LIM B

Chapter 8 – Emerging Cashflows used for Profit Testing

Profit Testing
•  This is a method of pricing a life insurance contract by looking at the
cashflows and surpluses each year

• Historically these were calculated and represented by the actuarial

symbols like or

• Computers can easily deal with cashflows, and we will use

spreadsheets to do this.
Advantages of profit testing
• Products are more complicated than they used to be, and profit-testing techniques
can be used when traditional actuarial EPV methodology does not work.

• Profit testing makes it easy to measure the rate of return achieved because
cashflows indicate when profit is made as well as how much profit is made(time
and amount for time diagram). Now can determine the return from the
company’s investment (ie the initial commission, expenses and reserve the
company has to set up at the outset)

• It is easy to carry out sensitivity analysis (ie varying the assumptions) to ascertain
how profitable the contract is under different “scenarios”
8.1 Review of the traditional
approach
Example
Consider a non-profit endowment assurance with the following contractual features:
• Term n=5 years
• Age at issue x=60
• Sum assures SA=$10,000 paid at the end of the year of survival or earlier death
• Initial expenses $100
• Renewal expenses 5% of premium per year

Calculate the annual premium, P, paid at the start of each year so that expected PV of
profit is $50 using the traditional approach. (Basis AM92 4%)
Solution
•Use
  the equation of value and tabulated EPVs
8.2 Emerging Cashflows(in & out)
• This approach is based on an explicit consideration of the expected
cashflows in each time period – usually monthly, or annually

• Define CFt as the assumed cashflows from time t-1 to time t,

accumulated to time t, per policy in force at time t-1.
Elements in cashflow CFt
• P  t = premiums at time t-1, BOY
• Et = expenses at time t-1, BOY
• it = investment return from t-1 to t, interest rate over the year
• Dt = benefit on death at time t, EOY
• qx+t-1 = probability of death during the year
• St = benefit on survival to time t, EOY

What is an expression for the whole cashflow CFt ?

Cashflow expression
• 
Consider the last example again, 1
policy/year
Year Premium Expenses Interest at 4% Death benefit = Survival Cashflow CFt
t 10,000q60+t-1 benefit
1 P 100+0.05P 4%(0.95P-100) 80.22 0 0.988P-184.22
2 P 0.05P 4%(0.95P)=0.038P 90.09 0 0.988P-90.09
3 P 0.05P 0.038P 101.12 0 0.988P-101.12
4 P 0.05P 0.038P 113.44 0 0.988P-113.44
5 P 0.05P 0.038P 127.16 9,874.84 0.988P-10,000
Finding EPV from cashflows
• EPV = cashflow x prob of cashflow x discounting factor
• CF is for a policy that starts the year. P was paid.
Pr(starting the year and paying P, yielding EOY CF)

Year CFt p
t-1 x vt EPV
t
1 0.988P - 184.22 1 0.96154 -177.13+0.95P
2 0.988P - 90.09 0.99198 0.92456 -82.63+0.9061P
3 0.988P - 101.12 0.98304 0.88900 -88.37+0.86344P
4 0.988P - 113.44 0.97310 0.85480 -94.36+0.82182P
5 0.988P – 10,000 0.96206 0.82193 -7907.46+0.78126P

• The total of the last column is 4.32262P -$8349.95, so for a $50 EPV,
P=$1,943.25 (same as traditional method, with rounding)
Recalculate the cashflows using this
premium
Year Premium Expenses Interest at 4% Death benefit = Survival Cashflow CFt
t 10,000q60+t-1 benefit
1 1943.30 197.17 69.85 80.22 0 1735.76
2 1943.30 97.17 73.85 90.09 0 1829.89
3 1943.30 97.17 73.85 101.12 0 1818.86
4 1943.30 97.17 73.85 113.44 0 1806.54
5 1943.30 97.17 73.85 127.16 9,874.84 -8080.02
8.3 Allowance for Reserves: Profit
Testing
• The example above ignores the cost of setting up and maintaining
reserves.
• This is important because the insurer’s owners (typically
shareholders) want to receive a return on their capital (often used for
reserve, asset). A=L+C. Reserve comes from capital(not cash in/out)
• Adding in the cost of setting up and maintaining reserves to the
cashflows is called profit testing
• The set of end year cashflows are called the profit profile or profit
vector
• As with the cashflows, we find the emerging profit per policy in force
at the start of the year
The profit vector
• Define PROt to be the assumed accumulated EOY profit made in the
year t-1 to t per policy in force at BOY after allowing for setting up the
reserves
• The profit vector is then PRO=(PRO1, PRO2,…..PROn)

