ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

CHAPTER 3
INSURANCE MODELS

We consider the concept of models for a single payment arising from the occurrence of a
defined random event. When this event occurred, a single payment of pre-determined
amount is paid as a consequence of the occurrence of the event. The payments are
contingent on the occurrence of the events. Models representing such payments are referred
to as contingent payment models. In cases where a financial loss (resulting from the
occurrence of the event) is reimbursed (in whole or in part) by another party, then we say
that the loss is insured. The party reimbursing the loss is called the insurer and the model
describing the reimbursement arrangement is an insurance model.

Insurance systems are established to reduce the adverse financial impact of random events.
Specifically we are interested to develop models for life insurance to reduce the financial
impact of the random event of untimely death.

Denote Z as the present value random variable of the benefit payment. Thus Z gives the
value, at policy issue, of the benefit payment. We have

Z = bv

b : Benefit payment function

v : Discount function (the interest discount factor from the time of payment back to the
time of policy issue)

In cases where the benefit b is payable at the moment of death, Z depends on the time-
to-failure (or future lifetime) random variable T x . We referred this as the insurance payable
at the moment of death.

In cases where the benefit b is payable at the end of year of death, Z depends on the
curtate future life random variable K x . We referred this as the insurance payable at the end
of year of death.

The expected value of Z, E[Z ] , is called the actuarial present value (APV) of the
insurance.

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3.1) Insurance Payable at the Moment of Death (Continuous Case)

We proceed to find the APV of various types of insurance payable at the moment of death.
The principal symbol for the APV of these types of insurance is A . Before we proceed,
recalling some of the information concerning the time-to-failure (or future lifetime) random
variable T x is crucial.

S x (t ) : probability that (x) will survive for another t years

Fx (t ) : probability that (x) will fail (die) within t years

P( X  x + t ) P( X  x + t )
S x (t ) = P (Tx  t ) = = t px Fx (t ) = P (Tx  t ) = = t qx
P( X  x) P( X  x)

In particular, we have f x (t ) = S x (t )  x (t ) = t p x  x + t .

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3.1.1) Whole Life Insurance

For a whole life insurance, benefits are payable immediately following on the death at any
time in the future.

For a unit of benefit, we have bt = 1 and vt = v .

t

The present value random variable is therefore Z = v t

The actuarial present value (APV) of the insurance is the expected value of Z, E[Z ] given
by,

  
A x = E[ Z ] =  v t f x (t ) dt =  v t t p x  x + t dt =  e − t t p x  x + t dt
0 0 0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

The j-th moment of the distribution of Z can be expressed as

   j
E[ Z j ] =  v tj f x (t ) dt =  v tj t p x  x + t dt =  e − ( j ) t t p x  x + t dt = A x
0 0 0

Furthermore,

   2
E[ Z 2 ] =  v 2t f x (t ) dt =  v 2 t t p x  x + t dt =  e − ( 2 ) t t p x  x + t dt = A x
0 0 0

It follows that
2
Var [ Z ] = E[ Z 2 ] − ( E[ Z ]) 2 = A x − ( A x ) 2

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3.1.2) n-year Term Life Insurance

For an n-year term life insurance, benefits are payable if the insured dies within n years
from policy issue. For a unit of benefit, we have

1 tn
bt =  and vt = v t
0 tn

 vt tn
The present value random variable is therefore Z = 
 0 tn

The actuarial present value (APV) of the insurance is the expected value of Z, E[Z ] given
by,

n n n
A x:n = E [ Z ] =  v t f x (t ) dt =  v t t p x  x + t dt =  e − t t p x  x + t dt
1

0 0 0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

The j-th moment of the distribution of Z can be expressed as

n n n j
E[ Z j ] =  v tj f x (t ) dt =  v tj t p x  x + t dt =  e − ( j ) t t p x  x + t dt = A x:n
1

0 0 0

Therefore the j-th moment of the distribution of Z is actually equal to the APV but evaluated
at the force of interest j . In general, we have E[ Z ] @  t = E[ Z ] @ j t . Now,
j

n n n 2
E[ Z 2 ] =  v 2t f x (t ) dt =  v 2 t t p x  x + t dt =  e − ( 2 ) t t p x  x + t dt = A x:n
1

0 0 0

It follows that

2
Var [ Z ] = E [ Z 2 ] − ( E [ Z ]) 2 = A x:n −( A x:n ) 2
1 1

Whole life insurance is the limiting case of the n-year term life insurance as n →  (why?)

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3.1.3) n-year Pure Endowment Insurance (will be discussed in details in 3.2.3)

For an n-year pure endowment insurance, benefits are payable at the end of n years if the
insured survives at least n years from policy issue. For a unit of benefit, we have

 0 k = 0,1,2,..., n − 1
bk +1 =  and vk +1 = v n
 1 otherwise

 0 k = 0,1,2,..., n − 1
The present value random variable is therefore Z =  n
 v otherwise

The actuarial present value (APV) of the insurance is the expected value of Z, E[Z ] given
by,

 
= E [ Z ] =  v k +1 k | q x =  v n k | q x = v px = n E x
n
A 1 n
x:n k =0 k =n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

Because the pure endowment will be paid only at time n, assuming the life survives,
therefore, there is only a discrete time version.

