā61
We can repeat this until
P(40) [retire at age 65]

00
= 20− p40 · 0.65 · 1 p60 · 1 p61 · 1 p62 · 1 p63 · 1 p64
02 (258)
= 25 p40 e −20µ · 0.65
E(40) [PV(Benefit) | retire at age 65] = 150000e −25δ Ā65
We now have enough information to complete the proof.
Proof.
For benefit after retirement, we have
5
X
E(40) [PV(Benefit)] = Bk(40) Pk(40)
k=0
Bk(40) = E(40) [PV(Benefit) | retire at age 60 + k]
= 150000e −(20+k)δ Ā60+k for k ∈ {0, · · · , 5} (259)
Pk(40) := P(40) [retire at age 60 + k]
02
= 20+k p40 e −20µ · 0.6k · 0.4 for k ∈ {0, · · · , 4}
02
P5(40) = 25 p40 e −20µ · 0.65
Substitution and arithmetic lead to the form in the theorem statement.
Also notice that via the Tower property for conditional expectations, we
have a direct version of the proof:

E(40) [PV(Benefit)] = E(40) E(60) [PV(Benefit)]
5
02
X (260)
= 20 E40 e −20µ · Bk(60) Pk(60)
k=0
where
Bk(60) = E(60) [PV(Benefit) | retire at age 60 + k]

= 150000e −kδ Ā60+k for k ∈ {0, · · · , 5}
Pk(60) := P(60) [retire at age 60 + k] (261)
= k p60 · 0.6k · 0.4 for k ∈ {0, · · · , 4}
P5(60) = 5 p60 · 0.65
Markov Chain Model of Employment
The US government has studied models of employment and has come up

with the following observation:
P[Unemployed finds job by end of the year] = pf ∈ (0, 1)
P[Employed loses job by end of the year] = pl ∈ (0, 1)
Define Wk to be the probability a worker is employed at the beginning of
year k, Nk the probability she is not working at the beginning of year k.
Then

Wk+1 1 − pl pf Wk
= (262)
Nk+1 pl 1 − pf Nk
Finally, assume that Wk + Nk = 1.
The US government has studied models of employment and has come up

with the following observation:
P[Unemployed finds job by end of the year] = pf ∈ (0, 1)
P[Employed loses job by end of the year] = pl ∈ (0, 1)
Define Wk to be the probability a worker is employed at the beginning of
year k, Nk the probability she is not working at the beginning of year k.
Then

Wk+1 1 − pl pf Wk
= (262)
Nk+1 pl 1 − pf Nk
Finally, assume that Wk + Nk = 1.

Question: Does Wk → W for some W ∈ (0, 1)?
It follows that the matrix can be diagonalized as
!
pf pl pl
1 − pl pf pl −1 1 0 pf +pl pf +pl
=
pl 1 − pf 1 1 0 1 − pf − pl − pf p+p
l
l
pf
pf +pl
(263)
It follows that the matrix can be diagonalized as
!
pf pl pl
1 − pl pf pl −1 1 0 pf +pl pf +pl
=
pl 1 − pf 1 1 0 1 − pf − pl − pf p+p
l
l
pf
pf +pl
(263)
Define
!
pl pl
pf +pl pf +pl Wk
~qk = (264)
− pf p+p
l
l
pf
pf +pl Nk
Hence,

1 0 A
~qk+1 = ~qk ⇒ ~qk = (265)
0 1 − pf − pl B(1 − pf − pl )k
Hence,

1 0 A
~qk+1 = ~qk ⇒ ~qk = (265)
0 1 − pf − pl B(1 − pf − pl )k
Returning to our original notation,
pf
Wk p −1 1 0
= l ~qk
Nk 1 1 0 1 − pf − pl
pf
p −1 1 0 A
= l
1 1 0 1 − pf − pl B(1 − pf − pl )k
pf (266)
−1 A
= pl
1 1 B(1 − pf − pl )k+1
pf
A pl − B(1 − pf − pl )k+1

=
A + B(1 − pf − pl )k+1
Solving for our parameters A, B, we see that

pf
W0 A pl − B(1 − pf − pl )
=
N0 A + B(1 − pf − pl )
 1 
pf
A 1+ pl
⇒ =  pf N0 −W 
B pl 0
1−pf −pl
Solving for our parameters A, B, we see that

pf
W0 A pl − B(1 − pf − pl )
=
N0 A + B(1 − pf − pl )
 1 
pf
A 1+ pl
⇒ =  pf N0 −W 
B pl 0
(267)
1−p −p
 pf f l
pl
!
pf
Wk pf
∴ →  1+ pl  = pl +p f
 
pl
Nk 1
p pl +pf
1+ pf
l
Homework Questions
HW: 8.1, 8.2, 8.4, 8.5, 8.8, 8.10, 8.11, 8.15, 8.16, 8.21, 8.22
Plan Type
We consider two types of retirement plans.