So

• CFt uses the actual cashflows and interest earned during the year
• PROt modifies CFt by incorporating the cost of setting up and
maintaining the reserves (ie the profits and losses emerging during
the policy term on the invested capital)
Calculating PROt
•Tip:
  Create a column of reserves(tV) often using policy values, V(t)

• During the year, interest is earned = t-1V it

• At the end of the year, we need to establish a reserve of tV with
probability px+t-1, proportion of life that survived year
• At the start of the year the reserve held is t-1V
• We add these items to the cashflows CFt
The increase in reserve
• 

The increase in the reserve is . This can be written

If it is positive, more capital is needed to support the policy
If it is negative, reserves are released(negative negative) and can be paid out as
profit
The profit signature, σt
•  σt is the assumed accumulated EOY profit after allowing for reserves
in the year , per policy sold at time 0 Proportion of original
life that starts year
• Total expected PV of profit (for owners/shareholders) is then found by
discounting the elements of the profit (generated by ins. co) signature

Note we have discounted at the same rate of interest as we

accumulated the cashflows and reserves in finding CFt and PROt We will
return to this point later
Example again
•Let  us assume that the reserves are the net premium policy values, based on
AM92 Ult at 4%, then the net premium is:

We can calculate other reserves recursively from 5V=10,000

Or, we can use the tables

Table showing the elements of the profit
vector
Year Cashflow(t) t-1 V Interest on reserves Increase on reserves

1 1,735.76 -0.25 -0.01 1,805.46

2 1,829.89 1,819.81 72.79 1,868.39
3 1,818.86 3,721.73 148.87 1,933.44
4 1,806.54 5,712.94 228.52 2,000.77
5 -8,080.02 7,802.22 312.09 -7,802.22

𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑜𝑛𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠𝑦𝑟4=𝑝
 
634 𝑉− 3 𝑉=7,802.22×0.988656−5712.9 4=2,000.77
 Pr(x is alive at start
Profit vectors and profit signature of year to contribute
to profits)
Discount
Year Cashflowt Interest on Increase on PV
t-1V PROt t-1px σt factor at profit
t reserves reserves
4%
1 1,735.76 -0.25 -0.01 1,805.46 -69.72 1.00000 -69.72 0.96 -67.03
2 1,829.89 1,819.81 72.79 1,868.39 34.29 0.99198 34.01 0.92 31.45
3 1,818.86 3,721.73 148.87 1,933.44 34.29 0.98304 33.71 0.89 29.97
4 1,806.54 5,712.94 228.52 2,000.77 34.29 0.97310 33.37 0.85 28.52
5 -8,080.02 7,802.22 312.09 -7,802.22 34.29 0.96206 32.99 0.82 27.11

• The expected PV of profit allowing for the reserves is the sum of the
final column ($50), The same as not allowing for reserves – this is
for a particular reason. See 1st bullet point on slide 24.
Pattern of profits
• The typical pattern is σt<0 in the early years of a contract and σt>0 in
the later years
• Negative profit in the early years is known as new business strain
• It represents the support that is needed from the providers of the
capital to write new policies
• Providers of capital will expect a good rate of return on their
investment or they will invest elsewhere
8.4 Profit measurement
•  We calculated the expected PV of profit using the same interest rate
(4%) for the reserving and premium basis, $50.

