Lecture 2

Class: TY BSc
Subject : Pricing and Reserving for Life Insurance Products
Subject Code: PUSASQF506A
Chapter: Unit 1 Chapter 2
Chapter Name: Life Assurance and Annuity Contracts

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Today’s Agenda
0. Introduction

1. Life Assurance Contracts

1. Whole Life Assurance
2. Term Assurance
3. Pure Endowment
4. Endowment Assurance Contracts
5. Deferred Assurance

2. Life Annuity Contracts

1. Whole Life Annuities
2. Temporary Annuities
3. Deferred Annuities
4. Guaranteed Annuities
5. Continuous Annuities

3. Premium Conversion Formulae

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0 Introduction
Discuss:
What are assurance contracts? What are annuity contracts? And what is the difference between the two benefits?

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0 Introduction
• A life insurance pays a benefit (single) to the insured policyholder upon death or survival.
• The benefit may be payable whenever the insured dies, or may be payable only if the insured dies within a
fixed number of years, or may be payable only if the insured dies after a fixed number of years. The benefit
may vary depending on when death occurs.

• A life annuity contract provides payments of amounts, which might be level or variable, at stated times,
provided a life is still then alive.

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0 Motivation
• We are interested in calculating the expected value of the present value of the benefit. This is the amount we
would put aside today to fund the benefit.

• For a large group of independent policyholders, if we set aside the expected present value of the benefit for
each policyholder, the law of large numbers tells us that we will have approximately enough money to pay all
the benefits when they become due.

• We would also like to calculate the variance of the present value of the benefit. Then we can use the normal
approximation to determine the size of the fund that has a high probability of being adequate to pay all the
benefits.

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Revision

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0 Introduction
Types of Insurance Contracts
We will consider valuation of the following kind of contracts:

Whole life Endowment

Term assurance Pure Endowment
assurance assurance
• The benefit under • A term assurance • A pure endowment • A sum assured is
such a contract is an contract is a contract contract provides a payable either on
amount, called the to pay a sum assured sum assured at the death during the term
sum assured, which on or after death, end of a fixed term, or on survival to the
will be paid on the provided death provided the end of the term. The
policyholder's death. occurs during a policyholder is alive. sums assured
specified period, payable on death or
called the term of the survival need not be
contract. the same, although
they often are.

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1.1 Whole Life Assurance
The benefit under such a contract is an amount, called the sum assured, which will be paid on the policyholder's
death.

1.1.A Expected Present Value

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1.1 Whole Life Assurance

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 Generalization
In General, we can always express the EPV of a life-contingent benefit by considering each time point
at which the benefit can be paid, and summing over all possible payment times the product of:

(1) the amount of the benefit,

(2) the appropriate discount factor, and
(3) the probability that the benefit will be paid at that time.

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1.1 Whole Life Assurance
1.1.B Variance of Present Value Random Variable

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1.1 Whole Life Assurance

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Question
An insurance on [70] pays 1000 at the end of the year of death if [70] dies after 1 year but not
after 3 years.
You are given:
(i) Mortality is based on the following 2-year select-and-ultimate table:

(ii) i = 0.04
(iii) Z is the present value random variable for the insurance.

Calculate E[Z].

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Solution

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Question
Assume the same mortality and interest as the previous question. An insurance on [70] pays a
benefit of 1000 at the end of the year if death occurs in the first year and 2000 at the end of the year if death
occurs in the second year. Let Z be the payment random variable for this insurance.

Calculate Var(Z).

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Solution

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1.1.C Benefits payable immediately on death
So far we have assumed that assurance death benefits have been paid at the end of the year of death. In
practice, assurance death benefits are paid a short time after death, as soon as the validity of the claim can be
verified.

Thus, Real life insurance pays the benefit soon after the death of the policyholder.

Assuming a delay until the end of the year of death is therefore not a prudent approximation, but assuming
that there is no delay and that the sum assured is paid immediately on death is a prudent approximation.

Try to write the present value random variable for whole life assurance, assuming benefit of $1 is payable
immediately on death.