A Defined Contribution plan specifies how much an employer will
contribute, as a percentage of salary, into a plan.
A Defined Benefit plan specifies a level of benefit, most likely
related to the employee’s salary near retirement. Here, contributions
may need to be updated based on the investment returns to ensure
that the benefit is met.
Replacement Ratio
Also, defining the Replacement Ratio
pension income in the year after retirement

R := (268)
salary in the year before retirement
the benefit under DB plans and target under DC plans may aim for
R ∈ (0.5, 0.7). (269)

This of course assumes the member survives the year following retirement.
Salary Scale Function
We can also use a deterministic model to define the salary scale {sy }y ≥x0
beginning at some suitiable initial age x0 where the value of sx0 can be set
arbitrarily.
Salary Scale Function
We can also use a deterministic model to define the salary scale {sy }y ≥x0
beginning at some suitiable initial age x0 where the value of sx0 can be set
arbitrarily.
The ratio usually given is
sy salary received in year y to y + 1

= (270)
sx salary received in year x to x + 1
and, assuming that salaries are increased continuously, the salary rate at
age x is defined to be sx− 1 .
2
Example 9.1
The final average salary for the pension benefit provided by a pension plan
is defined as the average salary in the three years before retirement.
Members’ salaries are increased each year, six months before the valuation
date
A member aged exactly 35 at the valuation date received 75000 in
salary in the year to the valuation date. Calculate his predicted final
average salary assuming retirement at age 65.
A member aged exactly 55 at the valuation date was paid salary at a
rate of 100000 per year at that time. Calculate her predicted final
average salary assuming retirement at age 65.
Assume a salary scale where sx0 +y = 1.04y sx0 .
Example 9.1
For first case

1 s62 + s63 + s64
savg = 75000 ·
3 s34
(271)
75000
· 1.0428 + 1.0429 + 1.0430 = 234019

=
3
For second case
1 s62 + s63 + s64
savg = 100000 ·
3 s54.5
(272)
100000 7.5 8.5 9.5

= · 1.04 + 1.04 + 1.04 = 139639
3
Now read Example 9.2 for more practice and Example 9.3 for setting the
DC contribution.
Stochastic Pension Model
We can define a multiple decrement model for a pension plan via states


 0 if (x) is a member at age x + t
1 if (x) has withdrawn by time x + t



Y (t) = 2 if (x) has retired due to disability by age x + t
3 if (x) has retired due to age at x + t




4 if (x) has died in service by age x + t

0 >NNN
>> NN
>> NNN
>> NNN
> NNN
'
1 2 3 4
Figure: Pension Plan Flow Chart. In a DC plan, benefit on exit is the same.
However, in a DB plan different benefits may be payable on different forms of exit.
Example 9.4
A pension plan member is entitled to a lump sum benefit on death in

service of four times the salary paid in the year up to death. Assuming the
multiple decrement model with
µ01 w
x = µx
µ02 i
x = µx = 0.001
µ03 r
x = µx (273)
µ04
x = µdx = A + Bc x
= 0.00022 + (2.7 × 10−6 ) · 1.124x
Example 9.4
Assume



0.1, if x < 35

0.05, if 35 ≤ x < 45
µw
x =


0.02, if 45 ≤ x < 60

0, if x ≥ 60
(
0 if x < 60
µrx =
0.1, if 60 < x < 65
and
P [(x) retires at (60) | survives in employment to (60)] = 0.3

(274)
P [(x) retires at (65) | survives in employment to (65)] = 1
Example 9.4
Calculate, for a member aged 35, the probability of retiring at age 65.
Notice the similarities to Example 8.12.
Example 9.4
Calculate, for a member aged 35, the probability of retiring at age 65.
Notice the similarities to Example 8.12.
For t ∈ (0, 10), we have
Z t
00 w i r d
t p35 = exp − µ35+s + µ35+s + µ35+s + µ35+s ds
0
Z t
35+s

= exp − 0.05 + 0.001 + 0 + A + Bc ds (275)
0
2.7 × 10−6

35 t

= exp −0.05122t + 1.124 1.124 − 1
ln (1.124)
It follows that 00
10 p35 = 0.597342
Example 9.4
For t ∈ [10, 25), we compute
00
t p35
00
= P [ (35, 0) → (35 + t, 0) | (35, 0) → (45, 0) ]
10 p35
Z t−10
w i r d
= exp − µ45+s + µ45+s + µ45+s + µ45+s ds
0
Z t−10
45+s

= exp − 0.02 + 0.001 + 0 + A + Bc ds
0
2.7 × 10−6

1.12435 1.124t−10 − 1

= exp −0.02122(t − 10) +
ln (1.124)
00
00 25 p35
⇒ 25− p35 = · p 00 = 0.712105 · 0.597342 = 0.425370
00 10 35
10 p35
00 00
and 25+ p35 = 0.7 · 25− p35 = 0.297759
(276)
Example 9.4
For t ∈ (25, 30), we compute
00
t p35
= P (35, 0) → (35 + t, 0) | (35, 0) → (60+ , 0)