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3.1.4) n-year Endowment Insurance

For an n-year endowment insurance, benefits are payable if the insured dies within n years
from policy issue or if the insured survives at least n years. For a unit of benefit, we have

 vt tn
bt = 1 and vt =  n
v tn

 vt tn
The present value random variable is therefore Z =  n
 v tn
=v min( t , n )

The actuarial present value (APV) of the insurance is the expected value of Z, E[Z ] given
by,

 n 
A x:n = E[ Z ] =  v t f x (t ) dt =  v t t p x  x + t dt +  v n t p x  x + t dt = A x:n + A
1
1
0 0 n x :n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

   2
E[ Z 2 ] =  v 2t f x (t ) dt =  v 2 t t p x  x + t dt =  e − ( 2 ) t t p x  x + t dt = A x:n
0 0 0

It follows that

2
Var [ Z ] = E [ Z 2 ] − ( E [ Z ]) 2 = A x:n −( A x:n ) 2

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3.1.5) Deferred Insurance

For an n-year deferred whole life insurance, benefits are payable only if the insured dies at
least n years following issue. For a unit of benefit, we have

0 tn
bt =  and vt = v t
 1 tn

 0 tn
The present value random variable is therefore Z =  t
v tn

The actuarial present value (APV) of the insurance is the expected value of Z, E[Z ] given
by,

 
n| A x = E[ Z ] =  v t f x (t ) dt =  v t t p x  x + t dt
n n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

   2
E[ Z 2 ] =  v 2t f x (t ) dt =  v 2 t t p x  x + t dt =  e − ( 2 ) t t p x  x + t dt = n| A x
n n n

It follows that
2
Var [ Z ] = E[ Z 2 ] − ( E[ Z ]) 2 = A x −( n| A x )
2
n|

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Example 1 (Some useful formula)

Show that

(a) A x:n = A x:n + A 1

1
x :n

(b) A x = A x:n + n | A x
1

(c) n| A x = n E x Ax+n (The notation A 1 = n E x = v n n p x is often used)

x:n

(d) A x:n = A x − n E x A x + n
1

Solution

(a)


(c) n| Ax =  v t t p x  x + t dt
n

=  v u + n u + n p x  x + u + n du let t =u+n
0

=  v u + n n p x u p x + n  ( x + u ) + n du
0

= v n n p x  v u u p x + n  ( x + u ) + n du
0

= n E x Ax+n

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Example 2 (Constant Force of Mortality Assumption) (APV)

Show that under the constant force of mortality  ,


(a) A x =
 +

(b) A x:n = (1 − e − (  + ) n )
1

 +
(c) A = e − (  + ) n
1
x :n

 +  e − (  + ) n
(d) A x:n =
 +

(e) n| A x =  e − (  + ) n
 +

Solution

(a)


A x =  v t t p x  x + t dt
0

=  e − t e −  t  dt
0

=   e − (  + ) t dt
0

− 
=  e − (  + ) t 
 + 0


=
 +

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Example 3 (Constant Force of Mortality Assumption) (Variance)

Assume constant force of mortality  . Let Z 1 , Z 2 , Z 3 , Z 4 and Z 5 denote, respectively,

the present value random variables for the whole life insurance, the n-year term life
insurance, the n-year pure endowment insurance, the n-year endowment insurance, and the
n-year deferred whole life insurance. Show that

 2
(a) Var [ Z1 ] =
(  + 2 )(  +  ) 2

(b) Var [ Z 3 ] = v n px  n qx
2n

Determine an expression for Var [ Z 2 ] , Var [ Z 4 ] , and Var [ Z 5 ] .

Solution

(a)
 
E[ Z1 ] = A x =  v t t p x  x + t dt =
0  +
2  
E[ Z12 ] = A x =  v 2 t t p x  x + t dt =
0  + 2
2

    2
Var[ Z1 ] = E [ Z1 ] − E [ Z1 ] =
2 2
− =
 + 2   +   (  + 2 )(  +  ) 2

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Example 4 (Constant Force)

An insurance contract issued on a life aged x will pay RM1 at the moment of death if the
insured dies before reaching age x + 10 and will pay RM1 if the insured survives 10 years.
You are given

•  x +t = 0.01 for all t

•  t = 0 .06

Calculate the actuarial present value of this insurance contract.

Solution
 +  e − (  + ) n
For one unit of the 10-year endowment insurance, using A x:n = , we have
 +
 +  e −10(  + ) 0.01 + 0.06 e −10( 0.01+ 0.06) 1 − 0 .7
APV = A x:10 = = = 7 (1 + 6e )
 + 0.01 + 0.06

Example 5 (Constant Force)

An insurance contract issued on a life aged 30 will pay RM1,000 at the moment of death
if the insured dies before reaching age 40 and will pay RM2,000 if the insured survives to
age 40. You are given

•  30+t = 0.01 for all t

•  t = 0 .05

Calculate the actuarial present value of this insurance contract.

Solution (Answer: 500

3
(1 + 11e−0.6 ) )

Use A x:n = A x:n + A1

1 . (why?)
x :n

 
Since A x:n = (1 − e − (  + ) n ) , we have A30:10 = (1 − e −10(  + ) ) =
1 1

 +  +

Since A 1 = e − (  + ) n , we have A 1 = e −10(  + ) =

x :n 30:10

Therefore the actuarial present value of this insurance contract is

1, 000 A30:10 + 2, 000 A =

1
1
30:10

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Example 6 (Constant Force)

An insurance contract issued on a life aged 70 will pay RM5 at the moment of death if the
insured dies before reaching age 90 and will pay RM1 if the insured dies after age 90. You
are given

•  70+t = 0.02 for all t

•  t = 0 .04

Calculate the actuarial present value of this insurance contract.

Solution

Use A x = A x:n + n | A x . (why?)

