Simulation

Week 8: Life Insurance

Søren Asmussen∗
October 20, 2004

Life insurance mathematics covers situations like pensions, widow pension,

invalidity- or unemployment insurance as well as of course traditional life in-
surance. The contract signed will entitle the insured to certain benefits (cash
payments from the company) in return for certain contributions (premiums to
the company).
The age of an insured upon time of signing the contract is traditionally
denoted by x and the remaining life time Tx . Thus Tx is a r.v. with distribution
Fx depending on x. Clearly,

F0 (x + y)
Fx (y) = P(Tx ≤ y) = P T0 ≤ x + y  T0 > x =
1 − F0 (x)
where T0 is the life length of a newborn baby and F0 its distribution. We return
to the choice of F0 later.
In reality, all time units will be discrete (years, months, etc.) but many
calculations and formulas are simpler in continuous time so we treat only that
case (the modifications are usually trivial, though in discrete time one has to
face issues like rounding and whether an event should be classified as happening
at the start or the end of a period).
An important feature in the modeling and analysis is discounting. With a
constant (continuous) interest rate r, this asserts that a payment of m monetary
units at time t = T > 0 has a value of m(0) = me−rt at time t = 0 (often referred
to as the present value). The rationale is the fact that n(0) monetary units put
in the bank at time t = 0 at time t will have developed into n(t) at time t where
d
n(t) = rn(t) .
dt
The unique solution of this ODE is n(t) = n(0)ert . Thus if we take n(0) = m(0),
we have m = n(t). In other words, we are indifferent whether we get paid m at
time t or m(0) at time 0.

1 Simple examples
We start by benefits.
∗ Departmentof Theoretical Statistics. Department of Mathematical Sciences,
Aarhus University, Ny Munkegade, 8000 Aarhus C, Denmark; asmus@imf.au.dk;
http://home.imf.au.dk/asmus

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Life insurance This pays b at the time of death so the present value is be−rTx .
The payment may only take place in a certain age span (x+m, x+n] where
0 ≤ m < n ≤ ∞, in which case the present value is be−rTx I(m < Tx ≤ n).
Life annuities This pays b at a continuous rate until Tx so that the present
value is Z Tx
b

e−rt b dt = 1 − e−rTx .
0 r
The payments may be delayed until time m > 0, as would typically be the
case in pension arrangements, giving a present value of
Z Tx
b −rm

I(Tx > m) e−rt b dt = e − e−rTx I(Tx > m) .
m r

The payments may also terminate at n > m (contingent on survival to

age x + n).
Endowment Here b is paid at n provided the insured is still alive so the present
value is be−rn I(Tx > n).

The simplest forms of contributions are (a) a lump sum c paid at t = 0 (the
present value is just c), (b) a continuos payment at rate c up to n contingent
upon survival. This has the same form as a life annuity with m = 0 so by similar
reasoning the present value is
Z Tx ∧n
c

e−rt c dt = 1 − e−r(Tx ∧n) .
0 r

2 The equivalence premium

The equivalence principle asserts that benefits and contributions in a contract
should be tuned to have the same expected value. For example, for a life annuity
with the premium payable as a lump sum at t = 0, this means
b

1 − Ee−rTx = c,
r
and the l.h.s. of this identity is referred to as the equivalence premium. For a
different example, consider an endowment with continuous paymnent in [0, m].
The equivalence principle then gives
c

be−rn P(Tx > n) = 1 − Ee−r(Tx ∧n)
r
so the equivalence premium is

e−rn P(Tx > n)

c = rb . (1)
1 − Ee−r(Tx ∧n)
There are some obvious reasons that calculating the premium via a naive
implementation of the equivalence principle cannot be the right way:
• Administration costs are not taken into account

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 • The future interest rate and mortality rates are not completely known
• Even if the previous points are dealt with, one is running a business where
expenses and incomes just balance. Thus, there is no profit which in turn
(in the presence of randomness) can be proved to imply that the company
will be eventually ruined.
In practice, the equivalence principle is nevertheless the one used for premium
calculation, but with a twist in the implementation, to use an interest rate and
a set of mortality rates which are not the ones one expects to be in force but
biased in favour of the company. Such a set of rates in referred to as the first
order basis.
In which direction the rates of interest and mortality should be biased in
order to be in favour of the company depends crucially on the type of contract.
RT
Consider for example a life annuity with present value 0 x e−rt b dt. This is a
decreasing function of r so it is clear that the r of the first order basis should be
smaller than the interest rate one expects to be in force. Similarly, the present
value is increasing in Tx so that the first order basis would have a distribution
of Tx which is in some sense larger than the true one. This is certainly the
case if one takes the λ(x) to be smaller than the true ones for all x. For a life
insurance, there is also an easy answer, see the Exercises. However, for many
types of contracts the situation is less clear cut. For example, it is not clear
whether (1) is increasing or decreasing in r.