00
25+ p35
Z t−25
w i r d
= exp − µ60+s + µ60+s + µ60+s + µ60+s ds
0
2.7 × 10−6

1.12460 1.124t−25 − 1

= exp −0.10122(t − 25) +
ln (1.124)
(277)
It follows that the probability of retirement at exact age 65 is
00

00 t p35 00

30− p35 = 00 25+ p35 = 0.175879 (278)
25+ p35
Now calculate: P35 [withdrawal], P35 [retirement], P35 [disability retirement]
and P35 [death in service].
Service Table
We can represent the multiple decrement model for pensions in tabular

form. Begin by defining a minimum integer entry age x0 and
corresponding arbitrary radix (cohort) lx0 . With these, we can organize a
table with entries
wx0 +k = lx0 k px000 px010 +k

ix0 +k = lx0 k px000 px020 +k
rx0 +k = lx0 k px000 px030 +k (279)
dx0 +k = lx0 k px000 px040 +k
lx0 +k = lx0 k px000
and it follows that
lx = lx−1 − wx−1 − ix−1 − rx−1 − dx−1 (280)
Service Table
It follows that we can use the service table to answer questions like
P24
k=0 w35+k
P35 [withdraws] =
l35
P29
i35+k
P35 [retires in ill health] = k=0
l35
P30 (281)
r35+k
P35 [retires for age reasons] = k=0
l35
P29
d35+k
P35 [dies in service] = k=0
l35
For long-horizon investments with uncertain returns (forecasts may only be
valid for a small horizon), using tabular methods with UDD approximation
is common in pension valuation. See Example 9.5 for a comparison
with exact methods.
Valuation:Contributions
Employees in a pension plan pay contributions of 6% of their previous

month’s salary at each month end until age 60. Calculate the EPV at
entry of contributions for a new entrant aged 35, with a starting salary
rate of 100000 using the model µ01 02 03 04
x = λ, µx = γ, µx = 0 and µx = µ
for x ∈ (35, 60). Assume a constant force of interest δ and a salary scale
function sy = e y for y ∈ (35, 60).
Valuation
Per month, the contribution amount is a scaling of 0.06 100000

12 = 500. It
follows that
300
X k k
00 12 −δ 12
E [PV(Contributions)] = 500 k p35 e e
12
k=1
300
X k k k
= 500 e −(µ+γ+λ) 12 e 12 e −δ 12
k=1
(282)
1 − e 300x
= 500e x
1 − ex
−µ−γ−λ−δ
x=
12
Valuation:Benefits
For a DB plan, the basic annual pension benefit is equal to n · SFin · α,

where n is the total number of years of service, SFin is the average salary
in a specified period before retirement (ie. three years preceding exit) and
α is the accrual rate, usually between 0.01 and 0.02.
Valuation:Benefits; Example 9.6
Estimate the EPV of the accrued age retirement pension benefit for a
member aged 55 with 20 years of service, whose salary in the year prior to
the valuation date was 50000.
Assume that mid-year age retirements happen at exactly halfway into
the year.
Assume the final average salary is defined as the earnings in the three
years before retirement.
Assume α = 0.015.
Calculate this EPV by using elements of a corresponding service table.
Note that for this problem,
n · SFin · α = (20)(50000)(0.015) = 15000

sy −3 + sy −2 + sy −1 (283)
zy =
3
as well as
zy
E [Projected Final Salary | Retirement at age y ] = 50000 . (284)
s54

r60− z60 5 (12) r65− z65 10 (12)
∴ E [PV(Benefits)] = 15000 v ä60 + v ä65
l55 s54 l55 s54
r + z60.5 5.5 (12)
+ 15000 60 v ä60.5
l55 s54
4 (285)
X r60+k z60.5+k 5.5+k (12)
+ 15000 v ä60.5+k
l55 s54
k=1
sy −3 + sy −2 + sy −1
zy =
3
One can program this using numerical software, using linear interpolation
for mid-year quantities. Read Examples 9.8, 9.9 for a discussion on
withdrawal pension.
Plan Funding
Assuming..
All employer contributions to a fund are paid the start of the year.
There are no employee contributions.
Any benefits payable during the year are paid exactly half-way though
the year.
We define the normal contribution due at the start of the year t to t + 1
for a member aged x at time t as Ct .
Plan Funding
Assuming..
All employer contributions to a fund are paid the start of the year.
There are no employee contributions.
Any benefits payable during the year are paid exactly half-way though
the year.
We define the normal contribution due at the start of the year t to t + 1
for a member aged x at time t as Ct .
Using reserving principles studied earlier, we have the equation
tV + Ct = E [PV(Benefits for mid-year exits)] + v 1 px00 t+1 V (286)
Example 9.9
Assume a pension plan with the following valuation methods:

Accrual rate: 1.5%
Final salary plan
Pension based on earnings in the year before age retirement
Normal retirement at age 65
The pension benefit is a life annuity payable monthly in advance
There is no benefit due on death in service
No exits other than by death before normal retirement age
Example 9.9
Calculate the value of the accrued pension benefit and normal contribution
due at the start of the year using a projected unit funding (PUC), where
interest is set at 5% per year, salaries increase at 4% per year and assume
a constant mortality µ before and after retirement.
Example 9.9
Calculate the value of the accrued pension benefit and normal contribution
due at the start of the year using a projected unit funding (PUC), where
interest is set at 5% per year, salaries increase at 4% per year and assume
a constant mortality µ before and after retirement.
s64
SFin = 50000 = 50000(1.04)15 = 90047
s49
(12)
0V = 0.015 · 20 · SFin · 15 p50 · v 15 · ä65
∞
1 X k −µ k
= 12994.24 · e −15µ · v 15 · v 12 e 12 (287)
12
k=0
12994.24
= q
15µ 15 12 1
12e · 1.05 · 1 − 1.05e µ
Example 9.9
It follows that our equation for C is

(12)
= 0.015 · 21 · SFin · 14 p51 · v 14 · ä65
1V
21 0V
(288)
∴ C = v · p50 · 1 V − 0 V = 0 V − 0 V =
20 20
Consider the traditional unit credit funding approach, and see how this
affects our previous calculation. Also, read over Example 9.10 which allows
for benefits payable on exit during the year.
Homework Questions
HW: 9.1, 9.3, 9.5, 9.7, 9.9, 9.12, 9.13
Law of Total Variance
Recall that for two random variables X , Y in a probability space (Ω, F, P)

we have the Tower Property
h i
E E[X | Y ] = E[X ]
h i (289)
E E[Y | X ] = E[Y ]
and so it follows that

2
V [X ] = E X 2 − E[X ]
h i h i2
= E E X 2 | Y − E E[X | Y ]
h i h i2 (290)
= E V [X | Y ] + E[X | Y ]2 − E E[X | Y ]
h i h i
= E V [X | Y ] + V E[X | Y ]
Deviation as a Risk Measure
n on
Assuming a sequence of i.i.d. Random Variables Xk , one measure
k=1
of the risk associated to the average
n
1X
X̄n := Xk (291)
n
k=1
is the total variance

h i
ρn (X ) := V X̄n (292)
Correspondingly, we say that such a risk is Diversifiable if

limn→∞ ρn (X ) = 0, and not diversifiable otherwise.
n on
Note that if Xk are dependent but otherwise identically distrbuted
k=1
with correlation coefficient ρ, mean µ and variance σ 2 , then
nσ 2 + n(n − 1)ρσ 2
ρn (X ) = → ρσ 2 6= 0 (293)
n2
For a history of variance as a risk measure in Modern Portfolio Theory and
the corresponding use of diversfication, click here and references within.
n on
Recall that for any random variable Y and i.i.d. sequence Xk with
k=1
identical copy X
n
h1 X i n
h h1 X ii n
h h1 X ii
V Xk = E V Xk | Y + V E Xk | Y
n n n
k=1 k=1 k=1
n on
k=1
identical copy X
n
h1 X i h h1 Xn ii h h1 Xn ii
n n n
k=1 k=1 k=1 (294)
1 h h ii h h ii
= E V X |Y +V E X |Y
n
n on
k=1
identical copy X
n
h1 X i h h1 Xn ii h h1 Xn ii
n n n
k=1 k=1 k=1 (294)
1 h h ii h h ii
= E V X |Y +V E X |Y
n
h h ii
It follows that ρn (X ) → 0 as long as V E X | Y = 0.
Connection with CLT
Note that by the Central Limit Theorem,

h k i k √n
lim P X̄n − µ ≥ √ = lim Φ − =0 (295)
n→∞ σ n→∞ σ
This says that for uncorrelated r.v.’s, since the variance of the aggregate
mean is linear in n, we have the deviation of the aggregate mean from the
individual mean asymptotically disappears.
Note that if our sequence is correlated, then there is the adjust CLT that
states the above, except the limit is now
√
n · X̄n − µ
rh
P∞ i → Z ∼ N(0, 1) (296)
2
σ + i=2 Cov [X1 , Xi ]
Example of Diversifiable Risk
n on
Consider the case where we have an i.i.d. sequence Xk
k=1
Xk ∈ {0, 1}
(297)
P[Xk = 1] = t px · (1 − s px+t ).
It follows that
n
1X
X̄n = Xk (298)
n
k=1
models the sample probability of deaths of a population of n alive at age x

where death occurs between age x + t and age x + t + s. This is of course
a binomial random variable with p = t px · (1 − s px+t ).
Example of Diversifiable Risk
We can see that for a copy X of the sequence,