1


Since A x:n = (1 − e − (  + ) n ) , we have
1

 +

 0.02
A70:20 =
1
(1 − e − 20(  + ) ) = (1 − e − 20( 0.02+ 0.04 ) ) = 13 (1 − e −1.2 )
 + 0.02 + 0.04


Since n| Ax =  e − (  + ) n , we have
 +

 0.02
20| A70 =  e − 20(  + ) = e − 20( 0.02+ 0.04 ) ) = 13 e −1.2
 + 0.02 + 0.04

Therefore the actuarial present value of this insurance contract is

−1.2
5A70:20 + 1 20| A70 = 53 (1 − e
1
) + 13 e −1.2 = 13 (5 − 4e −1.2 )

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Example 7 (Constant Force) (Varying Force)

A whole life insurance contract issued on a life aged x provides a benefit of RM1,000 at
the moment of death. You are given

 0.01 t5
•  x +t = 
0.02 t5
•  t = 0 .06

Calculate the actuarial present value and variance of this insurance contract.

Solution

First, we split the insurance into a 5-year term insurance ( Z 1 ) and a 5-year deferred whole
life insurance ( Z 2 ).

• For the 5-year term insurance,  = 0.01 and  = 0.06 . Therefore

 −0.35
E [ Z 1 ] = A x :n = (1 − e − (  + ) n ) = 17 (1 − e
1
)
 +

2  −0.65
E [ Z 12 ] = A x:n = (1 − e − (  + 2 ) n ) = 131 (1 − e
1
)
 + 2

• For the 5-year deferred whole life insurance, we use n| A x = n E x A x + n

First calculate 5 E x , the 5-year pure endowment using  = 0.01 and  = 0.06 .

A 1 = 5 E x = e − (  + ) n = e −5(  + ) = e −0.35 and 2 A 1 = 52 E x = e − (  + 2 ) n = e −5(  + 2 ) = e −0.65

x:5 x:5

Next calculate A x + 5 using  = 0.02 and  = 0.06 .

 2 
A x +5 = = 1
and A x + 5 = = 1
 + 4
 + 2 7

Therefore,
E[ Z 2 ] = 5| A x = 5 E x A x +5 = 14 e −0.35

E [ Z 22 ] = 5| A x =52E x Ax +5 = 17 e −0.65
2 2

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Finally,

E[ Z ] = E[1, 000 Z1 + 1, 000 Z 2 ]

= 1, 000. 17 (1 − e−0.35 ) +1,000. 14 e −0.35
= 1,000. 281 (4 + 3e −0.35 )
= 250
7
(4 + 3e−0.35 )

Actuarial present value of this insurance contract is 250

7
(4 + 3e −0.35 ) .

E[ Z 2 ] = E[(1,000Z1 + 1,000Z 2 )2 ]
= 1,0002 E[ Z12 ] + 1,0002 E[ Z 2 2 ] (because Z 1 and Z 2 are mutually exclusive)
= 1,0002. 131 (1 − e −0.65 ) +1,0002. 17 e −0.65
= 1,0002. 911 (7 + 6e −0.65 )

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 1,0002. 911 (7 + 6e −0.65 ) −[1,000. 281 (4 + 3e −0.35 )]2 = 63,663

Variance of this insurance contract is 63,663 .

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Example 8 (Constant Force) (Varying Force, Varying Interest, Varying Benefit)

A life insurance contract issued on a life aged x provides a benefit of RM100 at the moment
of death if death occurs in the first 10 years and RM50 if death occurs after 10 years. You
are given

 0.01 t  10
•  x +t = 
 0.02 t  10

 0.05 t  10
• t = 
 0.04 t  10

Calculate the actuarial present value and variance of this insurance contract.

Solution

First, we split the insurance into a 10-year term insurance ( Z 1 ) and a 10-year deferred
whole life insurance ( Z 2 ).

• For the 10-year term insurance,  = 0.01 and  = 0.05 . Therefore

 −0.6
E [ Z 1 ] = A x :n = (1 − e −(  + ) n ) = 16 (1 − e
1
)
 +

2  −1.1
E [ Z 12 ] = A x:n = (1 − e −(  + 2 ) n ) = 111 (1 − e
1
)
 + 2

• For the 10-year deferred whole life insurance, we use n| A x = n E x A x + n

First calculate 10 E x , the 10-year pure endowment using  = 0.01 and  = 0.05 .

Ax :101 | =10 E x = e − (  + ) n = e −0.6

2
Ax :101 | = 102E x = e − (  + 2 ) n = e −10(  + 2 ) = e −1.1

Next calculate A x +10 using  = 0.02 and  = 0.04 .

 2 
A x +10 = = 1
and A x +10 = = 1
 +  + 2
3 5

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Therefore,
E[ Z 2 ] = 10| A x =10 E x A x +10 = 13 e −0.6

2 − 1 .1
A x =102E x A x +10 = 15 e
2
E [ Z 22 ] = 10|

Finally,

−0.6
E [ Z ] = E [100 Z 1 + 50 Z 2 ] = 100. 16 (1 − e ) + 50. 13 e −0.6 = 50
3

50
Actuarial present value of this insurance contract is 3 .

E [ Z 2 ] = E [(100 Z 1 + 50 Z 2 ) 2 ]
= 100 2 E[ Z1 ] + 50 2 E[ Z 2 ] (because Z 1 and Z 2 are mutually exclusive)
2 2

= 100 2 111 (1 − e −1.1 ) + 50 2 15 e −1.1

= 772 .9164

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 495 .1386

Variance of this insurance contract is 495.1386.

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Example 9 (Constant Force) (Varying Benefit)

A whole life insurance contract issued on a life aged x provides a benefit payable at the
moment of death. You are given

•  x +t = 0.01 for all t

•  t = 0 .06
• bt = e 0.05t

Calculate the actuarial present value and variance of this insurance contract.

