Theory of Interest and Mathematics of Life Contingencies

Review Notes

Table of Contents
1. Time Value of Money .................................... 2 1.1. Accumulation and Amount Function 2 1.2. Simple and Compound Interest ........ 2 1.3. Measures of Interest ......................... 3 1.4. Force of Interest ................................ 5 1.5. Miscellaneous Models....................... 6 2. Analysis of Annuities ..................................... 7 2.1. Annuities ............................................ 7 2.2. Perpetuities ....................................... 8 2.3. General Annuities and Perpetuities.. 9 2.4. Inflation Rate ................................... 11 2.5. Continuous Annuities ...................... 11 2.6. Annuities Payable at a Different Frequency than Interest is Convertible ...................................... 12 3. Cash Flow Analysis ...................................... 15 3.1. Yield Rates ....................................... 15 3.2. Existence and Uniqueness of the Yield Rate ......................................... 15 3.3. Interest Measurement of a Fund .... 15 3.4. Approximation Methods ................. 16 3.5. Reinvestment Rates ........................ 17 3.6. Miscellaneous Methods .................. 17 4. Loan Repayment.......................................... 19 4.1. Amortization Scheduling ................. 19 4.2. Sinking Fund Method ...................... 19 5. Analysis of Financial Instruments ............... 21 5.1. Financial Instruments ...................... 21 5.2. Callable Bonds ................................. 21 6. Survival Models ........................................... 23 6.1. Future Lifetime Random Variable... 23

6.2. Force of Mortality ........................... 23 6.3. Mean and Variance of ................ 24

6.4. Curtate Future Lifetime Random Variable ........................................... 24 6.5. Fractional Ages ................................ 25 6.6. Special Laws of Mortality................ 26 6.7. Life Tables ........................................ 26 6.8. Select and Ultimate Life Tables ...... 26 7. Analysis of Life Insurances .......................... 28 7.1. Life Insurances................................. 28 7.2. Relationship Between Insurances Payable at Moment of Death and End of Year of Death .............................. 29 7.3. Variance of ................................. 30

7.4. Varying Benefit Insurance............... 30 7.5. Commutation Notations ................. 30 8. Analysis of Life Annuities ............................ 32 8.1. Life Annuities................................... 32 8.2. Continuous Life Annuities ............... 33 8.3. Life Annuities Payable at a Different Frequency than Interest is Convertible ...................................... 34 8.4. Commutation Notations ................. 34 9. Premiums and Reserves.............................. 35 9.1. Net Level Premiums ........................ 35 9.2. Gross/Expense-Loaded Premiums.. 38 9.3. Benefit Reserves Prospective Approach ......................................... 39 9.4. Benefit Reserves Retrospective Approach ......................................... 40 9.5. Other Reserve Formulas ................. 41

1. Time Value of Money 1.1. Accumulation and Amount Function An initial amount of money invested on a fund/portfolio is called the principal or capital An amount of money withdrawable from the fund/portfolio at time is called the accumulated value, denoted by The difference between the accumulated value and the principal is called the interest A negative interest is called loss A unit measurement for time is called the period Consider an initial investment of 1 at time o The accumulated value at time of this investment is denoted by ( ), known as the accumulation function

level and is not reinvested back into the fund Let be the interest earned on the ( ) ( ) period, then For the SIRM with an initial value of 1 at o o o The accumulated value at is ( ) ( ) The accumulated value at is ( ) ( ) Recursively, the accumulated value at is ( )

Remarks: 1. 2. 3. ( ) ( ) is normally increasing ( ) is not necessarily continuous Now consider an initial investment of o The accumulated value at time of this investment is denoted by ( ), known as the amount function The SIRM takes the form of a step function, Ideally, the SIRM should be true Suppose interest accrues continuously, i.e. ( ) is continuous ( ) ( ) o Note that ( ) The accumulated value at time can be divided into the interest part, ( ) , and the principal part Accumulating the principal periods later plus the interest yields the equality

Remarks: ( ) 1. ( ) ( ) 2. 3. The properties of the amount function is similar to that of the accumulation function

1.2. Simple and Compound Interest The simple interest rate model (SIRM) is where the interest earned per period is
2

( )

( ( ) ( ) ( ) ( )

) ( )

( ) ( )

( )

( ) ( )

( ) ( ) ( ) ( ) ( )

( )

( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )

( )

Therefore, ( ) is linear ( ) ( ) ( ) ( ) ( ) ( ) ( ) o o If ( ) ( ) ( )

( ) ( ) * ( ) +

( ) ( )

( ) ( ), If ( ) then ( ) o Therefore, ; ( )( ) moreover, ( ) The compound interest rate model (CIRM) is where the interest earned by the fund is immediately reinvested back into the fund For the CIRM with initial value of 1 at o The accumulated value at is ( ) ( ) o The accumulated value at is ( ) ( ) ( ) o Recursively, the accumulated value ) at is ( ) ( Similar to the SIRM, suppose interest accrues continuously ) ( ) ( ) o Note that ( If the initial value of 1 is accumulated for periods, its accumulated value is reinvested back into the fund Accumulating ( ) more periods yields the equality o

( ) * ( )+, then ( ) ( ) * ( ( ) Therefore, )+ ( ); moreover, ( ) ( )( )

1.3. Measures of Interest 1. Effective Rate of Interest Amount of interest earned by a deposit of 1 at the beginning of the period, during that period, where the interest is credited at the end of the period We denote the ERI of the period by o For the SIRM ( ) ( ) ( ) ( ) ( ) ( ( ) ( )
3

