Chapter I-2

An Overview
This is the most important chapter in Part I of this book. Here we get
introduced to the fundamental concepts of Life Contingencies such as the
actuarial present value, premiums and reserves. The material in Chapters
I-6 through I-9 is mostly an elaboration of the ideas of this chapter using
actuarial symbols and some simple relations.
2.1. Two questions: The Life Contingencies part of this course addresses
two questions. They are illustrated by the following example, which happens
to employ a simple, important, fundamental and extremely useful swindle.
Please continue reading even after you have spotted it!
Example 2.1.1: Imagine a group of 10 people celebrating their 90-th birth-
day. An insurance agent is attending the party and talks them into buying
life insurance. He promises to pay a sum of 1 (this could be 1 thousand
dollars or 1 million cents, the units really do not matter) upon the death of
each insured. The death benet will be paid at the end of the year of death.
For this service, each person will pay a premium of P on every birthday that
the individual is alive, starting on the 90th birthday.
The insurer will deposit the premiums in a fund that will pay interest at an
annual rate of 6%, and withdraw (and overdraw if necessary) from the fund
the requisite amounts to pay for death benets.
It turns out that 2 people die during the rst year, 3 during the second year,
3 during the third year and the remaining 2 during the fourth year.
1. How much should the premium be?
2. What is the amount per survivor in the fund at the end of two years?
These two questions constitute the core of Life Contingencies part of Exam
M.
Solution: You can picture what is going on with the aid of the gure and
the table below.
19
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 20
Figure 1:
Time Number Amount insurer has in the fund
alive
Beginning of 1-st year 10 10 P
End of 1-st year 8 10 P (1.06) 2
Beginning of 2-nd year 8 10 P (1.06) 2 + 8P
End of 2-nd year 5 10 P (1.06)
2
2(1.06) + 8P(1.06) 3
Beginning of 3-rd year 5 10 P (1.06)
2
2(1.06) + 8P(1.06) 3 + 5P
End of 3-rd year 2 10 P (1.06)
3
2(1.06)
2
+ 8P(1.06)
2
3(1.06)
+5P(1.06) 3
Beginning of 4-th year 2 10 P (1.06)
3
2(1.06)
2
+ 8P(1.06)
2
3(1.06)
+5P(1.06) 3 + 2P
End of 4-th year 0 10 P (1.06)
4
2(1.06)
3
+ 8P(1.06)
3
3(1.06)
2
+5P(1.06)
2
3(1.06) + 2P(1.06) 2
At the time of issue the fund has 10P. At the end of the rst year this
amount will grow to 10P(1.06) and there will be benet payments to two
persons. So the amount at the end of the rst year is 10P(1.06) 2. At
the beginning of the second year, premium payments by 8 survivors will be
added to the fund. That will grow by 6% at the end of the second year and
three benet payments will be made and so on.
Question 1: This question, namely, what the premium should be, cannot
be answered as it is posed. The insurer may charge whatever premium he
wants! In order to determine the premium uniquely we have to impose other
requirements. One possibility is to require that the insurer must neither gain
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 21
nor lose anything from this contract. Although this requirement is unrealistic,
it does give a rough idea of the premium. The insurer may modify it using
other considerations. This requirement is called the Equivalence Principle
and the premium so calculated is called the Benet Premium.
The equivalence principle would then require that (by the end of the contract)
10 P (1.06)
4
2(1.06)
3
+ 8P(1.06)
3
3(1.06)
2
+5P(1.06)
2
3(1.06) + 2P(1.06) 2 = 0. (1)
Rearranging the terms and dividing by 10(1.06)
4
, we get
P
_
1 + 0.8(1.06)
1
+ 0.5(1.06)
2
+ 0.2(1.06)
3
_
= 0.2(1.06)
1
+ 0.3(1.06)
2
+ 0.3(1.06)
3
+ 0.2(1.06)
4
. (2)
This gives the benet premium, P = 0.365758. Since the amount of premium
stays xed every year, it is called a Level Premium.
Question 2: What is the amount per survivor in the fund at the end of two
years? We will get two equivalent expressions as answers for this question.
Some of the manipulations of expressions here are essential to bring out their
meaning.
Since there are 5 survivors at the end of two years, the amount the insurer
has available per survivor at the end of the second year is (see the table)
(1/5)
_
10 P (1.06)
2
2(1.06) + 8P(1.06) 3
_
=
10
5
(1.06)
2
_
P
_
1 + 0.8(1.06)
1
_

