ANUx Introduction to Actuarial Science

Lesson 1

Valuing Cash Flows

Time Value of Money
Actuarial work typically involves the investigation of some sort of financial process over a period of
time. This is certainly the case for the Life Insurance example we discussed in the Prologue and that
will be considered throughout the course.
Whenever we want to think about a financial process over a period of time, it is essential that we
consider the time value of money. Whilst entire introductory university courses are based on the
concept of the time value of money, in this Lesson were just going to present the key elements that
will be relevant to this course.

Interest
The concept of interest is a foundation of the capitalist structure that most Western economic
markets are based on. Essentially it simplifies down to the fact that if Party X (who may be an
individual or an institution) loans money to Party Y (who may also be an individual or an institution),
then Party Y will make a payment to Party X for the service provided by Party X. This payment is
usually expressed as a percentage of the amount loaned, with this percentage being known as the
interest rate.
A numerical example will make this clearer:

Party X makes a loan of $100 to Party Y

At some point in time in the future Party Y pays the $100 loan back to Party X
In addition to repaying $100, Party Y also pays interest at a rate of 5% on the loan, which
results in an interest payment of 5% x $100 = $5
The total amount repaid by Party Y is therefore $100 + $5 = $105

In summary, Party Y has borrowed $100 from Party X, but has repaid Party X an amount of $105 at
some time in the future.
If we let the interest rate be i , and the initial amount borrowed by Party Y be P , then we can see
that the amount repaid by Party Y is equal to P Pi P(1 i) or $100 x 1.05 = $105. The cash
flows from Party Ys perspective are:
Borrows from Party X

Repays Party X

$100
P

-$105
- P(1 i)

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Accumulated Value
The example above was mostly expressed from Party Ys perspective. If we want to think of this
from Party Xs perspective, we would say that Party X has invested P , which has become an
accumulated value of P(1 i) . The cash flows from Party Xs perspective are:
Loans to / Invests in
Party Y

Accumulated Value

-$100
-P

$105
P(1 i)

Interest Rates and Time Horizons

The previous example did not specify a time horizon for the investment made by Party X. Of course
most investments will be made over a certain period of time, and hence the time period that the
interest rate applies to will need to be defined.
Expanding upon the previous example, lets imagine that Party X made the $100 investment for a 1
year period, and that the interest rate was 5% per year (per year is usually called per annum). Since
the period of the investment is the same as the period over which the interest rate applies (1 year),
the accumulated value of the $100 investment is still $105 as it was previously.
But what if the investment made by Party X was over a 7 year period instead of a 1 year period? We
know that the accumulated value after the first 1 year period that the interest rate applies for is
$100 x 1.05.

If this amount is reinvested after 1 year (i.e. P $100 1.05 ), then the accumulated value
after 2 years is equal to [$100 x 1.05] x 1.05 = $100 x 1.052.
Similarly, if this amount is reinvested after 2 years, then the accumulated value after 3 years
is equal to [$100 x 1.052] x 1.05 = $100 x 1.053.
It follows, therefore, that the accumulated value after 7 years is equal to $100 x 1.057 =
$140.71.

In more general terms, we could say that if Party X invests P for a period of n years at an interest
rate of i per annum, then the accumulated value, A , at the end of the n years would be:

P(1

i)n

Initial Investment

Accumulated Value

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A
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P(1

i)n

ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

This form of interest calculation is known as effective compound interest other ways of calculating
interest such as simple interest and nominal compound interest will not be considered in this course.
In addition, to simplify matters all time periods considered in this course will be expressed in years
(i.e. per annum).

Practice Question 1.1

An individual invests $10,000 at an interest rate of 2% per annum. Calculate the accumulated value
after 10 years.

Assessment Question 1.1

A life insurer receives $500,000 in premiums and invests them at an interest rate of 3.5% per annum.
Calculate the accumulated value after 2 years.

Present Value
Lets now imagine a situation where a party knows they need to achieve a particular accumulated
value at some time in the future. For example, an insurer might be expecting to have to make a
claim payment to a policyholder at some time in future. Given that we know from the above
analysis that interest affects the value of money over time, how much does the insurer need to set
aside today in order to have enough to make the claim payment in future?
Well start with a simple numerical example that is similar to what we have looked at previously.
Party X now wishes to ensure they have $100 in 7 years from today. If the interest rate is 5% per
annum, how much does Party X need to set aside today?
Essentially what we are saying here is that the accumulated value, A , needs to be $100 in 7 years
from now. Lets place this information on the same timeline we have looked at previously:
Initial Investment

Accumulated Value

P(1

i)n

$100

What we now want to do is solve the above equation for P , given that we already know the values
of A , n and i :

P (1

i )n

$100

P (1.05)
$100
$100
P
$100(1.05)
1.057
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$71.07
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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

We can hence say that Party X needs to set aside $71.07 today to ensure they will have $100 in 7
years from now. This amount is said to be the present value of $100 in 7 years from now.
In more general terms, we could say that if Party X requires an amount A in n years from today,
and the interest rate is i per annum, then the present value, P , today would be:

A(1

i)

where v

(1

Av n
i)

Note that this is simply a rearrangement of the accumulated value equation above; the notation
v

(1

i)

is standard actuarial notation used in present value calculations. The process of

multiplying a cash flow by some power of v is often described as discounting the cash flow.