( )

( ) )

( )

period, where interest is credited at the start of the period We denote the ERD of the period by o For the SIRM ( ) ( ( ) ( ) ( ))

o o

Therefore, for the SIRM, constant , as For the CIRM ( ) ( ( ) ( ) ( ) ( ( ) ( ( ) ) ( ( ) ) ( ) ( ( ) ( ) ) ) ) ( )

is

For the CIRM ( ) ( ( ) ( ) ) )

) (

For the SIRM, , while it is constant for the CIRM 3. Nominal Rate of Interest Suppose ( ) is the nominal rate of interest per year/period, payable/convertible/compounded every . / of a year/period, then the ERI per
( )

Therefore,

for as

the CIRM, is constant

. / Thus, (

of a year/period is ( ) (
( ) ( )

and

( )

Suppose we know ( ) and we want to know ( ) so as to achieve the specified value of ( ), known as the present value problem Consider the CIRM with ERI , then ( ) ( ) ( ) ( )( ) ( ) , called the discount Let ( ) factor, then ( )

4. Nominal Rate of Discount Suppose ( ) is the nominal rate of discount per year/period, payable/convertible/compounded every . / . / Thus, ( ) ( of a year/period, then the ERD per
( )

of a year/period is ( )
( )

( *

( )

and

2. Effective Rate of Discount Amount of interest earned by a deposit of 1 done at the end of the period, during that
4

Theorem: For a CIRM ( ) ( ( (

( )

( )

( ) ) * )
( )

( ( + *

o ) ) Theorems:

Therefore,

( Remark:

Assuming we have a CIRM, with constant interest rate , then ( ) * +

1. Discount is also known as advance interest

Suppose, however, that interest varies over time, i.e. is the ERI of the period, then ( ) ( ) ( )

Theorem: Equations of Value Let and be the net contributions at time , be the net returns at time , then

If the force of interest varies, then ( ) ( ) { ( ) { } }

1.4. Force of Interest Suppose that we give (nominal) interest continuously o We define the force of interest as the instantaneous rate of change for our fund/portfolio o We take
( ) ( )

Proof: ( ) ( ) ( ) ( ) ( ) ( ) { ( ) }

, hence

( )

( ( * + *

If we have
( )

such that

1.5. Miscellaneous Models 1. Fractional Periods

The SIRM maximizes the accumulated value ( ), while the CIRM maximizes the for accumulated value for Therefore, the SIRM is preferred for fractional periods ( ) Let o If is the ERI during the ( ) ( period, then )( ) 2. Simple Discount Let be the ERI on the whole periods, ( ) then Since , we can take , thus, ( ) , where is known as the simple rate of discount

2. Analysis of Annuities 2.1. Annuities An annuity is a series of periodic payments The duration of an annuity is called its term Annuities may be, in nature, deterministic (annuity-certain), or probabilistic (contingent annuity) Types of Annuity Certain 1. Annuity Immediate Consider an -year annuity that pays amounts of 1 at the end of each year, starting from the 1st up until the year, with ERI o The present value of the annuity at , denoted by | , is given by
|

) starting from the 1st up until the ( year, with ERI o The present value of this annuity at , denoted by | , is given by |

The accumulated value of the annuity at , denoted by | , is given by | |( ( ( ) ) ) )( ( ) )

( ( (

) ) )

The accumulated value of the annuity at , denoted by | , is given by

| |(

3. Deferred Annuities Consider an AI that pays amounts of 1, starting at up until , with ERI o The present value of the annuity at deferred by periods, denoted by | , is given by
| | | |

) )( ) ) o ( ) ) (
|

( ( (

2. Annuity Due Consider an -year annuity that pays amounts of 1 at the beginning of each year
7

The accumulated value of the deferred AI is nothing but |

Similarly, consider an AD that pays amounts of 1, starting at up until o The present value of the annuity at deferred by periods, denoted by , is given by |
| |

c.

Proof:
|

( ( ( ( |

) ) ) )

| ( |

| )

The accumulated value of the deferred AD is nothing but | 2.2. Perpetuities An annuity with an infinite number of payments, with , is called a perpetuity Consider a perpetuity immediate, that is (
|(

Properties: a.
|(

Proof: ) ( )

| |

| b.
|

Next, consider a perpetuity due, that is ( ) | |

Proof:
|

Consider an -year perpetuity immediate that pays amounts of 1 per year, that is ( )
| | |

Next, consider an -year perpetuity due that pays amounts of 1 per year, that is ( )
| |

( (

) )

For a perpetuity immediate that pays amounts of 1 per year, we define the current value as ( )
| |

( ( o

)
|

Similarly, for a perpetuity due, we define the current value as ( ) | | (

Specifically taking and The present value, denoted by ( ) |, is given by ) ( ) |

| |

Remarks: 1. The accumulated value is the function for during or after the last payment 2. The present value is the function for before or during the first payment 3. The current value is the function for during the derivation of the annuity

| |

| The accumulated value, denoted by ( ) | , is given by ( ) ( ) | ( ) |( | )

2.3. General Annuities and Perpetuities Consider an -year AI paying an initial amount of at , and increasing each succeeding payment by o The present value is given by ( ) ( ( ( ) ) )