1
Solution (Answer: 12 )


E[Z ] =  bt v t t p x  x +t dt
0

=  e 0.05t e −t e − t  dt (under constant force)
0

=  e 0.05t e −0.06t e −0.01t 0.01 dt
0

= 0.01 e −0.02t dt
0


E [ Z 2 ] =  bt2 v 2 t t p x  x +t dt
0

=  e 0.1t e −2t e − t  dt (under constant force)
0

=  e 0.1t e −0.12t e −0.01t 0.01 dt
0

= 0.01 e −0.03t dt
0

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 =

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Example 10 (Uniform Distribution Assumption) (APV)

1
Mortality is uniformly distributed with  x = for 0  x   .
−x
Show that

a − x
(a) A x =
−x
an
(b) A x:n| =
1

−x
 n 
(c) Ax:n1| = e −n 1 − 
 −x
− n
e a − x − n
(d) n| Ax =
−x

Solution:

t 1
Note that t p x = 1 − and f x (t ) = t p x  x + t = (why?)
−x −x

(a) Ax =  v t t p x  x +t dt
0
−x
= v t t p x  x +t dt
0
1 −x
=
−x 0
v t dt

a − x
=
−x
n
because an = 0
v t dt

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Example 11 (Uniform Distribution Assumption)

A 20-year deferred insurance contract issued to a life aged 35 pays a benefit of 10 at the
moment of death if death occurs no earlier than 20 years from now. You are given

1
• x =
100 − x

•  t = 0 .06

Calculate the actuarial present value and variance of this insurance contract.

Solution

t 1 1 1
Note that under uniform distribution, f x ( t ) = t p x  x + t = (1 − )( )= =
− x − x−t  − x 65

E[Z ] =  bt v t t p x  x + t dt
n
65
=  10 e −t 1
65 dt
20
65
= 10
65 20
e −0.06t dt
−0.06( 20 )
= 10 1
65 [ 0.06 ][ e − e −0.06( 65) ]
= 0.72039


E [ Z 2 ] =  bt2 v 2 t t p x  x +t dt
0
65
=  10 2 e −2t 1
65 dt
20
65
= 100
65 
20
e −0.12 t dt
−0.12( 20)
= 100 1
65 [ 0.12 ][ e − e −0.12( 65) ]
= 1.15780

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 0.63884

e −  n a − x − n e −2 n a − x − n
Ax = Ax =
2
(Exercise) (Use n| and n| to find Var[Z].)
−x −x

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Example 12 (Uniform Distribution Assumption)

A special whole life insurance contract issued to a life aged 30 pays a benefit of 1,000 at
the moment of death if death occurs before age 60 and 500 if death occurs after age 60.
You are given
1
•  30+ t =
70 − t

•  t = 0 .05

Calculate the actuarial present value and variance of this insurance contract.

Solution

30
E [ Z1 ] =  bt v t t p x  x + t dt
0
30
=  1000e − t 1
70
dt
0
30
70 
= 1000 e −0.05t dt
0

= 221.96281

70
E [ Z 2 ] =  bt v t t p x  x +t dt
30
70
=  500e − t 1
70
dt
30
70
= 500
40  30
e −0.05t dt
= 27.56185

E[ Z ] = E[ Z1 ] + E[ Z 2 ] = 249.52466

E[ Z12 ] =

E[ Z 2 2 ] =

E[ Z 2 ] = E[ Z12 ] + E[ Z 2 2 ] =

Var[ Z ] = E[ Z 2 ] − E[ Z ]2 = 75, 228

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Alternative method (Exercise)

First, we split the insurance into a 30-year term insurance ( Z 1 ) and a 30-year deferred
whole life insurance ( Z 2 ).

• For the 30-year term insurance,

an (1 − e − n ) /  (1 − e −0.05( 30) )
E [ Z 1 ] = A x :n = = = = 0.221963
1

−x −x 70(0.05)

2
2 an (1 − e −2n ) / 2 (1 − e −0.10( 30) )
E [ Z 12 ] = A x:n = = = = 0.135745
1

−x −x 70(0.10)

• For the 30-year deferred whole life insurance, we use n| A x = n E x A x + n

e −  n a − x − n e −n (1 − e − ( − x −n ) ) e −0.05( 30) (1 − e −0.05( 40) )

E[Z 2 ] = n| Ax = = = = 0.0551237
−x ( − x ) 70(0.05)
2 e − 2  n 2 a − x − n e −2n (1 − e −2 (  − x − n ) ) e −0.1(30) (1 − e −0.1(40) )
E [ Z 22 ] = n| A x = = = = 0.0069822
−x ( − x )2 70(0.1)

Finally,

E [ Z ] = E [1, 000 Z1 + 500 Z 2 ] = 1,000(0.221963) + 500(0.0551237) = 249.525

Actuarial present value of this insurance contract is 249 .525 .

E[ Z 2 ] = E[(1,000Z1 + 500Z 2 )2 ] = 1,0002 E[ Z12 ] + 5002 E[ Z 2 2 ] (why?)

= 1, 000 (0.135745) + 500 (0.0069822)
2 2

= 137, 490
Var [ Z ] = E [ Z ] − E [ Z ] = 75, 228
2 2

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Example 13 (Normal Approximation)(Application)(n-year term insurance)

A company sells an appliance with a 5-year warranty. The warranty pays 100 at the time
of failure if the appliance fails within 5 years. You are given

• The constant force of failure for each appliance is  = 0.1

•  t = 0 .05

• 250 appliances are sold at one time

• The variance of coverage of 1 on n insureds is n times the variance of a coverage

of 1 on one insured.

Using the normal approximation, calculate the size of the fund needed at the time of sale
in order to have a 95% probability of having sufficient funds to pay for failures under the
warranty.