hP i
n
h i V k=1 Xk
V X̄n =
n2
nV [X ]
= (299)
n2
1 h i h i
= · t px · (1 − s px+t ) · 1 − t px · (1 − s px+t )
n
→0
and so the risk is diversifiable.
Example of Non-Diversifiable Risk
Consider now the case where the Xk model the loss associated with a
member of an insured population. If each member has loss function Xk
and theh premiums
i are charged in keeping with the EPP, then we expect
that E Xk = 0 for all k ∈ {1, . . . , n} .
Example of Non-Diversifiable Risk
Consider now the case where the Xk model the loss associated with a
member of an insured population. If each member has loss function Xk
and theh premiums
i are charged in keeping with the EPP, then we expect
that E Xk = 0 for all k ∈ {1, . . . , n} .
If, however, the forecasted yield rate used is a random variable Y , then if
E[Xk | Y ] 6= 0 we have non-diversifiable risk as
h i h h ii
V X̄n → V E X | Y 6= 0. (300)
Q : 294 : SOA MLC Study Guide
An insurer issues a number of identical special 1-year term life insurance

policies.
Each policy has a death benefit of 1000 payable at the end of the year of
death, on condition that:
The policyholder dies during the year; and
A stock index ends the year below its value at the start of the year.
Both conditions must be satisfied for the death benefit to be paid.
Furthermore, you are given:
Future lifetimes of the policyholders are independent

qx = 0.05 for all x.
The probability that the stock index ends the year below its value at
the start of the year is 0.1 for all years.
Future lifetimes of the policyholders and the value of the stock index
are independent.
The annual effective rate of interest rate is 3%.
XN denotes the total present value of benefits for N policies.
Calculate
p
V [XN ]
lim (301)
N→∞ N
Define F = {Fund drops below current level in the next year} . Then
P[F ] = 0.1
1000
E[XN | F ] = N × qx = 48.54N
1+i
(302)
E[XN | F c ] = 0
∴ E[XN ] = E[XN | F ] × P[F ] + E[XN | F c ] × P[F c ]
= 4.854N
Also,
1000 2
V [XN | F ] = N × qx (1 − qx ) = 44773.31N
1+i
V [XN | F c ] = 0
h i
E V [XN | 1{F } ] = V [XN | F ] × P[F ] + V [XN | F c ] × P[F c ]
= 4477.331N
h i 2 2
V E[XN | 1{F } ] = E[XN | F ] × P[F ] + E[XN | F c ] × P[F c ]
h i2
− E XN
2
= 48.54N × 0.1 − (4.854N)2 = 212.05N 2
√
√
p
V [XN ] 212.05N 2 + 4477.331N
⇒ lim = lim = 212.05 = 14.56
N→∞ N N→∞ N
(303)
Homework Questions
HW: 10.1, 10.2, 10.3, 10.5, 10.6
Reserves
Recall the need for policy values when negative future cash flows were
expected. In this lecture, we cover the idea of reserves, which is the actual
amount of money held by the insurer to cover future liabilities associated
with contracts.
Reserves
The insurer may decide to set aside assets in reserve as equal to the net
premium policy values on a certain (reserve) basis.
Reserves
For example, consider an n−year term insurance contract issued to a life x
with sum insured S. Since we use the net premium basis to compute fixed
premiums, it follows that
1
Ax:n
P=S
äx:n
Reserves
1
Ax:n
P=S
äx:n
1
⇒ Rt = t V = SAx+t:n−t − Päx+t:n−t (304)
1
Ax+t:n−t

1 äx+t:n−t
= SAx:n · 1
−
Ax:n äx:n
Reserves
1
Ax:n
P=S
äx:n
1
⇒ Rt = t V = SAx+t:n−t − Päx+t:n−t (304)
1
Ax+t:n−t

1 äx+t:n−t
= SAx:n · 1
−
Ax:n äx:n
The cost of setting up, from t − 1 to t, the reserve amount of t V is at
time t equal to t V · px+t−1 when valued at time t−
i.e. the proportion of contracts that survive to the end of the year.
Notation
At time t, just before and just after, we have quantities that are assets
and costs.
At time (t − 1)+ , we have the cost Et associated from t − 1 to t.

Between (t − 1)+ and t− , we have the payout S settled at time t−
with expected value S · qx+t−1 .
At time (t − 1)+ , we have the asset t−1 V which grows at the interest
rate i to value (1 + i) · t−1 V at time t−
At time (t)− , we have the cost t V · px+t−1 .
Profits
Correspondingly, we can set up an equation for the profit at time t,

denoted by Prt :

Prt = t−1 V + P − Et (1 + i) − Sqx+t−1 − t Vpx+t−1 (305)
The Profit Vector

~ := Pr0 , . . . , Prn
Pr (306)
is comprised of elements that represent the expected profit at the end of

the year given that the policy is in effect at the start of the year.
Profits
~ comprised of elements
The Profit Signature is the the vector Π
Πt := t−1 px Prt (307)

that represent the expected profit at the end of the year given that the
policy was in effect at age x.
Profit Measures
Recall that for any set of cash flows Ct , the internal rate of return IRR (if
it uniquely exists) is the interest rate j such that
n
X Ct
= 0. (308)
(1 + j)t
t=0
In accordance with the IRR, the insurer may set a minimum hurdle or risk
discount rate r such that the contract is satisfiably profitable if IRR > r .
EPV of Future Profit
If the IRR does not exist, the insurer may seek to measure the profitability
via the Net Present Value computed using the risk discount rate:
n
X Πt
NPV := (309)
(1 + r )t
t=0
Profit Margin and DPP
Another measure is the ratio of NPV to E[PV (Premiums)]:
NPV
Profit Margin := (310)
E[PV (Premiums)]
as is the discounted payback period DPP:
m
( )
X Πt
DPP := min m : ≥0 (311)
(1 + r )t
t=0
which represents the time until the insurer starts to make a profit.
A question naturally arises of how to jointly measure interest risk and
profit. One may even compute the marginal changes in the profit measures
with respect to change in risk discount factor r .
Example 11.1
A special 10-year endowment insurance is issued to a healthy life aged 55.