If we take to approach infinity such that we have a PI with an initial payment of 1, increasing by 1 thereafter, we define the present value, denoted by ( ) | , as

Let

( ) |

( ) | | |

( ) | |

The accumulated value, denoted by ( ) | , is given by ) ( ) | |

Now, we take and The present value, denoted by ( ) | , is given by ) ( ) |

| | | | | |

If we take to approach infinity such that we have a PD with an initial payment of 1, increasing by 1 thereafter, we define the present value, denoted by ( ) | , as ( ) | | |

( ) | The accumulated value, denoted by ( ) | , is given by ( ) ( ( ) | ) |( ( ) )

|

Now, for a n -year AD paying an initial amount of at , and increasing each succeeding payment by o The present value is given by ( ) (
|

Then, if we take and The present value, denoted by ( ) | , is given by ( ) ( ) |

|

( (

)+ ( )

The accumulated value, denoted by ( ) | , is given by ) ( ( ) | )

|

| o

Thus, if we take and The present value, denoted by ( ) | , is given by

10

2.4. Inflation Rate Inflation is the change in the price of the commodity due to the law of supply and demand Inflation rate is determined by the consumer price index Consider an -year AI having an initial payment of 1 and each payment thereafter ( ), increases by a factor of with as the ERI per year o The present value is defined as ( ) ( ( (( ) o (( ( ) ) + ) ) ) ( ( * )

| |

The accumulated value, denoted by | , is given by ( ) | |( ( ( ) ) )( )

If we let

( ) , where is the inflation rate and the real/adjusted interest rate, then ( o )
|

For an annuity with inflation rate, the accumulated value is nothing but the present value accumulated by the original interest

Now, consider an -year annuity that pays at a rate of at time o The present value, denoted by ( ) | , is given by ( ) ( ) | | |

2.5. Continuous Annuities Suppose the function is continuous First, consider the -year annuity that pays at a rate of 1 per year o The present value, denoted by |, is given by o

( |

The accumulated value, denoted by ( ) | , is given by

11

( ) | ( ) |( ( |

) )( )

We then divide the period into two: the Interest Conversion Period (ICP), and the Payment Period (PP)

| Lastly, we take the -year annuity with payments at the rate of at time o The present value, denoted by () | , is given by ( ) () | ( | ( ) ( ) | ) | | o The accumulated value, denoted by ( ) | , is given by ( ) ( ) | ( ) |( ( ) |

Case 1: ICP is less than PP Let there be PPs per ICP, with as the ERI per ICP Consider the annuity that pays unit amounts at time , divided equally at the end of each PP o The present value, denoted by is given by ( )
( ) | ( ) , |

( )

The accumulated value, denoted by

( ) , |

is given by ( )
( )

( ) |

For the same annuity that pays at the beginning of each PP o The present value, denoted by , | is given by |
( ) ( ) ( )

) |

2.6. Annuities Payable at a Different Frequency than Interest is Convertible Recall that in evaluating annuities, we let be the ERI per period, in which case we take one period to be the time between periods of payments

The accumulated value, denoted by , is given by | |

( ) ( )

)
( )

Next, we consider the annuity that pays at the rate of at time , divided equally at the end of each respective PPs

12

The present value, denoted by

) ( )( , is given by |

( )

) ( )( | ( ) | ( ) | (

( | .( .(

) ) ) / |
( )

/ |
( )

) | )( )

( |

( )

( )

( )

( )

The accumulated value, denoted by ( ) , is given by |

( ) ( ) | ( )

) (

( )

|
( )

) |

( )

| o

( ) ( )

For the same annuity that pays at the beginning of each PP o The present value, denoted by
) ( )( , is given by | ( ) ) |

The accumulated value, denoted by (

( )

, is given by ) |
( ) ) |

( )

( o

|
( )

( )

( ) ( )

Case 2: ICP is greater than PP The accumulated value, denoted by

( ) ( ) , is given by | ( ) ( ) |

|
( )

Lastly, consider the annuity whose payments increase by o (

( ) ( )

We make the outstanding assumption that there are exactly ICPs per period Consider the annuity that pays amounts of 1 every periods starting from the periods up until the ( ) period, with ERI o ( The present value is given by ) ( ( ) )

per PP

The present value, denoted by , is given by ) |

13

(
| |

| | o ( The accumulated value is given by ) (

| |

)(

| | Similarly, if we consider an annuity that pays amounts of 1 every periods starting ) immediately up until the ( period o The present value is given by ( )
( )

| |

| | o ( The accumulated value is given by ) (

| |

)(

| |

14

3. Cash Flow Analysis 3.1. Yield Rates We first define the variables as the investors net contribution at time , as the investors net return at time , and as the investors outstanding balance at time Let ( ) be the net present value of all the s under the ERI ()

alternating signs in our s, then we are sure of the uniqueness of the yield rate Theorem: Let be the outstanding balance of a fund , ), and at time , then if , then there exists a unique YR for the said fund

Proof: Suppose and are the YRs of the fund, and , without loss of generality Define as the fund balance at time corresponding to and as the fund balance at time corresponding to ( ( ( ( ) ) ) )

Now, a yield rate of an investors portfolio is an ERI for which ( ) ( ) ( )

Notes:

( ) , where is the ERI for the investors portfolio/account

Remark: 1. The yield rate and the present value are inversely related

Therefore, the yield rate is unique

3.2. Existence and Uniqueness of the Yield Rate Without loss of generality, will be used * +, Suppose that then ( ) o By the Descartes Rule of Signs, if we have an odd number of alternating signs in our s, then we are sure of the existence of a yield rate o By the same line of reasoning, if there is exactly one pair of
15