• This is the only result possible using the traditional approach

• From the capital provider’s point of view, the profit signature

represents the expected future payoffs. The capital provider/investor
will discount these payoffs based on their own views. It is unlikely this
will be the same rate of interest as was used for pricing the contract
Different methods of measuring
profit
• Expected PV of profit at the Risk Discount Rate (RDR)

• The Discounted Payback Period (DPP)

• The Internal Rate of Return (IRR)

• The profit margin

We will use ip to denote the interest rate in the actuary’s pricing and/or valuation
basis
8.4.1 The Risk Discount Rate (RDR)
•  The investor will choose a risk discount rate that depends on the rate
of return on comparable risky assets

• If gilts are yielding 6% per annum, the investor might choose a risk
discount rate when assessing risky projects

• The investor can discount the profit signature at his chosen RDR and
then use some profit criteria to determine whether or not to invest
Expected PV of profits at RDR
•  The expected PV of profit is which gives the same result as the
traditional approach if
• It is unlikely that because:
1. The actuary will set ip no higher than risk-free interest rates in order to set a
conservative basis-possibly even legeally mandatory
2. The investor will choose ir above the risk-free rate of interest because future cashflows
are risky (future mortality, interest and expenses are uncertain)
• In recent practice , AMEX used 20% in early 90’s
• In our example, the expected PV of profit at =.1 is $33.33 (<$50
because >
Profit target or criterion
•  The investor will need to set a profit target or criterion
• This might be related to the amount the salesperson earns from
selling the policy
• The investor(could be the insurance co.) might require a profit equal
to half of the initial commission, for example
• If we suppose that the initial commission amounts to half the initial
expenses, then we will need EPV(profit)>$25 (
• In our example, the profit of $33.33>$25. Hence, investment occurs
and sales can begin.
See slide 29
8.4.2 Profit Margin
•  The profit margin(using RDR) is EPV of profit expressed as a
proportion of EPV(premiums) ie what part of each premium is profit

• The profit criterion may then be a profit margin of x%

Example
•Suppose
  we require a profit margin of 1% of premiums
Pr(being alive to
pay premium)
Discount
Year Premium t-1px factor at EPV of prem
10%
1 1,943.30 1.00000 1 1,943.30
2 1,943.30 0.99198 0.909091 1,752.47
3 1,943.30 0.98304 0.826446 1,578.79
4 1,943.30 0.97310 0.751315 1,420.76
5 1,943.30 0.96206 0.683013 1,276.94
7,972.26

The profit margin is so the policy fails

8.4.3 The Discounted Payback
Period (DPP)
•  The DPP is the time taken to repay the new business strain with
interest at the RDR
• It is the smallest t such that

• The faster the strain is repaid (ie smaller t), the sooner the insurer can
invest in a new project
• The insurer might set a criterion, for example that the DPP should be
not more than 5 years
Example
• Suppose the profit signatures σt are given as before, and ir=10%
Year σt Discount Cumulative
factor profits
−1 −2
−69.72(1.1) +34.01(1.1) =−69.72×0.909+34.01×0.826=−35.27
 
1 -69.72 0.909091 - 63.38
2 34.01 0.826446 - 35.27
3 33.71 0.751315 - 9.94 Cumulative profit
4 33.37 0.683013 12.85 becomes +ve at t=4
5 32.99 0.620921 33.33

• The DPP is 4 years so it passes the test

8.4.4 Internal Rate of Return (IRR)
• The
  IRR is the rate of interest at which the EPV of future profits is zero

• It cannot always be used as there may be no solution or more than one solution
• A profit criterion might be for example that the IRR is at least as great as the
RDR, which means that the EPV of profits at the RDR is positive
• Our example passes the test

DPP and IRR have been widely used for evaluating profits from investment
projects in corporate finance
8.4.5 Profit measurement in
practice
When deciding on an appropriate price which meets our profit
criterion, we carry out the following procedure:
• Evaluate the four profit measures when designing a new product or
setting premium rates
• Adjust premiums/benefits until the profit criteria are passed
• Consider marketing implications – you must be able to sell the
product (eg competitors’ premiums)
8.5 Actuarial Bases
•We
  have seen that

and

• This includes premiums, policy values and other cashflows.

