ACST359 / ACST819 Actuarial Modelling

Lecture Notes 1 – Review

In this lecture notes we review some basic concepts including the lifetime distribution
function, survival function, force of mortality, Gompertz’ and Makeham’s laws,
heterogeneity, underwriting, selection, and binomial and Poisson models.

1.1 Introduction

In life insurance, actuaries are dealing with the future lifetime of prospective and
current policyholders in calculating premiums and reserves. This future lifetime is an
unknown and so a model is needed to describe its behaviour.

Denote (x) as a life aged exactly x. Let T x be the future lifetime of (x). This T x is a
random variable which has a probability distribution. Generally, we use one year as
the time unit.

1.2 Lifetime Distribution Function

We define the distribution function of T x as (for t > 0):

Fx (t ) = Pr(Tx  t )
which is the probability that (x) dies within the next t years.

An actuarial notation for this is t qx = Fx (t ) . When t = 1, it is simply stated as q x ,

which is referred to as the mortality rate at age x.

1.3 Survival Function

We define the survival function of T x as (for t > 0):

S x (t ) = Pr(Tx  t ) = 1 − Fx (t )
which is the probability that (x) survives for the next t years.

An actuarial notation for this is t px = S x (t ) . When t = 1, it is simply stated as p x . It is

obvious that t px +t qx = 1 .

1.4 Survival Probabilities

The definition of the survival function can be expressed as:

S x (t ) = Pr(Tx  t ) = Pr(T0  x + t | T0  x )
Pr((T0  x + t )  (T0  x )) Pr(T0  x + t ) S 0 (x + t ) p
= = = (i.e. t p x = x +t 0 )
Pr(T0  x ) Pr(T0  x ) S0 (x ) x p0

which can be rearranged as S0 (x + t ) = S0 (x )S x (t ) (i.e. x+t p0 = x p0 t px ).

In words, the probability that (0) survives for x + t years is equal to the probability
that (0) survives for x years multiplied by the probability that (x) survives for t years.

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We can also see that (for s , t > 0):
x + s + t p0 p p
s +t p x = = x + s 0 x + s +t 0 = s p x t p x + s
x p0 x p0 x + s p0

In words, the probability that (x) survives for s + t years is equal to the probability that
(x) survives for s years multiplied by the probability that (x + s) survives for t years.
Similarly, we can see that s +t p x = t p x s p x +t .

1.5 Force of Mortality

We define the force of mortality at age x as:

 x = lim+ Pr(T0  x + dx | T0  x )
1
dx →0 dx

For small dx, we can ignore the limit and rearrange the above as:
 x dx  Pr(T0  x + dx | T0  x) = Pr(Tx  dx)

In words, the probability that (x) dies within a short time dx is approximately equal to
 x multiplied by dx. In effect,  x represents an instantaneous measure of mortality at
age x.

1.6 Relationship between  x and t px

We deduce the density function of T x as (for t > 0):

f x (t ) = Fx (t ) = t q x = − t p x
d d d
dt dt dt

We can also see that:

f x (t ) = Fx (t ) = lim+ (Fx (t + dx ) − Fx (t )) = lim+ (Pr(Tx  t + dx ) − Pr(Tx  t ))
d 1 1
dt dx → 0 dx dx → 0 dx
= lim+ (Pr(T0  x + t + dx | T0  x ) − Pr(T0  x + t | T0  x ))
1
dx →0 dx

1 Pr(x  T0  x + t + dx ) − Pr(x  T0  x + t )
= lim+
dx →0 dx Pr(T0  x )
1 Pr(T0  x + t + dx ) − Pr(T0  x ) − Pr(T0  x + t ) + Pr(T0  x )
= lim+
dx →0 dx Pr(T0  x )
1 Pr(T0  x + t + dx ) − Pr(T0  x + t )
= lim+
dx →0 dx Pr(T0  x )
Pr(T0  x + t ) 1 Pr(x + t  T0  x + t + dx )
= lim+
Pr(T0  x ) dx → 0 dx Pr(T0  x + t )
S (x + t )
lim+ Pr(T0  x + t + dx | T0  x + t )
1
= 0
S 0 (x ) dx→0 dx
= S x (t ) x+t =t p x  x+t

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We then come up with the following important relationship:
d
t p x =− t p x  x + t
dt

We further develop this relationship as:

1 d
s px = − x+ s
s p x ds

ln ( s p x ) = −  x + s
d
ds
( )
t d t
0 ds ln s p x ds = − 0  x+ s ds
ln ( t p x ) = −   x + s ds
t

t (
p x = exp −  0 μ x + s ds
t
)
1.7 Relationship between  x and t qx

Stating the distribution function of T x in terms of the density function, we can see that:
q x = Fx (t ) =  f x (s ) ds = 
t t
t s p x  x + s ds
0 0

In words, the probability that (x) dies within the next t years is equal to the sum of the
probability that (x) survives for s years multiplied by the probability that (x + s) dies
within a short time ds. Since it is impossible to die more than one time, we can add up
these mutually exclusive probabilities.

1.8 Gompertz’ Law

Under Gompertz’ Law, it is assumed that:

 x = Bc x

This is a simple mathematical function for modelling the force of mortality across
different ages. It fits the middle and older ages fairly well.

We derive the survival probabilities as:

= − (
  t
= −)  ( =
t

 x+s
− )
x c  
s t

=  −
( ) 
 Bc x c t − 1
p exp ds exp Bc ds exp

Bc   exp 
ln c  0 
t x x+s
0 0
    ln c 
which can be simplified with ln g = − B ln c as:
t p x = exp (ln g c (c − 1)) = g
x t c x (c t −1)

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1.9 Makeham’s Law

Under Makeham’s Law, it is assumed that:

 x = A + Bc x
where the term A is often used to allow for accidental deaths that do not depend on
age.

We derive the survival probabilities as:

p = exp (
− 
t
 ds)= exp −  ( (
t
A + Bc ) )
x+ s
ds = exp

 − A t −
( ) 
Bc x c t − 1
t x 0 x+ s 0  
 ln c 
which can be simplified with ln g = − B ln c and s = exp(− A) as:
p = s t g c (c −1)
x t

t x

Gompertz’ Law is a special case of Makeham’s Law with A = 0.

1.10 Heterogeneity

Imagine we are a life insurance company. If we estimate the mortality rate from a
heterogeneous population, we get an ‘average’ rate. If we use this average rate to
calculate the premiums, the healthier lives are overcharged while those with poor
health are undercharged. If there is another company who prices correctly, the
healthier lives will leave us and go to that company, while those with poor health will
come to us. We will then lose money! It is thus important to take appropriate
covariates or rating factors into account, provided the amount of information we have.

Life insurance contracts are called policies and the customers are called policyholders.
These contracts are based on the principle of utmost good faith, in which both parties
to a contract must be honest in disclosing information about themselves that may
affect the other party’s decision to enter into the contract.

To buy a policy, a prospective policyholder must fill in a proposal that states all the
relevant information. The life insurance company then assesses the risk under the
proposal and this process is called underwriting. If the insurer accepts the proposal,
the policyholder has to pay premiums to the insurer to start and continue the cover.

1.11 Selection

Selection generally refers to dividing lives into separate groups so that each group has
more homogeneous mortality experience (e.g. age, gender, education, occupation,
marital status, genetics). This practice is to make sure benefits are properly priced for
each group and not undercharged or overcharged. Selection can also refer to certain
actions of the customers against the insurer. The following are different types of
selection, which are not mutually exclusive.

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Initial Selection

Initial selection means that policyholders have relatively good health at the policy
start (due to underwriting) and this effect wears off over time. So a policyholder first
entering into a contract is treated as being subject to lower mortality rates (select rates)
but later to normal mortality rates (ultimate rates) after the selection effect wears off.

Reverse Selection

Reverse selection is similar to initial selection but in an opposite direction. It means

that the lives have relatively poor health at the start, e.g. ill-health pensioners under a
pension scheme may recover later.

Adverse Selection

Adverse selection occurs when prospective policyholders select against the insurer.
One example is when an individual has had a genetic test but is not obliged to disclose
this information to the insurer, and so the individual may be undercharged for a life
cover.

Class Selection

Class selection refers to dividing lives into groups based on such characteristics as age,
gender, smoker, occupation, and medical history. This practice is to ensure the
policies are priced appropriately.