_
0.2(1.06)
1
+ 0.3(1.06)
2
__
(3)
With P = 0.365758 this expression equals 0.41826.
By noting from Eq.(2) that
P
_
1 + 0.8(1.06)
1
_

_
0.2(1.06)
1
+ 0.3(1.06)
2
_
= 0.3(1.06)
3
+ 0.2(1.06)
4
P
_
0.5(1.06)
2
+ 0.2(1.06)
3
_
we can rewrite the expression in Eq.(3) as
(1/5)10(1.06)
2
__
0.3(1.06)
3
+ 0.2(1.06)
4
_
P
_
0.5(1.06)
2
+ 0.2(1.06)
3
__
=
_
(3/5)(1.06)
1
+ (2/5)(1.06)
2
_
P
_
1 + (2/5)(1.06)
1
_
(4)
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 22
With P = 0.365758, the right-hand side of Eq.(4) also gives 0.41826. The
expressions in Eqs.(3) and (4) are called benet reserves. They are equal.
The reason they are equal is that we calculated the premium by the equiv-
alence principle. We derived the expression in Eq.(4) from that in Eq.(3)
by using Eq.(2), which is the equivalence principle. The equality of the two
expressions says that the that the funds at the end of two years should go
towards covering the net future liability. We will say more about these two
formulas later.
But, before we go any further, I am sure you have recognized the swindle
here. What is the point of calculating the premium after they are all dead?
Or do we know ahead of time how many will die each year?
The answer is at the very foundation of not only the theory of insurance but
also of a lot of areas that use Statistics. We say, yes, we know how many
people will die.. sort of. We simply assert that the data we have in Example
2.1.1 about the proportion of deaths doesnt pertain just to this group of
90-year-olds, but to all 90-year-olds that we will be concerned with. An au-
thoritative table that lists the number of individuals from a closed population
that survive to various ages is called a life table. This group of population is
called a survivorship group. How this table is constructed does not concern
us here. You will be given such a table, called the Illustrative Life Table
(ILT), in the exam. You can download it from the SOA web site.
Imagine for a moment that the number of survivors in Example 2.1.1 does
indeed come from such an authoritative table, and an extract is given below.
Here l
x
stands for population aged x.
x 90 91 92 93 94
l
x
10 8 5 2 0
In a universal table such as this, the initial population, 10, is not very rel-
evant. The table could just as well have the populations listed as 100, 80,
50, 20 and 0. The reason is that as you can see from Eqs.(2)-(4) (since the
premium and the reserve are amounts per person) only the proportion of
deaths and proportion of survivors are needed. For example, in Eq.(2), 50%
of the original population survives two years and each pays a premium of
P. Similarly, in Eq.(4), which represents the reserve at the end of two years
when the population is 5, the factor (3/5) corresponds to the proportion of
those 5 who die within the next year and each death gets a benet of 1.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 23
We identify the proportion of survivors with probability of survival and the
proportion of deaths with probability of death. For instance, if the table says
that out of a population of 10, 2 die over a period, then we interpret that
as the probability that a randomly chosen person will die in that period is
0.2. Conversely, if we are given that the probability of death over a period is
0.2, it is very convenient to visualize it as, say, 20 people out of a population
of 100 dying over that period, or even 0.2 people out of a population of 1,
blissfully ignoring the fact that there cannot be 0.2 people. This is the reason
why the swindle is very useful. The table model is called a deterministic
model and the model resulting from the interpretation of the proportions as
probabilities is called a probabilistic model.
Let us now return to Example 2.1.1. Consider Eq.(2). First look at the
right-hand side. 0.2 is the proportion of deaths (probability of death) during
the rst year. For each death a benet of 1 is paid at the end of the rst
year. The factor (1.06)
1
is the present value of unit benet paid at the end
of one year. Similarly, 0.3 is the proportion of deaths (probability of death)
during the second year. The present value of the benet of 1 paid at the end
of two years is (1.06)
2
. And so on. Thus the n-th term on the right-hand
side is the present value of the benet paid at the end of n-years multiplied
by the probability of death in the n-th year. To put it dierently, it is the
Expected Value of the present value of the benet. The expected value of
the present value of a payment is known as the Actuarial Present Value,
APV for short, of that payment.
Now consider the expression in the left-hand side of Eq.(2). The rst term
corresponds to the proportion of population that is alive at time of issue
times the present value of P paid at time of issue. The second term is the
proportion of population alive one year later times the present value of an
amount of P paid at the beginning of next year and so on. The k-th term is
the present value of premium paid times the proportion of population that
survives k-years. If we interpret the proportion of population that is alive at
time k as the probability of survival of an individual to time k, then what we
have on the left-hand side of Eq.(2) is the expected value of the present value
of the premiums paid, or the APV of the premiums paid by an individual.
Thus the equivalence principle can be stated as
APV of Premiums = APV of benet(s).
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 24
At this point it is worth noting that the death benet is a one time payment,
whereas the premium payment is an annuity.
2.2. General denitions: Henceforth we will denote an individual aged
x by (x). Suppose an insurance policy is written for (x). Suppose that a
benet of b
k+1
will be paid at the end of year k, if death occurs during year
k, k = 0, 1, . This means, if T is the time of death (measured from the
time of issue) and k T < k + 1, then a benet of b
k+1
will be paid at
time k + 1. The present value of the benet paid at the end of year k is
b
k+1
v
k+1
, where v = (1 + i)
1
is the discount factor
1
corresponding to the
annual interest rate i. Then
APV of death benet =