• An actuarial basis is a set of assumptions used to carry out one or
more actuarial calculations
Actuarial bases
• The assumptions include interest, mortality, expenses and other
assumptions such as bonus rate, surrenders and morbidity

Different bases may be used for different purposes. For example

• The pricing actuary may choose a reasonable, prudent set of
assumptions when setting premiums
• The valuation actuary will use a basis that satisfies the regulator
• The finance director wants to estimate future profits using a realistic
estimate of the future
 
In this equation:
• The premiums would be calculated using the premium basis
• The policy values would be calculated using the valuation basis
• All other elements would be calculated using the experience basis

It is likely all of these bases are different

Scenario testing or sensitivity
analysis
If our assumptions are not correct, how will profit be affected?
We can find out by varying the experience basis and re-calculate the
profit.
Example
Suppose the valuation basis uses 4% interest to satisfy the regulator,
but the finance director/CFO thinks that 5% is a more realistic return on
assets.
We can investigate the effect on profits of using 5% interest to calculate
the reserves and cashflows.
Reserves calculated at 4% interest,
but 5% assumed to be earned on
assets
V
Year Premium Expenses Interest Death Survival Cashflowt t-1 Interest on Increase on PROt p
t-1 x σt
at 5% benefit benefit given reserves at 5% reserves

1 1,943.30 197.17 87.31 80.22 - 1,753.22 -0.25 -0.01 1,805.46 -52.26 1.00000 -52.26

2 1,943.30 97.17 92.31 90.09 - 1,848.35 1,819.81 90.99 1,868.39 70.95 0.99198 70.38

3 1,943.30 97.17 92.31 101.12 - 1,837.32 3,721.73 186.09 1,933.44 89.97 0.98304 88.44

4 1,943.30 97.17 92.31 113.44 - 1,825.00 5,712.94 285.65 2,000.77 109.88 0.97310 106.92

5 1,943.30 97.17 92.31 127.16 9,872.84 -8,061.56 7,802.22 390.11 -7,802.22 130.77 0.96206 125.81
EPV of Profit
The EPV of profit at the RDR of 10% is $228.25 (was $33.33)
Interest at 4% Interest at 5%
Year σt Discount factor Cumulative profits Year σt Discount factor Cumulative profits
1 -69.72 0.90909 - 63.38 1 -52.26 0.90909 - 47.51
2 34.01 0.82645 - 35.27 2 70.38 0.82645 10.66
3 33.71 0.75131 - 9.94 3 88.44 0.75131 77.11
4 33.37 0.68301 12.85 4 106.92 0.68301 150.14
5 32.99 0.62092 33.33 5 125.81 0.62092 228.25
Effect of varying one element of the
basis
What is the effect of varying any one element of the three bases,
premium, valuation or experience?

Eg experience basis
• Higher interest => higher profit
• Higher expenses => lower profit
• High mortality – depends on the product
1. Term insurance => lower profit
2. Annuity => higher profit
Effect of varying the premium basis
All else being equal
• A higher premium will increase profit
• A lower premium will decrease profit

Therefore
• Higher interest => lower premium => lower profit
• Higher expenses => higher premium => higher profit
• High mortality – depends on the product
1. Term insurance => higher premium => higher profit
2. Annuity => lower premium => lower profit

• NOTE: This assumes a net premium valuation basis, so that a change in the office premium does
not affect policy values
Effect of varying the valuation basis
In most cases a change in the valuation basis will affect policy values

• Higher interest => lower policy values => lower reserves

• Higher expenses => higher reserves
• High mortality – depends on the product
1. Term insurance => higher reserves
2. Annuity => lower reserves

The question is: how does a change in the valuation basis affect profits?
Example – fix experience basis at AM92
Ult 4%
•We
  will consider two different net premium valuation bases:

1. 4% and AM92 Ult => Net premium

2. 6% and AM92 Ult => Net Premium =
Comparing profit from different
valuation bases
Valuation basis: 4% AM92
Cashflowt t-1 V given Interest on reserves Increase on reserves PROt p
t-1 x σt
(4%)
1,735.76 -0.25 -0.01 1,805.46 -69.72 1.00000 -69.72
1,829.89 1,819.81 72.79 1,868.39 34.29 0.99198 34.01
1,818.86 3,721.73 148.87 1,933.44 34.29 0.98304 33.71
1,806.54 5,712.94 228.52 2,000.77 34.29 0.97310 33.37
-8,080.02 7,802.22 312.09 -7,802.22 34.29 0.96206 32.99

Valuation basis: 6% AM92

Cashflowt V given Interest on reserves Increase on reserves
t-1 PROt p
t-1 x σt
(4%)
1,735.76 0.33 0.01 1,734.40 1.37 1.00000 1.37
1,829.89 1,748.76 69.95 1,829.44 70.40 0.99198 69.84
1,818.86 3,610.73 144.43 1,930.13 33.16 0.98304 32.60
1,806.54 5,597.46 223.90 2,037.01 -6.57 0.97310 -6.40
-8,080.02 7,722.07 308.88 -7,722.07 -49.06 0.96206 -47.20
Remarks
• A higher valuation rate => lower reserves

• In the early years, setting up smaller reserves leads to larger profits/ smaller losses.
This is because the profit vector includes the increase in reserves as a cost.

