Chapter 4 - Insurance Benefits

Section 4.4 - Valuation of Life Insurance Benefits

(Subsection 4.4.1) Assume a life insurance policy pays $1
immediately upon the death of a policy holder who takes out the
policy at age x.
The present value of this payment is:

where δ = ln(1 + i). This present value Z is a random variable,

because the future life time of this person, Tx , is itself a random
variable.

4-1
The Expected Present Value (EPV) of this future payment is:

Z ∞
= e−δ t fx (t) dt
0
Z ∞
= e−δ t t px µx+t dt
0

The second moment of this random present value is :

E Z 2 = E { e−δ Tx }2 = E e−2δ Tx
     

≡ 2 Ax

4-2
Here is superscript 2 on the left indicates that this computation of Ax
uses twice the force of interest (which is NOT the same thing as
twice the interest rate). Consequently, the variance of the random
present value Z is:

Of course, if the policy pays a benefit of s dollars, then the expected

present value is

EPV = E[s Z ] = s Ax ,

and the random benefit’s variance is

Var [s Z ] = s2 2 Ax − {Ax }2 .

4-3
Example 4-1: Suppose fx (t) = ω2t2 for 0 < t < ω, and zero elsewhere.
Find the EPV and Var[ Z ] in this setting.

4-4
Example 4-2: Assume T40 is a continuous random variable with
constant force of mortality .03. If a whole life policy pays 100
immediately upon death and the force of interest is δ = .04, find the
EPV of this insurance claim.

4-5
(Subsection 4.4.2) Assume the life insurance policy pays $1 at the
end of the policy year in which the person dies.
The present value of the random benefit is now:

Z = ν Kx +1

where Kx = b Tx c is the curtate future life time random variable.

The Expected Present Value is therefore,

= ν P[Kx = 0] + ν 2 P[Kx = 1] + ν 3 P[Kx = 2] + · · ·

= ν qx + ν 2 1 |qx + ν 3 2 |qx + · · ·

4-6
Recall that when k ≥ 1,

The second moment of this random present value is:

∞
2
X
2
Ax = E[Z 2 ] = ν k +1 k |qx
k =0

∞
X
k +1
= ν2 k |qx
k =0

which is the same as the computation of Ax when the force of

interest is doubled, i.e. the effective interest rate is j satisfying

4-7
The variance of the random present value is

Var [ Z ] = 2 Ax − (Ax )2 .

Example 4-3: Suppose qx+0 = .1, qx+1 = .4, and qx+2 = 1.0 with
i = .25 then find Ax and Var [ Z ].

4-8
(Subsection 4.4.3) Assume the life insurance policy pays $1 at the
1 th
end of the ( m ) fraction of the policy year in which the person dies.
Typically, m = 1, 2, 4 or 12.
(m) (# of sub-periods suvived)
With Kx = m , the EPV of the benefit is:
 (m) 1  1


2


3

(m)
Ax = E ν Kx + m = ν m 1 qx + ν m 1  1 qx + ν m 2  1 qx + · · ·
m m m m m

The variance of the random present value is

(m) (m)
Var [ Z ] = 2 Ax − (Ax )2 ,
(m) (m)
where 2 Ax is computed like Ax with the force of interest doubled,
i.e. with ν replaced with ν 2 .

4-9
Example 4-4: A three year old red fox buys a whole life policy that
pays 1 at the end of the half-year in which death occurs. Let i = .05
and assume UDD within each year. Use the life table to find the EPV
of this insurance claim.
x lx dx
3 2194 1931
4 263 263
5 0

4-10
(Subsection 4.4.4) Recursive Computation
In discrete cases with benefit payments of $1 at the end of the policy
year of death the values of Ax are computed based on a life table.
These tables have a maximum life length ω beyond which no person
is assumed to live. That is, there is a value ω such that

qω−1 = P[ person dies before age ω | person lives to ω − 1 ] = 1.

If a policy was taken out by someone age ω − 1, then

Aω−1 = E ν Kω−1 +1 = ν.
 