k=0
b
k+1
v
k+1
Pr(k T < k + 1). (5)
In order to calculate the probability of death in year k we can use the life
table. If l
x
denotes the population aged (x), then Pr(k T < k + 1) is just
the proportion of the population aged x now that will die between ages x+k
and x +k + 1. Hence
Pr(k T < k + 1) = (l
x+k
l
x+k+1
) /l
x
. (6)
Now let us look at the premium payment. Quite generally, suppose that,
starting now, when a person is x years old, a payment will be made at the
beginning of every year that (x) is alive. The amount may vary from year
to year. Let
k
be the amount to be paid at time k if (x) is alive. These
payments may be made by (x) to an insurer as premiums, or they may be
paid to (x), in which case they are annuity payments. The k-th payment
is
k
with probability Pr(T > k) and 0 with probability Pr(T k). The
expected value of the present value of the k-th payment is
k
v
k
Pr(T > k).
Since the expected value is additive, the expected value of the present value
of all the payments is
APV of Premiums (or annuity) =

k=0

k
v
k
Pr(T > k). (7)
Since Pr(T > k) is the proportion of people who have survived k years,
Pr(T > k) = l
x+k
/l
x
. (8)
1
Appendix B at the end of Chapter I-1 has a summary of denitions and symbols for
some interest theory entities.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 25
The equivalence principle asserts that the expression in Eq.(5) for the APV
of benet and that in Eq.(7) for the APV of premiums should be equal.
Example 2.2.1: An insurance on (80) will pay 1000 at the end of the year
of death if death occurs within 3 years (and nothing otherwise). Mortality
follows the Illustrative Life Table. i = 0.06. Calculate the annual level benet
premium.
Solution: The benet is b
k+1
= 1000 if k = 0, 1 or 2 and 0 otherwise
2
. The
present value of the benet is 1000(1.06)
(k+1)
if k = 0, 1 or 2 and 0 otherwise.
From the ILT, l
80
= 3, 914, 365, l
81
= 3, 600, 038, l
82
= 3, 284, 542 and l
83
=
2, 970, 496. Number of deaths in year k = 0 is 3, 914, 365 3, 600, 038 =
314, 327, in year k = 1 it is 3, 600, 038 3, 284, 542 = 315, 496, and in year
k = 2 it is 3, 284, 542 2, 970, 496 = 314, 046. Using Eqs.(5) and (6), the
APV of benets is
1000(1/3, 914, 365)
_
(314, 327)(1.06)
1
+ (315, 496)(1.06)
2
+ (314, 046)(1.06)
3
_
= 214.851.
If P is the annual premium, from Eqs.(7) and (8), the APV of premiums is
P(1/3, 914, 365)
_
3, 914, 365 + 3, 600, 038(1.06)
1
+ 3, 284, 542(1.06)
2
_
= 2.6144 P.
Equating the two APVs we get 214.851 = 2.6144 P or P = 82.18.
2.3. Benet Reserves: The amount in the insurers fund per survivor is
the reserve. That plus the expected future premiums must cover the expected
future liabilities. There are two ways to look at reserves.
The retrospective method: In Example 2.1.1, the end-of-the-year amount
presented in the last column of the table on Page 20 divided by the number
of survivors is the end-of-the-year reserve. We calculated it for the second
year in Eq.(3). Now let us interpret it.
P {1 + 0.8(1.06)
1
} is the APV (at issue) of the premiums paid in the rst
two years. {0.2(1.06)
1
+ 0.3(1.06)
2
} is the APV of the benets paid in
the rst two years. The dierence is the expected present value at issue of
the net amount in the fund. At the end of two years this will accumulate
2
Note that k = 0 means that death occurs within 1 year, k 1 means death occurs
within 2 years and so on. See the beginning paragraph of Sec. 2.2.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 26
by a factor of 1.06
2
. There are only half as many survivors (5 out of 10) as
the number at issue. So the reserve is obtained by dividing the accumulated
amount by 1/2 (since the reserve is the amount in the fund per survivor).
Quite generally, if we denote the reserve at time k by
k
V , then, counting time
from issue,
k
V =
1
v
k
Pr[T > k]
{APV of Premium for k years - APV of benets for k years} .
(9)
As before, if we use the ILT, we set
Pr[T > k] =
l
x+k
l
x
.
The prospective method: Now let us look at the expressions in Eq.(4).
At the end of two years there are 5 persons that are 92 years old. Three die
in the next year and two the year after that. Clearly then the right-hand side
