FUNDAMENTALS OF ACTUARIAL PRACTICE (FAP)

Module 5: Designing and Pricing an Actuarial Solution

Section 3: Pricing Models

Overview of Pricing Models

Model Overview
Setting prices on goods and services for sale is one of the most important decisions management makes. Pricing
decisions have a direct and immediate effect on the profitability of a firm and, ultimately, on its survival. Following is
an example of a typical exercise used to demonstrate the underlying pricing principles in economics and calculus
courses.
Assume that the price for a product is to be set to maximize the profit of the seller. Profit is determined by:
Profit at price p = (price) x (number sold at price p)
– (expense for each additional unit sold) x (number sold at price p)
– (constant expenses not a function of sales)
In symbols:
P ( p)  pD ( p )  eD( p )  c , where P ( p ) is profit with price p, D( p ) is the number demanded at price p, e is the
expense per unit sold and c is the constant expenses. Typically, the number demanded decreases as the price
increases. In search for a maximum profit, we must determine the point where the marginal change in profit is
zero (since aggregate profit will decline from this point forward). If we take the first derivative of the aggregate
profit formula and set it to zero, we get P( p)  D( p)  pD( p)  eD( p)  0 and obtain the following equation to
solve for the optimal price p.
D( p )  (e  p) D ( p ) .
That is, the optimal price occurs when the aggregate demand equals the expected reduction in demand
by increasing the price multiplied by the marginal profit (p-e) on each new sale.
Is pricing in actuarial science a variant of this model? There are several answers to this question.
 The objective of many actuarial pricing projects is not to maximize profits. For example, in determining the expense
for employee benefits, such as pensions, profit is not the objective. In addition, some insurance companies are
mutual organizations and minimizing insurance costs to their customers, rather than profits, is the goal.
 Unlike most commercial transactions, the expenses (e) of the unit of insurance sold are not known with certainty at
the time of the sale. The fundamental determinant of the cost of a unit of insurance is a random variable at the time
of the sale.
 The demand function, D( p ) , is hard to estimate in insurance because some insurance purchases are compelled, or
restricted, by law, lenders or regulators.
The price for a unit of insurance has several components:
 Actuarial present value of benefits.
 Actuarial present value of administrative expenses and expenses associated with distribution.
 Actuarial present value of profit margins.
m5s3-01_PricingModels.doc Copyright ©2008 by Society of Actuaries 1
These components have been determined when the policy is sold. These amounts may be spread out over the contract
period, keeping the actuarial present value of the future premiums stream equal to the actuarial present value of
benefits, expenses, and profits at issue. The profit component is simply one of three components of the premium and
is typically the smallest component. Nevertheless, the profit component receives considerable attention in pricing
financial security products for which it is relevant. The issue is to which characteristic of the policy premium should
the profit margin be related?
For example, the profit might be a simple percentage of the benefit and expense components of the premium. Such
constant percentage profit loadings are common for many goods and services.
A second alternative might be to relate profit to the primary risk taken under the policy. For example, a savings policy
might relate profit to a slight reduction in the interest rate credited on the policy. In a policy primarily with benefit
risk, the average number of expected losses or average expected loss amount might be increased in the pricing
formula to provide a profit margin in the resulting premium.
Yet another alternative is to think of the primary investment that company organizers have made and relate profit
margins to the return on that investment. This is the Internal Rate of Return method introduced in Module 3. The
cost of building and maintaining a distribution system is an example of such an investment from which an acceptable
return must be received.

Examples
Short-Term Coverages
These coverages include most property/casualty and health coverages. The key component of the model is
N 
E[Benefits]  E   X i 
 i 1 
where X i is the random loss from claim I and N is the random number of claims in the policy period. Assuming that the
random variables X 1 , X 2 , and N are independent, we have Benefit premium or expected loss cost = (Expected
number of claims) x (Expected claim amount).

Long-Term Coverages
Note, in the following formulas, e  t represents the discount for interest from time 0 to time t where e  is the
discount for one time period. Life insurance, long-term care insurance and pension plans are examples. We have the
components,
 
Actuarial present value of benefits   e t E[ Bt ] fT (t )dt   e t E[ Pt ]ST (t )dt
0 0

where T is the random time of benefit payment, with density function fT (t ) and survival function ST (t ) , Bt is the
random benefit payment for a benefit paid upon death at time t and Pt is the random benefit payment for a benefit
paid for being alive at time t. For life insurance, the random variable Bt  bt , a constant that may depend on the time
of death. The second term is likely zero. Some life insurance policies have a random benefit where the amount may
depend in the earning of a fund or the performance of an index. For life annuities or pension plans, the first term is
usually zero while the second term reflects the amount paid. It may be uncertain, for example, in a pension plan the
benefit amount may depend on future earnings or future inflation adjustments. The second term may be a sum rather
than an integral should the payments be at discrete time points rather than made continuously.

m5s3-01_PricingModels.doc Copyright ©2008 by Society of Actuaries 2

We note that Actuarial present value of benefits is typically set equal to the actuarial present value of future premiums.
If, for example, level premiums of  are paid at times t0 , t1 , (where the number of times may be finite) if the
policyholder is alive, then
Actuarial present value of benefits  Actuarial present value of premiums

   e  ti ST (ti ).
i 0
The action of requiring that Actuarial present value of premiums = Actuarial present value of benefits is an example of
an application of the equivalence principle.

Objectives
The objectives of pricing models differ more as a consequence of the objective of the insurer than the practice area.
For example, mutual organizations owned by their policy holders are committed to working toward low cost coverage
for their policy holders. Insurers owned by stockholders have the same objectives as other public corporations.
Pricing employee benefits for employers has as its objective the accurate pricing of benefits and deferred
compensation for accounting and budget planning for the sponsor. Government sponsored insurance plans seldom
have profit objectives and may have sources of funds other than premiums.

m5s3-01_PricingModels.doc Copyright ©2008 by Society of Actuaries 3