3.3. Interest Measurement of a Fund Consider a company having an initial net asset of at the start of the fiscal year Moreover, let be the net asset at the end of the same year o The accumulated value is given by ( ) ( o ) ( )

Approximating the YR by using simple interest

( | ( )

)) ( )

We then create a line passing through ( )) and ( ( )) ( The zero of this line will approximate the zero of ( ) Ideally, must be small, so as to attain a better approximate Suppose we know ( ) and ( ) and we want to find , -| ( ) , ( ) ( )o One formula is derived as ( ) ( ) ( ) ( )

Define * (

* *

) (

Let be the net interest earned by the company during the whole year

( ) ( )

( ) ( ) (

( )

( ) ( )

( ) ( ) ( ) ( ) ( ) )( ) ( ) ( )

o ( )

A similar formula is derived as ( ) ( ) ( )

( ) 3.4. Approximation Methods 1. Linear Interpolation ( )

( ) ( ) (

( )

( ) ( )

( ) ( ) ( ) ( ) ( ) )( ) ( ) ( )

2. Newton-Raphson Method

We first initialize and , such that ( ) and ( ) , as stated by the Intermediate Value Theorem
16

We first initialize , then compute for the function value ( ), and its first derivative value, ( ) The tangent line is defined as ( )( ) ( ), where is solved by letting The whole process is repeated until is | ( )| attained satisfying The iteration formula is given by ( ) ( )

( ) | ( | ( ) ( ) )

),

Lastly, consider an -period annuity due o The accumulated value is given by ( ) ( ) | ( ( ) )

3.5. Reinvestment Rates Consider an initial deposit of 1 at ( ) ( ), o Normally, assuming that both principal and interest is reinvested back For some cases, the interest earned by the primary fund is being reinvested at a secondary fund with less interest rate (which might be zero) This new interest rate is called the reinvestment rate We denote the interest rate credited by the primary fund with , and the interest rate used by the second fund with , with , usually Consider a deposit of 1 at o The accumulated value is given by ( )
|

For the three payment patterns, the present value at is nothing but the accumulated value at discounted for periods using the yield rate ( ) ( )( )

Now, consider a unit annuity immediate paying for periods o The accumulated value is given by

3.6. Miscellaneous Methods There are 2 underlying elements present in cash flow analysis: time and money We make a distinction between interest rates: time-weighted which depends solely on time, and money-weighted which depends on both time and money; an example of this is the yield rate Consider an asset manager that manages a portfolio with more than one investor o At , is given by the investors o At , if a new investor contributes to , only the original investors will get o At , the new investor joins in the shares of the original investors in

17

Methods for Fund Resource/Balance Allocation 1. Portfolio Method Uses the YR for one period, where the new investor is treated like any other investor 2. Investment-Year Method Introduces new money rates, which are given in an investment-year calendar (IYC) o In using an IYC, a selected investor is subjected to a different set of investment rates for a certain time period before being subjected to the portfolio rate (or, in the above example, the interest rate of the original investors) o The calendar is used from left to right (until the PR), and then down

18

4. Loan Repayment 4.1. Amortization Scheduling Consider a loan for years with an initial loan balance of | We can repay the loan by means of an -year unit AI o We want to find out what part of our payments go to repaying the original loan, and what of it goes to paying the interest Define as the outstanding loan balance at time , as the payment at time , as the principal repaid at time , and as the interest paid at time For this method of loan repayment, the initial loan balance is set to be | which, eventually, would be zero at the final period, with unit periodic payments The amortization schedule is given as follows: o

4.2. Sinking Fund Method Consider the equation

| |

Proof: We define
|

as the annual payments of an ( ) , and

|

-year AI with

as the annual payments of an -year AI with ( ) plus interest earned by a unit loan ( ( ( ( (( ) ) ) ) ) ) ( ( ( ) ) )

| | | |

TOTAL | | The following formulas are used for amortization scheduling:

Notes: In making a schedule, we always compute last If , then it is called a balloon payment, whereas if , then it is called a drop payment

In contrast to the amortization method, the sinking fund method assumes that the borrower pays periodic interest while investing on a fund (that usually earns at a lower rate than the loan) so as to accumulate the necessary principal to repay his debt We assume that the loan credits at a rate and the sinking fund earns at a rate We define as the interest paid at time , as the sinking fund deposit at time , as the interest earned by the sinking fund at time , as the sinking fund balance at

19

time , and as the outstanding loan balance at time The sinking fund method is given as follows:

The following formulas are used for the sinking fund method:

20

5. Analysis of Financial Instruments 5.1. Financial Instruments A stock is a share of a company/corporation A bond is a formal contract of indebtedness, usually issued by the borrower Types of Bonds 1. 2. Accumulation Bond Usually defined by its accumulated value Coupon Bond Defined by face value at expiry plus periodic payments of interest

Define as the face value of the bond (usually by hundreds), as the redemption value of the bond, as the periodic coupons, as the yield rate of the bond, as the coupon rate of the bond, and as the purchase price o The present value is given by ( )
| | | | |

