Life Insurance and Superannuation Models Week 3: Premiums

ACTL 3002 Life Insurance and Superannuation

Models
Michael Sherris
School of Risk and Actuarial Studies, Australian School of Business
University of New South Wales
ARC Centre of Excellence in Population Ageing Research

Week 3:
Premiums

1/41

Life Insurance and Superannuation Models Week 3: Premiums

Plan

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

2/41

Life Insurance and Superannuation Models Week 3: Premiums

Overview

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

3/41

Life Insurance and Superannuation Models Week 3: Premiums

Overview

Week 3: Premiums

Overview
Net premium:
Net (random) future loss
Principle of equivalence
Discrete premiums
Whole of life, limited premiums, term life, endowment
Premiums paid m times per year
Continuous premiums

4/41

Life Insurance and Superannuation Models Week 3: Premiums

Overview

References

References
Dickson et al. Chapter 6 (6.1 to 6.7)
Will cover rest of Chapter 6 in Week 6
Chapters 6 and 7 covered over Weeks 3, 4, 5 and 6

5/41

Life Insurance and Superannuation Models Week 3: Premiums

Net Premiums

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

6/41

Life Insurance and Superannuation Models Week 3: Premiums

Net Premiums

Net premiums

Net premiums
Values only the benefits provided
No allowance for allocated expenses, profit or contingency
margins

Principle of equivalence
Other premium principles (covered in other courses)

7/41

Life Insurance and Superannuation Models Week 3: Premiums

Net Premiums

Net Random Future Loss

An insurance contract is an agreement between two parties
The insurer agrees to pay for insurance benefits;
In exchange for insurance premiums to be paid by the insured

Denote by PVFB0 the present value, at time of issue, of

future benefits to be paid by the insurer.
Denote by PVFP0 the present value, at time of issue, of
future premiums to be paid by the insured.
The insurers net random future loss is defined by
0L

8/41

= L = PVFB0 PVFP0

Life Insurance and Superannuation Models Week 3: Premiums

Equivalence Principle

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

9/41

Life Insurance and Superannuation Models Week 3: Premiums

Equivalence Principle

Principle of equivalence

The principle of equivalence

EPV of benefit outgo = EPV of net premium income
The net premium is the amount of premium required to meet
the expected cost of the insurance or annuity benefits under a
contract, given mortality and interest rate assumptions.
The net premium is determined according to the principle of
equivalence by setting
E [L] = 0.

10/41

Life Insurance and Superannuation Models Week 3: Premiums

Equivalence Principle

Principle of equivalence

For example, for a unit of benefit payment, let Z be the PV

r.v. associated with the life insurance benefits and Y is the
PV r.v. associated with the life annuity premium payments,
with the premium payable annually, then
L = Z Y
so that
= E (Z )/E (Y )

11/41

Life Insurance and Superannuation Models Week 3: Premiums

Equivalence Principle

Different Possible Payment Assumptions

Premium payment
annually

m-thly of the year

continuously

12/41

Benefit payment
at the end of the year of death
at the end of the m1 th year of death
immediately upon death
at the end of the year
at the end of the m1 th year of death
immediately upon death
at the end of the year
at the end of the m1 th year of death
immediately upon death

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

13/41

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Fully Discrete Annual Premiums - Whole Life Insurance

(WLI)

Consider, for example, the case of a unit WLI with level

annual premium payment. Here the loss function is
L = vK

+ 1

aK +1 ,

for K = 0, 1, 2, ...

By the principle of equivalence, we have

E (L) = E (v K

14/41

+ 1

) E (
aK +1 ) = 0

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Discrete payments - WLI

Hence if we denote by Px then

= Px =

Ax
ax

The variance of the loss function

Var (L) =

15/41

2A
x

2 A (A )2
(Ax )2
x
x
=
(d ax )2
(1 Ax )2

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Example

Assume that the survival model is given by, `90 = 100,

`91 = 72, `92 = 39, `93 = 0. And the annual interest rate
i = 0.06. All of `90 = 100 people buy $1000 of fully discrete
whole life, paying net level annual premiums 1000P90 at the
beginning of each year. Find the annual net premium and
illustrate the aggregate accounting in a table to show how the
insurer breaks even after three years.

16/41

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Solution
Solution.
a90 =

X
k=0

v k k p90 = 1 1 +

72
1
39
1

+
+0

1.06 100 (1.06)2 100

1
Note A90 = 1 d a90 , d = 1 v = 1 1.06
= 0.05660377.
So A90 = 0.8853.
90
= 0.436895 and 1000P90 = 436.9.
P90 = Aa90

17/41

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

WLI - discrete payments

Net premium
Px =
and since
ax =

Ax
ax

1 Ax
d

We have then

18/41

1
ax

= Px + d

Px

dAx
1 Ax

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Exercise
Consider a fully discrete whole life insurance of 1, 000 issued
to (60), the annual benefit premium was calculated using the
following assumptions: i = 6%, q60 = 0.01376,
1000A60 = 369.33, and 1000A61 = 383.00.
A particular insured is expected to experience a first-year
mortality rate 10 times the rate used to calculate the annual
benefit premium. The expected mortality rates for all other
years are the ones originally used.
1

19/41

Calculate the expected loss at issue for this insured based on

the original benefit premium.
Why do you think there is a loss?

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

WLI with h Premium Payments - Limited premiums

The loss function in this case is

L=

vK
vK

+ 1
+ 1

aK +1
ah

for K = 0, 1, , h 1
for K = h, h + 1,

Applying the principle of equivalence, we have

=

20/41

h Px

Ax
ax:h

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Exercise Consider a whole life insurance with annual premiums

and a 20-year premium paying term issued to a life aged 30, with
sum insured $200,000 payable at the end of the year of death,
assuming AM92 Ultimate mortality and interest rate of 4%.