Practice Question 1.2

Calculate the present value, at an interest rate of 6% per annum, of a cash flow of $20,000 due in 25
years.

Assessment Question 1.2

An individual is required to make a payment of $1,500 in 3 years from today. Calculate the amount
that must be set aside today in order to have sufficient money to make the repayment. Use an
interest rate of 5.5% per annum.

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Multiple Payments
The techniques for valuing multiple payments are similar to the techniques for valuing single
payments described above.

Accumulated Value
We will use the Life Insurance example described in the Prologue to demonstrate this. The table is
reproduced below:

Year
0
1
2
3
4
5

Premium Received
535,824

Interest Received
21,433
20,870
18,805
17,184
13,704

Claims Paid
35,498
72,512
59,334
104,177
89,265

Actual Reserves
535,824
521,759
470,117
429,588
342,595
267,034

First we should note that the Interest Received is simply 4% of the Actual Reserves at the previous
year, e.g. 20,870 = 521,759 x 0.04. This represents an interest rate of 4% per annum. The Actual
Reserves are the accumulated value of the insurers cash flows at that point in time. In addition to
interest, there are hence only two cash flows that affect the accumulated value; the Premium
Received (which is a positive cash flow for the insurer) and the Claims Paid (which is a negative cash
flow for the insurer).
Well now recreate the Actual Reserves using the techniques described above. We will do it in two
ways, first by accumulating multiple cash flows and then iteratively.

Accumulating multiple cash flows

We now want to recreate the Actual Reserve of 267,034 at Year 5 by accumulating multiple cash
flows until Year 5. This is done as follows:
Year

Premium Received

Claims Paid

535,824

35,498

72,512

59,334

104,177

89,265

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Note
A positive cash flow accumulated at 4%
p.a. for 5 years from Year 0 to Year 5
A negative cash flow accumulated at 4%
p.a. for 4 years from Year 1 to Year 5
A negative cash flow accumulated at 4%
p.a. for 3 years from Year 2 to Year 5
A negative cash flow accumulated at 4%
p.a. for 2 years from Year 3 to Year 5
A negative cash flow accumulated at 4%
p.a. for 1 years from Year 4 to Year 5
A negative cash flow that occurs at the
same time as the accumulated value

ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

We can hence calculate the Actual Reserve at Year 5 as follows:

535, 824(1.04)5
59, 334(1.04)2
267, 034

35, 498(1.04)4

104,177(1.04)1

72, 512(1.04)3
89, 265

Iteratively
An iterative approach builds the accumulated value year-by-year by incorporating all of the cash
flows up until that date.

At Year 0 the Actual Reserves are simply equal to the premium received at Year 0.
At Year 1 the Actual Reserves must incorporate interest on the Actual Reserves at Year 0, in
addition to allowing for the negative claim cash flow that occurs at Year 1. Since the Actual
Reserves at Year 0 must be accumulated for 1 year until Year 1, we can calculate the Actual
Reserves at Year 1 as follows:
A

35, 498

521, 759

At Year 2 the Actual Reserves must incorporate interest on the Actual Reserves at Year 1, in
addition to allowing for the negative claim cash flow that occurs at Year 2. We can hence
calculate the Actual Reserves at Year 2 as follows:
A

535, 824(1.04)1

521, 759(1.04)1

72, 512

470,117

This process can be repeated until Year 5.

The iterative approach is particularly useful when looking at a life insurers Actual Reserves, as it
allows the Actual Reserves to be investigated at each year, rather than at a single time period. This
approach is typically implemented in a computer spreadsheet tool, which we will look at in Lesson 2.

Practice Question 1.3

Recalculate the Actual Reserves of the insurer in the previous example at Year 5 using an interest
rate of 6% per annum.

Assessment Question 1.3

An individual invests an amount of $5,000 in a bank account today, knowing that they will need to
withdraw $1,000 in 1 year, $500 in 2 years and $2,000 in 3 years. If the interest rate on the amount
invested is 2.5% per annum, calculate the amount of money in the bank account immediately after
the $2,000 withdrawal in 3 years from today.