3 Regulation
In vitually any country, the life insurance business is heavily regulated by the
government in order to protect the insurance buyers. There are (at least) two
basic concerns:

• To ensure that the company will be able to meet its obligations. This is
done by demanding that the reserve (the bank account, investments etc.)
is at least the expected future payments to the policy holders, and by re-
quiring the premiums to be sufficiently large to ensure that the probability
of the company making a loss is very small.
• To put limits on the companys profit. This may appear to be in conflict
with the requirements on not too small premiums. The most common
way to overcome this is via bonus, a payment going back to the insured
which is calculated using the second order basis, that is, the interest and
mortality rates which were actually in force during the running time of the
contract. For a simple example of a possible implementation, consider a
life insurance with a lump premium of c = bEe−rTx calculated using a first
order basis which at time Tx turned out to have been correct for the λ(y)
but not for the r used, say the value at time t ≤ Tx was r(t). Assuming
the company is allowed to make 15% profit, the premium should then have
 RT
been c∗ = 1.15b exp − 0 x r(t) dt rather than c and the payment is then
raised from b to bc/c∗ .

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4 Mortality modeling
Recall that x is the age of the insured and Tx ≥ x his/her remaining life time.
If T0 is the life length of a newborn baby and F0 its distribution, then

F0 (x + y)
Fx (y) = P(Tx ≤ y) = P T0 ≤ x + y  T0 > x =
1 − F0 (x)

where T0 is the life length of a newborn baby and F0 its distribution.

The distribution F0 and thereby the Fx is usually described in terms of
the mortality rate (or hazard rate) λ(y) at age y. Its interpretation is that the
probability of an individual of age y to die before y + dy is λ(y) dy. The relation
R x = f (x)/F (x) where F (x) = 1−F (x);
to the cdf F (x) and the density f (x) is λ(x)
conversely, F (x) = e−Λ(x) where Λ(x) = 0 λ(y) dy. To see this, let g(x) = F (x).
Then
g(x + dx) = g(x)(1 − λ(x)dx)
(the probability of surviving to age x+dx is the probability of survival to x times
the probability of not dying before x + dx). Since g(x + dx) = g(x) + g ′ (x)dx,
it follows by removing g(x) from both sides and dividing by dx that g ′ (x) =
−λ(x)g(x), or in terms of h(x) = log g(x) that h′ (x) = g ′ (x)/g(x) = −λ(x).
Integrating, we get h(x) = −Λ(x) + c; that c = 0 follows since g(0) = 1 so
h(0) = 0.
A common model is the Gompertz-Makeham distribution
b
λ(x) = a + becx , Λ(x) = ax + (ecx − 1).
c
Here one thinks of a as a baseline mortality (accident etc.), whereas the ex-
ponential term expresses the way in which mortality grows with age. Danish
insurance companies traditionally employ the so-called G82 base parameters

a = 0.0005, b = 0.000075858, c = log(1.09144).

The hazard rate and the density are given in the following figures.
The shape of the density is obviously close to what one expects for human
mortality. Whether the G82 parameters exactly match the mortality in the
population is not that essential because of later regulation by bonus.
For simulation, the easiest way to generate a GM r.v. is acceptance rejection.
It is seen from the plot of the density that a majorizing density is the uniform
density u(x) ≡ u = 0.0085 on [0, 120] for which f (x) ≤ 4u(x), x ≤ 120. Thus,
the algorithm for generating T0 is
1. Generate two independent uniforms U, V on (0, 1).
2. Let Y = 120U (trial for T0 )
3. if V ≤ f (Y )/4u, output T0 = Y ; otherwise return to 1.
If instead one wants to generate Tx , say for x = 55, the modification is

1. Generate two independent uniforms U, V on (0, 1).

2. Let Y = 120U (trial for T55 + x)

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 1.4

1.2

0.8

0.6

0.4

The G82 mortality rate

0.2

0
0 20 40 60 80 100 120

0.035

0.03

0.025

0.02

0.015

0.01 The G82 density

0.005

0
0 20 40 60 80 100 120

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 3. If Y < 55, return to 1
4. if V ≤ f (Y )/4u, output T0 = Y − 55; otherwise return to 1.