5.2. Callable Bonds For the usual bond, the investor can only realize his return at maturity of the bond Callable bonds are defined as bonds redeemable/callable prior to maturity For callable bonds, we price the bond such that the investors minimum YR is satisfied, i.e. we get the possible prices of the bond and get its minimum Consider the scenario: suppose we have a bond with periodic coupons of that will mature at after 2 periods, and is callable a period before maturity at . If an investor having a YR of at least is going to buy the bond, how much is she willing to pay? o The prices of the bond are given by
|

( o

o (
|

Note that, in general, the two prices are not equal, and without loss of generality, Suppose we price the bond at ; however, if the investor calls the bond at , we realize that () ( )( )

( o o

This formula is called premium/discount formula Usually, we assume that is not explicitly given and

the if o Obviously, ; moreover, , thus, we cant price the bond at In the other case where we price the bond at , whatever the scenario is, i.e. the bond is called or matured, then ( ) ( ( ) )
|

Types of Bonds with respect to 1. Premium 2. Discount 3. Par

21

Therefore, we take to be the bond price In general, when ricing a callable bond, we take all possible bond prices for each admissible coupon date, then we take the minimum Next, consider a bond that matures at time at par, and is callable at any coupon date form time up until time at Suppose we have an investor with a YR of at least , whose bond with period coupons may be matured with face value , or called with redemption value
| |

This means that the bond is called, which is just priced as Therefore, in general (i.e. there are more callable periods), we price the bond as

( o

If the bond is selling at a premium, i.e. , then )

| |

So if we want to be minimum, then we take the minimum time, i.e. we price at the earliest possible time If the bond is selling at a discount, i.e. , then )
| |

So if we want to be minimum, then we take the maximum time, i.e. we price at the latest possible time If the bond is selling at par, i.e. , then )
| |

22

6. Survival Models 6.1. Future Lifetime Random Variable Consider a life aged , denoted by ( ) o Let be the continuous random variable representing the future lifetime of ( ), then is defined as the age-at-death random variable for ( ) Associated with is the distribution function ( ), which is the probability that ( ) dies within years ( ) is also known as the lifetime distribution from age , denoted by ( ) Define the survival function ( ) ( ), which is the probability that ( ) will survive to age , denoted by The survival function can be viewed as the probability of ( ) surviving more years given an earlier survival of years; i.e. ( ) ( ( ( ( ( ( ) ) ) | ) ) )

Remarks: 1. 2. Proof: ( ( ) ( ( ) , defined as the probability that ( ) dies between ages and , or the deferred mortality probability, is given as
| |

) )

( ( )

3.

( (

) (

4.

6.2. Force of Mortality The force of mortality is the instantaneous rate of mortality ( ) ( ( ( ( ) ( )
( ) ( )

Thus, the total survival probability can be expressed as a product of more survival probabilities

) ) ) ( ) ( )

Properties of the Survival Function: a. b. c. ( ) ( ) ( ) is a decreasing function

is called the force of mortality,

denoted by

23

can be expressed as
( ) ( )

( ) , ( )

( ) , ( )

or

Using

( ) ( )

6.3. Mean and Variance of ( ) as the expected future Define lifetime of ( ), the complete expectation of life, or simply the mean of , denoted by ( )

( ) ( ) ( )| { o If { , then } } ( )

| Define the variance of ( ) ( )

as

( )

The probability density function ( ) can be expressed by and the force of mortality ( ) ( ( ( ) ( ) ( ( ) ) ( ( ( ( ) ( )) ( ( ) ( ) ) ) ) ) ) ( ( ) )

( )

6.4. Curtate Future Lifetime Random Variable Let be the discrete random variable representing the number of completed future years of ( ) prior to death, which is the integer part of the future lifetime for ( ) Note that Define the probability mass function as ( ) ( ) ( ) ( ) ( ( ) ( )

24

Define

as the curtate expectation of life ( ( ) ) ( )

6.5. Fractional Ages There are two assumptions when dealing with probabilities with fractional ages: the uniform distribution of deaths (UDD), and constant force of mortality (CFM) ( ) ( ) Let 1. Uniform Distribution of Deaths Linear interpolation is used for integer-age probabilities o For ( ( ( ( ( ) ) ) ( ( ( ) ) ) ) ( ) ( ) ) ( ( ( ) ( ) ) )

Define the variance of ( ) ( ) ( ( ( ) ( )

( ) ( ) ( ) ) ( )

Thus,

moreover,

For the force of mortality,

( ) ; Thus, moreover, the density/mass function is simply The earlier derivations are used for fractional-age probabilities o For o

( ( )

25

( ( )

) (

( ) ) ( )

( ) ( )

2. Gompertz (1825) , , )( ) is defined as the aging hazard ( ) * ( )+

where

Thus,

2. Constant Force of Mortality The force of mortality is constant between integer ages, but differs for every interval For integer-age probabilities, { { * o Thus, + * +; moreover, } }

3. Makeham (1860) ( ) , )( ) , where is defined as the accident hazard ( ) * ( )+ 4. Weibull (1939) , )( ) ( ) * +

* + For the force of mortality, { * + }

6.7. Life Tables A life table (illustrative) is a roster of mortality probabilities and other actuarial indices for integer ages under a certain rate/force Define as the expected number of survivors to age , and as the expected number of newborns ca be expressed as the ratio of over ; thus, can be expressed as

For fractional-age probabilities, o Since is independent of * + then o

Thus, the density/mass function is

Define as the expected number of deaths between ages and , which is given by can be expressed as the ratio of over