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1.1.C Benefits payable immediately on death

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Discuss
Given below is the timeline for whole life assurance with benefit payable immediately on death. With the help of it,
discuss the intuition/logic behind the EPV of the benefit.

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Discuss
Here, we are assuming that the interest rate is fixed and Constant. Do you think that is appropriate?

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1.2 Term Assurance
Under a term insurance policy, the death benefit is payable only if the policyholder dies within a fixed term of, say,
n years.

1.2.A Expected Present Value

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1.2 Term Assurance

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1.2 Term Assurance
1.2.B Variance of Present Value Random Variable

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1.2.C Benefits payable immediately on death

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Question
CT5 September 2017
A special whole life assurance policy is issued on a life aged 50 exact.

Under this policy the sum assured, payable at the end of the year of death, is 1 unit for
the first 10 years decreasing to 0.75 units thereafter.

(i) Calculate the expected present value of the benefit.

(ii) Determine the variance of the present value of the benefit.

Basis:
Mortality AM92 Ultimate
Interest 4% per annum

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Solution

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Solution

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Question

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Solution

We observe that values increase as x increases, reflecting the fact that the probability
of death in a 10- year period increases with age for the survival model we are using.

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1.3 Pure Endowment
A pure endowment contract provides a sum assured at the end of a fixed term, provided the
policyholder is then alive.

1.3.A Expected Present Value

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1.3 Pure Endowment

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1.3 Pure Endowment
1.3.B Variance of Present Value Random Variable

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1.4 Endowment Assurance Contracts
An endowment assurance provides a combination of a term assurance and a pure endowment.

The sum insured is payable on the death of (x) should (x) die within a fixed term, say n years, but if (x) survives for
n years, the sum insured is payable at the end of the nth year.

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1.4 Endowment Assurance Contracts
1.4.A Expected Present Value

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1.4 Endowment Assurance Contracts
1.4.B Variance of Present Value Random Variable

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1.4.C Benefit Payable Immediately on death

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1.4.C Benefit Payable Immediately on death

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Question

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Solution

The actuarial values of the 10-year endowment insurance functions do not vary
greatly with x, unlike the values of the 10-year term insurance functions.

The reason for this is that the probability of surviving 10 years is large (10p20 =
0.9973, 10p60 = 0.9425) and so for each value of x, the benefit is payable after 10
years with a high probability

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1.5 Deferred Assurance Contracts
Deferred insurance refers to insurance which does not begin to offer death benefit cover until the end of a
deferred period

1.5.A Deferred Whole Life Assurance

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1.5 Deferred Assurance Contracts
1.5.A Deferred Whole Life Assurance

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1.5 Deferred Assurance Contracts
Deferred Whole Life Assurance

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1.5 Deferred Assurance Contracts
1.5.A Deferred Whole Life Assurance

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1.5 Deferred Assurance Contracts
1.5.B Deferred Term Assurance

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1.5 Deferred Assurance Contracts
1.5.B Deferred Term Assurance

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1.6 Claims Acceleration Process

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1.6 Claims Acceleration Process

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1.6 Further Approximation

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1.7 Functions for Select Lives

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1.8 Evaluating Assurance Benefits

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Question

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Solution

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2 Life Annuity Contracts
The term life annuity to refer to a series of payments to (or from) an individual as long as the individual is alive
on the payment date.

The valuation of annuities is important as annuities appear in the calculation of premiums, policy values
and pension benefits.

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2 Life Annuity Contracts
Types of Annuity Contracts
We consider four varieties of life annuity contract:

Whole life Temporary Deferred Guaranteed

level annuity level annuity annuity. annuity.
• Annuities under • Annuities under • Annuities under • Annuities under
which payments are which level which the start of which payments are
made for the whole payments are made payment is deferred made for the whole
of life, with level only during a limited for a given term, of life, or for a given
payments, called a term, called a called a deferred term if longer, called
whole life level temporary level annuity. a guaranteed
annuity or, more annuity or, more annuity.
usually, an usually, just a
immediate annuity. temporary annuity.

Further, we consider the possibilities that payments are made in advance or in arrears.

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2.1 Whole life annuities payable annually in
arrears
An immediate annuity is one under which the first payment is made within the first year.