Solution

Let Z denote the present value of payment random variable. Under constant force of failure,

we know that A x:n = (1 − e − (  + ) n ) . Now,
1

 +

0 .1
E [Z ] = 100 (1 − e − ( 0.1+ 0.05)( 5 ) ) = 35 .1756
0.1 + 0.05

0 .1
E [ Z 2 ] = 100 2 (1 − e − ( 0.1+ 2 ( 0.05))( 5) ) = 3160 .6028
0.1 + 2( 0.05)

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 1923.2800

The 95th percentile of the standard normal distribution is 1.645. Therefore the fund needed
is 250 E[ Z ] + 1.645 250Var[ Z ] = 9, 934.56

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Example 14 (Normal Approximation)(Application)(Whole life insurance)

100 independent lives, each age 35, wish to establish a fund that will pay a benefit of 10 at
the moment of death of each life. They will each contribute an equal amount at the
inception of the fund and will then make no further payments to the fund. You are given

•  x = 0.05

•  t = 0 .03

• The variance of coverage of 1 on n insureds is n times the variance of a coverage

of 1 on one insured.

Using the normal approximation, determine the minimum amount that must be contributed
to the fund by the group to have 95% confidence that all claims will be paid.

Solution

Let Z denote the present value of payment random variable. Under constant force of

mortality, we know that A x = . Now,
 +

0.05 25
E [Z ] = 10 =
0.05 + 0.03 4

0.05 500
E [ Z 2 ] = 10 2 =
0.05 + 2( 0.03) 11

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 6.392045

The 95th percentile of the standard normal distribution is 1.645. Therefore the fund needed
is 100 E [ Z ] + 1.645 100 Var [ Z ] = 666 .59

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Example 15 (Normal Approximation)(Application)(n-year term insurance)

A 5-year term insurance of 1,000 is payable at the moment of death. You are given

•  x +t = 0.03 for all t

•  t = 0 .05

• An initial fund of 200 per insured is set up

• The variance of coverage of 1 on n insureds is n times the variance of a coverage

of 1 on one insured.

Using the normal approximation, calculate the number of insureds k needed so that there
is a 95% chance that the fund is sufficient.

Solution

Let Z denote the present value of random variable of this insurance payment. Under

constant force of mortality, we know that A x:n = (1 − e − (  + ) n )
1

 +
Now,

E [Z ] = 1, 000 (1 − e − (  + ) n )
 +
0.03
= 1, 000 (1 − e − (0.03+ 0.05)(5) )
0.03 + 0.05
=


E [ Z 2 ] = 1, 000 2 (1 − e − (  + 2 ) n )
 + 2
0.03
= 1, 000 2 (1 − e − (0.03+ 2(0.05))(5) )
0.03 + 2(0.05)
=

Var[ Z ] = E[ Z 2 ] − E[ Z ]2 =

We solve kE[ Z ] + 1.645 kVar[ Z ] = 200k and obtained k =

Therefore 45 insureds are needed.

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3.2) Insurance Payable at the End of Year of Death (Discrete Case)

We proceed to find the actuarial present value of various types of insurance payable at the
end of year of death. The principal symbol for the actuarial present value of these types of
insurance is A . Before we proceed, recalling some of the information concerning the
curtate future lifetime random variable K x is crucial.

The probability function of K x is given by

P ( K x = k ) = P ( k  Tx  k + 1)
= P (Tx  k ) − P (Tx  k + 1)
= S x ( k ) − S x ( k + 1)
= k p x − k +1 p x
= k +1 qx −k qx
= k| q x
= probabilit y that ( x ) will die between ages x + k and x + k + 1

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3.2.1) Whole Life Insurance

For a whole life insurance, benefits are payable at the end of year of death at any time in
k +1
the future. For a unit of benefit, we have bk +1 = 1 and vk +1 = v .

The present value random variable is therefore Z = v k +1

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

 
Ax = E[Z ] =  v k +1 k | q x =  v k +1 k p x q x + k
k =0 k =0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

3.2.2) n-year Term Life Insurance

For an n-year term life insurance, benefits are payable at the end of year of death if the
insured dies within n years from policy issue. For a unit of benefit, we have

 1 k = 0,1,2,..., n − 1
bk +1 =  and vk +1 = v k +1
 0 otherwise

 v k +1 k = 0,1,2,..., n − 1
The present value random variable is therefore Z = 
 0 otherwise

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

n −1 n −1
A1 = E [ Z ] =  v k +1 k | q x =  v k +1 k p x q x + k
x:n
k =0 k =0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

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3.2.3) n-year Pure Endowment Insurance

For an n-year pure endowment insurance, benefits are payable at the end of n years if the
insured survives at least n years from policy issue. For a unit of benefit, we have

 0 k = 0,1,2,..., n − 1
bk +1 =  and vk +1 = v n
 1 otherwise

 0 k = 0,1,2,..., n − 1
The present value random variable is therefore Z =  n
 v otherwise

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

 
A 1 = E[ Z ] =  v k +1 k | q x =  v n k | q x = v n n px = n E x
x:n k =0 k =n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

3.2.4) n-year Endowment Insurance

For an n-year endowment insurance, benefits are payable if the insured dies within n years
from policy issue or if the insured survives at least n years. For a unit of benefit, we have

 v k +1 k = 0,1,2,..., n − 1
b k +1 = 1 and vk +1 = n
 v otherwise

 v k +1 k = 0,1,2,..., n − 1
The present value random variable is therefore Z =  n
 v otherwise
= v min( k +1, n )

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

 n −1 
Ax:n = E[ Z ] =  v k +1 k | q x =  v k +1 k p x q x + k +  v n k p x q x + k = A1 + A 1

k =0 x:n
k =0 k =n x :n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

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3.2.5) Deferred Insurance

For an n-year deferred whole life insurance, benefits are payable only if the insured dies at
least n years following issue. For a unit of benefit, we have

