Policy Value Calculation and Recursive Formulas

Lecture 10 - Policy Values
Lecturer: Trần Minh Hoàng
Actuarial Mathematics 1
Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 1 / 45

Table of Contents
1 The future loss random variable
2 Policy Values
3 Recursive formulae for policy values
4 Annual Profit
5 Policy values with continuous cash flows
6 Thiele’s Differential Equation

The future loss random variable

The future loss random variable
We introduced the future loss random variables Ln0 and Lg0 for an insurance
policy previously as the present values of the future benefits and expenses
(for gross future loss) less future premiums at time 0.
In order to estimate future loss some time after the insurance policy is issued,
we extend these definitions of future loss random variables as follows.
Lnt = PV of benefits outgo at time t - PV of net premium income at time t

Lgt = PV of benefits outgo at time t + PV of expenses at time t
− PV of gross premium income at time t.
Note that the subscripts t indicate that the present values are calculated at
time t i.e. t years after the insurance policy is issued.

Convention
Lnt and Lgt are the future loss random variables conditioning on the event that
the insurance policy is still in force at time t.
That means we implicitly assume that the insured life or the annuitant is still
alive after t years.
We adopt the following conventions:
I Premiums at time t are paid at time t + .
I Benefits at time t are paid at time t − .
That means if we want to calculate Lt then
I Premiums at time t are regarded as future premiums and thus are included in
Lt .
I But benefits at time t are considered as past benefits and thus are excluded
from Lt .

Policy Values

Policy Values
Definition
The policy value, t V, for a policy in force at duration t years after it was
purchased is the expected value at that time (i.e. t) of the future loss random
variable (gross or net). That is
tV = Et (Lt ).
where Et (.) indicates the expected value is taken at time t.

Equivalent Formulation
Equivalent formulation of t V is as follows
tV = PV of benefits outgo + PV of expenses - PV of premiums at time t.
The gross and net policy values are calculated based on the gross and net
premiums respectively
Therefore, if the premiums are determined using the equivalence principle
then 0 V = 0.

Example
An insurer issues a whole life insurance policy to a life aged 50. The sum insured
of $100,000 is payable at the end of the year of death. Level premiums of $1,300
are payable annually in advance throughout the term of the contract.
Calculate the gross premium policy value five years after the inception of the
contract, assuming that the policy is still in force, using the following basis:
Survival model: Standard Ultimate Survival Model.
Interest: 5% per year effective.
Expenses: 12.5% of each premium.

Example
Consider a 20-year endowment policy purchased by a life aged 50. Level premiums
are payable annually throughout the term of the policy and the sum insured,
$500K, is payable at the end of the year of death or at the end of the term,
whichever is sooner. The basis used by the insurance company for all calculations
is the Standard Ultimate Life Table, 5% per year interest and no allowance for
expenses.
a) Calculate the annual net premium, P, using the equivalence principle.
b) Calculate t V for t = 10 and t = 11, in both cases just before the premium
due at time t is paid.

Intuitively, the policy value at time t represents the amount the insurer
should have in its investments at that time so that, together with future
premiums, the insurer can, in expectation, pay future benefits and expenses.
Most insurance companies are required to regularly calculate the sum of the
policy values for all policies and also the value of all the company’s
investments.
For an insurance company to be financially sound, the investments should
have a greater value than the total policy value.
This process is called a valuation of the company. In most countries,
valuations are required annually by the insurance supervisory authority.
In the literature, the terms reserve, prospective reserve and prospective
policy value are sometimes used in place of policy value.

Recursive formulae for policy values

Annual Case
Consider a policy issued to a life (x) where cash flows – premiums, expenses and
claims – can occur only at the start or end of a year.
Suppose this policy has been in force for t years, where t is a non-negative
integer.
Pt - the premium payable at time t,
et - the premium-related expense payable at time t,
St+1 - the sum insured payable at time t if the policyholder dies in the year,
Et+1 - the expense of paying the sum insured at time t + 1,
tV and t+1 V - the gross premium policy value at time t and t + 1,
it - the effective interest rate from time t to t + 1.

Recursive formula - Annual Case
Proposition
For a policy issued to a life (x) where cash flows can only occur at the beginning
or at the end of the year, the gross premium policy value at time t and t + 1 are
related by
(t V + Pt − et ) (1 + it ) = qx+t (St+1 + Et+1 ) + px+t (t+1 V) .