6.6. Special Laws of Mortality 1. De Moivre (1724) ( )

, )(

), where

is defined as

the limiting age

6.8. Select and Ultimate Life Tables When the probability is defined by a survival function appropriate for newborns, under the single hypothesis that the newborn has survived to age ceteris paribus, an aggregate table is used When additional knowledge is available about ( ), then special forces of mortality
26

that incorporate those information as considered to construct a select life table The conditional probability of death in each year of duration is denoted by , * + The impact of selection may diminish with time, i.e. , In general, , - is the probability that a person aged , selected at age , will die within years, with the impact of selection diminishing over time, i.e.
, -

The smallest integer satisfying the above is called the select period of the policy and beyond this is the ultimate period

27

7. Analysis of Life Insurances 7.1. Life Insurances There are two ways of paying the death benefit (DB): DB paid at the moment of death (MOD), and DB paid at the end of year of death (EOYOD) A single payment for the coverage that is made at the beginning of policy issue is called the net single premium (NSP), expected present value (EPV), or the actuarial present value (APV) Define as the benefit function, as the discount factor function, as the present value function, and as the random variable representing the present value of the death benefit at policy issue Types of Insurances Payable at Moment of Death (MOD)

3. -year Pure Endowment This provides an endowment benefit (EB) of 1 only if ( ) survives to age , )( ) The EPV, denoted by , or more
|

commonly,

, is given by ( )

4. -year Endowment This provides a DB of 1 if ( ) dies within years and an EB of 1 if ( ) survives to age ) The EPV, denoted by
, | )( , |, )(

is given by

( )
|

1. Whole Life Insurance Insurance issued to ( ) with unit DB payable at MOD, for any time The EPV, denoted by , is given by ( ) 2. -year Term Insurance Insurance issued to ( ) with unit DB if MOD occurs within the next years , )( ) , )( ) The EPV, denoted by , is given by
|

5. -year Deferred Whole Life Insurance Similar to the Whole Life Insurance, but the coverage is deferred years from policy issue , )( ) The EPV, denoted by | , is given by
|

( )
|

( )

28

Types of Insurances Payable at End of Year of Death (EOYOD) If death occurs between integer ages, the benefit will be paid a year immediately after the curtate lifetime The random variable will then be * + ( ), in general 1. Whole Life Insurance * +( ) The EPV, denoted by 2. -year Term Insurance * +( ) The EPV, denoted by
, is given by |

7.2. Relationship Between Insurances Payable at Moment of Death and End of Year of Death Define as the random variable representing the fractional time between the actual time of death and the curtate Consider the whole life insurance assuming a UDD over each unit interval ,

is given by

3.

-year Pure Endowment * +( ) The EPV, denoted by by

|

, or

, is given

4.

-year Endowment
* +(

)
|,

+(

The EPV, denoted by

| |

is given by

5.

-year Deferred Whole Life Insurance * +( ) The EPV, denoted by

| |

, is given by
|

Thus, be assuming UDD on a unit interval, the following identities are established: 1. 2. 3.
29

| |

| | |

4. 5.

| |

Case 2: EOYOD ( )
* +(

) ) , is

7.3. Variance of Define the raw moments as ( )

The NSP for this case, denoted by ( given by ( ) ( )

Theorem: Without loss of generality, consider a whole life insurance issued to ( ) payable at MOD o Let be the force of interest at time , the benefit function, and the discount function based on o If ( ) Corollary: The form of the variance of , in general, is the difference of the insurance measured at double-force, and the square of the insurance at single-force , then ( )

2. Decreasing Insurance Suppose that the NSP is to be found for an -year term insurance with DB of , where is the number of completed years, if DB is payable at (i) MOD, and (ii) EOYOD Case 1: MOD ( is given by ( )
|

, denoted by

)(

) ) , |

The NSP for this case, denoted by (

Case 2: EOYOD 7.4. Varying Benefit Insurance 1. Increasing Insurance Suppose that the NSP is to be found for a whole life insurance of 1 if ( ) dies during the 1st year, 2 if ( ) dies during the 2nd year, and so on, if benefit is payable at (i) MOD, and (ii) EOYOD Case 1: MOD
( )(

( is given by ( )

+(

) ) , |

The NSP for this case, denoted by (

)(

) ) , is

The NSP for this case, denoted by ( given by

7.5. Commutation Notations Consider an insurance that pays benefits at EOYOD o The EPV of this insurance can be solved using the elements found in an illustrative life table
30

Define the following symbols

2. Proof:

Identities of Commutation Notations 1. Proof: ( ( ) )

|

3. 4.
|

Proof:

2. 3. Identities with EOYOD Insurances

5. ( Proof:

1. Proof: 6. ( 7. ( ) )
| ( | )

( ( (

) ) )

31

8. Analysis of Life Annuities 8.1. Life Annuities A life annuity is a series of payments made continuously or at equal intervals while a given life survives Payments may be due at the beginning of the payment intervals an annuity-due or at the end of each payment interval an annuity-immediate Consider a life annuity-due with unit level payments o Define as the present value random variable of payments to be made by the annuitant o The general form of is | , the present value of an annuity-due of an annuitant, for the complete years of life plus 1 The EPV can be seen as the inner product of the valuated payments of an annuity-certain and the survival probabilities, or as the inner product of the present value random variable and the probability mass function

The EPV, denoted by , is given by ( ) ( ( ) )

2. -year Temporary Annuity This annuity pays amounts of one for as long as ( ) shall live for years ) Define +( | * |
* +(

