ANUx Introduction to Actuarial Science

Prologue

Actuarial work in Life Insurance

The Introduction to Actuarial Science course is structured over 7 lessons. Lessons 1-5 involve
developing the fundamentals required to be able to undertake the full financial modelling of a Life
Insurance company which is done in Lessons 6-7. Lessons 1-2 consider the basic issues related to
investment and the timing of cash flows. Lessons 3-4 consider uncertainty in the timing of cash
flows, particularly as they relate to the timing of premium and claims cash flows. Lesson 5 draws
Lessons 1-2 and Lessons 3-4 together.

Each Lesson contains explanatory material, written here or in video form on the edX platform,
broken up by a number of questions to give you practice and to test your understanding of the
material. The final component of each Lesson will be a written summary of the key concepts of the
Lesson.

We recognise that people with a wide variety of backgrounds will be taking this course and that
many students will have already seen some of the material during previous study or work
experience. This is especially likely to be the case in Lessons 1 and 2.

Noting this, if you believe you are sufficiently familiar with a topic, you may like to skip straight to
the summary and then the exercises without reviewing the explanatory material beforehand. You
can of course go back to the explanatory material if you wish.

The questions themselves take on a number of forms:

Practice Questions these are questions that give you an opportunity to practice the
application of the explanatory material, without the pressure of it counting toward
assessment.
Assessment Questions these may have a similar structures to Comprehension and Practice
Questions, but will count towards the assessment of the course.
Extension Questions these are harder than other questions in the course and provide a
challenge to students who are already comfortable with the material. They have been
designed specifically with those who are already familiar and/or confident with the material
in mind. They do not count towards the assessment of the course, although it is
recommended that you have a look at the solutions for the extension questions even if you
have not or were not able to attempt them.

Solutions to questions will be provided on edX; for Assessment Questions they will only be available
once you have got a correct answer or exhausted your final attempt at the question.

Details on assessment weighting and grading policies can be found on edX.

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Course design decisions

Actuarial science involves using techniques and knowledge from a range of disciplines such as
mathematics, statistics, economics, finance, accounting, computer science, etc. One consideration
when we were putting this course together is that we didnt want the course to simply consist of a
lesson or two on each of the above disciplines that didnt come together in any coherent way. We
wanted to give you an experience (at least at a simplified level) of what an actuary does in practice.
Hence we wanted to centre the course around a specific example of actuarial practice.

Actuaries work in a very wide variety of practice areas, as can be seen from the Table below:

Practice Area Proportion

General Insurance 24.7%
Life Insurance 22.7%
Superannuation (Pensions) 7.8%
Banking 7.2%
Investment/Fund Management 5.8%
Risk Management 3.1%
Reinsurance 2.9%
Data Analytics 2.5%
Health Insurance 2.0%
Education 1.9%
Wealth Management 1.3%
Management 1.0%
Source Actuaries Institute Year in Review 2014

We have decided to pick one practice area, namely Life Insurance, as the specific example of
actuarial practice in this course. We have chosen Life Insurance, not just because it is an area where
a large number of actuaries work, but because it is an area that lends itself to the sorts of simplified
examples of actuarial work we will consider in this course. Youll hear from actuaries who work in
Life Insurance as well as other practice areas during the course.

In many countries, life insurance is typically sold by large financial services institutions that also offer
other products such as loans (e.g. home mortgages), investment funds, non-life insurance (e.g.
motor vehicle insurance), etc. We wont concern ourselves too much with these other products, but
the remainder of this Prologue will give you a brief and simplified introduction to how Life Insurance
works from the institutions (which well now call the insurers) perspective.

Additionally, an insurer may be a for-profit or a not-for-profit insurer. For simplicity, during this
course we will assume the insurer is a not-for-profit insurer, which means the actuary does not need
to consider profits when making decisions.

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Basic elements of Life Insurance

Start of product (Sale)

Initially the insurer sells a life insurance product to an individual, who is known as a policyholder
the actual product purchased by the individual is known as a policy. There are many different types
of life insurance products well talk about some of them during the course, but for the moment the
type of product is not important.

The sale of a life insurance product will typically involve the policyholder paying a premium to the
insurer, i.e. there is a transfer of money from the policyholder to the insurer. From the insurers
point of view this is a positive cash flow. Some life insurance products require policyholders to pay
a single premium at the start of the policy, whilst others will require regular premiums to be paid by
the policyholder over the duration of the policy.

Actuaries are involved in setting the premium that is to be charged to prospective policyholders.
They must ensure that this premium is sufficient to ensure the continuing financial stability of the
insurer.

End of product (Claim)

In return for the premium paid by the policyholder to the insurer, the insurer promises to make a
payment back to the policyholder (or their dependents, e.g. family) upon certain events occurring
(e.g. the death of the policyholder). The payments are known as a claim and are a negative cash
flow for the insurer. Note that the timing of these payments is typically unknown to the insurer; for
example the timing of the future death of a policyholder is not known to the insurer. Claims may be
made on a one-off basis or as a regular payment to a policyholder.

Investment

Since there is a period of time between the insurer receiving the premium from a policyholder and
later on paying a claim to a policyholder, the insurer needs to decide how to invest these premiums
before claims are paid. Any interest earned on the investment of these premiums is a positive cash
flow for the insurer.

Actuaries are involved in deciding on how these premiums are to be invested by the insurer.

Calculations of Reserves Required

Since premiums are received by the insurer before claims are paid to policyholders, this means that
after the sale of a policy the insurer will be holding money that it may have to return via a claim at
some stage in future. This money is known as a reserve and is simply the sum of the positive and
negative cash flows of the insurer.

Every so often, the insurer will want to know if the Actual Reserves will be sufficient to pay the
future claims of the policyholders in other words Does the insurer have enough money?!
Actuaries are involved in comparing the Actual Reserves held with the reserves likely to be required
(the Required Reserves) to pay the future claims of the policyholders.
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Numerical representation of the basic elements of Life Insurance

The following is a numerical representation of the material presented above. For simplicity we
assume that a number of policyholders all purchase their policy at exactly the same time (which we
denote as Year 0) for a single premium, and then interest and claims occur at fixed time intervals
after that. The reserves are the Actual Reserves at each time, calculated as the reserve at the
previous time period along with any positive and negative cash flows during the period. Required
Reserves are not presented.

Year Premium Received Interest Received Claims Paid Actual Reserves

0 535,824 535,824
1 21,433 35,498 521,759
2 20,870 72,512 470,117
3 18,805 59,334 429,588
4 17,184 104,177 342,595
5 13,704 89,265 267,034

The following questions give you an idea of how questions might be structured in the course.

Question P.1

Which of the following statements best describes the timing of when premiums and claims are
typically paid in respect of a policyholder?

A) Premiums are paid by a policyholder before claims are paid by the insurer
B) Premiums are paid by a policyholder at the same time as claims are paid by the insurer
C) Premiums are paid by a policyholder after claims are paid by the insurer

Question P.2

What are reserves for a life insurer?

A) Reserves are the interest earned on investments made by the insurer

B) Reserves are money held by the insurer, initially from premium receipts, to pay for future
claims
C) Reserves are actuaries who give a second opinion on the premium to be charged on a life
insurance product

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