21/41

Write an expression for the loss function.

Calculate the net annual premium.

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Term life insurance

n-yr term:

L=

v K + 1 aK +1
0 an

for K = 0, 1, , n 1
for K = n, n + 1,

The corresponding premium formula is

1
=
Px:n

22/41

A1x:n
ax:n|

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Example
Calculate the annual premium for a 10-year term insurance for
a 30-year old with a sum assured of $500,000, assuming
AM92 Ultimate mortality and interest rate of 4% pa. Assume
that the death benefit is paid at the end of the year of death.

23/41

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

n-yr endowment

n-yr endowment loss RV


L=

v K + 1 aK +1
v n an

for K = 0, 1, , n 1
for K = n, n + 1,

The premium formula is

Px:n =

24/41

Ax:n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Limited premium n-yr endowment

Limited premium h-pay, n-yr endowment (h < n)

K +1
aK +1
v
L=
v K + 1 ah
n
v ah

for K = 0, 1, , h 1
for K = h, ..., n 1
for K = n, n + 1, .

Premium Formula is
h Px:n

25/41

Ax:n
ax:h

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

n-yr pure endowment

n-yr pure endowment


L=

0 aK +1
v n an

for K = 0, 1, , n 1
for K = n, n + 1, .

The corresponding premium formula is

Px: n1 =

26/41

Ax: 1n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Exercise
Prove :
Px:n =

27/41

n Px

+ Px: 1n (1 Ax+n )

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

n-yr deferred WL annuity with n-yr premium

n-yr deferred WL annuity with n-yr premium payment


L=

0 aK +1
v n aK +1n an

for K = 0, 1, , n 1
for K = n, n + 1, .

Premium Formula is
P(n| ax ) =

28/41

Ax: 1n ax+n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Insurances

Premiums paid m times a year - Summary

Insurance Plan
WLI
n-year term I

Benefit paid
at the EOY of death
at the moment of death
at the EOY of death

n-year
endowment
h-pay, WHI

at
at
at
at

(m)

Px

(m)

= Ax /
ax
(m)
(m)
P (Ax ) = Ax /
ax
(m)
(m)
P 1 = A1x:n /
ax:n
x:n

the
the
the
the

moment of death
EOY of death
moment of death
EOY of death

at the moment of death

h-pay,

at the EOY of death

n-year
endowment

at the moment of death

29/41

(m)
P (m) (A1x:n ) = A1x:n /
ax:n
(m)
(m)
Px:n = Ax:n /
ax:n
(m)
P (m) (Ax:n ) = Ax:n /
ax:n
(m)
(m)
= Ax /
ax:h
h Px
(m)
(m)
(Ax ) = Ax /
a
hP

x:h
(m)
(m)
ax:h
h Px:n = Ax:n /
(m)
(m)
(Ax:n ) = Ax:n /
ax:h
hP

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

1 Overview
2 Net Premiums
3 Equivalence Principle
4 Insurances
5 Continuous insurance

30/41

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully continuous premiums - whole life insurance

Consider fully continuous level annual premiums for a unit

whole life insurance payable immediately upon death of (x).
The loss function is expressed as
L = v T aT
By the principle of equivalence, and denoting the net premium
Ax ), we have
by P(

Ax ) = Ax
= P(
ax

31/41

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully continuous premiums - whole life insurance

Variance of the insurers loss function:

i2

h
Var (L) = 2 Ax (Ax )2 1 + (P(Ax )/)
=

32/41

2A
x

(Ax )2
=
(ax )2

2A
x

(Ax )2
(1 Ax )2

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Endowment Insurance Premiums

For an n-year endowment insurance, loss function is:


L=

v T aT , T n
v n an
T n

Net premium formula:

Ax:n
= P(Ax:n ) =
ax:n

33/41

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Endowment Insurance Premiums

Variance of the insurers loss function:

h
ih
i2
2
Var (L) =
Ax:n (Ax:n )2 1 + (P(Ax:n )/)
=

34/41

2A
x:n

(Ax:n )2
=
(ax:n )2

2A
x:n

(Ax:n )2

(1 Ax:n )2

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Premium Identities
Whole life insurance:
P(Ax ) =

Ax
1
=
ax
1 Ax

Endowment insurance:
P(Ax:n ) =

35/41

1
ax:n

Ax:n
1 Ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully Continuous Contracts

n-yr term

L=

v T aT , T n
0 an
T n

The corresponding premium formula is

1

P(Ax:n ) =

36/41

Ax:n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully Continuous Contracts

h-pay, whole life


L=

v T aT , T h
v T ah , T > h

The corresponding premium formula is

h P(Ax )

37/41

Ax
ax:h

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully Continuous Contracts

h-pay, n-yr endowment

T
v aT , T h
v T ah , h < T n
L=
n
v ah , T > n
Premium Formula is

h P(Ax:n )

38/41

Ax:n
ax:h

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully Continuous Contracts

n-yr pure endowment


L=

0 aT , T n
v n an , T > n

Premium Formula is
P(Ax: 1n ) =

39/41

Ax: 1n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Fully Continuous Contracts

n-yr deferred WL annuity


L=

0 aT ,
T n
v n aT n an , T > n

Premium Formula is
P(n| ax ) =

40/41

Ax: 1n ax+n
ax:n

Life Insurance and Superannuation Models Week 3: Premiums

Continuous insurance

Overview and Summary

Main ideas
Net premiums
Principle of equivalence
different contracts - whole of life, term, limited premium
different payment frequency
Next week
Reserves and Policy Values
41/41