Chapter 4. Life Insurance.

Manual for SOA Exam MLC.

Chapter 4. Life Insurance.
Section 4.1. Introduction to life insurance.

c 2009. Miguel A. Arcones. All rights reserved.

Extract from:
”Arcones’ Manual for the SOA Exam MLC. Fall 2009 Edition”.
available at http://www.actexmadriver.com/

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Level benefit insurance in the continuous case

In this chapter, we will consider a cashflow of contingent

payments, i.e. the payments depend on uncertain events modeled
as a random variable.
Definition 1
The (APV) actuarial present value of a cashflow of payments is
the expectation of its present value at the time of purchase of this
cashflow.
The expected present value is also called the expected present
value and the net single premium.
The present value of a cashflow of payments can be random
because many reasons. A possibility that payments are made only
with a certain probability. A contingent cashflow is a cashflow
whose payments are uncertain. Usually, we are able to estimate the
probability that a contingent payment is made.
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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Recall that i is the annual effective rate of interest, v = (1 + i)−1

is the annual discount factor, δ = ln(1 + i) is the force of interest
(or continuously compounded annual rate of interest).

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 1
Consider the contingent cashflow

Payment C1 C2 ··· Cm
Probability that payment is made p1 p2 ··· pm
Time (in years) t1 t2 ··· tm

Here, pj , 1 ≤ j ≤ m, is the probability that j–th payment Cj is

made. Compute the actuarial present value of this contingent
cashflow.

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 1
Consider the contingent cashflow

Payment C1 C2 ··· Cm
Probability that payment is made p1 p2 ··· pm
Time (in years) t1 t2 ··· tm

Here, pj , 1 ≤ j ≤ m, is the probability that j–th payment Cj is

made. Compute the actuarial present value of this contingent
cashflow. (
1 if the j − th payment is made,
Solution: Let δj =
0 if the j − th payment is not made.
The
Pm present value random variable of this cashflow is
−t
j=1 Cj (1 + i) δj . The actuarial present value of this cashflow is
j

 
Xm Xm m
X
E Cj (1 + i)−tj δj  = Cj (1 + i)−tj pj = Cj v tj pj .
j=1 j=1 j=1
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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

We consider an insurance policy on a certain entity. Let T be the

age–at–death of this entity. Under this insurance policy, the
policyholder receives a payment at a certain time in the future.
Both the amount of the payment and the payment date depend on
T . Let bt be the benefit payment made when failure happens at
time t. Let vt be the discount factor when failure happens at time
t. The present value of the benefit payment is denoted by
Z = bT vT .
The actuarial present value of this benefit is
Z ∞
E [Z ] = bt vt fT (t) dt.
0
The bar over X is to denote that the continuous r.v. T is used.
When the entity in the insurance contract is (x), T is Tx and
Z ∞ Z ∞
E [Z ] = bt vt fTx (t) dt = bt vt · t px µx+t dt.
0 0
If the benefit payment is made at the time of death, then vt = v t . 6/14
c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 2
For a whole life insurance on (60), you are given:
(i) Death benefits are paid at the moment of death.
(ii) Mortality follows the de Moivre model with terminal age 100.
(iii) i = 7%.
(iv) bt = (20000)(1.04)t , t ≥ 0.
Calculate the mean and the standard deviation of the present value
random variable for this insurance.

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 2
For a whole life insurance on (60), you are given:
(i) Death benefits are paid at the moment of death.
(ii) Mortality follows the de Moivre model with terminal age 100.
(iii) i = 7%.
(iv) bt = (20000)(1.04)t , t ≥ 0.
Calculate the mean and the standard deviation of the present value
random variable for this insurance.
Solution: The present value random variable is
 T60
T60 T60 −T60 1.04
Z = bT60 v = (20000)(1.04) (1.07) = (20000) .
1.07

The density of T60 is

1
fT60 (t) = , 0 ≤ t ≤ 40.
40
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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Solution: The present value random variable is

 T60
T60 T60 −T60 1.04
Z = bT60 v = (20000)(1.04) (1.07) = (20000) .
1.07
The density of T60 is
1
fT60 (t) = , 0 ≤ t ≤ 40.
40
Hence,
t 1.04 t 40
40 

(20000) 1.07
Z
1.04 1
E [Z ] = (20000) dt =
0 1.07 40 40 ln(1.04/1.07) 0
1.04 40


(20000)( − 1)
1.07
= = 11945.06573,
40 ln(1.04/1.07)
2t 1.04 80
(20000)2 ( 1.07
Z 40

− 1)

2 2 1.04 1
E [Z ] = (20000) dt =
0 1.07 40 80 ln(1.04/1.07)
=157748208.7,
Var(Z ) = 157748208.7 − (11945.06573)2 = 15063613.41,
p √ 9/14
c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

In some cases, these insurance products depend on the time

interval of failure K . If bt and vt are constant functions in each
interval (k − 1, k], then T and K are in the same interval
(k − 1, k], bT = bK and vT = vK . In this case the present value of
the benefit payment is
Z = bK vK .
The actuarial present value of the benefit payment is
∞
X ∞
X
E [Z ] = bk vk P{K = k} = bk vk P{k − 1 ≤ T < k}.
k=1 k=1

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

When the entity in the insurance contract is (x), K is Kx and

∞
X ∞
X
E [Z ] = bk vk P{Kx = k} = bk vk · k−1 |qx .
k=1 k=1

Recall that

P{Kx = k} = P{k − 1 ≤ Tx < k} = P{k − 1 ≤ X − x < k|X > x}

s(x + k − 1) − s(x + k)
= = k−1 |qx = k−1 px · qx+k−1 = k−1 px − k px .
s(x)

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 3
A four–year warranty in a digital television will pay $400(5 − k) if
the television breaks during the k–th year, k = 1, . . . , 4. The
payment will be paid at the end of the year. The effective annual
1000
discount rate is 4%. The survival function is s(x) = (x+10) 3,

x ≥ 0. Find the actuarial present value of this warranty benefit.

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

Example 3
A four–year warranty in a digital television will pay $400(5 − k) if
the television breaks during the k–th year, k = 1, . . . , 4. The
payment will be paid at the end of the year. The effective annual
1000
discount rate is 4%. The survival function is s(x) = (x+10) 3,

x ≥ 0. Find the actuarial present value of this warranty benefit.

Solution: The actuarial present value of the warranty benefit is
4
X
400(5 − k)v k (s(k − 1) − s(k)) = 712.1391022.
k=1

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.
 Chapter 4. Life Insurance. Section 4.1. Introduction to life insurance.

4
X
400(5 − k)v k (s(k − 1) − s(k))
k=1
 
1000 1000
=(1600)(0.96) −
(10)3 (1 + 10)3
 
2 1000 1000
+ (1200)(0.96) −
(1 + 10)3 (2 + 10)3
 
3 1000 1000
+ (800)(0.96) −
(2 + 10)3 (3 + 10)3
 
4 1000 1000
+ (400)(0.96) −
(3 + 10)3 (4 + 10)3
=381.98046582 + 190.89406461 + 87.43850706
+ 30.82606472 + 21.00000000 = 712.1391022.

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c 2009. Miguel A. Arcones. All rights reserved. Manual for SOA Exam MLC.