Preliminary Knowledge On Insurance Pricing

The Time Value of Money

Which would you prefer -- $10,000 today or $10,000 in 5 years?

Obviously, $10,000 today. You already recognize that there is TIME VALUE OF MONEY!!

Why TIME?

Why is TIME such an important element in your decision?

TIME allows you the opportunity to postpone consumption and earn INTEREST, which is known as TIME VALUE OF MONEY

Types of Interest

Simple Interest
Interest paid (earned) on only the original amount, or principal borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

Why Compound Interest?

Future Value of a Single $1,000 Deposit
20000
Future Value (U.S. Dollars)

15000 10000 5000 0 1st Year 10th Year 20th Year 30th Year

10% Simple Interest 7% Compound Interest 10% Compound Interest

Present value (PV)

The present value (PV) formula has four variables:

PV is the value at time=0 FV is the value at time=n i is the rate at which the amount will be compounded each period n is the number of periods

The cumulative PV of future cash flows can be calculated by

Example: Present value

PV of $1 to be paid 5 year from now at an interest rate of 5%

Payment $ . . . . . 1 Time 0 1 2 3 4 5
PV 1 (1 5%) 5

PV of a cash flow which pays $1 at the end of each year for 5 years
Payment $ . 1 1 1 1 1 Time 0 1 2 3 4 5
PV 1 1 1 1 1 (1 5%) (1 5%) 2 (1 5%) 3 (1 5%) 4 (1 5%) 5
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Future value (FV)

Future Value formula:

FV PV (1 i) n
for one payment for a cash flow

FV PVt (1 i) t
t 0

FV of todays $1 at the end of the fifth year at an interest rate of 5%

Payment $ 1 . . . . . Time 0 1 2 3 4 5

FV 1 (1 5%) 5

FV of a stream of deposit of $1 for 5 years

Payment $ 1 1 1 1 1 . Time 0 5%) 1 25 3 4 5 FV (1 (1 5%) 4 (1 5%) 3 (1 5%) 2 (1 5%)
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