(because Kω−1 ≡ 0)

If a policy was taken out by someone age ω − 2, then

Similarly, a policy taken out at age x has expected present value

Ax = νqx + ν 2 px qx+1 + ν 3 px px+1 qx+2 + · · ·

h i
= ν qx + px νqx+1 + ν 2 px+1 qx+2 + ν 3 px+1 px+2 qx+3 + · · ·


showing that

So Ax can easily be computed as long as Ax+1 is known. Since we

know the final value, Aω−1 = ν, we can use backward recursion to
compute Ax values for all the ages x in the life table.

4-12
Example 4-5: Use i = .05 and complete the Ax column.
x qx Ax
0 .01246
1 .02245
2 .08619
3 .37745
4 1.00

4-13
(Subsection 4.4.5) Term Insurance
Under a term insurance policy payment is only made if the insured
person dies before a fixed term (n years) ends. After the n years the
policy pays no benefits (has no value).
(a) Continuous Immediate Benefit Case: Here the benefit of $1 is
paid immediately upon death of the policy holder. So the present
value of the benefit is:
 −δT
e x if Tx ≤ n
Z =
0 if Tx > n

The expected present value of the benefit is

4-14
The second moment of the random present value is
Z n
2 1
Ax:n| = e−2δt t px µx+t dt.
0

which results from doubling the force of interest. Its variance is then
1 1
2
Var [Z ] = 2 Ax:n| − Ax:n| .

(b) Discrete Annual (mth ly ) Benefit Case:

When the benefit is paid at the end of the year in which death
occurs, the expected present value of the benefit is

1 th
and when it is paid at the end of the ( m ) portion of the year in
which death occurs it is
nm−1
(m)1
X k +1

A x:n| = ν m k  1 qx .
m m
k =0

4-15
Example 4-6 : Suppose that beyond age x there is a constant force
1
of mortality µx and a constant force of interest δ. Find Ax:n| .

4-16
(Subsection 4.4.6) Pure Endowment
A pure endowment benefit pays $1 at the end of the policy term of n
years if the insured person of age x survives the policy term of n
years.
The present value of the benefit is the random variable

ν ≡ e−δn if Tx ≥ n
 n
Z =
0 if Tx < n

The expected present value of the benefit is

There is no difference between continuous and discrete random life

lengths in this setting. Pure endowment is a tool for describing more
complex insurance instruments and is not sold as a separate policy.

4-17
The symbols

are used interchangeably. We see this as a discounted survival

function.

4-18
Example 4-7 : Suppose Tx is de Moivre (0, ω − x) and the interest
1
rate is constant, find Ax:n| .

4-19
(Subsection 4.4.7) Endowment Insurance
Endowment insurance pays a benefit of $1 if the insured person of
age x dies before the end of the policy term of n years or it pays $1
at the end of the term if that person survives the term of n years.
The present value of the benefit is the random variable

ν x ≡ e−δTx if Tx < n
 T
Z =
ν n ≡ e−δn if Tx ≥ n

= ν min(Tx ,n) .

The expected present value of a continuous benefit paid

immediately at death is therefore

4-20
Its variance is:
 2
Var [Z ] = 2 Ax:n| − Ax:n| .

where 2 Ax:n| is computed in the same manner as Ax:n| only with a

doubled force of interest, i.e. δ is replaced by 2δ and ν is replaced by
ν 2.

The annual and mth ly discrete cases are completely analogous,

producing EPV’s of:

Ax:n| = A1x:n| + Ax:n|

1
annual

and
(m) (m) 1 1
A x:n| = A x:n|
+ Ax:n| . mth ly

4-21
Note, for example that in the annual case,
 K +1
ν x if Tx < n
Z = n
ν if Tx ≥ n

= ν min(Kx +1,n)
and so

4-22
 1
Example 4-8 : You are given Ax:n| = .4275, δ = .055 and
µx+t = .045 for all t. Find Ax:n| .

