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Lesson 5
Year
Cash Flow
1,000
1,000
Probability
40%
60%
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Calculating the EPV of a series of cash flows is the same as calculating the present value of a series of
cash flows with the additional component of multiplying each cash flow by its probability of
occurring. In the example above, and assuming an interest rate of 4% per annum, the EPV is
calculated as:
EPV
1, 000 0.4 v 5
1, 000(0.4 1.04
1, 000 0.6 v 7
5
0.6 1.04 7 )
$784.72
More generally, the expected present value of a series of cash flows can be calculated as:
EPV
t
Year
Premium
500
500
500
500
500
p30
Probability
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p30
p30
p30
p30
Page 2
n-2
n-1
500
500
n 2
p30
n 1
p30
In this instance n 1 reflects the latest possible Year at which a premium might be paid (i.e. n
premiums are paid in total), which might be a fixed number depending on the product or might be
based on the maximum possible age a policyholder is assumed to live until.
Using the EPV formulae above, the EPV of the premiums is calculated as follows:
n 1
500
EPV
p30
vt
t 0
Note that we have deliberately not put a border around this formula because the EPV of the
premiums will be dependent upon the exact structure of the product. Perhaps premiums are only
paid every 5 years? Perhaps only a single premium at Year 0 is paid? The EPV will be dependent
upon this structure.
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Claims
The same techniques described above can be used to calculate the EPV of claims. Imagine now that
the product above pays a claim of $50,000 to the policyholders dependent(s) at the end of the year
of death of the policyholder. Note that this assumption that claims are paid at the end of the year of
death allows us to assume that claim payments are made at integer years only. It is not realistic but
it does make our calculations easier!
Lets place these claim cash flows on a timeline for a policyholder who took up the policy at age 30,
with the probability that the insurer pays a claim being
Year
Claim
Probability
1|1 30
1 30
2|1 30
q :
t 1|1 30
3|1 30
n-1
50,000
50,000
n 2|1 30
n 1|1 30
Using the EPV formulae above, the EPV of the claims is calculated as follows:
50, 000
EPV
t 1|1 30
vt
t 1
Again this is the EPV for this specific product structure only and may differ if the product changes
structure.
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EPV income
EPV outgo
For an insurer, this is particularly useful when thinking about the premiums that the insurer might
wish to charge on an insurance product. In this instance income is the premiums received by the
insurer, whilst outgo is the claims paid by the insurer. The interest rate for present value purposes is
the interest rate the insurer expects to receive on its Actual Reserves.
A premium set in this way is called the risk premium, a concept we discussed in Lesson 2, and is
essentially the premium required by the insurer so that the premium income received is expected to
be sufficient to pay the claim outgo. Of course whether or not the premium income received will
actually be sufficient will depend on whether the experience of the insurer (e.g. mortality rates and
interest received) matches the assumptions made in calculating the risk premium. Well cover this
issue further in Lessons 6 and 7.
Finally, it should also be noted that, in practice, the calculation of premiums is far more complicated
than what has been described above. For example, the following are additional factors that we have
ignored, and would need to be considered by an actuary and the insurer in setting premiums:
The likelihood that a policyholder might lapse their policy i.e. the policyholder chooses
to stop paying premiums and discontinue the policy
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The cost of running the insurance company e.g. salaries, property, IT, etc.
The tax and regulatory environment that the insurer operates in
What sort of buffer is desired when setting the premium i.e. how much risk is the insurer
prepared to take that premiums will not be sufficient to cover claims?
The desired profit level of a for-profit insurer
The premiums that competitors are charging
You might like to discuss the effect that these factors might have on the premium charged in the
forum, where a thread has been created specifically for this topic.
$X
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Random variables
Lets return to the very first spreadsheet we looked at in this course, the annuity certain we
considered in Lesson 2, which is available for download in the relevant Courseware of the edX
version of the course.
One of the inputs to this spreadsheet was the interest rate, which was a factor that affected the
calculation of the claim amount and the Actual Reserves. This input was fixed (also known as
deterministic) and so the cash flow model gave a single answer to the outputs of interest (most
likely the claim amount or the Actual Reserves at the completion of the policy).