The benefits under the policy are
50000 if at the end of a month the life is disabled, having been
healthy at the start of the month,
100000 if at the end of a month the life is dead, having been healthy
at the start of the month,
50000 if at the end of a month the life is dead, having been disabled
at the start of the month,
50000 if the life survives as healthy to the end of the term.
On withdrawal at any time, a surrender value equal to 80% of the net
premium policy value is paid, and level monthly premiums are payable
throughout the term while the life is healthy.
Example 11.1
Other elements of the profit testing basis are as follows:

Interest: 7% per year.
Expenses: 5% of each gross premium, including the first, together
with an additional initial expense of 1000.
The benefit on withdrawal is payable at the end of the month of
withdrawal and is equal to 80% of the sum of the reserve held at the
start of the month and the premium paid at the start of the month.
Reserves are set equal to the net premium policy values.
The gross premium and net premium policy values are
calculated using the same survival model as for profit testing
except that withdrawals are ignored, so that µ03
x = 0 for all x.
The net premium policy values are calculated using an interest
rate of 5% per year.
Example 11.1
The monthly gross premium is calculated using the equivalence principle
on the following basis:
Interest: 5.25% per year.
Expenses: 5% of each premium, including the first, together with an
additional initial expense of 1000.
(a) Calculate the monthly premium on the net premium policy value
basis.
(b) Calculate the reserves at the start of each month for both healthy
lives and for disabled lives.
(c) Calculate the monthly gross premium.
(d) Project the emerging surplus using the profit testing basis.
(e) Calculate the internal rate of return.
(f) Calculate the NPV, the profit margin (using the EPV of gross
premiums), the NPV as a percentage of the acquisition costs, and the
discounted payback period for the contract, in all cases using a risk
discount rate of 15
Example 11.1
The model for state transition in this model follows the flow chart below:
0 (Healthy) / 1 (Disabled)
PPP
PPP
PPP
PP'
3 (Withdrawn) 2 (Dead)
Figure: Multiple State Model
Example 11.1
The associated rate matrix for Profit Testing is

 
−0.035 0.01 0.015 0.01
 0 −0.03 0.03 0 
Q̃(t) = 
 0
 (312)
0 0 0 
0 0 0 0
and the associated rate matrix for gross premium and net premium
policy values is
 
−0.025 0.01 0.015
Q(t) =  0 −0.03 0.03  (313)
0 0 0
Example 11.1 - Diagonalization of Q̃
 
−1 0.894427 0.245036 0.438025
 0 0.447214 −0.0439573 0.634545 
U= 
0 0 −0.0439573 0.634545 
0 0 0.967519 −0.0532764
 
−0.035 0 0 0
 0 −0.03 0 0
D=  0
 (314)
0 0 0
0 0 0 0
 
−1 2 −1.28571 0.285714
 0 2.23607 −2.23607 0
U −1 = 


0 0 0.0871109 1.03753 
0 0 1.58197 0.0718735
Example 11.1 - Diagonalization of Q̃
It follows that if we do allow for withdrawal, our transition probability
matrix P(t) = exp (tQ) has the solution
 −0.035t 01 02 03

e t p̃55 t p̃55 t p̃55
 0 e −0.03t 1 − e −0.03t 0 
P̃(t) =  0
 (315)
0 1 0 
0 0 0 1
where
01
t p̃55 = 2e −0.03t − 2e −0.035t
02
t p̃55 = 0.71428571 + 1.285714287e −0.035t − 2e −0.03t
5 9
= + e −0.035t − 2e −0.03t (316)
7 7
03
t p̃55 = 0.285714287 − 0.285714287e −0.035t
2 2
= − e −0.035t
7 7
Example 11.1 - No Withdrawal
If we do not allow for withdrawal, however, our transition probability

matrix P(t) = exp (tQ) has the simpler solution
e −0.025t 2e −0.025t − 2e −0.03t 1 + 2e −0.03t − 3e −0.025t

 
P(t) =  0 e −0.03t 1 − e −0.03t .

