LIFE PRICING FUNDAMENTALS

Dr Taonaziso Chowa
LAW OF LARGE NUMBERS

28 June 2018
 The Weak Law of Large Numbers: For each n =
1, 2, . . ., suppose that R1, R2, . . . , Rn are
independent random variables on a given
probability space, each having finite mean and
variance. Assume that the variances are
uniformly bounded; that is, assume that there is
some finite positive
n
number M such that 2i  M for
all i. Let Sn   R i Then,
i 1

 S  E  Sn  
P n     0 as n  
 n 
2
LAW OF LARGE NUMBERS

28 June 2018
 Take coins. Have each student flip the coin ten
times and count the number of heads. Collect the
results.
 Let a head be one and a tail be zero. Set R equal
to one or zero as the coin toss yields a head or tail,
respectively, on toss i = 1, 2, . . . . What do the
sums represent?
 What is the expected value of S2? Note that S2 can
be 0, 1 or 2 with probability ¼, 2/4, and ¼. Hence,
the expected value is E(S2) = ¼ (0) + ½ (1) + ¼ (2)
= 1 and E(S2)/2 = ½. Similarly, S3 can be 0, 1, 2, 3
with probability 1/8, 3/8, 3/8, and 1/8. Hence, the 3

expected value is E(S3) = 1/8 (0) + 3/8 (1) + 3/8 (2)

+ 1/8 (3) = 12/8 = 1 ½ and E(S )/3 = (1 ½)/3 = ½.
LAW OF LARGE NUMBERS

28 June 2018
 Note that it follows by induction or direct calculation
that E(Sn)/n = ½.

 What is your realized S2? S10? What was your

S2/2? What was your S10/10? My S2 was 1 and so
my S2/2 was ½. My S10 was 9 and my S10/10 was
9/10. What does the Weak Law of Large Numbers
say about the probabilities of these results?

4
PRICING OBJECTIVES

28 June 2018
 Adequacy
 The payments generated by a block of policies plus
any investment return on same must be sufficient to
cover the current and future benefits and costs
 Equity
 This equity refers to setting premiums commensurate
with the expected losses and expenses; it also
suggests no cross subsidization. The equity notion
sets a floor.
 Not excessive
 The excessive notion sets a ceiling
 Regulation 5
 Competition
ELEMENTS OF RATE MAKING

28 June 2018
 Probability of insured event
 Mortality and morbidity tables
 Time value of money
 Premiums paid now
 Interest on accumulated funds

 Promised benefit
 period of coverage
 level of coverage
 type of coverage

 Loading or expenses, taxes, contingencies and

profit 6
THE AGE PATTERN OF MORTALITY
 Fig 1 Annotated Graduated qx curve and its Components
THE AGE PATTERN OF MORTALITY

28 June 2018
 The graph has the following features, which are typical of
life tables based on human mortality in modern times:
 (1) Mortality just after birth (“infant mortality”) is very
high.
 (2) Mortality falls during the first few years of life.
 (3) There is a distinct “hump” in the function at ages
around 18–25. This is often attributed to a rise in
accidental deaths during young adulthood, andis called the
“accident hump”.
 (4) From middle age onwards there is a steep increase in
mortality, reaching a peak at about age 80.
 (5) The probability of death at higher ages falls again (even
though qx continues to increase) since the probabilities of 8
surviving to these ages are small.robability of insured
event
THE LIFE TABLE

28 June 2018
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THE LIFE TABLE

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THE LIFE TABLE

28 June 2018
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THE LIFE TABLE - SOLUTIONS

29 June 2018
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THE LIFE TABLE

28 June 2018
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 THE LIFE TABLE

29 June 2018
 An important special case for actuarial calculations is m
= 1, since we often use probabilities of death over one
year of age. By convention, we drop the “m” and write:

 In other words, n|qx is the probability that a life aged x will

survive for n years but die during the subsequent year, ie die
between ages x + n and x + n +1 has the following features,
which are typical of life tables based on human mortality in
modern times:
 It can be shown that:
14
 LIFE INSURANCE RATE COMPUTATION

 Yearly renewable term life

insurance
Table 2-5
Illustrative Net Level Premium Calculation
1 2 3 4 5
The YRT covers the life for one
Richard D. MacMinn:

 Net Level Present Value

This allows us to calculate
the present value of a

year at a set premium and is

Number one dollar premium flow
Premium to be of Total Net
Living at the Present Value per customer.
Policy Year Paid Annually Level
renewable by Each
Survivor
Beginning of Factor at 5%
Each Year
Premiums [(2)
x (3) x (4)]
 The YRT premium for a 30 year 1 1 100,000 1.0000 $100,000

old male would be $1.73 per 2

3
1
1
67,000
41,205
0.9524
0.9070
$63,810
$37,374
$1,000 of coverage while it would 45 1 21,427 0.8638 $18,509

be $1.38 for a female the same

1 7,328 0.8227 $6,029
Total PV $225,722

age. If investment income is

Richard:
This is the level premium or premium per
year. premium $395.40

included then the company The $225,722 is the present value per dollar

would set the premium at $1.65

in premiums paid each year of the policy.
Hence, that times the premium per year must
equal the present value of the claims, i.e.,

and $1.31 for males and females the $89,251,339. By altering the interest
rate in table 2-3 cell C1 is possible to see how

respectively
the level premium changes in table 2-5 cell
E12

 Single premium plan

 Level premium plan

15 28 June 2018
Table 2-5
Illustrative Net Level Premium Calculation
1 2 3 4 5 Richard D. MacMinn:
This allows us to calculate
Net Level Present Value the present value of a
Number one dollar premium flow
Premium to be of Total Net
Living at the Present Value per customer.
Policy Year Paid Annually Level
Beginning of Factor at 5%
by Each Premiums [(2)
Each Year
Survivor x (3) x (4)]
1 1 100,000 1.0000 $100,000
2 1 67,000 0.9524 $63,810
3 1 41,205 0.9070 $37,374
4 1 21,427 0.8638 $18,509
5 1 7,328 0.8227 $6,029
Total PV $225,722
Richard:
This is the level premium or premium per
year. premium $395.40
The $225,722 is the present value per dollar
in premiums paid each year of the policy.
Hence, that times the premium per year must
equal the present value of the claims, i.e.,
the $89,251,339. By altering the interest
rate in table 2-3 cell C1 is possible to see how
the level premium changes in table 2-5 cell
E12

16 28 June 2018
 SINGLE PREMIUM PLAN
Table 2-2
 This plan provides multi-
year coverage for a single Modified Version of 1980 CSO Mortality Table
1 2 3 4
premium now Probability Number
Number Living
 This eliminates the rising Age (Beginning of
of Death
(During
Dying
(During
premiums associated with Year)
the Year) the year)
the YRT. 95 100,000 0.330 33000

 This gives the insurer the 96 67,000 0.385 25795

ability to generate 97 41,205 0.480 19778

compound interest and

98 21,427 0.658 14099
99 7,328 1.000 7328
reduce the rate for
coverage 100 0

17 28 June 2018 Copyright macminn.org

 LEVEL PREMIUM PLAN

 If some of the 100,000 T

pt
policyholders prefer to pay aT   t1
premiums on an annual basis t  1 (1  r)
then how much must be charged
per year to make the insurer 1 1
 p1  p 2  p3
indifferent between the single 1r 1  r 
2
premium and the annual level
premium? 1 1
Let pt be the proportion of the p 4  p5 L

1  r  1  r 
3 4
insured population alive at the
beginning of policy year t. Let at
be the annuity factor for the


premium payment stream.
Let x be the level premium. aT x  pv T (L)
Then x must satisfy the last
equation on the RHS.

18 28 June 2018 Copyright macminn.org

 STUDY QUESTIONS
 Siamese Insurance has just issued a Term Assurance
Policy with a sum Assured of Sh2.7 million with a term
of five years. The Underwriter expects no deaths
during the first two years. Dearth can occur in third,
fourth and fifth years with probability of 0.1, 0.2, and
0.25 or the life survive the term of the policy with no
liability to the company.
 Find the (single annual premium) expected present
value of the pay-out of one such policy? Use: i=12%p.a

 A loan of Sh160,000 was issued to be repaid by a level

annuity certain payable annually in arrears over a
term of 10 years and calculated at an interest rate of
14% p.a.
19
 Find the initial amount of the annual repayment?