in Eq.(4) is the APV of the future benets for each 92-year-old minus the
APV of the future premiums (determined at time of issue) received from each
person who is 92 years old now. Thus, in general, the Prospective Formula
for the reserve at the end of k years is
k
V = APV of future benets for (x +k) APV of future premiums from (x +k)
(10)
Note that the premium in this equation is the premium determined at issue
for (x). We showed in Eqs.(3) and (4) that the two formulas give the same
answer.
Example 2.3.1: A 3-year theft insurance on a new car will pay 20,000 if
the car is stolen during the rst year, 15,000 if it is stolen in the second year
and 10,000 if it is stolen in the third year. The payment will be made at the
end of the year of loss.
For this insurance, the rst years premium is twice the premium for the
second and third years. Premiums will be paid at the beginning of each year
for three years so long as the car is not stolen. Each year, assuming that the
car has not been stolen by the beginning of the year, the probability that it
will be stolen during that year is 0.1. The annual interest rate is 0.06.
The premiums are based on the equivalence principle.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 27
Calculate the rst years premium.
Solution: Suppose that K is the year that the theft occurs. K = 0 will
correspond to the theft occurring between times 0 and 1 year. Then Pr(K =
0) = 0.1. Pr(K = 1) is the probability that the car is not stolen in the rst
year and it is stolen in the second year, which is (0.9)(0.1) = 0.09. Similarly
Pr(K = 2) = (0.9)(0.9)(0.1) = 0.081. If the car is stolen during the rst year,
an amount of 20,000 will be paid at the end of the rst year. The present
value of this is 20, 000(1.06)
1
. Similarly if the car is stolen in the second year
the PV will be 15, 000(1.06)
2
and if it is stolen in the third year, the PV
will be 10, 000(1.06)
3
. Therefore the APV of benets is the expected value
of the present value, which is
20, 000(1.06)
1
(0.1)+15, 000(1.06)
2
(0.09)+10, 000(1.06)
3
(0.081) = 3768.3793.
Let P be the second and third year premiums. The premium for the rst year
is 2P. Since the probabilities that the car will not be stolen at the beginning
of K = 0, K = 1 and K = 2 are 1, 0.9 and 0.9
2
respectively, the APV of
premiums is (see Eq.(7))
2P +P(1.06)
1
(0.9) +P(1.06)
2
(0.81) = 3.5699537P.
Equating the two APVs we get P = 1055.58. The rst years premium is
2P = 2111.16
Example 2.3.2: In Example 2.3.1 calculate the benet reserve at the end
of two years.
Solution: At time 2, there is one premium to be made and one benet to
the amount of 10,000 if the car is stolen. Hence by the prospective formula
(Eq.(10)), the reserve is
(10, 000)(1.06)
1
(0.1) 1055.6 = 112.
By the retrospective formula, Eq.(9),
2
V =
1.06
2
Pr(T > 2)
[2P +P(1.06)
1
Pr(K > 1)
20, 000(1.06)
1
Pr(K = 0) 15, 000(1.06)
2
Pr(K = 1)]
=
1.06
2
(0.9)(0.9)
[2P +P(1.06)
1
(0.9) 20, 000(1.06)
1
(0.1)
15, 000(1.06)
2
(0.9)(0.1)] = 112.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 28
What if..? This is all very well. But then how do you calculate the premium
if the insured is of age, say 25.6 at issue, or if you need to pay the benet
right after (at the moment of) death? The tables can give you survival
probabilities only for integer ages. There are two ways to handle this.
To nd the population at integer ages, do an interpolation.
Throw out the table and simply postulate a continuous distribution for
the future lifetime.
Either way you get a continuous distribution for the future lifetime, which
we deal with now.
2.4. Continuous case: The denition of APV as the expected value of
the present value still holds. Eqs.(5) and (7) need to be modied with the
sums replaced by integrals and probabilities replaced by pdf and cdf.
Suppose a person is x years old at issue of an insurance contract. Suppose
that the insurance will pay an amount B(T) at the moment, T, of the persons
death measured from the time of issue. We treat T as a random variable with
known pdf f(t). Let be the (constant) force of interest. Then the present
value of the payment is B(T) e
T
. The APV is the expected value of the
present value of the payment. That is,
APV =
_

