ANUx Introduction to Actuarial Science

Lesson 2

Applications of Valuing Cash Flows

In Lesson 1, we looked at basic techniques for valuing single, multiple, and multiple regular cash
flows as both accumulated and present values. These basic techniques are fundamental to much
actuarial work.
In this Lesson we are going to look at more complicated applications of the valuation of cash flows.
These applications will consider both additional concepts relating to the valuation of cash flows, as
well as the use of spreadsheets in the valuation of cash flows.

Equations of Value
It is often useful to represent the cash flows in a financial process as a mathematical equation that
balances the positive (income) and negative (outgo) cash flows according to the dates of the
transactions and their equivalent time values of money. An equation of value equates the present
value of income to the present value of outgo:

PV income = PV outgo

By way of example, imagine an insurer sells a policy that requires an individual to pay a premium of
X both today and in 1 year from today. This policy will result in claims paid to the policyholder of
$1,000 in both 2 years and 3 years from today. Our aim is to calculate the value of X that will
ensure the insurer receives sufficient premium income to pay the claim outgo, using an interest rate
of 3.5% per annum. This is known as the risk premium.
Lets put this information on a timeline:

Year

Income

X
1,000

1,000

Outgo

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

We need to calculate the value of X , such that the present value of income at Year 0 is equal to the
present value of outgo at Year 0.

PV income

1, 000v 2

PV outgo

1.966184X
X

Xv

X (1.035)

1, 000v 3

1.966184X

1, 000(1.035)

1, 000(1.035)

1, 835.45

1, 835.45

933.51

Thus the risk premium to be charged on this product is $933.51.

Linking Equations of Value to Valuing Cash Flows

Note that the formula for an equation of value is also equivalent to saying that;

PV income

PV outgo

or in other words that the present value of all cash flows is equal to zero. We know from Lesson 1
that if we have the value of a set of cash flows at a specific point in time we can accumulate or
discount that value to get the value of the set of cash flows at any time. Since the present value of
the set of cash flows in an equation of value is equal to zero, then the value of the set of cash flows
at any time is also equal to zero:

0 (1

i)

Therefore the accumulated value of the set of cash flows (the Actual Reserves) at Year 3 should also
be zero. We can show this using the iterative approach we saw in Lesson 1.

At Year 0 the Actual Reserves are simply equal to the premium received at Year 0 = $933.51.
At Year 1 the Actual Reserves must incorporate interest on the Actual Reserves at Year 0, in
addition to allowing for the premium income that occurs at Year 1. We can hence calculate
the Actual Reserves at Year 1 as follows:
A

933.51(1.035)1

933.51

1, 899.69

At Year 2 the Actual Reserves must incorporate interest on the Actual Reserves at Year 1, in
addition to allowing for the claim outgo that occurs at Year 2. We can hence calculate the
Actual Reserves at Year 2 as follows:
A

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1, 899.63(1.035)1

1, 000

966.18
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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

At Year 3 the Actual Reserves must incorporate interest on the Actual Reserves at Year 2, in
addition to allowing for the claim outgo that occurs at Year 3. We can hence calculate the
Actual Reserves at Year 3 as follows:
A

966.18(1.035)1

1, 000

0.00

We have thus proved that the calculated risk premiums of $933.51 are exactly sufficient to cover the
future claims under the policy.

Practice Question 2.1

Calculate the single risk premium to be charged today on an insurance product that pays claims of
$30,000 in 5 years from today, $50,000 in 10 years from today, and $70,000 in 15 years from today.
Use an interest rate of 8% per annum.

Assessment Question 2.1

Calculate the single risk premium to be charged today on an insurance product that pays regular
claims of $500 in 1,2,3,,25 years from today. Use an interest rate of 4% per annum.

Assessment Question 2.2 (Hard)

An insurance policy charges a regular risk premium, X , at Years 0,1,2,3,,9 from today. The policy
pays a claim of X 2 (i.e. X X ) in 15 Years from today. Calculate the value of X , assuming an
interest rate of 2% per annum.

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

Detailed Example Annuity Certain

The remainder of this Lesson will look at a specific product sold by an insurer, an annuity certain, in
more detail. Initially, we will consider the annuity certain using the same techniques we have
previously encountered. Later on in this Lesson we will develop a model of the annuity certain using
a spreadsheet tool.
In an annuity certains simplest form, the policyholder pays a single premium today, X . In return
the insurer makes a series of payments, C , back to the policyholder. Assuming that the series of
payments starts in 1 year from today and continues for n payments, lets look at this policy from the
insurers perspective on a timeline:

Year

Income

X
C

Outgo

n-1

Using an equation of value, the risk premium X can be seen to be equal to Can . This is a general
form of the result found in Assessment Question 2.1. Lets now look at the development of the
Actual Reserves of the insurer on an iterative basis.

Year
0

Premium Received
X

Claims Paid

Actual Reserves
X

???

???

n1

???

