You are on page 1of 8

# ANUx – Introduction to Actuarial Science

Lesson 7

Modelling a Life Insurance Company 2
In Lesson 6, we looked at the investigation of the financial condition of a life insurance company
through the use of simulations. In this Lesson we will continue to do this, whilst looking at further
modifications to the structure of the insurer that we considered in Lesson 6. You are encouraged to
refer back to the structure of the insurer that we considered in Lesson 6 as a starting point to the
material for this Lesson.
Before we look at these modifications, however, we wish to look further at the concept of reserves.
In Lesson 6 we projected the values of the Actual Reserves over the simulation process. In this
Lesson we will look at how an actuary measures the sufficiency of the Actual Reserves over time
after the product has been sold.

Expected Reserves
As we saw in Lesson 6, in a whole of life policy the premiums are much higher than the claim
amounts in the early years of the policy, resulting in the accumulation of Actual Reserves over the
duration of the policy. But how much should these reserves be? An actuary is very interested in the
answer to this question, as an insurer that does not hold sufficient reserves will be at risk of financial
collapse towards the end of the policy when claims tend to exceed premiums.
In order to determine an appropriate level for the reserves, we need to return to the techniques we
learned in Lesson 5 that we used to calculate the premium for a life insurance policy.
Recall that we set the risk premium by equating the expected present value (EPV) of the incomes
and outgoes of the insurer:

EPV income

EPV outgo

We can rewrite this as follows:

EPV income

EPV outgo

0

Essentially what this is telling us is that the EPV of all cash flows of the insurer is zero. Remember
that we have previously stated that we can calculate the value or EPV of a series of cash flows at any
time by knowing the value or EPV at one time and discounting or accumulating accordingly.

Version 1 (2015)

Page 1

then we would expect the Actual Reserves to be zero at the conclusion of the policy when no further cash flows remain. This has been built up by the premium and claim cash flows that have accumulated before Year s . since the policyholder is alive at Year s (there would be no further cash flows if they were dead) then all probabilities are expressed in terms of them being alive at age 40 s . we can calculate the Expected Reserves at Year s as follows: n Expected Reserves at Year s n 1 C q t s 1|1 40 s t s 1 Adam Butt Version 1 (2015) vt s P t s 1 Page 2 t s p40 s vt s . Using the whole of life example above. if the EPV of all cash flows at the commencement of the policy is zero. So what should the expected reserves be at Year s ? We still wish to work with the equation EPV income = EPV outgo .ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 The most obvious result of this is that. But we can also use this result to calculate the Expected Reserves (also known as the actuarial reserves or the required reserves) at a point in time during the policy. Let’s place this on a timeline for a policyholder who took up a whole of life policy at age 40: Year | | | 0 1 2 … | | s s+1 P Premium Probability 1 p40 C Probability 1 40 s | … n-1 n … P … s Claim | q n s 1 p40 s … C C … n s 2|1 40 s q q n s 1|1 40 s We would like to calculate the expected reserves for a single policyholder who is still alive at Year s . Hence we can re-express this equation at Year s as follows: Expected Reserves at Year s EPV income at Year s EPV outgo at Year s We would like to solve this equation for the Expected Reserves as thus rearrange it as: Expected Reserves at Year s EPV outgo at Year s EPV income at Year s This equation works for any form of life insurance product. (That the Actual Reserves are not zero is because the experience of the insurer is stochastic and doesn’t match the assumptions made in calculating the EPVs exactly). In addition. Note that all cash flows up until. the Expected Reserves at Year s . and including. but we now have an additional “cash flow” that exists at Year s . that year have already happened and so they are not placed on the timeline.

Assume an interest rate of 6% per annum (i. Note that the Expected Reserves for all policyholders is simply the Expected Reserves for a single policyholder multiplied by the number of policyholders alive at that point in time.e. use a spreadsheet tool to calculate the probability that the Actual Reserves will be greater than the Expected Reserves at Year 20.ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Note that. we have deliberately not put a border around this formula because the EPV of the cash flows will be dependent upon the exact structure of the product.1. like in Lesson 5. calculate the Expected Reserves at Year 20 for a single alive policyholder who purchased a whole of life product at age 40 which requires a premium equal to the premium calculated in Assessment Question 6. Practice Question 7. Practice Question 7.2 and provides a claim of \$400. Adam Butt Version 1 (2015) Page 3 .2 For the insurer scenario outlined in Lesson 6 and the questions above.1 For the same product and assumptions as Practice Question 7.1 Using a spreadsheet tool. Assessment Question 7. use a spreadsheet tool to calculate the Expected Reserves at Year 30 for a single alive policyholder.000 at the end of the year of death of the policyholder. the mean interest rate in the scenario) and that mortality rates follow the Australian Life Tables 2010-12 (female rates) and available for download in the relevant Courseware of the edX version of the course.