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.

Adam Butt
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.

in order to be consistent with the original calculation of Expected Reserves. Adam Butt Version 1 (2015) Page 4 . the Actual Reserves will be greater than the Expected Reserves.2. an alternative approach to calculating Expected Reserves is to calculate the expected accumulated value of the cash flows at Year s . calculate the probability that. i.1 (Hard) If the premium is calculated as a risk premium (see Lesson 5). which is available for download in the relevant Courseware of the edX version of the course. which is available for download in the relevant Courseware of the edX version of the course. Those who are feeling less confident can look at the final version.2 In the updated solution file to the simulations (including Expected Reserves). Assessment Question 7. the division adjusts this to be the Expected Reserves at Year s for a policyholder who is alive at Year s . which is available for download in the relevant Courseware of the edX version of the course. that: s s P t p40 (1 i )s t C t 0 n q t 1|1 40 i )s (1 t s p40 t 1 n 1 C q t s 1|1 40 s t s 1 vt s P t s p40 s vt s t s 1 Note that the division by s p40 is to reflect the fact that the above calculation without the denominator is the Expected Reserves at Year s for a policyholder who is alive at Year 0. which for the example above would give you: s Expected Reserves at Year s s P t p40 i)s (1 t C t 0 q t 1|1 40 (1 i)s t s p40 t 1 Show mathematically that the two different calculations of Expected Reserves give the same results. and the video which demonstrates this from scratch. If you are feeling confident you should attempt to do this yourself right now without going any further. We will use the premium which was calculated in Assessment Question 6. We would now like to incorporate the Expected Reserves for each year of each simulation for the insurer scenario outlined in Lesson 6 into the simulation work.ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Extension Question 7. in a random future year (except Year 0).e.

or adding money to.5 x Expected Reserves.ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Adjustments to Actual Reserves Whilst the premium charged and investment strategy chosen are the primary factors that will affect the financial position of an insurance company. the insurer now wishes to take money from the Actual Reserves whenever the Actual Reserves exceeded the Expected Reserves by more than 50%. Practice Question 7.3 For the insurer scenario outlined above. calculate the revised probability that the premium charged will be sufficient to cover the claims cash flows for the following premium amounts:    the value calculated in Assessment Question 6. the insurer will add money to the Actual Reserves equal to the lessor of: o o The amount required to increase the Actual Reserves to 80% of the Expected Reserves. From Year 1 onwards.2 $2. in which case the Actual Reserves are set to zero.500 Assessment Question 7. Using the updated solution file to the simulations (including Expected Reserves). it is possible for an insurer to make adjustments by taking money from. calculate the revised probability that the premium charged will be sufficient to cover the claims cash flows for the following premium amounts:    the value calculated in Assessment Question 6.000 $2.3 For the insurer scenario outlined above. which is available for download in the relevant Courseware of the edX version of the course. the Actual Reserves.000 $2.500 Adam Butt Version 1 (2015) Page 5 . the insurer now wishes to add money to the Actual Reserves whenever the Actual Reserves are more than 20% less than the Expected Reserves. except where the Expected Reserves are negative. From Year 1 up until and including Year 30 of the policy. or 30% of the premium income received at the time the adjustment is being made. instead of removing money from the reserves. Using the updated solution file to the simulations (including Expected Reserves). These adjustments will typically be linked to a comparison between the values of the Expected Reserves and the Actual Reserves. the insurer will take away any money in the Actual Reserves that is greater than 1. which is available for download in the relevant Courseware of the edX version of the course. whenever the Actual Reserves are more than 20% less than the Expected Reserves.2 $2.

claims are only paid to policyholders whilst they are alive). The insurer will sell 5.4 An insurance company wishes to sell a life annuity policy to policyholders aged 60.000 life annuity policies to policyholders aged exactly 60 at Year 0. Assume that interest rates each year follow a normal distribution with a mean of 4% and a standard deviation of 3%.000 to policyholders at Year 1. 2. The questions will test your understanding of the simulation process we have looked at in these two lessons. First calculate the risk premium for a single policyholder. Then. produced by the Australian Government Actuary. This policy will be sold for a single premium at age 60 and will pay annual claims of $25. 3. and available for download in the relevant Courseware of the edX version of the course. and update it for the revised policy design. Calculate the probability that the premium charged will be sufficient to cover the claims cash flows for the following premium amounts:    The risk premium calculated above 90% of the risk premium 110% of the risk premium Adam Butt Version 1 (2015) Page 6 . assuming an interest rate of 4% per annum. and mortality rates as described above. which is available for download in the relevant Courseware of the edX version of the course. Assume that mortality rates are equal to 90% of the Australian Life Tables 2010-12 (female rates).… until the death of the policyholder (i.e. Note that the final mortality rate should be maintained at 1. Practice Question 7. but in the context of a different type of life insurance product. adjust the simulation file prepared in this Lesson.ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Additional Questions The final component of the learning material for the course is a series of questions that ask you to make further adjustments to the insurance scenario outlined in Lesson 6 and expanded upon in this Lesson.

From Year 1 up until and including Year 20 of the policy. using the same assumptions as Practice Question 7.000. which is available for download in the relevant Courseware of the edX version of the course.ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Assessment Question 7. so that the life annuity is sold to policyholders aged exactly 80 at Year 0. the insurer will take away any money in the Actual Reserves that is greater than (1 Y %) Expected Reserves. Calculate the probability that this premium will be sufficient to cover the claims cash flows. Calculate the value of Y % such that the revised probability that the premium of $450. Adam Butt Version 1 (2015) Page 7 .4. except where the Expected Reserves are negative. in which case the Actual Reserves are set to zero. Assessment Question 7.4 Adjust the simulation spreadsheet produced for Practice Question 7. First calculate the risk premium for a single policyholder.5 Adjust the simulation spreadsheet produced for Practice Question 7. Calculate the probability that the premium charged will be sufficient to cover the claims cash flows for the following premium amounts:    The risk premium calculated above 90% of the risk premium 110% of the risk premium You may like to discuss the reason for the difference in probabilities compared to Practice Question 7.000 will be sufficient to cover the claims cash flows is 95%.4. so that the premium charged is $450. The insurer now wishes to take money from the Actual Reserves whenever the Actual Reserves exceed the Expected Reserves by more than Y % .4.4 in the forum thread for this question. which is available for download in the relevant Courseware of the edX version of the course.

claims are only paid to policyholders whilst they are alive).ANUx – Introduction to Actuarial Studies – Lesson 7 – Modelling a Life Insurance Company 2 Summary of the Lesson 7 Material  Expected Reserves are the amount of Actual Reserves an insurer would hold to be equal to the expected present value of the future cash flows. 3. 2. These adjustments are typically linked to a comparison between the values of the Expected Reserves and the Actual Reserves.  Under a life annuity policy.e. Adam Butt Version 1 (2015) Page 8 . a policyholder purchases the policy from the insurer for a single premium and receives annual claims at Year 1. or adding money to.… until the death of the policyholder (i. the Actual Reserves. Expected Reserves at Year s EPV outgo at Year s EPV income at Year s  It is possible for an insurer to make adjustments by taking money from.