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ACTL1001, Week 9 ,10

Life Insurance

Outline:
Life Insurance Contract Types
Actuarial Management:
– Premium Rating
– Probability of Ruin and Solvency
– Valuation: (Conditional) Policy Liabilities
– Investment Policy

Reading
(Req) Sherris, Ch 8
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Historical Context
Earliest form of life insurance contract - Assessmentism
– Short-term, Health requirement, Renewal subject to health, Cost increased with
age
– Problems - cover not provided when most needed, adverse selection on renewal
(selective withdrawals)
Scientific Life Insurance
– Developed by James Dodson
– Health requirements were only required on entry, Policies were guaranteed renewal
regardless of health
– Contracts were for longer terms than one year including for the whole of life
– Premiums charged were level and varied with age at entry and the term of the
contract, Extra premiums were charged for extra health risks.
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Life Insurance Products - Traditional policies

Whole of life
– Sum insured on death of the life insured regardless of when the life dies, can be
limited term premium
Non-participating
Participating - Bonus (profit share) is usually added as a percentage of the sum
insured (simple bonus) or as a percentage of the sum insured plus previous
bonuses (compound bonus), Reversionary bonus - paid on claim or maturity.
Endowment Assurance
– An endowment assurance pays the sum insured on death within a specified term
or survival to maturity.
– Combines life insurance cover payable on death (death cover ) with savings payable
on maturity of the contract.
Pure Endowment
– Sum insured benefit paid on survival to the end of the term of the policy.
– Earlier death - usually a return of premiums with interest.
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Life Insurance Products - Current Policy Types

Term insurance
– Sum insured paid on death within a specified term.
– Pays nothing on survival to the end of the policy term.
– Reducing term insurance - to cover a housing loan with reducing balance
– Renewable term insurance policy - increasing premium rates, guaranteed renew-
able.
Life Annuities
– Lump sum (consideration or the single premium) paid to purchase the annuity.
– Income stream in return (may be indexed)
– Variants: Immediate; Deferred; Indexed
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Unbundled Policies (Universal life in USA) - Savings and protection (insurance) com-
ponents
– Premiums - single premiums or as regular premiums.
– (Variants: Investment account policy and the unit linked policy).
– Premiums are paid into the account, Expenses are charged to the account includ-
ing a mortality charge for any life insurance cover and a charge for any disability
cover.
– Balance of the account after expenses and mortality charges is invested by the
company.
– Fund invested in assets such as shares, fixed interest, property
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Disability
– Additional benefits - rider disability benefits or TPD (Total and Permanent Disability)
benefits.
– Separate disability income policies provide a percentage of the insured’s income in
the event of disability for a fixed period or to a fixed age
Critical Illness
– Critical illness policies pay a benefit if the insured suffers specified illnesses or
surgical procedures (heart attack, cancer)
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Actuarial Management - Premium rating

Consider - Term insurance on a life (x) for a term of n years, sum insured S
Assumptions
– the death benefit of S is paid at the end of the year of death
– interest rates are constant and do not vary with the time to receipt of a cash flow,
and
– the effective interest rate per year is i (in practice interest rate varies with time to
payment).
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Term insurance - Claim Payments

T (x) is the future lifetime (a continuous random variable) for a life (x)
X is the age-at-death (also a continuous random variable)
T (x) = X x
Will require probability that death occur aged "x + k last birthday", with x + k integer
If death occurs when the life is aged x + k last birthday where k = 0; 1; 2; : : : n 1
then the present value of the claim payment at the end of the year of death will be
Sv k+1 for k = 0; 1; 2; : : : n 1
=
0 for k n
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Expected present value of the claims payment.

Let K = integer part of T (x) ; Probability that death will occur when the life is aged
x + k last birthday where
K = integer part of T (x)
Probability distribution of K (a discrete random variable)
Pr [K = k] = Pr [k T (x) < k + 1] :
= (k px) (qx+k ) ; k = 0; 1; 2; : : : n 1
Expected present value of the claim payments for the term insurance is
n 1
X
Sv k+1 (k pxqx+k )
k=0
= SA1x: n
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Example
Determine the expected present value of the claim payments for a 5 year term insur-
ance on a life aged 20 with sum insured $100000 using the following mortality rates
and a 6% p.a. effective interest rate.
Probability =
Age qx k vk+1 kp20
kp20q20+k
20 0.00192 0 0.9433962 1.0000000 0.0019200
21 0.00181 1 0.8899964 0.9980800 0.0018065
22 0.00160 2 0.8396193 0.9962735 0.0015940
23 0.00138 3 0.7920937 0.9946794 0.0013727
24 0.00118 4 0.7472582 0.9933068 0.0011721
Expected
value 0.0067206
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Premiums
Annual premium P
Present value of the premium due at age x + k is
P v k for k = 0; 1; 2; : : : n 1
0 for k n
For a life aged x the probability that they will be alive at age x + k and will pay the
premium then due is k px.
Expected present value of the premiums at age x

n 1
X
P v k (k px) = a•x : n

k=0
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Example
Determine the expected present value of premiums of 1 p.a. payable in advance for
a 5 year term insurance on a life aged 20 using the following mortality rates and a
6% p.a. effective interest rate,
Age qx k vk kp20
20 0.00192 0 1.0000000 1.0000000
21 0.00181 1 0.9433962 0.9980800
22 0.00160 2 0.8899964 0.9962735
23 0.00138 3 0.8396193 0.9946794
24 0.00118 4 0.7920937 0.9933068
Expected
value 4.4502088
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Exercise: Principle of Equivalence