 0 k = 0,1,2,..., n − 1
bk +1 =  and vk +1 = v k +1
 1 otherwise

 0 k = 0,1,2,..., n − 1
The present value random variable is therefore Z =  k +1
 v otherwise

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

 

n| Ax = E[ Z ] =  v k| qx =  v
k +1 k +1
k| qx
k =0 k =n

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

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Example 16 (Some useful formula)

Show that

(a) Ax:n = A + A 1 1
x:n x :n

(b) Ax = A 1 + n | Ax
x :n

(c) n| Ax = n E x Ax + n (The notation A 1 = n Ex = v n n px is often used)

x:n

(d) A1 = Ax − n E x Ax + n
x :n

Solution

(a)

(b)

Ax =  v k +1 k | q x
k =0
n −1 
=  v k +1 k | q x +  v k +1 k | q x
k =0 k =n

= A1 + n| Ax
x:n

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Example 17 (Uniform Distribution Assumption) (APV)

1
Mortality is uniformly distributed with  x = for 0  x   .
−x
Show that
a − x
(a) Ax =
−x
an
(b) A =
−x
1
x :n

= e − n  1 −
n 
(c) A 
− x
1
x :n 
e −  n a − x − n
(d) n | Ax =
−x

Solution (exercise)

t 1
(a) Note that t p x = 1 − and qx = (why?)
−x k|
−x

Ax =  v k +1 k | q x
k =0

1  − x −1 k +1
=  v
 − x k =0
a n −1
because n  v
k +1
= −x a =
−x k =0

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Example 18 (Standard Ultimate Life Table)(n-year endowment insurance)

Consider a 20-year endowment insurance on a life currently age 60 with face amount of
1000 with benefit payable at the end of the year of death. You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05

Calculate the actuarial present value of the insurance.

Solution

The actuarial present value of the insurance is

1, 000 A60:20 = 410.40

Example 19 (Standard Ultimate Life Table)(n-year term insurance)

Consider a 5-year term insurance on a life currently age 45 with face amount of 1,000 with
benefit payable at the end of the year of death. You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05

Calculate the actuarial present value and variance of the insurance.

Solution

Using A 1
= Ax − n E x Ax + n . (Why we cannot use Ax:n = A + A ?)1 1
x :n x:n x :n

The actuarial present value of the insurance is

1, 000 A 1 = 1, 000 ( A45 − 5 E 45 A50 )

45:5

1, 000 2 2 A 1 = 1,0002 ( 2 A45 − 52 E45 2 A50 )

45:5

= 1,0002 ( 2 A45 − v 5 5 E45 2 A50 ) (because 5 E45 = v 5 p45 = v .v 5 p45 = v 5 E45 )

2 10 5 5 5

The variance is = 16, 337 − (19.42) 2 = 3, 400

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Example 20 (Standard Ultimate Life Table)(Special insurance)

Consider a special insurance on a life currently age 65 with face amount of 1,000 with
benefit payable at the end of the year of death if death occurs between ages 70 and 80, and
600 if death occurs after age 80. You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05

Calculate the actuarial present value of the insurance.

Solution (Answer: 231.83)

We can view this special insurance as a 5-year deferred whole life insurance for 1,000
minus a 15-year deferred whole life insurance for 400.

For the 5-year deferred whole life, since n| Ax = n E x Ax + n , we have 5| A65 =5 E65 A70

For the 15-year deferred whole life, again since n| Ax = n E x Ax + n , we have

15| A65 =15 E65 A80
= 5 E 65 10 E 70 A80 (because m+n E x = m E x n E x + m ) (See Tutorial 3)

The actuarial present value of the insurance is

1,000 5| A65 − 400 15| A65 = 1, 000 5 E 65 A70 − 400 5 E 65 10 E 70 A80

=

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Example 21a (Standard Ultimate Life Table)(Normal Approximation)

A group of 400 independent individuals age 40 each purchases a whole life insurance of
1,000. You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05
• The variance of coverage of 1 on n insureds is n times the variance of a coverage
of 1 on one insured.

Using the normal approximation, calculate the size of the fund needed so that there is a
95% probability that the fund will be adequate to pay all benefits.

Solution

Let Z denote the present value random variable of the insurance.

E [Z ] = 1, 000 A40 =

E [ Z 2 ] = 1, 0002 2 A40 =

Var[ Z ] = E[ Z 2 ] − E[ Z ]2 =

The 95th percentile of the standard normal distribution is 1.645. Therefore the fund needed
is 400 E[ Z ] + 1.645 400Var[ Z ] = 51,512.83

Example 21b (Standard Ultimate Life Table)(Normal Approximation)

A fund is set up to pay a death benefit of 10 to each of 1,000 lives age 65. You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05
• The variance of coverage of 1 on n insureds is n times the variance of a coverage
of 1 on one insured.

Using the normal approximation, calculate the initial amount of the fund needed so that
there is a 80% probability that the fund will be adequate to pay all of its claims.

Solution (Exercise)
(Hint: The 80th percentile of the standard normal distribution is 0.842)
(Answer: 3,592.52)

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Example 22 (Short-term insurance)(Constant Force)

A 3-year endowment policy is issued to a life age 30 with benefit of 1,000 payable at the
end of year of death. You are given

•  x = 0.12
•  t = 0 .09

Calculate the actuarial present value of this insurance contract.