Time Selection

Mortality levels do change over time. Generally, mortality rates decrease with time as
technology improves. Changes in mortality experience can also be induced by
changes in living conditions, nutrition, hygiene, health care, working conditions, and
underwriting rules. Time selection can be tackled by choosing an appropriate
mortality investigation period and making necessary adjustments to the estimated
figures.

Spurious Selection

Spurious selection occurs when it is deemed that there is a certain form of selection in
place but in fact there is not. The observed effect has actually been caused by other
factors such as heterogeneity. One example is that a population has its observed
mortality levels changing over time and it seems like time selection, but actually there
is a change in the proportions of smokers and non-smokers while the underlying
mortality levels of smokers and non-smokers do not change at all.

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1.12 Binomial Model

Assume that we are dealing with a homogeneous population of size N and the lives
are independent.

Assume that the ith life is observed between ages x + ai and x + bi for 0  ai  bi  1 .
The observations on different lives can be made at different points of time during the
mortality investigation.

Let Di be a random variable which is zero if the ith life survives its observation period
and is one if the life dies within the period. Let d i be the observed value of Di . The
probability that the life dies within the period is bi − ai q x + ai . Then we can see that:
Di ~ Ber ( bi − ai )
q x + ai with Pr (Di = 0 ) = 1− bi − ai q x + ai and Pr (Di = 1)= bi − ai q x + ai

Let D = i =1 Di (i.e. total number of deaths) and d = i =1 d i be its observed value.

N N

The expected value of D is:

( ) ( )
N N N N
(D ) =  (Di ) =  bi −ai q x + ai =  1−bi −ai p x + ai =  1− ai p x + ai +1−ai q x + ai −bi −ai p x + ai
i =1 i =1 i =1 i =1

( ( ))
N N N
= 1− ai q x + ai − bi − ai p x + ai 1−1−bi p x + bi =  1−ai q x + ai −  bi −ai p x + ai 1−bi q x +bi
i =1 i =1 i =1

We use the Balducci assumption to simplify the situation and the expected value of D
is then expressed as:
N N
(D ) =  (1 − ai ) q x −  (1 − (Di ))(1 − bi ) q x
i =1 i =1

Using moments matching, we substitute d and d i into the equation above and get the
following estimate of the mortality rate at age x:
d d d
qˆ x = N = N =
N
 (bi − ai ) + deaths
 (1 − ai ) −  (1 − di )(1 − bi )  (1 − ai ) −  (1 − bi ) survivors  (1 − ai )
i =1 i =1 i =1 survivors

in which the denominator is called the initial exposed to risk E x , where the survivors
contribute the period of length bi − ai (from ages x + ai to x + bi ) and the deaths
contribute 1 − ai (from ages x + ai to x + 1 ).

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For those lives who die within their observation periods, let x + ti be the age of death
of the ith life for ai  ti  bi . We express the initial exposed to risk as:
N N
E x =  (1 − ai ) −  (1 − d i )(1 − bi )
i =1 i =1
N N N
=  (1 − d i )(1 − ai ) +  d i (1 − ai ) −  (1 − d i )(1 − bi )
i =1 i =1 i =1
N N N
=  (1 − d i )(bi − ai ) +  d i (ti − ai ) +  d i (1 − ti )
i =1 i =1 i =1

=  (b − a ) +  (t
survivors
i i
deaths
i − ai ) +  (1 − t )
deaths
i

in which the sum of the first two components is called the central exposed to risk E xC
with the survivors contributing the period of length bi − ai (from ages x + ai to x + bi )
and the deaths contributing ti − ai (from ages x + ai to x + ti ).

The initial exposed to risk is so equal to the central exposed to risk plus the time from
death to the end of the year of age for the deaths i.e. E x = E xC + i =1 d i (1 − ti ) .
N

We can make a further rough assumption that the deaths occur at age x + 1/2 on
average (i.e. ti = 1 2 ) and so E x  E XC + d 2 . This assumption is reasonable when
mortality is low, only one decrement (i.e. mortality here) is studied, and the
investigation period is long. Then the estimate of the mortality rate at age x becomes:
d d
qˆ x =  C
Ex Ex + d 2

Note that the subscript x of E x and E xC in the denominator refers to the lives who are
between ages x and x + 1, i.e. the lives are ‘aged x last birthday’, within their
observation periods. The term ‘aged x last birthday’ is an example of age label. The
observed total number of deaths in the numerator also refers to the same age label.
This is different to the one we have been using so far, ‘aged exactly x’. Later we will
cover how to deal with various other age labels in counting the number of deaths and
calculating the exposed to risk when data is limited.

