About two ways of finding premiums

Method 1

The first is the usual way that we use by “equivalence principle” by finding EPV of Benefits, EPV of
expenses, EPV of premiums and then:

EPV of Premiums = EPV of Benefits + EPV of Expenses

If they don’t mention any specific method and just say “calcaulate premium”, this is the method you
use. They also mention sometimes “calculate premium by setting the expected value of gross
future loss random variable to zero”. This also means that you have to use the same equivalence
principle to calculate premium. Just the words are complicated.

Method 2

The second method is by using a “discounted cashflow projection”

In this method you will solve by making tables just like you make for profit testing and equate total
NPV of profit to 0 (if no other criteria is given). You will be given a different interest rate and risk
discount rate also, just the way it is given for profit testing. Those could be same values, too, but
they will mention that.

You start by assuming premium as P and then the usual columns for expenses, interest, death cost,
maturity cost and profit vector, signature and NPV. Multiply with the required probabilities just the
way we do for profit testing.

Refer to Q12 iii) , Q24 from Booklet 8. The last question from Sept 2020 paper was to be solved
using this method.

Refer Q 28.5 (from course notes) → here they have said “Show that the office premium to the
nearest pound is 2610, if Net present value of profit is 25% of the office premium.”

Now in this question 28.5, they haven’t specifically mentioned which method we should use but by
reading show that “Net Present Value of Profit” is 25% of Premium, we should understand that in
method 1 there is nothing like that. But in Method 2, we do find premium by calculating NPV of
Profit. So it has to be method 2 to be used here. Also, if you see there are two rates given → one is
investment return and the other is risk discount rate. That should also make it clear that it is method
2.
About finding net premium reserves for a with profits contract for profit

testing.

Note: This is only to be used in with profits contracts where we are usually asked to find a NET
PREMIUM RESERVE. Questions from chapter 21 are usually about finding gross premium reserves
which would be done just the way we do normally→ so this is not for that. This is only if a particular
contract in a profit testing question is a with profits one.

Lets say the contract given in profit testing is a with profits endowment assurance contract and the
life’s age is 61 and the term of the contract is 4 years.

We have to find the column “expected cost of increase in reserves” for which we will need to find
reserves. Let’s say they have given that: company holds net premium reserves assuming AM92
Ultimate Mortality and 4% p.a. interest.

Let’s take the basic SA as 20,000 and the bonus rate as 5% p.a. simple. So each year bonus amount is
1000.

(Now here it won’t matter if the bonuses are vested at the start of the year or end of the year, as we
have to know how many bonuses are declared by the time we are calculating the reserve. So in both
cases by time 1, 1 bonus would have been declared so we’ll include 1 bonus in 1V, by time 2, 2
bonuses would have been declared so we will take 2 bonuses in 2V and so on.)

Now here, you will NOT be using the normal formula that you use for calculating net premium
̈ ̅̅̅̅̅̅
reserves in profit testing i.e.
̈ ̅

The first step is calculation of Net Premium. In this Net Premium you won’t include any bonus.

So here,

̈ ̅ ̅

From this you will get the value of P or premium that you will use to calculate all of the reserves.

Formula for net premium reserves is,

Net Premium Reserve = EPV of Benefits – EPV of Premiums

̅ ̈ ̅

Here one bonus has been included in sum assured. Had it been compound bonus of b% (start or end)
the SA here would have been 20000(1+b)
 ̅ ̈ ̅

Here one bonus has been included in sum assured. Had it been compound bonus of b% (start or end)
the SA here would have been 20000(1+b)2

̅ ̈ ̅

Here one bonus has been included in sum assured. Had it been compound bonus of b% (start or end)
the SA here would have been 20000(1+b)3

Note: The same P calculated initially has been used here for all the reserves.

This method to be only used for with profits contracts mentioned in PROFIT TESTING QUESTIONS for
calulation of NET PREMIUM RESERVES only.
About super-compound bonus Sum assured calculation

(This part is not very important, but check it once. There was a small error in the SA formula given in
the video)

→ FOR MATURITY BENEFIT

Mostly your question in the exam will only be for sum assured paid on maturity.

Now, irresepective of if bonuses are vested at start of year or end of year, on maturity, the person
gets all the n bonuses.

So, the formula for maturity benefit in the nth year considering a term of n years and bonus rate b1
on basic sum assured and bonus rate b2 on bonus will be:

(Check question 19.10 part (i) (3) → from course notes)

→ FOR DEATH BENEFIT

If bonuses are vested at start of the year

Death Benefit in tth year = ̅

If bonuses are vested at end of the year

Death Benefit in tth year = ̅̅̅̅̅

(there is no question in notes for super compound bonus on death)