)
|,

The EPV, denoted by

|

is given by
|

3. -year Deferred Whole Life Annuity This annuity pays amounts of one for as long as ( ) shall live after years from issuance ) Define ( +( | |) * The EPV, denoted by
| |

, is given by

Types of Discrete Life Annuities 1. Whole Life Annuity This annuity pays amounts of one for as long as ( ) shall live ) Define +( | * The EPV can be derived in two ways ( ) |

4. -year Certain and Life Annuity This annuity pays amounts of one for the 1st years, and then for as long as ( ) shall live ) Define +( | * |
* +(

The EPV, denoted by , is given by | | |

|

32

8.2. Continuous Life Annuities Consider a life annuity that pays amounts of one continuously o The general form of would then be is the age-at| , where o death random variable The general form of the EPV would then be the integral of the product of the discount function and the survival probabilities

The variance is given by ( ) ( ( ( ) ) )

2. -year Term Life Annuity Define | , )( ) The EPV, denoted by

| |,

)(

is given by
|

Types of Continuous Life Annuities 1. Whole Life Annuity Define )( ) | , The expected value of such: ( ) | | The EPV, denoted by , is given by ( ) ( ( ) ) | ( ) can be derived as

The variance is given by (

|)

|/

3. -year Deferred Whole Life Define ( | |) , The EPV, denoted by

| |

)(

, is given by

The variance is given by (

|

) (
|

( )

4. -year Certain and Life Annuity Define | , )( ) |

)(

The EPV, denoted by , is given by | | |

|

33

8.3. Life Annuities Payable at a Different Frequency than Interest is Convertible Consider an EOYOD whole life annuity-due that pays amounts of every . / of a

3. 4.

| ( ) |

( )

. .
|

/ / (

( )

( )

. ) 5. (
|

/ )
( ) |

period o The EPV for this annuity with payments per year, denoted by
( ) ( )

, is given by 8.4. Commutation Notations Since life annuities are based on life insurances, the same symbols will be used Identities for Life Annuities 1.

( ) ( )

However, similar annuities are not included in the life table as such; thus, the payments must be expressed in terms of yearly life annuities

Proof:

Theorem: Under UDD,

( )
( )

; thus,

( ) ( )

( ) ( )

)
( )

( ) ( )

( )

( )

( ) ( )

2.

( ) ( )

( ) ( )

Proof:
|

Identities of Life Annuities Payable at a Different Frequency than Interest is Convertible 1. 2.

|

( )

( )

. (
)

34

9. Premiums and Reserves 9.1. Net Level Premiums Define as the loss random variable, i.e. the random variable representing the difference of the present value of benefits and the present value of premiums at time

Types of Net Level Premiums per Life Insurance and Annuity 1. Ordinary Life A fully discrete NLP, denoted by by A semi-continuous NLP, denoted by ( ), is given by ( )

, is given

Theorem: Equivalence Principle The net level premium is derived from the zero expected loss at the initial time, i.e. ( ) ( ( ) ( ) ( ) ) ( ) An
( )

A fully continuous NLP, denoted by ( ), is given by ( )

ly fully discrete NLP, denoted by , is given by

( ) ( )

A fully continuous net level premium is a combination of an insurance payable at MOD and insurance premiums payable continuously A fully discrete net level premium is a combination of an insurance payable at EOYOD and insurance premiums payable at the beginning of each year A semi-continuous net level premium is a combination of a discrete/continuous insurance and a continuous/discrete insurance premium; the former combination is more common in practice ly premiums are net level premiums whose payments of insurance premiums are payable times per year

An
( )

ly semi-continuous NLP, denoted by ( ), is given by

( )

( )

( )

2. -year Term A fully discrete NLP, denoted by given by

| |

, |

is

35

semi-continuous . /, | is given by .

NLP,

denoted

by

A fully continuous NLP, denoted by (

|

), is given by (
|

/ |

| |

| |

A fully continuous NLP, denoted by . /, | is given by . / |

| |

An
( ) |

ly fully discrete NLP, denoted by , is given by

( ) |

An
( ) , |

ly fully discrete NLP, denoted by is given by

( ) | | ( ) |

| ( ) |

An
( )

ly semi-continuous NLP, denoted by (

|

), is given by

( )

An
( )

ly semi-continuous NLP, denoted by . /, is given by |

( )

| ( ) |

/ |

| ( ) |

4. -year Endowment A fully discrete NLP, denoted by given by

| |

is

3. -year Pure Endowment A fully discrete NLP, denoted by given by

| |

, is A semi-continuous ( | ), is given by (
|)

NLP,

denoted

by

| |

semi-continuous (
|

NLP,

denoted

by

), is given by (
|

A fully continuous NLP, denoted by ( | ), is given by (

|)

| |

| |

36

An
( ) , |

ly fully discrete NLP, denoted by is given by

( ) | | ( ) |

6. -pay -year Term A fully discrete NLP, denoted by given by

| |

, |

is

An
( )

ly semi-continuous NLP, denoted by (

| ),

is given by (
|) | ( ) |

semi-continuous . /, | is given by .