But we know that, unless the insurer invested the Actual Reserves in a way that generated a
guaranteed interest rate, the interest rate is not fixed, but will vary over time. This is especially the
case if the insurer invests the Actual Reserves in assets such as shares or property that provide
volatile rates of return.
Therefore, what we would really like to do is to make the interest rate random (also known as
stochastic) rather than fixed. This is achieved by making the interest rate a random variable rather
than a fixed input. Whilst the possible material we could cover on random variables is extremely
large, in this Lesson were just going to look at the briefest of elements that will be relevant to this
course.
In the context of the work we are doing in this course, a random variable is an input that can take a
variety of possible values rather than a single fixed value. The variety of values that a random
variable could take is said to be the distribution of that random variable.
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14
12
Density
10
0
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
Random Variable
The curved line you see is the density of the distribution. You can think of the density of the
distribution a little like the top of the bars of a histogram, but a histogram where the bars are so
narrow that they have no width at all. It is necessary for these bars to have no width because the
normal distribution can take any value (it is continuous) its not like rolling a six-sided dice (the
outcome of which is also a random variable) which can only take the values 1, 2, 3, 4, 5, or 6 (it is
discrete).
The normal distribution has two parameters, the mean
. In the
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14
Distribution 1
Distribution 2
12
Density
10
0
-60.0%
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
Random Variable
The blue line is the same line as before, although the x-axis is now wider. The red line has
8%
and
12% . Thinking in terms of interest rates, the line with mean 8% and standard deviation
12%, gives a relatively high average interest rate of 8% per annum, but it is also relatively volatile
(i.e. shorter and fatter).
For example, the probability that Distribution 1 will result in an interest rate of less than 0% is
0.0478, whilst for Distribution 2 it is 0.2525. This is the area under the curves to the left of 0%.
(Note that the total area under both curves is equal to 1). Conversely, the probability that
Distribution 1 will result in an interest rate of greater than 15% is 0.0004, whilst for Distribution 2 it
is 0.2798. This is the area under the curves to the right of 15%.
Note that this discussion relates to interest rates for a single year only and not the per annum rate
for all future years. For the remainder of this course we will assume that interest rates are
independent from year to year; i.e. the interest rate in Year n has no impact on the interest rate in
Year n 1 .
A spreadsheet tool is available for download in the relevant Courseware of the edX version of the
course that allows you to play around with normal distributions with different and and look at
the probabilities of various outcomes. A demonstration of this tool will be provided in the video
material for this Lesson in the Courseware on edX. You can find the final version of the spreadsheet
worked on in the edX video as a download in the relevant Courseware of the edX version of the
course.
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Courseware of the edX version of the course. We first generate a random number between 0 and 1
using the =RAND() function in the spreadsheet tools. We can then use the =NORMINV function
to convert this random number into a random interest rate from the desired normal distribution.
600 0.01
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random value from this distribution it would be necessary to round it to the nearest whole number
(and set a minimum of zero) to restore its discrete nature.
Well finish this Lesson by noting that one of the assumptions underlying the generation of random
death rates as described above, is that, like the fact that all dice rolls are independent of each other,
all lives are independent of each other. In other words, the event of one person dying or not has no
impact on the event of another person dying or not.
Does this assumption seem reasonable to you? What impact would it have on the calculations
performed above? You might like to discuss your thoughts on these questions in the forum, where a
thread has been created specifically for this topic.
Adam Butt
Version 1 (2015)
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Calculating the expected present value (EPV) of a series of cash flows is the same as
calculating the present value of a series of cash flows with the additional component of
multiplying each cash flow by its probability of occurring:
EPV
t
The equation of value concept is readily applicable to EPVs as well, as per the following
formula:
EPV income
EPV outgo
This equation of value can be used to calculate a risk premium for an insurance policy by
equating the EPV of premiums with the EPV of claims.
A common distribution used for interest rates is a normal distribution, which has a mean of
and a standard deviation of .
The distribution of the number of deaths can also be said to approximately follow a normal
distribution with a mean nq and a standard deviation nq(1 q ) , where n is the number
of individuals and q is the underlying mortality rate.
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