Proof
Suppose the policy has been in force for t years, then the life (x) is now aged
x + t.
tV = E(Lt ) = E(Lt |Kx+t = 0)P(Kx+t = 0) + E(Lt |Kx+t ≥ 1)P(Kx+t = 0)

= qx+t E(Lt |Kx+t = 0) + px+t E(Lt |Kx+t ≥ 1)
= qx+t (1 + it )−1 (St+1 + Et+1 ) − (Pt − et ) +

px+t E((1 + it )−1 Lt+1 − (Pt − et ))

= −(Pt − et ) + (1 + it )−1 [qx+t (St+1 + Et+1 ) + px+t E(Lt+1 )]
= −(Pt − et ) + (1 + it )−1 [qx+t (St+1 + Et+1 ) + px+t (t+1 V)] .
Rearranging the above equation, we obtain the recursive formula.

Example: Policy Value For Term-Insurance
Consider an n-year term insurance issued to a life aged x with sum insured S
payable at the end of the year of death. Suppose premium of P is paid annually in
advance. Note that

P if 0 ≤ t < n, S if 0 ≤ t < n,
Pt = & St+1 =
0 if t ≥ n, 0 if t ≥ n.
The recursive formula for t V is given by
(t V + Pt )(1 + i) = qx+t St+1 + px+t (t+1 V) .
Therefore, for 0 ≤ t < n
tV + P = v (qx+t S + px+t (t+1 V))
and
nV = px+n (n+1 V) .
Clearly, n+1 V = 0, thus n V = 0.

Example (continued)
The future loss random variable Lt is given by
Lt = Sv Kx+t +1 × 1{Tx+t ≤n−t} − P ä min(Kx+t +1,n−t) .
The policy value at time t, t V, is

1 − P äx+t:n−t .
tV = S Ax+t:n−t
In this case, we can directly verify the recursive formula as follows. For t = n,
1 − P äx+t:0 = 0.
nV = S Ax+t:0
For t < n, we need the following two formulae

1 1
Ax+t:n−t = v qx+t + px+t Ax+t+1:n−t−1 ,
äx+t:n−t = 1 + v px+t äx+t+1:n−t−1 .

Example (continued)
As a result,
1 − P äx+t:n−t + P
tV + P = S Ax+t:n−t
1
= S(v qx+t + px+t Ax+t+1:n−t−1 ) − Pv px+t äx+t+1:n−t−1

1
= Sv qx+t + v px+t S Ax+t+1:n−t−1 − P äx+t+1:n−t−1
= v (qx+t S + px+t (t+1 V)) .
Therefore, the recursive formula for term-insurance is verified.

Example
Consider a 30-year term insurance issued to a life aged 30 with sum insured
$100,000 payable at the end of the year of death. Premium of $210 is paid
annually in advance during the term of the insurance. Basis:
Mortality follows the Standard Ultimate Life Table,
Interest at 5% per annum effective,
Initial expenses of 2% of the sum insured,
Renewal expenses of 5% of each premium after the first.
Write down the recursive formula that can be used to calculate the policy values
of this policy at time t = 0, 1, .., 30

Example
Consider a 15 year endowment insurance issued to a life aged 30 with sum insured
$100,000 payable at the end of the year of death. Premium of $1675.06 are paid
annually in advance during the term of the endowment insurance. Basis:
Mortality follows the Standard Ultimate Life Table,
Interest at 5% per annum effective,
Initial expenses of 2% of the sum insured,
Renewal expenses of 5% of each premium after the first.
Write down the recursive formula that can be used to calculate the policy values
of this policy at time t = 0, 1, .., 15

Annual Profit

Annual Profit
Quite often the experience (interest, mortality and expenses) are different
from that used in a premium basis.
These differences lead to profit and loss.
Generally, we expect that
I interest higher than expected leads to profit,
I expenses lower than expected leads to profit,
I mortality higher than expected leads to loss for insurance policies and profit
for annuity contracts.