The algorithms are easily programmed, but not very effficient; for example, the
acceptance probability for T0 is just 1/4 and for T55 even lower. However, for
the average user this is of little concern compared to the effort in speeding up
the algorithms by factors of 2 or 3.

5 Exercises
1. If T0 has cdf F (x), density f (x) and hazard rate λ(x) = f (x)/F (x) where
F (x) = 1 − F (x), what is then the hazard rate λ(x) of Tx ?
2. Assume that the time unit is years. The yearly interest rate i is then defined by
one monetary unit increasing to 1 + i in a year. Find the formula connecting i
and the continuous interest rate r.
3. Assume insted that interest is added every half year, increasing the account by
a factor of 1 + i2 /2. If i2 = 5%, what is then i?
4. How should the parameters of the first order basis compare with the actual ones
for a life insurance with n = ∞?
5. Explain what is the relevance for the Assignment of the following material on
the delta method.

6 The delta method

Ofte, one faces estimation of f (x, y) where f is a known function but x, y are un-
known numbers that have to be estimated from R replicates (X1 , Y1 ), . . . , (XR , YR )
of a bivariate r.v. (X, Y ) with EX = x, EY = y (note that X, Y may be depen-


dent). The obvious estimate is fb = f X, Y where

R R
1 X 1 X
X = Xr , Y = Yr ,
R r=1 R r=1

but how should one estimate the error and thereby give a confidence interval?
This is what the delta method is about.
The idea is just to use a Taylor expansion around (x, y) which with fx =
∂f /∂x, fy = ∂f /∂y the partial derivatives means


fb − f (x, y) = f X, Y − f (x, y)
R


1 X
≈ fx (x, y) X − x + fy (x, y) Y − y = (Zr − z)
R r=1

where Zr = fx (x, y)Xr + fy (x, y)Yr , z = EZ = fx (x, y)x + fy (x, y)y. Since
Z1 , . . . , ZR are i.i.d., we have
R
1 X
√ (Zr − z) → N (0, ω 2 )
R r=1

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 √
where ω 2 = V ar(Z). This suggests R(fb −√ f (x, y)) → N (0, ω 2 ) so that the
b
95% confidence interval should be f ± 1.96ω/ R.
In practice, we have the complication that not only ω 2 but also fx (x, y), fy (x, y)
are not known so that we cannot observe the Zr . The obvious procedure is to
approximate Zr by

Zr∗ = fx (X, Y )Xr + fy (X, Y )Yr ,

let
R
1 X ∗ ∗
2
b2 =
ω Zr − Z
R − 1 r=1
√
and use the confidence interval fb ± 1.96b
ω/ R.
NB The above introduction to the delta method is written with undergradu-
ates in mind. After later courses, you will know the multivariate central limit
theorem which enables a somewhat more streamlined presentation.

7 Assignment
Consider a contract with benefits Y and premium payable as a lump sum c
at t = 0. When calculating c via the equivalence principle, the size of safety
margin (loading) will usually depend on how risky the contract is in the sense
of variability of Y around its expected value. Any measure of variability would
involve the distribution of Y which is in general difficult to calculation so we
will use simulation to compare the benefits
b1

Y1 = 1 − Ee−rTx , Y2 = b2 Ee−rTx
r
of two types of contracts, a life annuity and a life insurance. Take x = 55 and
use r = 5% and the G82 Gompertz-Makeham parameters; as help, you will be
given a S function generating Tx with this distribution.
As first measure of variability, we take the variances EY12 /EY1 −1, EY22 /EY2 −
1. Give simulation estimates for both r.v.’s and, if time permits, a confidence
interval using the delta method. You will be helped by be given a S function in
the setting of the delta method with f (x, y) = x/y
As second measure of variability, take if time permits the VaR (value at
risk) y0.99 defined as the 99% quantile in the distribution of a r.v. Y , that is,
the number satisfying P(Y ≥ y0.99 ) = 0.01. The use of the VaR comes from
mathematical finance where one thinks of Y as a potential loss. A simulation
estimate is obtained by simulating (say) R = 105 replications Y1 , . . . , YR and
the empirical 99% quantile (details later).

References
[1] H.U. Gerber (199x) Life Insurance. Springer.

[2] R. Norberg (2002) Basic Life Insurance Mathematics. Lecture Notes used by the
actuarial studies at the Univ. Copenhagen.