We know that the Actual Reserves of the insurer at Year 0 are equal to the premium received, X ,
and that if X

Can then the Actual Reserves of the insurer at Year n will be zero. The Actual

Reserves at any other time can be calculated on an iterative basis as we have done previously. A
general form for the calculation of the Actual Reserves at Year t , A(t ) , is;

A(t )

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A(t

1) (1

i)

PR(t ) CP(t )

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

where PR(t ) is the Premium Received at Year t and CP(t ) is the Claims Paid at Year t .

Extension Question 2.1

Show mathematically that the Actual Reserves at Year t , A(t ) , where 0
A(t )

Can

n , follow the rule:

Note that the result of Extension Question 2.1 makes intuitive sense. In order for the Actual
Reserves at Year n to be zero, Actual Reserves at any point in time have to be equal to the present
value of the future claims (less the present value of any future premiums) to be paid from that point
in time onwards. This then gives us the following table:

Year
0

Premium Received
X

Claims Paid

Actual Reserves
X

Can

Can

Ca1

For a simple annuity certain with a premium paid at Year 0 only, the Actual Reserves, A(t ) , at Year
t , where 0 t n , are:

A(t )

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Can

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

Application in Spreadsheets
Given the iterative and often tedious nature of the calculations above, it is logical to implement the
financial process in a spreadsheet tool. When financial processes are incorporated into a
spreadsheet tool they are often called cash flow models, a term which we will use throughout the
rest of the course.

Spreadsheet use in this Course

The spreadsheets used in this course can be downloaded for your own personal use and were
created using Microsoft Excel, which is the default software for spreadsheet use in this course.
However they should be able to be opened in any of Excel, Excel Online and/or Calc (Open Office) on
any of PC, Mac, iOS and/or Android devices. The spreadsheets have not been tested on Google
Sheets, although they are likely to work there as well.
You are not required to have any background in spreadsheet use to complete the course the
spreadsheet work we do will be relatively basic and you should have no problems picking it up even
if you have no experience in any of the above software.

A note on Excel Online

For those who dont have Excel loaded onto their computers, Excel Online is an appropriate
alternative. Excel Online is a free, but limited, version of Excel which is hosted online. All
spreadsheets we use in this course will be able to be opened and used in Excel online. Note that you
will need to have a Microsoft account to use Excel online.

A note on Open Office

Another alternative is Open Office, which is a free, open source suite of software that somewhat
mimics Microsoft Office. All spreadsheets we use in this course will be able to be opened and used
in Open Office Calc, the Open Office equivalent of Excel.

A note on submitting work you have done in spreadsheets to discussion forums

At various times during the course, you may like to share spreadsheet work you have done in forum
posts. This will be achieved by you providing a link to a Cloud storage source of the work you have
undertaken. You may choose whatever Cloud storage provider you like (Google Drive, OneDrive,
DropBox, etc.), as long as it can generate an external link to a file so anyone can open/download it
without an account.
We ask that you be aware of the differences between the software options when sharing your
spreadsheet work. Clearly, there will be no issue if you do not incorporate features into your work
that are only available in the software you choose. In particular, note that we will be not using any
of the scripting features of Excel (VBA) and OpenOffice (which supports a range of languages) in the
course.
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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

However, if you do wish to incorporate additional features in your work, such as scripting, that are
not compatible with Excel Online, please note this in your forum post.
One other thing you may have noticed about the course structure is that there is no explicit support
for collaboration on files. This is deliberate, as allowing for collaboration with many 1,000s of
students can be problematic for system resources! However, I encourage you to undertake any
informal collaboration with other students that you might like to do.

Our First Task

The first task we will undertake will be to incorporate the annuity certain described above into a
spreadsheet. The annuity certain spreadsheet file is available for download in the relevant
Courseware of the edX version of the course. A full demonstration of the creation of this
spreadsheet, using X 500, 000 , i 5% per annum and n 25 years can be found in the
relevant Courseware of the edX version of the course. Note that this gives a claim payment of:

X
an

500, 000

1.05
0.05

25

35, 476.23

Whilst this written version of the Lesson will not contain the detail of the creation of the
spreadsheet, some general notes about the creation of cash flow models in spreadsheets are now
provided.
In any cash flow model, it can be useful to think of the functions being performed in the spreadsheet
as being related to inputs (also known as assumptions), calculations or outputs of the model. The
calculations can be thought of as the intermediate mathematical work and formulae required to
generate the solution required. In the example above, A(t ) A(t 1) (1 i) PR(t ) CP(t ) is
a calculation. The inputs can be thought of as the parameters and constants underlying the
calculations. For example, the interest rate i is an input. The outputs are simply the results of the
calculations that are of interest, which in the example above would depend on the focus of the
insurer. For example, the insurer may be most interested in the Actual Reserves at Year n.
In order to make the spreadsheet as easy to read as possible, inputs calculations and outputs are
typically separated in a spreadsheet and/or given different formatting.