Policy values with continuous cash flows

Policy values with continuous cash flows
The concept of policy values can be readily generalized to continuous cash

flows.
For example, premiums or annuities can be considered as being paid
continuously, benefits as being paid immediately on death, etc.
Policy values then can be calculated at any time rather than just at regular
intervals.
Instead of the recursion formula we will develop a differential equation to
calculate policy values.

Example
Consider an n-year term insurance which is deferred by u years issued to a life
aged x. Sum insured S is payable immediately on death and premium is payable at
the rate of P per annum until the end of the deferred period. Express the policy
value of this insurance contract in terms of standard actuarial functions.

Solution
The future loss random variable is given by
Sv Tx+t × 1{u−t<Tx+t <u+n−t} − P ā min(Tx+t ,u−t)

if t ≤ u
Lt =
Sv Tx+t × 1{Tx+t <u+n−t} if t > u
Therefore, the policy value is

1
S(u−t Ex+t )Ax+u:n − P āx+t:u−t if t ≤ u
t V = 1
S Ax+t:n+u−t if t > u
Suppose premium P is set under the Equivalence Principle, i.e. such that 0 V = 0.
Then 1
S(u Ex )Ax+u:n
P= .
āx:u

After some algebraic manipulation we obtain

ā
1
S Ax+u:n 1 − x+t:u−t if t ≤ u

āx:u
tV =
 1
S Ax+t:n+u−t if t > u
We can check that t V is continuous everywhere but is not differentiable at t = u.

The graph of t V is shown in the next slide.

Thiele’s Differential Equation

Consider a policy issued to a life (x) under which premiums and

premium-related expenses are payable continuously and the sum insured,
together with any related expenses, is payable immediately on death.
Suppose this policy has been in force for t years, where t > 0.
Let us denote
I Pt , et as the annual rates of premium and premium-related expense payable at
time t,
I St , Et as the sums insured and expenses payable at time t if the policyholder
dies at exact time t,
I δt as the force of interest per year assumed earned at time t, and,
I
t V as the policy value at time t.

Theorem
Policy value, t V, satisfies the following differential equation
d
t V = δt (t V) + (Pt − et ) − µx+t (St + Et − t V),
dt
= (µx+t + δt )t V + (Pt − et ) − µx+t (St + Et ).

Example: Whole Life Policy
Consider a whole life policy with sum insured $1 payable immediately on the death
of x, with no premiums, with a constant force of interest δ. Then, the policy value
at time t is
t V = Āx+t .
Thiele’s differential equation in this case states that
d Āx+t
= (µx+t + δt ) Āx+t − µx+t .
dt

Example: Whole Life Annuity
Consider a whole life annuity policy with zero sum insured and with annual rate of
payment of -$1 until the death of x (i.e. the insurer is paying premiums to (x)),
with a constant force of interest δ. Then, the policy value at time t is
tV = āx+t .
Thiele’s differential equation in this case states that

d āx+t
= (µx+t + δt ) āx+t − 1.
dt

Example: Whole Life Policy with Annual Premium
Consider a whole life policy with sum insured S payable immediately on the death
of x, with net premiums of P per annum payable continuously, with a constant
force of interest δ. Then, the policy value at time t is
tV = S Āx+t − P āx+t .
Thiele’s differential equation in this case is

d
t V = (µx+t + δt )t V + P − µx+t S
dt
which can be easily deduced from the previous two formulae.

Numerical Solutions of Thiele’s Differential Equation
Usually, Thiele’s differential equation cannot be solved analytically.

However, we can obtain numerical solutions for policy values by employing
numerical methods.
One such method is called Euler’s method.
The idea is to divide the time interval into many sub-intervals of size h where
h called the step size is small then approximate
d t V − t−h V
tV ≈ .
dt h
We then obtain a recursive formula to calculate t V provided that we have a
starting point say n V = 0 in case of a n-year term insurance or n V = S in
case of a n-year endowment insurance.

Example
Consider a 20 year endowment insurance issued to a life aged 40. The sum insured
is S = $100, 000 and is payable immediately on death or on survival, and level
premiums are payable continuously throughout the policy term at the rate of P
per annum.
Survival model: Makeham’s law
µx = A + Bc x
where A = 0.00022, B = 2.7 × 10−6 and c = 1.124.