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2.1 Whole life annuities payable annually in
arrears
2.1.A Expected present value

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2.1 Whole life annuities payable annually in
arrears

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2.1 Whole life annuities payable annually in arrears
2.1.B Variance of Present Value Random Variable

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2.1 Whole life annuities payable annually in
advance
An annuity-due is one under which payments are made in advance.

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2.1 Whole life annuities payable annually in
advance
2.1.C Expected Present Value

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2.1 Whole life annuities payable annually in
arrears
2.1.D Variance of Present Value Random Variable

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2.1 Whole life annuities - Relationship

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2.2 Temporary annuities payable annually in arrears
A temporary immediate annuity differs from a whole life immediate annuity in that the payments are
limited to a specified term.

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2.2 Temporary annuities payable annually in arrears
2.2.A Expected Present Value

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2.2 Temporary annuities payable annually in arrears
2.2.B Variance of Present Value Random Variable

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2.2 Temporary annuities payable annually in advance
A temporary immediate annuity-due has payments that are made in advance and are limited
to a specified term.

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2.2 Temporary annuities payable annually in advance
2.2.C Expected Present Value

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2.2 Temporary annuities payable annually in advance
2.2.D Variance of Present Value Random Variable

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2.2 Temporary annuities - Relationship

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2.3 Deferred Annuities - Arrears
Deferred annuities are annuities under which payment does not begin immediately but is deferred for one or
more years.

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2.3 Deferred Annuities - Arrears
2.3.A Expected Present Value

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2.3 Deferred Annuities - Due

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2.3 Deferred Annuities - Due
2.3.B Variance of the present value random variable

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2.4 Guaranteed Annuities - Due
A guaranteed annuity differs from a whole life annuity in that the payments have a minimum specified term.

Consider a guaranteed annuity contract to pay 1 at the start of each future year for the next n years, and at the
start of each subsequent future year provided a life now aged x is then alive.

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2.4 Guaranteed Annuities - Due
2.4.A Expected Present Value

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2.4 Guaranteed Annuities - Due
2.4.A Expected Present Value

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2.4 Guaranteed Annuities - Due
2.4.B Notation

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2.4 Guaranteed Annuities - Due
2.4.C Variance of the present value random variable

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Discuss
Variance for the deferred annuity-due and the variance of the guaranteed annuity-due are the same.
Discuss why?

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2.4 Guaranteed Annuities - Arrears

2.4.C Expected Present Value

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2.4 Guaranteed Annuities - Arrears
2.4.D Variance of the present value random variable

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2.5 Continuous Annuities

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2.5 Continuous Annuities

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2.5 Continuous Annuities

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2.6 Approximations

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Question

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Solution

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2.7 Evaluating Annuity Benefits

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2.8 Annuities Payable m times per year
For premiums, annuities and pension benefits, the
annual form of the annuity would be unusual.

We now consider the question of how annuities, with

payments made more than once each year but less
frequently than continuously, may be evaluated.

2.8.A Whole life mthly annuity due

Consider first an annuity of total amount 1 per year,
payable in advance m times per year throughout the
lifetime of (x), with each payment being 1/m.

This is plotted on the time line below:

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2.8 Annuities Payable m times per year

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2.8 Annuities Payable m times per year

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3 Premium Conversion Formulae

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Question
CT5 September 2015

A special annuity pays 5,000 per annum for five years increasing to 6,000 per annum for the next five
years and increasing further to 7,000 thereafter. The payments for the first five years are guaranteed and
thereafter are contingent on survival. The annuity is payable monthly in advance.

Calculate the expected present value of this annuity for a life aged 60 exact. Show all
your workings.

Basis:
Mortality PMA92C20
Interest 4% per annum

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Solution

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Question
CT5 April 2010

100 graduates aged 21 exact decide to place the sum of £1 per week into a fund to be shared on their
retirement at age 66 exact.

Show that each surviving member can expect to receive on retirement a fund of approximately £7,240.

Basis:
Rate of interest 4% per annum
Mortality AM92 Ultimate

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Solution

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Question

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Solution

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Question

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Solution

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