Premiums in insurance determined using principle of equivalence - equate expected
present value of premiums to expected present value of claims plus expenses (then
load for profit)
Example: Determine the premium for a 5 year term insurance on a 20 year old
male with sum insured of $100000 using the previous mortality rates and a 6% p.a.
effective interest rate, and with initial expenses of $500, and maintanence expenses
of $100 per premium.
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Probability of ruin
Insurance companies are concerned about solvency (well at least the regulators and
policyholders usually are!)
Assume
– n one-year term insurance policies,
– probability each policy will claim during the year is qx,
– each policy has sum insured of L
– all the lives are independent, expenses other than claims are ignored, investment
earnings are ignored
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Probability that there will be j claims in a year from the n policies (binomial distribu-
tion)
n j
Pr (J = j claims) = q (1 qx )n j
j = 0; 1; 2 : : :
j x
Total claims = T : if Xi takes the value L if the ith life dies during the year or 0 if the
life survives then
Xn
T = Xi = JL
i=1

Expected value of total claims in a year

E [T ] = E [JL] = E [J] L = nqxL
Variance of total value of claims in a year
V ar [T ] = V ar [JL] = V ar [J] L2 = nqx (1 qx) L2
The company receives - Total premiums of nP; Capital invested by shareholders is
assumed to be an amount C
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Probability the company will not be able to pay the claims will be the probability that
the total claims exceed the premiums plus capital
Pr [T > nP + C]
Probability of ruin is therefore
nP + C
Pr J >
L
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Probability of Ruin - Example

An insurance company sells one year term insurance policies on lives aged 20 for a
premium of $250 each with a sum insured of $100,000. It has sold 10000 indepen-
dent policies. The probability of a claim on a policy is 0.00192. The company has
capital of $500,000.
Determine the probability that the company will not have sufficient funds to pay its
total claims.
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Total premium income is

10000 250 = 2; 500; 000
Premiums plus capital available to meet claims is
2; 500; 000 + 500; 000 = 3; 000; 000
Since each claim is for $100,000, there is sufficient funds to meet a maximum of 30
claims.
Probability that there will not be sufficient funds to meet the claims is the probability
that the number of claims exceed 30
Number of claims
Binomial(10; 000; 0:00192)
Require
1 Pr [J 30] = 0:00796
In Excel this is easy =1 BIN OM DIST (30; 10000; 0:00192; T RU E)
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Probability of Ruin - Normal approximation

Recall: For a Normal random variable X with expected value (mean) and standard
deviation (variance of 2)
X
Z=

has a standard normal distribution

Z - Standard normal has expected value (mean) of zero and standard deviation
of 1
2
A normal random variable X with expected value and variance is obtained using
X= + Z
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Normal Approximation: Required probability of ruin, assuming that the number of

claims has a normal distribution, is
" #
nP +C
nP + C J nqx L nqx
1 Pr J = 1 Pr p p
L nqx (1 qx) nqx (1 qx)
" #
nP +C
nqx
= 1 Pr Z p L
nqx (1 qx)
where Z is a standard normal random variable with expected value zero and variance
equal to 1.
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Probability required
nP + C
Pr J >
L
where j is the number of claims and n = 10000; P = 250; C = 500000 and L = 100000:
The probability required is
Pr [J > 30]
For the binomial distribution
= nqx = 10000 0:00192 = 19:2
p p p
= nqx (1 qx) = 10000 (0:00192) (1 0:00192) = 19:163136 = 4:37757
Normal approximation is
30 19:2 30 19:2
1 Pr Z =1 Pr Z =1 Pr [Z 2:46712]
4:37757 4:37757
where Z is a standard normal random variable.
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From standard normal distribution tables we have

Pr [Z 2:46] = 0:9931
and
Pr [Z 2:47] = 0:9932
Using linear interpolation we obtain
712
Pr [Z 2:46712] + 0:9931 + [0:9932 0:9931] = 0:99317
1000
The required probability is
1 0:99317 = 0:00683
How good is the normal approximation in this case?
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Approximation to Binomial Distribution of Number of Deaths

0.10000

0.09000

0.08000

0.07000

0.06000
Probability

Binomial
0.05000 Normal
Poisson
0.04000

0.03000

0.02000

0.01000

0.00000
0 10 20 30 40 50 60
Number of Deaths
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Actuarial Management: Valuation of (Conditional) Policy Liabilities

Policy value of a liability for a life insurance policy is the expected present value of
future claims and expenses less the expected present value of future premiums.
Denote tVx:1 as the expected value of the policy liability at age x + t for the term
n

insurance on a life aged x for a term of n years with sum insured payable at the end
of the year of death, CONDITIONAL on survival at age x + t.
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If the life dies during the year, with probability qx+t; then the benefit of S is paid at the
end of the year.
The expected value of the (conditional) policy liability will then be equal to S since
this amount is due and payable on death and becomes the policy liability once the
life has died.
If the life survives to the end of the year, with probability px+t, then the expected value
of the policy liability will equal that for a life aged x + t + 1:
Recurrence relation
1 1
t Vx: n + P (1 + i) = qx+tS + px+t t+1 Vx: n

1 qx+tS + px+t t+1Vx:1 n

t Vx: n = P
(1 + i)
At the end of the policy term when t = n we have nVx:1 = 0: n
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Investment Policy
Investment policy determines the proportion of the total funds invested in the different
asset classes such as shares, property, fixed interest and cash.
Investment policy also specifies the maturity term of any fixed interest investments
and the currency of any investments.
Actuaries are concerned with the matching of asset cash flows and the liability ex-
pected cash flows.
Mismatching can cause insolvency or adverse profit results.
This has been a major problem with guarantees in life insurance products (in Aus-
tralia in the past and now in the UK
Matching investment strategy - when the cash flows on the assets from maturing
investments and investment income is determined so that they occur at the same
time and for the same amount as the expected future claims and expenses less
premiums.