0 0 1
(317)
Example 11.1 - Monthly Net Premium
For the equation of value, we determine for the monthly net premium P 0
119
00 t
X
0
E[Premium Income] = P t p55 v 12
k=0
E[Benefit] = 50000v 10 10 p55
00
119
X t+1
00 01 01 12
+ 50000 t p
55 1 p55+ t + t p55 1 p
55+ t v 12
12 12 12 12 12 12
k=0
119
X t+1
00 02
+ 100000 t p55 1 p
55+ t v
12
12 12 12
k=0
(318)
Using our solution for transition probabilities that don’t allow for
1
withdrawals, a discount rate of v = 1.05 and solving the resulting
geometric series for the EPV’s above, we return P 0 = 452.
Example 11.1 - Net Policy Values
Recall that t V (i) = E[ Loss | Y (t) = i]

Given the parameters of our contract, we have the boundary values
(0)
10 V =0
(1)
(319)
10 V =0
and the recursive equations
1 1
tV
(0)
= −P 0 + 1
00
p55+t v 12 t+ 1 V (0) + 1
01
p55+t v 12 (50000 + t+ 1 V (1) )
12 12 12 12
1
02
+ 100000v 12 1 p55+t
12
1
(1) 11 (1) 12
tV = 1 p55+t v12 1 V
t+ 12 + 50000 1 p55+t
12 12
(320)
A matrix (array) recursion method can be encoded via spreadsheet or
other numerical software to iterate backwards from t = 10.
Example 11.1 - Monthly Gross Premium
For the equation of value, we determine for the monthly gross premium P
119
00 t
X
E[Premium Income] = 0.95P t p55 v 12
k=0
E[Benefit] = 50000v 10 10 p55
00
119
X t+1
00 01 01 12
+ 50000 t p55 1 p
55+ t +
t p55 1 p
55+ t v 12
12 12 12 12 12 12
k=0
119
X t+1
00 02
+ 100000 t p55 1 p
55+ t v
12
12 12 12
k=0
+ 1000.
(321)
Using our solution for transition probabilities that don’t allow for
1
withdrawals, a new discount rate of v = 1.0525 , and solving the resulting
geometric series for the EPV’s above, we return P = 484.27.
Homework Questions
Finish Example 11.1

HW: 11.1, 11.3, 11.6, 11.7
Equity Linked Insurance
Modern insurance contracts can include some form of guarantee. These

are known in America as Variable Annuities and Segregated Funds in
Canada. The accumulating premiums the policyholder pays is invested on
the policyholder’s behalf. These premiums form the policyholder’s fund,
from which regular management charges are deducted by the insurer and
paid into the insurer’s fund to cover expenses and insurance charges.
On survival to the end of the contract term the benefit may be just the
policyholder’s fund and no more, or there may be a guaranteed minimum
maturity benefit (GMMB). There may also be a guaranteed minimum
death benefit (GMDB).
On survival to the end of the contract term the benefit may be just the
policyholder’s fund and no more, or there may be a guaranteed minimum
maturity benefit (GMMB). There may also be a guaranteed minimum
death benefit (GMDB).
There are very real consequences to the differences between financial
pricing and actuarial reserving. A short but excellent analysis can be found
in the paper by Bangwon Ko and Elias S. W. Shiu on Financial Pricing
and Actuarial Reserving.
Also consider A Heavy Traffic Approach to Modeling Large Life
Insurance Portfolios (Stochastic modeling of actuarial reserve, with Ito
integration of a time-changed Brownian Bridge.)
We follow the example set by Shiu and Ko now.
Stochastic Actuarial Reserving

Fix a probability space Ω, F, P and a standard Brownian motion W
that lives on this space.
Consider now a term contact with term T and let α denote the
management charges factor along with β representing the policyholder’s
participation factor.
Furthermore, assume mean and standard deviation parameters (µ, σ)
respectively and the corresponding Geometric Brownian Mutual Fund Asset
St = S0 e µt+σWt . (322)
Using this as the model of the asset returns upon which premiums are
invested, the policyholder wishes to purchase a contract that pays a
maturity benefit credited at a rate of return which is the greater of
the customer’s risk discount rate r , where r < µ or
the participation rate of the stock index returns of S.
Symbolically, for a current premium P invested in the , the contract

payout value at maturity is
S
rT T
V (T ) = (1 − α)P max e , 1 + β −1 . (323)
S0
Assume that the policyholder is able to fully participate in the returns from
the fund (i.e. β = 1.)
Then
S
ST rT T
V (T ) = (1 − α)P + (1 − α)P max e − ,0
S0 S0 (324)
:= V1 (T ) + V2 (T ).
Here, V1 (T ) is the net premium, or payoff, for investing in the index fund
and V2 (T ) is the guaranteed option payoff if the index fund
under-performs relative to the risk discount rate r .
How does one reserve to meet the obligations of V2 (T ).
One can see that the probability of a payout, that V2 (T ) 6= 0 is for large T
r − µ√
P[V2 (T ) 6= 0] = P[rT > µT + σWT ] = Φ T ≈ 0. (325)
σ
r − µ√
P[V2 (T ) 6= 0] = P[rT > µT + σWT ] = Φ T ≈ 0. (325)
σ
Since it is a low probability event that we have to prepare for a payout