The Effect of Assumptions

We now note that the work done on the annuity certain so far makes the assumption that all factors
affecting the annuity certain are known in advance, which of course wont be the case in practice.
For example, the interest rate may change over time, particularly if the insurer invests in risky assets
such as equities. Later on in the course well consider life annuities, where the claims payments are
dependent on the death of the policyholder in this case the value of n is uncertain.
We now wish to consider the effect of these inputs/assumptions on the cash flow model.
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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

For example, the relationship X

Can means that if the risk premium X is changed, then, all

other things remaining equal, the claim payment C will also change in the same proportion. Using
numbers, if X were to be doubled from $500,000 to $1,000,000, then C would also be doubled
from $35,476.23 to $70,952.46.
The remaining questions ask you to consider minor changes to the cash flow model and describe
their impact on other elements of the model. In all questions you should assume that only the
elements described in the question are changed, all other factors are held at their original level. You
may answer the questions intuitively and/or by adjusting the spreadsheet. If you do simply adjust
the spreadsheet, you should attempt to understand the reasoning behind the results.

Practice Question 2.2

The claims amount, C , is decreased. What impact does this have on the premium, X , required?
A) The premium required will be decreased
B) The premium required will be unchanged
C) The premium required will be increased

Assessment Question 2.3

The interest rate, i , is increased. What impact does this have on the claims, C , able to be paid?
A) The claims able to be paid will be decreased
B) The claims able to be paid will be unchanged
C) The claims able to be paid will be increased

Assessment Question 2.4

The term, n , of the annuity certain is decreased. What impact does this have on the claims, C , able
to be paid?
A) The claims able to be paid will be decreased
B) The claims able to be paid will be unchanged
C) The claims able to be paid will be increased

Assessment Question 2.5 (Hard)

The term of the annuity certain is increased to 30 years, along with an appropriate adjustment to the
claims paid for the premium of $500,000 to ensure the Actual Reserves at Year 30 are zero.
Calculate the Actual Reserves at Year 27, assuming the interest rate remains at 5% per annum.
You may complete this question either by hand or by making an appropriate adjustment to the
spreadsheet.

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

Extension Question 2.2

The details of the annuity certain are now changed so that at any one single time after the original
premium payment of the annuity, an additional premium can be paid to increase the value of the
regular claim payments made to the policyholder. A policyholder who bought the policy under the
original terms (i.e. X 500, 000 , i 5% per annum and n 25 years), wishes to make an
additional premium payment at Year 5 in order to increase the claims payments to $40,000 per
annum for the remainder of the policy. Calculate the amount of this additional premium payment
required to ensure the Actual Reserves at Year 25 are still zero.
Note that claim payments will only be increased from the Year after the additional premium is
received. Hence the claims from Year 1 5 will still be $35,476.23.
You should solve this question using an equation of value and then demonstrate the correctness of
the result by adjusting the annuity certain spreadsheet file and showing that the Actual Reserves at
Year 25 are still zero.

Extension Question 2.3

Update the annuity certain spreadsheet file to be based on the product described in Assessment
Question 2.2.

Extension Question 2.4

The annuity certain spreadsheet file is a very basic cash flow model. Adjust the cash flow model to
incorporate more flexibility. The flexibility you incorporate is left to you to consider, but some ideas
are:

A term that can be chosen by the user that will fully update throughout the spreadsheet
Claims payments that are not level, but are increasing by a fixed dollar amount, a fixed
percentage or can take any value in any year
An interest rate that may take different values in each year

Note that some of these examples will result in the X

Can relationship no longer being valid. In

this case the claim is no longer an output, but an input that can be chosen by the user. In fact, if you
wish to make the Actual Reserves at Year n be zero, you will need to make the risk premium an
output, which is a function of the claims inputs. Alternatively, you may want to make both premium
and claims be inputs and not concern yourself with setting the Actual Reserves at Year n to zero.
Post your adjustments to the forum and review what other students have done as well.

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ANUx Introduction to Actuarial Science Lesson 2 Applications of Valuing Cash Flows

Summary of the Lesson 2 Material

Equation of Value:
PV income = PV outgo

The risk premium is the premium charged so that the insurer receives sufficient premium
income to pay the claim outgo (i.e. the Equation of Value holds).

When the Equation of Value holds, then, assuming all experience matches assumptions, the
Actual Reserves at the end of the policy will also be zero:

The general form for the calculation of Actual Reserves, A(t ) , where PR(t ) is the Premium
Received at Year t and CP(t ) is the Claims Paid at Year t , is:
A(t )

1) (1

i)

PR(t ) CP(t )

In order for the Actual Reserves at Year n to be zero, Actual Reserves at any point in time
are equal to the present value of the future claims less the present value of any future
premiums to be paid from that point in time onwards. For a simple annuity certain with a
premium paid at Year 0 only, the Actual Reserves, A(t ) , at Year t , where 0 t n are:
A(t )

A(t

Can

Financial processes can be made into cash flow models in Excel or another spreadsheet tool
in order to speed up and simplify analysis.

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