Interest: i = 5% per annum.
a) Find an expression for the premium under the Equivalence Principle.
b) Write down the Thiele’s differential equation satisfied by t V for this policy.
c) Use Euler’s method with step size h = 0.5 to calculate t V and sketch the
graph of t V.

Solution:
a) Let S = 100, 000, x = 40 and n = 20. The future loss random variable at
time t is
Lt = Sv min(Tx+t ,n−t) − P ā min(Tx+t ,n−t) .
Therefore, the policy value at time t is
tV = S Āx+t:n−t − P āx+t:n−t .
Under the Equivalence Principle, premium is set such that 0 V = 0. Hence,
S Āx:n
P= = 3010.98.
āx:n

b) Thiele’s differential equation in this case is
d
t V = (µx+t + δ)t V + P − µx+t S
dt
c) Let h = 0.5. Using the approximation
d t V − t−h V
tV ≈ ,
dt h
Thiele’s differential equation can be rewritten as the following recurrence
equation
t V − t−h V
≈ (µx+t + δ)t V + P − µx+t S.
h

Rearranging we deduce
t−h V ≈ t V − h [(µx+t + δ)t V + P − µx+t S] .
At time 20 since the policy is still in force, the policyholder has survived 20 years
and will certainly receive the endowment benefit S. Thus, L20 = S and 20 V = S.
Therefore, using the recurrence equation and the fact that 20 V = S, we can
calculate 19.5 V, 19 V, ..., 0 V.
The plot of the exact solution of t V and the solution obtained from Euler’s
method are shown in the next slide.

Boundary Conditions
As seen in the previous example, in order to solve Thiele’s differential

equation numerically we need boundary conditions for t V.
The following are standard boundary conditions.
If t V is the policy value for an n-year term-insurance policy then n V = 0.
If t V is the policy value for an n-year endowment insurance policy with sum
insured S then
lim− t V = S.
t→n
If t V is the policy value for a whole life insurance policy and ω is the limiting
age of the survival model then
lim tV = 0.
t→ω −

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Lecture 10 - Policy Values

Lecturer: Trần Minh Hoàng

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 1 / 45

1 The future loss random variable

3 Recursive formulae for policy values

5 Policy values with continuous cash flows

6 Thiele’s Differential Equation

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 2 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 3 / 45

Lnt = PV of benefits outgo at time t - PV of net premium income at time t

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 4 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 5 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 6 / 45

where Et (.) indicates the expected value is taken at time t.

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 7 / 45

Equivalent formulation of t V is as follows

tV = PV of benefits outgo + PV of expenses - PV of premiums at time t.

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 8 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 9 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 10 / 45

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Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 12 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 13 / 45

(t V + Pt − et ) (1 + it ) = qx+t (St+1 + Et+1 ) + px+t (t+1 V) .

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 14 / 45

tV = E(Lt ) = E(Lt |Kx+t = 0)P(Kx+t = 0) + E(Lt |Kx+t ≥ 1)P(Kx+t = 0)

px+t E((1 + it )−1 Lt+1 − (Pt − et ))

Rearranging the above equation, we obtain the recursive formula.

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 15 / 45

The recursive formula for t V is given by

(t V + Pt )(1 + i) = qx+t St+1 + px+t (t+1 V) .

Therefore, for 0 ≤ t < n

tV + P = v (qx+t S + px+t (t+1 V))

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 16 / 45

The future loss random variable Lt is given by

Lt = Sv Kx+t +1 × 1{Tx+t ≤n−t} − P ä min(Kx+t +1,n−t) .

The policy value at time t, t V, is

For t < n, we need the following two formulae

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 17 / 45

Therefore, the recursive formula for term-insurance is verified.

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The concept of policy values can be readily generalized to continuous cash

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 27 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 28 / 45

The future loss random variable is given by

Sv Tx+t × 1{u−t<Tx+t <u+n−t} − P ā min(Tx+t ,u−t)

Therefore, the policy value is

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 29 / 45

We can check that t V is continuous everywhere but is not differentiable at t = u.

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 30 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 32 / 45

Consider a policy issued to a life (x) under which premiums and

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 33 / 45

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 34 / 45

Thiele’s differential equation in this case states that

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 35 / 45

Thiele’s differential equation in this case states that

Lecturer: Trần Minh Hoàng Lecture 10 - Policy Values Actuarial Mathematics 1 36 / 45