4-23
(Bonus Subsection 4.4.7.5) Special Continuous Models
(a) Constant Force of Mortality and Constant Force of Interest:
Consider a policy that pays $1 immediately at the death of the
insured. Assume also that there is a constant force of interest δ and
a constant force of mortality µx that describes survival beyond age
x. Now we recall that

t px = e−µx t and thus fx (t) = µx e−µx t for t > 0

For whole life it follows that

Z ∞ Z ∞
Ax = e−δ t µx e−µx t dt = µx e−(δ+µx ) t dt
0 0

−µx ∞
= e−(δ+µx ) t  which produces the formula

(δ + µx ) 0

4-24
It quickly follows that
µx
E Z 2 = 2 Ax =
 
and
(2δ + µx )
µx  µ 2
x
Var [Z ] = −
(2δ + µx ) (δ + µx )
1
Example 4-9 Same Setting: For term insurance, find Ax:n| and

Var [ Z ] .

4-25
Under these assumptions, the pure endowment term is:

n Ex = e−δn n px or

Of course, endowment insurance of $1 paid immediately at death or

the end of the term (whichever comes first) has an EPV of
1
Ax:n| = Ax:n| + n Ex .

4-26
(b) Uniform Distribution of Deaths and Constant Force of Interest:
Consider a policy that pays $1 immediately at the death of the
insured. Assume also that there is a constant force of interest δ and
a uniform (de Moivre) distribution of deaths beyond age x. Now we
recall that
ω−x −t 1
t px = and fx (t) = both for 0 < t < ω − x.
ω−x (ω − x)

For whole life it follows that

Z ∞
−δ Tx
e−δ t fx (t)dt
 
Ax = E e =
0

ω−x
−1
Z
1
ω−x
= e−δt dt = e−δt  or
0 (ω − x) δ(ω − x) 0

4-27
Moreover, under these assumptions, the term insurance EPV for
n < (ω − x) is

It is the same integral as above only with n as the upper bound.

Under these assumptions, the pure endowment term is:

n Ex = e−δn n px or

4-28
(Subsection 4.4.8) Deferred Insurance Benefits
Sometimes a policy does not begin to offer death benefits until the
end of a deferral period of u > 0 years.
Consider a term life insurance policy that does not begin insurance
coverage until time x + u and ends insurance coverage at x + u + n.
The present value of a $1 benefit paid immediately at death is:

0 if Tx < u or Tx > u + n
Z = −δT
e x if u < Tx ≤ u + n

and the expected present value is:

Changing the variable of integration from t to s = t − u in this

integral produces,

4-29
  Z n
 1
u A x:n| = e−δ(s+u) s+u px µx+s+u ds
0
Z n
= e−δu e−δs u px s px+u µx+s+u ds
0
Z n
−δu
=e u px e−δs s px+u µx+s+u ds, that is,
0

The nature of the integral boundaries in the original description of

this EPV yields

as an additional way to express the EPV of a deferred benefit in

terms of EPV’s of those that are not deferred.
4-30
Deferred policies are useful in describing or decomposing other
policies. For example, a 10 year term policy has EPV

1 1  1
A x:10| = A x:6| + 6 A x:4| .

That is, it is equivalent to a 6 year term policy plus a 6-year deferred

4-year term policy. A whole life policy is equivalent to a n-year term
policy plus a n-year deferred policy. So its EPV will satisfy
 
1 1
Ax = A x:n| + n Ax or Ax = A x:n| + n Ax .
 

This implies, for example,

Therefore we can compute EPV’s of term insurance policies from the

EPV’s of whole life policies.

4-31
Example 4-10: A 3-year deferred whole life policy pays 1 at the
moment of death. You are also given that
µt = .01 for 0 ≤ t ≤ 2 and = .02 for t > 2. We also have
δt = .05 for 0 ≤ t ≤ 2 and = .06 for t > 2. Find the actuarial present
value of this insurance.

4-32
 (m)
Section 4.5 - Relationships among Ax , Ax and Ax
As the number of potential benefit payment points per year, m,
increases death benefits are paid sooner (or possibly at the same
time point). Since the payment amount is the same, discounting over
a shorter period produces a larger expected present value.

4-33
Therefore,
(2) (4)
Ax < Ax < Ax
(m)
and, in general, Ax is an increasing function of m.
It follows that when m > 1,

But the differences between these values are relatively small and
can be approximated.

4-34
(a) Approximations assuming UDD (uniform distribution of deaths)
within each year
(m) ( # of sub-periods survived)
Let Kx = m and examine
h (m) 1 i
(m)
Ax = E ν Kx + m

∞
"  # " #
X (m) 1
 death in death in
Kx + m
= E ν [x + k , x + k + 1) P [x + k , x + k + 1)


k =0

Before continuing, we examine the conditional expected value on the

right.