0
B(t)e
t
f(t) dt. (11)
Continuous payment up to the moment of death: Suppose a payment
is made at a continuous rate of P(t) (that can vary in time) up to the moment
of death, T, of the life aged x, i.e., over the interval 0 < t < T. This payment
could be an annuity to the individual or premium payment by the individual.
Again, if is the force of interest and f(t) the pdf of T, what is the APV of
the payments?
The present value of the payments up to time T is
_
T
0
P(t)e
t
dt.
Let the cdf of T be F so that F

= f.
APV =
_

0
f(s)
_
s
0
P(t)e
t
dt ds
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 29
=
_

0
P(t)e
t
_

t
f(s) ds dt (interchanging the order of integration
3
)
=
_

0
P(t)e
t
{1 F(t)} dt. (12)
In particular if P(t) = P is the level premium, then the above expression
becomes
APV = P
_

0
e
t
[1 F(t)] dt. (13)
The level benet premium is calculated by equating the expressions in
Eqs.(11) and (13). Once we know how to calculate actuarial present val-
ues, the benet reserves can be found by Eq.(9) or Eq.(10).
Before giving more examples let us summarize what we will be dealing with
in Life Contingencies:
The actuarial present value (APV) of a payment(s) is the ex-
pected value of the present value of payment(s).
The benet premium is determined by the equivalence princi-
ple, which states that the APV of benets paid should equal
the APV of the premiums paid.
The benet reserve at time t is the expected amount that has
accumulated by time t per survivor. It also equals the APV
of the future benets minus the APV of the future premiums
at t.
In order to calculate the APV do the following: (1) Write
an expression for the present value of payment, (2) Identify
the distribution of the time of payment, and (3) Take the
expectation.
Example 2.4.1: An insurance will pay 1 at the moment of death of a person
aged x. The pdf of the persons future lifetime is f(t) = e
t
, t > 0. The
force of interest is . Calculate the APV of this insurance.
The entity is called the Force of Mortality or the rate of failure.
3
s goes from 0 to and for each s, t goes from 0 to s. Upon interchanging order, t
goes from 0 to and for each t, s goes from t to . You may verify this by drawing a
picture.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 30
Solution: Suppose that T is the time of death (measured from the time
of issue). Then an amount of 1 will be paid at T. The present value of the
payment is e
t
.
APV = E(e
T
) =
_

0
e
t
f(t) dt =
_

0
e
t
e
t
dt
=

+
(14)
This is an important result.
Example 2.4.2: In Example 2.4.1, suppose that the insured pays a benet
premium at a continuous constant rate of P. Calculate P.
Solution: Since T is exponentially distributed, 1 F(t) = e
t
. From
Eq.(13), the APV of premiums is
P
_