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Extension Question 1.1

Show that, mathematically, the two approaches described above for calculating the accumulated
value of the insurers cash flows give equivalent results.

Present Value
Present value calculations for multiple cash flows are typically not done iteratively, as we are
generally only interested in a present value today, unlike an accumulated value where we may wish
to investigate accumulated values over a number of years. Hence the first approach described
above is used; in this instance the present values of the individual cash flows are added together.

Practice Question 1.4

Calculate the present value at Year 0 of the claims paid by the insurer in the example above, using
the same interest rate of 4% per annum.

Assessment Question 1.4

Calculate the total present value today of the following cash flows:

$300 due in 2 years from today

$1,000 due in 5 years from today
$200 due in 15 years from today

Use an interest rate of 12% per annum.

Extension Question 1.2

Given the present value of the claims calculated in Practice Question 1.4, determine a mathematical
relationship between the present values of the cash flows of the insurer and the Actual Reserves at
Year 5 of the insurer. Are you able to easily calculate the Actual Reserves at Year 5 given that you
already have the present value of the claims paid at Year 0, and you also have the premium received
at Year 0?

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Multiple Regular Payments

A special type of example involving multiple payments is when the multiple payments are all
identical and evenly spaced. Consider the following example, where payments of 1 are made at year
1, 2, 3,...,n :

an

Year

sn

Amount

n-1

These types of payments are known by actuaries as an annuity certain and there are special
formulae that can be used to calculate the accumulated value at Year n , sn , and the present value
at Year 0, an , of these series of payments:

sn

an

(1

i)n
i

vn

Note that, as per the solution to Extension Question 1.2 above, the sn and an formulae can be
related by discounting the sn back n years:

sn v n

(1

i)n
i

vn

(1

i)n v n
i

vn

(1

i)n (1

i)
i

vn

vn

1
i

an

If the annuity payments are not equal to 1 (which of course they usually wont be!), then then
annuity value is simply equal to the annuity formula multiplied by the value of the payments. For
example, the present value at Year 0, of a series of payments (an annuity) of $100 at Year 1,2,3,,15,
at an interest rate of 3% per annum, is calculated as follows:

100an

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100

vn

1
i

100

1.03
0.03

15

$1,193.79

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Finally, as we did in Extension Question 1.2, we need to note that if we have the value of a series of
payments at a particular time, then we can use the techniques of taking accumulated and present
values to calculate the value at any time. Using the $100 annuity example again, lets say we wanted
to calculate the present value of the annuity at Year -3. Since we have the present value of the
annuity at Year 0, we can simply discount this value for a further 3 years. The present value at Year
-3 is hence:

1,193.79v 3

1,193.79(1.03)

$1, 092.49

Similarly, if we wanted the accumulated value of the annuity at Year 20, we can simply accumulate
the present value at Year 0 for 20 years. The accumulated value at Year 20 is hence:

1,193.79(1.03)20

$2,156.12

The reason this works was covered in the solution to Extension Question 1.2 to some extent,
although you wont need to worry about understanding this explanation throughout the rest of the
course.

Practice Question 1.5

Calculate the present value at Year 0, and the accumulated value at Year 30, of an annuity of
$25,000 paid at Year 1,2,3,,30. Use an interest rate of 4.5% per annum.

Assessment Question 1.5

An individual invests $2,000 every year for 40 years. Calculate the accumulated value of this
investment, at an interest rate of 7% per annum, at the time of the last $2,000 investment.

Assessment Question 1.6 (Hard)

Calculate the total present value today of the following cash flows:

$50 due in 1 year from today

$100 due in 2 years from today
$200 due yearly at 3,4,5,6,7,,20 years from today

Use an interest rate of 8% per annum.

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Extension Question 1.3

Using the techniques of summing geometric series, show that the sn formula is correct by summing
the accumulated values of the individual cash flows.

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ANUx Introduction to Actuarial Science Lesson 1 Valuing Cash Flows

Summary of the Lesson 1 Material

Accumulated Value in n years from today, A , of an investment today, P , at an interest

rate of i per annum:
A

P(1

i)n

Present Value today, P , of an amount due in n years from today, A , at an interest rate of
i per annum:
P

A(1

i)

where v

(1

Av n
i)

The accumulated/present values of multiple cash flows can be calculated by summing the
accumulated/present values of the individual cash flows together.

Alternatively for accumulated values, an iterative approach may be used, as it allows the
accumulated value to be investigated at each year.

Accumulated Value in n years from today, sn , of a series of payments of 1 in 1, 2, 3,...,n

years from today, at an interest rate of i per annum:
sn

i)n
i

(1

Present Value today, an , of a series of payments of 1 in 1, 2, 3,...,n years from today, at an

interest rate of i per annum:
an

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vn

1
i

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