APV of Cash Flows

Premiums and Reserves

Actuarial Mathematics II

Lecture 6

Dr. Shaiful Anuar

Institute Of Mathematical Sciences
University of Malaya

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows
Premiums and Reserves

Table of contents

1 APV of Cash Flows

Example
Example

2 Premiums and Reserves

Example
Example
Example

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows Example
Premiums and Reserves Example

APV of Cash Flows

In the conventional notation, the following actuarial notations

are used:
ij (i ,j)
t px = t Qx

Thus, in the alive-dead model introduced previously with (1)

refer to alive state and (2) refer to dead state:
11
t px = t px
12
t px = t qx
12
µx = µx
ii
0 px = 1 for i = 1, 2
ij
0 px = 0 for i, j = 1, 2 and i 6= j

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows Example
Premiums and Reserves Example

The PV of a cash flow upon transition to another state at

time k is

payment for transition (k, k+1) x discount factor

x probability of transition

For instance, the APV of the of insurance benefit of 1 payable

continuously due to transition from state i to state j given by:
Z ∞X
ij
Ax = v t t pxik µkj
x+t
0 j6=k

In the discrete case, the APV of the insurance benefit upon

transition to state j is given by:
∞
mj
X
Aijx = v k+1 k pxim px+t , m 6= j
k=0
Lecture 6 Actuarial Mathematics II
 APV of Cash Flows Example
Premiums and Reserves Example

The PV of a cash flow upon being in the state at time k is

payment for being in state (k, k) x discount factor

x probability of being in state

For instance, the APV of an annuity for a life aged x with

current state i paying 1 continuously while in state j (j may
equal to i ) is given by:
Z ∞
ij
ax = v t t pxij dt
0

In the discrete case, the APV of the annuity while in state j is

given by:
∞
X
äxij = v k k pxij
k=0

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows Example
Premiums and Reserves Example

Example 1
An insurance company issues a special 3-year insurance to a high
risk individual. The following homogeneous Markov chain model is
given:
(i) (1) active, (2) disabled, (3) withdrawn, (4) dead

1 2 3 4
 
1 0.4 0.2 0.3 0.1
2 
 0.2 0.5 0 0.3 

3  0 0 1 0 
4 0 0 0 1

(ii) changes in state occur at the end of the year

(iii) the death benefit is 1000, payable at the end of the year of death
(iv) i = 0.05
(v) the insured is disabled at the end of year 1

Calculate the actuarial present value of the prospective death

benefits at the beginning of year 2.
Lecture 6 Actuarial Mathematics II
 APV of Cash Flows Example
Premiums and Reserves Example

Solution

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows Example
Premiums and Reserves Example

Example 2
In a permanent disability model, µ01 02
x = 0.05, µx = 0.02, and
µ12 00 11 01
x = 0.03. Also δ = 0.06. Calculate ax , ax and ax .

Solution

Lecture 6 Actuarial Mathematics II

 APV of Cash Flows Example
Premiums and Reserves Example

Solution

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Premiums and Reserves

Under the multi-state models, the premium and reserve

calculation are made based on the cash flows viewed in two
perspectives:
(i) cash flow upon transition : for instance, the APV calculation
of benefit payments
(ii) cash flow while in states : for instance, the APV calculation of
premium streams
The reserve at duration t for an insurance policy which is in
state i at that time is denoted by t V (i ) .
When calculating the reserve is too complex, it can be solved
numerically using the Thiele’s differential equation with the
help of Euler’s method.

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Using the Thiele’s differential equation for the reserve, we

obtained:
n
d (i )

(ij)

µijx+t bt + tV (j) − tV (i )
X
(i ) (i )
tV = δt t V − Bt −
dt
j=0,j6=i

where
µijy denote the transition intensity between state i and j at age
y.
δt denote the force of interest per year at time t.
(i )
Bt denote the rate of payment of benefit while the
policyholder is in state i .
(ij)
bt denote the lump sum benefit payable instantaneously at
time t on transition from state i to state j.

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Assume Euler’s method on the above equation we get:

(i ) (i ) (i )
t−h V = tV (1 − δt h) + hBt
n  
(ij)
µijx+t bt + tV (j) − tV (i )
X
+h
j=0,j6=i

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Example 3
An insurance company classifies its driver as Preferred (State 1) or Standard
(State 2) starting at time 0 at the start of the first year when they are first
insured, with reclassifications occurring at the start of each new policy year.
The transition-probability matrices Qn from the state at time n at the start of
year n + 1 to the state at time n + 1 are
   
0.7 0.3 1 0.1 −0.1
Qn = +
0.4 0.6 n + 1 −0.2 0.2

A particular driver is Standard now, at the start of the fourth year. For
k = 0, 1, there is a cost of 10(1.1)k at the end of year 4 + k for a transition
from Standard at the start of that year to Preferred at the start of the next
year. These costs will be funded by allocations (premiums) P paid at time 3 if
the driver is Standard at time 3 and paid at time 4 if the driver is Standard at
time 4. The allocation is determined to be P = 3.1879 by the equivalence
principle, using 15% interest. Suppose that the driver is Standard at the start
of the fifth year; find the benefit reserve.

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Solution

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Example 4
In a permanent disability model, µ01 02
x = 0.05, µx = 0.02, and
µ12
x = 0.03. Also, δ = 0.06. An insurance policy on (x) pays a
continuous benefit of 1000 per year while one is disabled and a
10,000 benefit at the moment of death. Continuous premiums are
payable for 10 years only when the insured is in state 0. Calculate
the reserve at time 5 in state 0 and in state 1.

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Solution

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Example 5
A 10-year disability income policy on (x) is modeled with a Markov
chain model of the disability income model. A benefit of 1000 per
year is paid while sick and 10,000 upon death. Continuous
premiums of 250 per year are paid while the insured is healthy.
Given that:
µ01 02 10 12
x+10 = 0.08, µx+10 = 0.01, µx+10 = 0.05, µx+10 = 0.02,
µ01 02 9.9 12
x+9.9 = 0.07, µx+9.9 = 0.009, µx+10 = 0.04, µx+9.9 = 0.019
Calculate the reserves at time 9.8 in states 0 and 1 using Thiele’s
differential equation solved numerically using Euler’s method with
step h = 0.1.

Lecture 6 Actuarial Mathematics II

 Example
APV of Cash Flows
Example
Premiums and Reserves
Example

Solution

Lecture 6 Actuarial Mathematics II