0
e
t
e
t
dt =
P
+
. (15)
Since this is a benet premium its APV should equal the APV of benets
we calculated in Eq.(14). Hence P = .
Example 2.4.3: The future lifetime of John is exponentially distributed
with mean 50. John takes out life insurance that will pay an amount of
100,000 at the moment of death. If death is due to an accident, the policy
will pay an additional amount of 400,000. The probability that John will die
of an accident is 1/10-th of the probability that he will die of non-accidental
causes. Benet premium will paid at a constant rate as long as John is alive.
Assuming a force of interest of 0.05, calculate the annual benet premium.
Solution: First calculate the APV of the benet.
Step 1: Let T be the time of death. Count the benet in hundred thousands.
The benet is a random variable now. It is 1 with probability 10/11 (nonacci-
dental) and 5 with probability 1/11 (accidental). Therefore the expected ben-
et, given that death has occurred at time T, is 1(10/11) +5(1/11) = 15/11.
Its present value is (15/11)e
0.05T
.
Step 2: The pdf of T is 0.02e
0.02t
(exponential with mean 50). Hence the
expected value of the present value is
APV of benet = 0.02
_

0
e
0.02t
(15/11)e
0.05t
dt = (15/11)(0.02/0.07).
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 31
This is in hundred thousands.
Now calculate the APV of the premium. If the annual rate is P, then by
Eq.(15)
APV of premiums = P (1/0.07)
Equating this to the APV of benet we get
P = (15/11)(0.02) = 3/110.
The annual premium rate is 300, 000/110.
Example 2.4.4: The future lifetime of (x) is exponentially distributed with
mean 50 and the future lifetime of (y) is exponentially distributed with mean
40. An insurance on the two lives will pay an amount of 100,000 at the
moment of the second death. Benet premium will be paid at a constant rate
until the moment of the rst death. The force of interest is 0.03. Calculate
the premium rate.
Solution: Let the time of the second death be U. Then the PV of benet
is 100, 000e
0.03U
. To nd the APV we need the distribution of U, which is
the larger of the two lifetimes. For that use the results of Example 1.5.2 of
Chapter I-1 with
x
= 1/50 = 0.02 and
y
= 1/40 = 0.025.
f
U
(u) = 0.02e
0.02u
+ 0.025e
0.025u
(0.045)e
0.045u
.
The APV is
100, 000
_

0
e
0.03u
f
U
(u) du
= 100, 000
_

0
e
0.03u
_
0.02e
0.02u
+ 0.025e
0.025(u)
(0.045)e
0.045u
_
du
= (100, 000)
_
0.02
0.05
+
0.025
0.055

0.045
0.075
_
= 25454.5.
If W is the time of the rst death, then again from Example 1.5.2, Pr(W >
w) = e
(0.02+0.025)w
and the APV of the premiums is (see Eq.(12))
P
_

0
e
0.03w
e
(0.02+0.025)w
dw =
P
0.02 + 0.025 + 0.03
= P/0.075.
Equating the two APVs we get
P = (0.075)(25454.5) = 1909.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 32
Chapter Summary
Actuarial Present value: Express the present value in terms of the
time of payment random variable and take expectation. Examples:
The APV of an insurance that pays a benet of B(T) at time T(x)
the moment of death of (x), is
_

0
B(t)e
t
f
T(x)
(t) dt.
The APV of an insurance that pays a benet of b
K+1
at the end
of the year, K, K = 0, 1, , of death of (x) is

k=0
b
k+1
v
k+1
Pr (k T(x) < k + 1) =

k=0
b
k+1
v
k+1
l
x+k
l
x+k+1
l
x
.
The APV of a premium paid at a continuous rate of P(t) as long
as (x) is alive is
_