Solution

n −1
Using Ax:n = A + A 1 1 and hence Ax:n =  v k +1 k | q x + v n n p x , we have
x:n x :n k =0

A30:3 = vq30 + v 2 1| q30 + v 3 2| q30 + v 3 3 p30

= vq30 + v 2 1| q30 + v 3 ( 2 p30 − 3 p30 ) + v 3 3 p30
= vq30 + v 2 1| q30 + v 3 2 p30
= vq30 + v 2 p30q31 + v 3 2 p30
− t
= e − (1 − e −  ) + e −2 e −  (1 − e −  ) + e −3 (e −2  ) (Under constant force, t p x = e )
=

The actuarial present value of this insurance contract is 1, 000A30:3 =

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Example 23 (Short-term insurance)

A 3-year term policy is issued to a life age 40 with benefit of 1 payable at the end of year
of death. You are given

• q40 = 0.00278 , q41 = 0.00298 , q42 = 0.00320

• i = 0.06

Calculate the actuarial present value and variance of this insurance contract.

Solution
n −1
Using A 1 =  v k +1 k | q x , we have
x :n
k =0
2
A1 =  v k +1 k | q40
40:3 k =0

= vq40 + v 2 1| q40 + v 3 2| q40

= vq40 + v 2 p40 q41 + v 3 2 p40q42
= vq40 + v 2 p40 q41 + v 3 p40 p41 q42
= vq40 + v 2 (1 − q40 )q41 + v 3 (1 − q40 )(1 − q41 ) q42
= 0.00793879

2
A1 = v 2 q40 + v 4 (1 − q40 ) q41 + v 6 (1 − q40 )(1 − q41 ) q42
40:3

= 0.00707096

Var [ Z ] = 0.007008

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3.3) Recursive Formulas

Actuarial present value of insurance on (x) can be related to actuarial present value of
insurance on (x+1) recursively. The recursive formula allows us to construct full life tables
by starting at the end of the table and working backwards

Example 24 (Some useful recursive formulas)

Show that

(a) Ax = v q x + v p x Ax +1
(b) Ax = v qx + v px qx +1 + v 2 px Ax +2
2 2

(c) A 1
= v qx + v px A 1
x :n x +1:n −1

(d) Ax:n1| = vpx Ax +1:n −1 1|

(e) Ax:n = v q x + v p x Ax +1:n −1
(f) n| Ax = vpx A
n −1| x +1

Solution

(a)

(b) Ax = vq x + vp x Ax +1
= vq x + vp x (vq x +1 + vp x +1 Ax + 2 )
= v qx + v 2 px qx +1 + v 2 2 px Ax + 2

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Example 25 (Recursive formula)

A life table has the following values: A60 = 0.12970 , A61 = 0.13032 , A60:11| = 0.9506 .
Calculate q60 .

Solution (Hint: Use Ax = v q x + v p x Ax +1 ) (Answer : 0.006083)

Example 26 (Recursive formula)

For a whole life insurance of 1 issued to a life age 51 with death benefit payable at the
end of the year of death, you are given

• A51 − A50 = 0.004

•
2
A51 − 2A50 = 0.005
• i = 0.02
• q50 = 0.02

Calculate Var [ Z ] .

(Hint: Use Ax = v q x + v p x Ax +1 and Ax = v qx + v p x Ax +1 )

2 2 2 2
Solution

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3.4) Varying Benefits Insurance

Here, we consider the case where the benefit payments either increases or decreases in
arithmetic progression over all or a part of the term of the insurance. It is important to be
familiarize with symbols such as I A , I A , and IA for the increasing insurances and D A ,
 n!
D A , and DA for the decreasing insurances. The formula  t e dt = n +1 is useful.
n − ct
0 c

3.4.1) Continuous increasing whole life insurance

In this type of insurance, benefits are payable at the moment of death, where t is payable if
death occurs at exact time t, the benefit varies continuously.

bt = t and vt = v t

The present value random variable is therefore Z = t v t

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,


( I A) x = E[ Z ] =  t v t t p x  x + t dt
0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

3.4.2) Increasing whole life insurance

In this type of insurance, benefits are payable at the moment of death, with 1 payable if
death occurs during the 1st year, 2 if death occurs during the 2nd year, …, t if death occurs
during year t.

bt = t + 1 and vt = v t

The symbol   denotes the greatest integer function

The present value random variable is therefore Z = t + 1v
t

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,


( I A) x = E[ Z ] =  t + 1 v t t p x  x + t dt
0

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

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3.4.3) Continuous decreasing n-year term insurance

In this type of insurance, benefits are payable at the moment of death, where n − t is
payable if death occurs at exact time t, the benefit varies continuously.

bt = n − t and vt = v t

The present value random variable is therefore Z = ( n − t ) v t

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

n
D A x:n = E [Z ] =  ( n − t ) v t t p x  x +t dt
1

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

3.4.4) Decreasing n-year term life insurance

In this type of insurance, benefits are payable at the moment of death, with n payable if
death occurs during the 1st year, n − 1 if death occurs during the 2nd year, …, n − t + 1 if
death occurs during year t.

 n − t  t  n  vt tn
bt =  and vt = 
 0 tn 0 tn

The symbol   denotes the greatest integer function

 ( n − t  )v t tn
The present value random variable is therefore Z = 
 0 tn

The actuarial present value of the insurance is the expected value of Z, E[Z ] given by,

n
D A x:n =  ( n − t  )v t t p x  x + t dt
1

1
where v = = e − , i is the interest rate and  is the force of interest
1+ i

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ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

Example 27 (Varying Benefit Insurances) (Constant Force)

An insurance coverage pays a benefit of t at the moment of death if death occurs at time t.
You are given

•  = 0.02
•  t = 0.05

Calculate the actuarial present value and variance of this insurance contract.