• In the later years, setting up smaller reserves leads to smaller profit/ larger losses.
This is because less interest is earned, and larger increases in reserves are required.

In our example at 6% the later increases in reserves result in losses at the end of the
term.
Important result
• If the experience basis interest rate is the same as the RDR, then the
total profit discounted at the RDR is not affected by the valuation
basis.
Example
In our example, suppose the RDR=4%, then the expected profit is $50.
For valuation interest of 4% and 6%, calculate the expected profits and
check they are the same.
Proof
• 
But if is the experience basis interest rate this is
)]

=
Let in the middle sum
=
=
Proof continued
• 

=0 =sum assured or 0
None of these items depend on the valuation basis
8.6 Emerging cashflows versus actuarial
functions
Advantages of actuarial functions
1. Quick and easy to calculate

Disadvantages of actuarial functions

2. Ignore cost of setting up reserves
3. Provides no information about timing of cashflows
4. Difficult to use to price complex benefits
Emerging cashflows versus actuarial
functions
Advantages of emerging cashflows
1. Easy to implement using a computer, in particular, a spreadsheet
2. Allow for the cost of setting up reserves
3. Provide expected cashflows each year=>convenient for choosing assets
4. Can be used for calculating even the most complex benefits

Disadvantages of emerging cashflows

5. None, if computers are available
6. Even quicker to calculate commutation functions by computer
Example – May 2013 exam q4
A life insurer issues endowment policies with a term of 3 years. The sum
assured is £10,000 payable on maturity or at the end of the year of earlier
death.
Level annual premiums of £3,200 are payable a the beginning fo each year.
The office uses the following experience basis:
Interest: 4% pa in the 1st and 2nd year, 6% pa in the 3rd year
Mortality: 0.2% pa
Expenses: £250 at the start of the contract plus 1% of each premium
The reserves to be held at the end of the 1st and 2nd policy years per policy
in force are £4,000 and £7,000 respectively
Example – May 2013 exam q4
a. Calculate the profit vector for this policy. Show your steps clearly.
[5 marks]

b. Calculate the profit margin on this policy using a risk discount rate of 10% per
annum.
[3 marks]

c. Explain, with reasons, whether the profitability of this policy would increase,
decrease or stay the same if the valuation basis was strengthened. (Do not carry
out any further calculations)
[2 marks]
Example – solution (a)

Survival Interest on Increase on

Year Premium Expenses Interest Death benefit benefit
Cashflowt V given
t-1
reserves reserves
PROt

1 3,200.00 282.00 116.72 20.00 - 3,014.72 0.00 0.00 3,992.00 -977.28

2 3,200.00 32.00 126.72 20.00 - 3,274.72 4,000.00 160.00 2,986.00 448.72

3 3,200.00 32.00 190.08 20.00 9,980.00 -6,641.92 7,000.00 420.00 -7,000.00 778.08
Example – solution (b)
PROt p σt Discount factor at PV profit Year
t-1 x
10%
-977.28 1.00000 -977.28 0.909 -888.44 1
448.72 0.99800 447.82 0.826 370.10 2
778.08 0.99600 774.97 0.751 582.25 3
   Mort=0.2% 245.51   63.91  

Year Premium p
t-1 x Discount factor EPV
1 3,200.00 1.00000 1 3,200.00
3,200.00 2,903.27
 The profit margin is
2 0.99800 0.909091
3 3,200.00 0.99600 0.826446 2,634.06
8,737.33
Example – solution (c)
If the basis is strengthened, then the profitability of the policy would
reduce:

1. Since higher reserves need to be held and capital is tied up at a cost for
longer

2. And the risk discount rate is higher than the earned interest rate