0
P(t)e
t
_
1 F
T(x)
(t)
_
dt.
The APV of all the premiums
k
at the beginning of each year
that (x) is alive is

k
v
k
Pr (T(x) > k) =

k
v
k
l
x+k
l
x
.
Benet premium means the APV of premiums equals the APV of ben-
ets.
The benet reserve is the amount that is in the fund at a certain time. It
equals the APV of future benets minus the APV of future premiums.
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 33
Problems
1. An insurance will pay an amount of 1,000 at the end of this year if
(80) dies within one year. No payment will be made if (80) survives
one year. Using the ILT with i = 0.06,, calculate the APV of this
insurance. (75.75)
2. Peter is 10 years old now. He will receive an amount of 100,000 on his
25-th birthday if he survives. Using the ILT with i = 0.06, calculate
the APV of the payment. (This payment is called pure endowment.)
(41,122)
3. Pam has a computer. Its future lifetime is exponentially distributed
with mean 5. The moment the computer breaks down or at the end
of 5 years from now, whichever is earlier, Pam will spend 3,000 dollars
towards a new system. Pam will save money at a continuous, constant
rate of P per year towards the cost of the system for the next ve years.
The force of interest is 0.1.
(a) Using the equivalence principle, calculate P. (858.5)
(b) Calculate the benet reserve at the end of three years. (1,257.7)
4. The future life time of a new machine has the PDF f(t) = 0.05e
0.05t
, t >
0. A warranty will pay an amount of 1 at the moment of breakdown of
the machine if it breaks down within 5 years. The force of interest is
0.05. Calculate the APV of the payment. (0.197)
5. Consider the following table of lives:
Age 90 91 92 93 94
Number 100 80 50 10 0
Each of the hundred is issued a 3-year term insurance of 1 to be paid
at the end of the year of death. This means that an amount of 1 will
be paid at the end of the year of death if death occurs within 3 years of
issue. Nothing will be paid if death occurs after 3 years. With i = 0.06
(a) Calculate the benet premium. (0.35983)
(b) Calculate the benet reserve at the end of two years. (0.395)
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 34
6. A 3-year term insurance on a person aged 60 will pay 1000 if death
occurs during the rst year, 2000 if death occurs during the second
year and 3000 if death occurs during the third year. Payment will be
made at the end of the year of death. Premiums will be paid at the
beginning of each year that the insured is alive, for three years. Using
the Illustrative Life Table and i = 0.06,
(a) Calculate the benet premium. (28.41)
(b) Calculate the benet reserve at the end of two years. (17.95)
(c) What is the benet reserve at the end of three years? (0)
7. In addition to the death benet in Problem 6, suppose that the insur-
ance will pay an amount of 3,000 at the end of three years if the insured
survives 3 years. Answer the three questions of Problem 6. (This insur-
ance is called a three-year endowment insurance.) (889.52; 1,940.67;
3,000)
8. An insurance will pay an amount of 5 at the moment of Johns death.
Johns future lifetime has the pdf f(t) = 0.02e
0.02t
. The force of inter-
est is 0.08.
(a) Calculate the APV of this insurance. (1)
(b) Calculate the benet premium. (0.1)
(c) Calculate the benet reserve at time s from issue. (0)
9. *
4
A special insurance program is designed to pay a benet in the event
a product fails. You are given:
Benets are paid at the moment of failure

b
t
=
_
300, 0 t < 25
100, t 25
The PDF of the time of failure is f(t) = 0.04e
0.04t
, t 0

t
=
_
0.02 0 t < 25
0.03 t 25
4
Past SOA exam questions are marked with an asterisk
2009 by G.V. Ramanathan
Chapter I-2 - An Overview 35
Calculate the actuarial present value of this special insurance. (168.12)
10. A continuous payment will be made at an annual rate of P(t) as long
as a life (x) is alive but for not more than n years. If the cdf of the
future lifetime of (x) is F(t) and the force of interest is show that the
actuarial present value of the payments is
_
n
0
P(s)e
s
[1 F(s)] ds.
(This payment is called a n-year temporary annuity.)
11. Starting n- years from now a continuous payment will be made at an
annual rate of P(t) as long as the life (x) is alive. No payment will
be made for the rst n-years. If the cdf of the future lifetime of (x) is
F(t) and the force of interest is , derive an expression for the actuar-
ial present value of the payments. (This payment is called a n-year
deferred annuity.)
12. John is 55 now. If he survives 10 years he will then start receiving a
life annuity that will pay at a continuous rate of 50,000 as long as he
is alive. Johns future lifetime T has the pdf 0.02e
0.02t
. Using a force
of interest of 0.06 calculate the present value of this annuity. (280,831)
13. An n-year deferred annuity will pay at a continuous annual rate of 1 as
long as a life (x) is alive. The annuitant (x) will a pay a level benet
premium at a continuous annual rate of P over the n-years (called the
deferral period ) as long as he is alive. The future lifetime of (X)
has an exponential distribution with mean 1/. The force of interest is
. Express P in terms of and .
14. A 10-year deferred annuity will pay an amount of 1 at the beginning
of every year that John is alive. In turn, John will pay a premium
of P at the beginning of every year of the deferral period (as long
as he is alive). The probability that John will survive for k years is
(0.98)
k
, k = 0, 1, You are given that v = 0.9. Using the equivalence
principle
(a) Calculate P. (0.3984)
(b) Calculate the benet reserve at the end of 8 years. (5.843)
2009 by G.V. Ramanathan