NLP,

denoted

by

( )

/ |

| |

5. -pay Whole Life A fully discrete NLP, denoted by given by A semi-continuous ( ), is given by ( )

, is

A fully continuous NLP, denoted by . /, | is given by . / |

| |

NLP,
|

denoted

by

An
( ) , |

ly fully discrete NLP, denoted by is given by

( ) | | ( ) |

A fully continuous NLP, denoted by ( ), is given by ( )

|

An .

ly semi-continuous NLP, denoted by /, | is given by .

| ( ) |

An
( )

ly fully discrete NLP, denoted by , is given by

( ) ( ) |

/ |

7. -pay -year Pure Endowment A fully discrete NLP, denoted by given by

| |

, is

An
(

ly semi-continuous NLP, denoted by ) ( ), is given by

( )

( )

( ) |

37

semi-continuous (
|

NLP,

denoted

by

), is given by (
|

A fully continuous NLP, denoted by ( | ), is given by (

|)

| |

| |

An
( ) , |

ly fully discrete NLP, denoted by is given by

( ) | | ( ) |

A fully continuous NLP, denoted by (

|

), is given by (
|

| |

An
( )

ly semi-continuous NLP, denoted by ( | ), is given by

( )

An
( ) |

ly fully discrete NLP, denoted by , is given by (

|)

| ( ) |

( ) |

| ( ) |

An
( )

ly semi-continuous NLP, denoted by (

|

), is given by

9.2. Gross/Expense-Loaded Premiums Gross, or expense-loaded, premiums are those which consider the expenses made for the policy Types of Policy Expenses 1. Commission to the Soliciting Agents Agents are compensated by combination of salary and commission arrangement or by straight commission basis Uses a commission scale, although the commission percentage varies by plan and amount of benefit 2. Premium Tax A percentage of the premiums, net or gross 3. Government Tax Value-added, license, or city tax 4. Fees for Medical Examination and Inspection Reports Does not vary much by premium but they vary in the policy size

( )

| ( ) |

8. -pay -year Endowment A fully discrete NLP, denoted by given by

| |

|,

is

semi-continuous NLP, ( | ), is given by (

|)

denoted

by

| |

38

5. Overhead Expenses May vary in policy size Maintenance and settlement expenses In computing for gross premiums, the Cammack-type formula is used, i.e. the expected present value of contributions is the sum of the expected present value of benefits and the expected present value of the expenses

expected present value of the insurance from age minus the expected present value of the future benefit premiums payable from age For every net level premium, there is a corresponding net level benefit reserve, but without loss of generality, only fully continuous NLBRs will be considered

Types of (Fully Continuous) Net Level Benefit Reserves 1. Whole Life ( )

9.3. Benefit Reserves Prospective Approach Benefit reserves can be thought of as a part of the compensation that must be reserved in the insurance so that the beneficiary of the policyholder can receive the full benefit. Recall: Loss Random Variable

( )

2.

-year Term . / | (
|

. 3.

/ |

|* (

)(

-year Pure Endowment ) (

At

| for, without loss (

| |

of generality, a fully continuous loss, where is the appropriate net level premium Consider a fully continuous whole life insurance of 1 issued to ( ) o The random variable for the loss at time is | o The benefit premium, denoted by ( ), is given by ( ) ( ) ( ) ( |) ( )

(
,

|) (

)(

)(

4.

-year Endowment (
|)

(
,

|)

|) (

)(

)(

( )

5.

-pay -year Whole Life ( ) ( ( )

, )( |) ( )(

This approach, also known as the Prospective Approach, implies that the benefit reserve at time is equal to the
39

6.

-pay -year Term . ( / |

| , |

.
)(

/ |

|* (

)(

age to minus the actuarial accumulated value of the benefits paid Without loss of generality, consider a fully discrete whole life insurance o For the prospective method, o However, for the retrospective method,
| |

7.

-pay -year Pure Endowment ( ( ) (

)(

| | ,

| ,

)
)(

|) (

)(

) Theorem:

8.

-pay -year Endowment (

|)

|)

|) ( )(

)( )(

) )

| ,

9.4. Benefit Reserves Approach

Retrospective

Without loss of generality, consider again a fully discrete whole life insurance o The net level benefit reserve from the prospective approach is equal to the net level benefit reserve from the retrospective approach

Proof: .
|

Recall: Prospective Approach The prospective approach looks forward and calculates what is needed to cover future obligations The reserve at time is the actuarial present value of the insurance from age minus the actuarial present value of the future benefit premiums payable from age The retrospective approach, on the other hand, looks back at what funds have accumulated and need to be kept for the future The reserve at time is the actuarial accumulated value of the premiums from

/ | ) )) )

( ( ( (

) (( ) )

40

Note: The concept of the actuarial accumulated value (AAV) is similar with discounting an amount , i.e. if the APV of an amount from time is , then the AAV of an amount to time is

3. Annuity Reserve Formula Without loss of generality, consider a fully discrete whole life insurance using the prospective method ( ( 4. Facklers Method in Reserve Valuation This is one of the first recursion formulas developed for the computation of benefit reserves Without loss of generality, consider a fully discrete whole life insurance using the prospective method ( ( (( )( )
|

) )

( 9.5. Other Reserve Formulas 1. Premium Discount Formula This formula is analogous with that of callable bonds Without loss of generality, consider a fully discrete whole life insurance using the prospective method ( )

2. Paid-up Insurance Formula If after paying premiums from age to for a fully continuous whole life insurance (without loss of generality), the policyholder decides to stop paying premiums, the reserves can be given to the policyholder as a whole life insurance with death benefit ( ) (
( ) , ( )

) )

thus

( ) ( )

( ) ) ( )

41