4-35
 "  #
(m) 1
 death in
Kx + m
E ν [x + k , x + k + 1)


     
1 1
k+ m 1 2
k+ m 1 m
= ν + ν + ··· + νk+ m
m m m
 
1 k
 1 2 m

= ν ν m +ν m + ··· + ν m
m

(1−ν)
!  
k +1 ν k +1 i
=ν 1
=ν
m(ν −m
− 1) i (m)

where the last step follows because (1 − ν)/ν = i and

1
i (m) = m (1 + i) m − 1 .

4-36
Substituting this in the term at the bottom of the previous page
shows that under the UDD assumption
∞  
(m)
X
k +1 i
Ax = k px qx+k ν
i (m)
k =0

 ∞
X
i
= ν k +1 k px qx+k so
i (m)
k =0

Taking the limit as m → ∞ shows that under this UDD assumption

4-37
So motivated by the UDD assumption, we have the following
approximations;
 
(m) i
Ax ≈ (m) Ax
i
i 
Ax ≈ Ax and
δ
i 
Ax:n| ≈ A1x:n| + n Ex .
δ

4-38
(b) A claims acceleration approximation
This method is motivated by a UDD assumption, because under a
UDD assumption a death is equally likely to occur in any one of the
m time segments of the year. In this case the average claim
payment time during a given year is
m
11 12 1 m 1 X m+1
+ + ··· + = 2 j = .
m m m m m m m 2m
j=1

(m)
The approximation to Ax is made by making any payments during
the year at this average time within each year, producing
(m) m+1 m+1  m+1 
Ax ≈ ν 2m qx + ν 1+ 2m 1 qx + ν 2+ 2m 2 qx + · · ·
∞
m+1 X
−1
ν k +1 k qx

=ν 2m

k =0
∞
m−1 X
ν k +1 k qx

= (1 + i) 2m

k =0
4-39
Typically, we expect claims to increase over time. So when using the
average time within the year, we expect to move more claims back in
time than forward, thus accelerating claims (making them earlier
than anticipated). The above computation motivates

Letting m → ∞ produces

Likewise,
1
Ax:n| ≈ (1 + i) 2 A1x:n| + n Ex .

4-40
Example 4-11: Consider the following: (1) Ax with CFM µ∗ and CFOI
0 00
δ, (2) Ax with CFM µ∗ + c and CFOI δ, and (3) Ax with CFM µ∗ and
CFOI δ + c. Assume c > 0. Find the ordering among these 3 EPV’s.

4-41
Section 4.6 - Variable Benefits
When life insurance benefits are solely a function H(Tx ) of the future
life length of the policyholder, then

and the variance of the present value is

2
Var (PV ) = E ν 2Tx H 2 (Tx ) − EPVH .
 

Note that the second moment does not just require doubling the
force of interest, the benefit amount must also be squared.

4-42
When the benefit function is linear, e.g. H(t) = a + b t with a and b
constants, then

EPVH = a E ν Tx + b E Tx ν Tx
   

In the continuous case with the benefit being paid immediately upon
death, the notation is

in a whole life insurance setting and

Z n

1
ĪĀ x:n| ≡ t e−δ t t px µx+t dt
0

in a term insurance setting.

4-43
In a discrete setting with payments at the end of the year of death,
the present value random variable is

Z = ν Kx +1 (Kx + 1)

where Kx = bTx c.
Thus the EPV of whole life insurance, for example, is
∞
X
ν k+1 (k + 1) k qx


IA x =
k=0

and for term life insurance it is

 lx+k −lx+k +1
with k qx = k px qx+k = lx coming from a life table.

4-44
There are some problem settings in which the life insurance benefits
increase exponentially over time, i.e. they are multiplied by (1 + j)Tx .
The present value of the benefit is then
 1 + j T x
Z = ν Tx (1 + j)Tx = ≡ ν∗Tx
1+i
where
1 1 + j 
ν∗ = = , that is
1 + i∗ 1+i

So the EPV’s
1
Ax:i ∗ Ax:n|i ∗ Ax:i ∗ and A1x:n|i ∗

for the continuous and discrete cases are computed as before, only
with a new interest rate i ∗ .
4-45
Example 4-12: Consider a whole life policy payable immediately at
death, with constant force of mortality of µx , constant force of
interest δ, and variable payment of eα t where µx , δ and α are all
positive constants with α < µx + δ. Find the EPV.