V2 (T ) and since we can directly replicate the payoff V1 (T ) by initially
purchasing (1−α)P
S0 units of the index fund, an actuary may be tempted to
not reserve for the uncertain portion of the guarantee, V2 (T ), if the
contract has a relatively long term T .
r − µ√
P[V2 (T ) 6= 0] = P[rT > µT + σWT ] = Φ T ≈ 0. (325)
σ
Since it is a low probability event that we have to prepare for a payout

V2 (T ) and since we can directly replicate the payoff V1 (T ) by initially
purchasing (1−α)P
S0 units of the index fund, an actuary may be tempted to
not reserve for the uncertain portion of the guarantee, V2 (T ), if the
contract has a relatively long term T .
Is this a wise decision?
Stochastic Reserving for non-diversifiable risk
Given a random loss L, we define the quantile reserve, also known as the
Value at Risk with parameter α, as the amount which with probability α
will not be exceeded by the loss.
Symbolically, if L has a continuous distribution function FL , then the
α−quantile reserve is Qα where
P[L ≤ Qα ] = α. (326)
Stochastic Reserving for non-diversifiable risk
One feature that is missing in VaR is the description of what the loss could
be if it does exceed the quantile Qα . In this case, the Conditional Tail
Expectation (CTEα ) is defined as
CTEα = E[L | L ≥ Qα ]. (327)

A risk manager should not rely on static measures of risk involved with a
portfolio of liabilities. Rather, the CTE or VaR reserve should be regularly
updated to incorporate market information as it arrives. This allows
reserves which are held in less-risky (and possibly more liquid) funds to be
invested higher return and higher risk assets if current market information
dictates that CTE reserves can be reduced.
Homework Questions
Read Example 12.1 and Table 12.8

HW: 12.1 − 12.5

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STT 455-6: Actuarial Models

Actuarial Sciences Program

An insurance policy is a contract where the policyholder pays a

Fx (t) = P[Tx ≤ t] (1)

We have an important conditional relationship

P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]

We have an important conditional relationship

P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]

We have an important conditional relationship

P[Tx ≤ t] = P[T0 ≤ x + t | T0 > x]

Sx (t + u) = Sx (t)Sx+t (u) (4)

P[(0) survives beyond age 30] = S0 (30) = 1 − F0 (30)

Recall from basic probability that the density of Fx (t) is defined as

Recall from basic probability that the density of Fx (t) is defined as

P[x < T0 ≤ x + dx | T0 > x]

In general, we can show

One model of human mortality, postulated by Gompertz, is µx = Bc x ,

Of course, when A = 0, this reduces back to Gompertz’ Law.

Of course, when A = 0, this reduces back to Gompertz’ Law.

Some online resources:

Actuaries make the notational conventions

t px = P[Tx > t] = Sx (t)

(e̊30 ,e̊80 ) = (77.143, 34.286)

t px = P [Kevin still there]

Table: 2.1: Gompertz Model Statistics: (B, c) = (0.0003, 1.07)

x e̊x SD[Tx ] x + e̊x

As with all numerical schemes, this approximation can be refined when

Table: 2.2: Gompertz Model Statistics: (B, c) = (0.0003, 1.07)

An extension of Gompertz - Makeham Laws is the GM(r , s) formula

HW: 2.1, 2.2, 2.5, 2.6, 2.10, 2.13, 2.14, 2.15

lx0 +t = lx0 · t px0 (28)

lx+t = lx0 · x+t−x0 px0

lx+t = lx0 · x+t−x0 px0

So, if there are lx independent individuals aged x with probability t px of

E[Lt | L0 = lx ] = lx+t = lx · t px (30)

So, if there are lx independent individuals aged x with probability t px of

E[Lt | L0 = lx ] = lx+t = lx · t px (30)

Table: 3.1: Extract from a life table

and so Rx ∼ U(0, 1).

To show independence of Rx and Kx ,

HW: 3.1, 3.2, 3.4, 3.7, 3.8, 3.9, 3.10

We have spent the previous two lectures on modeling human mortality.

Consider a probability space (Ω, F, P) and an event A ∈ F.

K (ω) = 1 for all ω ∈ Ω (a.s.)

The equivalent interest rate i := e δ − 1 per year

Consider now the random variable

It follows that we need ∀r ∈ 0, m1 , m2 , ..., m−1 m+1

to compute statistics for our random variable

One of the computational tools we share directly with quantitative finance

One of the computational tools we share directly with quantitative finance

At age ω − 2, we have P[Kω−2 = 0] = qω−2 and so

Ax = vqx + vpx Ax+1

Recall that for Makeham’s law we have, respectively

For any positive integer m, it follows that for Makeham’s law:

For any positive integer m, it follows that for Power law:

Z = e −δTx 1{Tx ≤n} (53)

Pure endowment benefits depend on the survival policyholder (x) until at

Z = e −δn 1{Tx ≥n}

Endowment insurance is a combination of term insurance and pure

Endowment insurance is a combination of term insurance and pure

Endowment insurance is a combination of term insurance and pure

Suppose policyholder on a life (x) receives benefit 1 if u ≤ Tx < u + n.

Z = e −δTx 1{u≤Tx <u+n}