Also note that by the principle of correspondence it is important for the numerator and
denominator to have the same age label. Otherwise the estimate is not sensible.

The binomial model provides a convenient way to estimate the mortality rate.
However it only deals with the number of deaths but not directly with the underlying
process. It is also difficult to extend the model to more than one decrement (e.g.
model both illness and death). This model is used when information is limited and
when mortality is low.

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1.13 Binomial Model Simplified

Compared to the previous section, suppose now all the lives are aged exactly x at the
start of their observation periods and they are observed for one full year. It is an
idealised situation. Then the model of the total number of deaths is reduced to:
N
D ~ Bi(N , qx ) with Pr(D = d ) =  qxd (1 − q x )
N −d
for d = 0,1,2,..., N
d 
There is only one parameter q x . We find its maximum likelihood estimate as follows:
N
L =  q xd (1 − q x )
N −d

d 
N
ln L = ln   + d ln q x + (N − d ) ln (1 − q x )
d 
 d N −d
ln L = −
q x qx 1 − qx
2 d N −d
ln L = − 2 − 0
q x 2
q x (1 − q x )2
d N −d
− =0
qˆ x 1 − qˆ x
d
qˆ x =
N

The mean and variance of this estimator are deduced as:

 D  Nqx
(q~x ) =   = = qx (so it is an unbiased estimator)
N N
 D  Nqx (1 − q x ) q x (1 − q x )
Var (q~x ) = Var   = =
N N2 N
~
in which the estimator q x is normally distributed asymptotically and the variance of
this estimator is approximately calculated by putting q̂ x into the formula above.

(Accordingly, the mortality rate estimator under the more complicated model in the
previous section can be seen as roughly normally distributed and its variance can be
approximately calculated by qˆ x (1 − qˆ x ) Ex with qˆ x = d Ex .)

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1.14 Poisson Model

Again assume that we are dealing with a homogeneous population of size N. Assume
that the lives are independent and each life belongs to a certain age group during its
observation period (and we drop the subscript x). The observations on different lives
can be made at different points of time during the mortality investigation. Let D be the
total number of deaths and d be its observed value. Suppose the central exposed to
risk E C is calculated as the survivors’ observation periods plus the deaths’
observation periods till death like previously. Further assume that the force of
mortality is equal to a constant  for all lives during their observation periods.

The term E C  represents roughly the expected number of deaths during the mortality
investigation. Hence we formulate the model below for the total number of deaths:

( )
D ~ Pn E  with Pr(D = d ) =
C ( )(
exp − E C  E C  ) d

for d = 0,1,2,...
d!
where the central exposed to risk is treated as a fixed value.

We find the maximum likelihood estimate of  as follows:

L=
(
exp − E C  E C )( ) d

d!
(
ln L = −E  + d ln E C  − ln(d !)
C
)
 d
ln L = − E C +
 
2 d
ln L = − 2  0
 2

d
− EC + = 0
ˆ
d
̂ = C
E

The mean and variance of this estimator are deduced as:

 D  E 
C
( ) =  C  = C = 
~ (so it is an unbiased estimator)
E  E
 D  E  
C
Var (~ ) = Var  C  = = C
 E  EC
2
( )
E
~
in which the estimator  is normally distributed asymptotically and the variance of
this estimator is approximately calculated by putting ̂ into the formula above.

Note that the observed total number of deaths in the numerator and the central
exposed to risk in the denominator refer to the age group being specified.

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The Poisson model provides a sensible way to estimate the force of mortality since the
Poisson distribution models the number of random events happening within a certain
period of time. The model can also be extended to more than one decrement. While
there is a non-zero probability that the number of deaths is more than N, this
probability is usually very small and can be ignored. This model is used when
mortality is low.

A final note is that while the central exposed to risk is treated as a fixed value under
the model, it is indeed a random variable by nature as the number of deaths and time
of death are unknown at the start. This approximation is acceptable when mortality is
low. Otherwise the investigation can be adjusted by one of the following two ways to
ensure the central exposed to risk is a fixed value: (1) carry on the investigation until
the central exposed to risk arrives at a pre-specified value; (2) replace a death with
another independent and identical life at the time of death.

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