4-46
Example 4-13: Consider a whole life policy payable immediately at
death, with constant force of mortality of µx = .03 for all t > 0.
Assume δt = .01 for 0 ≤ t < 65 and = .02 for t ≥ 65. In addition the
benefit payment is bt = 200 for 0 ≤ t < 65 and = 100 for t ≥ 65.
Find the EPV.

4-47
Supplement to Chapter 4
Pure Endowment Revisited
The pure endowment term

assumes compound interest using a constant force of interest. Here

 1 n
νn = = e−δ n
1+i
with δ = ln(1 + i).
Note there are no assumptions made here about survival. It only
assumes use of the survival function t px . The term n Ex represents
discounting over a survived term of n years.

4-48
Moving the Vision Point When Computing an EPV
Sometimes potential insurance payments (benefits) don’t begin right
away. Pictured below is a 20-year term life insurance policy paying
$1 at the end of the year of death, but it is deferred 10 years, i.e.
there are no benefits paid if death occurs during the first 10 years for
the policyholder who buys the policy at time t = 0 when this person
is age x.

4-49
Earlier we described the EPV of this deferred life insurance as:

But we now approach this computation in a different manner.

Suppose we view the EPV of this policy from the vision point of
t = 10.

4-50
If the policy had been purchased at t = 10 the EPV would be
1
Ax+10:20| .

But, of course, it was purchased at t = 0. We must discount the EPV

back to t = 0 via

Here the discounting process must account for more than just the
interest rate. In order for any benefits to be paid, the policyholder
must first survive from age x to age x + 10. Thus we must discount
over a survived period of time, using the survival discount factor of
10 Ex . Therefore, in general

4-51
This process of discounting over a survived period, enables us to
compute EPV’s by breaking the time line (or potential benefit
payments) into disjoint insurance benefit segments and then
discounting each segment to time t = 0, taking the necessary
survival into account.

We refer to

In an expected life insurance benefit computation, if we were to

move the vision point into the future from, for example, t = 0 to t = u
where u > 0, we would divide by the survival discount factor, in this
case u Ex+0 , provided there were no potential benefit payments in
the interval [0, u] .

4-52
Example 4-14: Consider a 8-year deferred 40-year term life
insurance policy that pays 100 during the first 20 years and 200
during the second 20 years of insurance coverage with all payments
at the end of the year of death. Find expressions for the purchase
price (premium) of this policy at t = 0 and also the price if it was
purchased at t = 5.

4-53
Putting the Pieces Together
Knowing the formulas for the exponential and de Moivre distributions
and knowing how to discount while taking survival into account
enables us to quickly solve complex problems by segmenting them
into simpler settings in which both can be applied.
Example 4-15: A policyholder age x = 40 begins an endowment
policy that pays 200 at the moment of death or at age 65, whichever
comes first. Assume a de Moivre (0,50) distribution for future life
length and δ = .05. Find the EPV and Var[ Z ].

4-54
Example 4-16: A whole life policy pays 100 immediately at death.
We are given δt = .04 for 0 ≤ t ≤ 10 and = .05 for t > 10 plus
µx+t = .06 for 0 ≤ t ≤ 10 and = .07 for t > 10. Calculate the
premium for this insurance.

4-55
Example 4-17 (Example 4-10 revisited): A 3-year deferred whole life
policy pays 1 at the moment of death. You are also given that
µt = .01 for 0 ≤ t ≤ 2 and = .02 for t > 2. We also have
δt = .05 for 0 ≤ t ≤ 2 and = .06 for t > 2. Find the actuarial present
value of this insurance.

4-56
Example 4-18: A whole life policy pays 1 immediately at death for
the first 10 years and .5 after that. Given a constant force of
mortality of µ∗ and a constant force of interest of µ∗ , plus
EPV ≡ E[ Z ] = .3324, find Var[ Z ].

4-57