Solution


E [ Z ] = ( I A) x =  t v t t p x  x + t dt
0

=  t e −t e − t  dt
0

=   t e − (  + ) t dt
0

  n!
=
( +  )2
since 
0
t n e − ct dt =
c n +1
200
=
49


E [ Z 2 ] =  t 2 v 2t t p x  x + t dt
0

=  t 2 e −2 t e −  t  dt
0

=   t 2 e − (  + 2 ) t dt
0

2  n!
=
(  + 2 ) 3
since 
0
t n e − ct dt =
c n +1
40, 000
=
1, 728

Var [ Z ] = E [ Z 2 ] − E [ Z ]2 = 6.488423

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ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

Example 28 (Varying Benefit Insurances) (Constant Force)

An insurance coverage pays a benefit of t at the moment of death if death occurs at time t,
where t  10 . You are given

•  = 0.02
•  t = 0.05

Calculate the actuarial present value of this insurance contract.

Solution
10
E [ Z ] = I Ax:10 =  t v t t p x  x +t dt
1

0
10
=  t e −t e − t  dt
0
10
=   t e −(  + ) t dt
0

a10  + − 10e −10(  + ) u au  − ue − u

= 
− t
since te dt =
 + 0 

=
( 1− e −10 (  + )

 + ) − 10e −10(  + )

= 0.63594
 +

Example 29 (Varying Benefit Insurances) (Constant Force)

For a continuously increasing whole life insurance on a life age x, you are given

• The force of mortality is constant

•  t = 0 .06
• 2
A x = 0.25

Calculate the actuarial present value of this insurance contract.

Solution
 2 
Under constant force, A x = and A x = = 0.25 , which solve for  = 0.04
 +  + 2

E [ Z ] = ( I A) x =  t v t t p x  x + t dt
0

=  t e −t e − t  dt
0

=   t e − (  + ) t dt
0

  n!
=
( +  )2
since 0
t n e − ct dt =
c n +1
=4

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ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

3.5) Insurances payable m-thly

Consider a one-year term life insurance with benefit payable at the end of the m-th of the
year of death. We have
m −1
A1( m ) =  v
r +1
m
r px 1 qx+ r
x:1 m m m
r =0

Under the UDD assumption, we can show that r px 1 qx+ r = 1

m
q x . (Exercise)
m m m

Hence
m −1
qx  v
r +1
A1( m ) = 1
m
m

x:1
r =0

=q a (m)
x 1

= d
i(m)
qx
= i
i(m)
vqx
= i
i(m)
A1
x:1

Using similar concept, we can develop other formulas as follow

A1( m ) = i
i(m)
A1
x:n x :n

=
(m ) i
A x i(m)
Ax
Ax(:mn ) = i
i(m)
A1 +A 1
x :n x:n

n| Ax( m ) = i
i ( m ) n|
Ax

Furthermore, since as m →  , i (m ) →  , we have

A x:1 = lim A1( m ) = lim A1 =

1 i i
(m)  A1
m → x:1 m → i x:1 x:1

The limiting cases (under UDD assumption) for the above are

Ax = i

Ax
A x:n = i
1
 A1
x :n

A x:n = i
 A1 +A 1
x :n x:n

n| Ax = i
 n|
Ax

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ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

Comparison of insurances by the benefit payment frequency

Complete the table below by using Standard Ultimate Life Table with interest rate of 5%
per year and appropriate equations under UDD assumptions.

x 1
A x:10 A1( 4 ) A1( 2 ) A1
x:10 x:10 x:10

20 0.002142 0.002129 0.002116 0.002090

40

60

What are the reasons for this ordering?

The ordering reflects the fact that any payment under the continuous benefit will be paid
earlier than a payment under the quarterly benefit. The quarterly benefit will be paid earlier
than the end year benefit.

We will illustrate this by using timeline as below. Suppose the life dies at the time of 9.1.

time

9 10

School of Mathematical Sciences (SMS) page 97 August 2020 Semester

ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

Example 30 (UDD)(Insurances payable m-thly)

You are given

• Mortality follows the Standard Ultimate Life Table

• Deaths are uniformly distributed between integral ages
• i = 0.07

Calculate A47:2 .

Solution

We will use the formula A x:n = A x:n + Ax :n1|

1

Under UDD, A x:n = i

 A1 + Ax :n1|
x :n

First obtain A 1 = vq47 + v 2 1| q47

47:2

= vq47 + v 2 p47 q48

=

Then,

A 1 = v 2 2 p47
x :n

= v 2 p47 p48
=

Therefore, A47:2 = i
 A1 + A47:21|
47:2
=

School of Mathematical Sciences (SMS) page 98 August 2020 Semester

ASC2014 Life Contingencies I BSc (Hons) in Actuarial Studies

Example 31 (UDD)(Insurances payable m-thly)

You are given

• Mortality follows the Standard Ultimate Life Table

• i = 0.05
• Deaths are uniformly distributed between integral ages

(12 )
Calculate A50 .

Solution

We will use the formula Ax =

(m ) i
i(m)
Ax .

Then, A50 =
(12 ) i
i ( 12)
A50
= 0.1936

Example 32 (UDD)(Insurances payable m-thly)

You are given

• Deaths are uniformly distributed between integral ages

• i = 0.06
• q40 = 0.05
• A41 = 0.54

Calculate A40 .

Solution

From A x = i

Ax , we have A41 = 
i A41 = ln(1.06 )
0.06 (0.54 ) = 0.52442
Using Ax = v q x + v p x Ax +1 ,
A40 = v q40 + v p40 A41
= v q40 + v (1 − q40 ) A41
= 1.106 ( 0.05 ) + 1.106 (1 − 0.05 )( 0.52442 )
= 0.51717

School of Mathematical Sciences (SMS) page 99 August 2020 Semester