ANUx Introduction to Actuarial Science

Lesson 5

Valuing Uncertain Cash Flows

Given that we are just over half way through the course, now is an opportune time to remind
ourselves where we have been in the course and where we are going.
In Lessons 1-2 we investigated the valuation of cash flows, taking into account the time value of
money. In Lesson 3 we introduced the concept of state transitions, where an individual can move
between different states such as Healthy, Temporarily Ill, Permanently Ill, and Dead, which can affect
the underlying cash flows of a financial system. In Lesson 4 we looked at a specific example of a
state transition model, the Life Table, which provides information on probabilities of mortality at
certain ages.
In this lesson, Lesson 5, we start to integrate this material together. How do we work with a
financial system where the cash flows occur across a range of times and are uncertain?
In Lessons 6-7 we will take all of the material we have learned up until the end of this lesson and
apply it to project the cash flows of an insurance company and investigate its financial position.
Clearly an insurance company is an example of a financial system that works with uncertain cash
flows across a range of times. Even the simplest life insurance product will typically have premiums
and/or claims paid at different times that are dependent on the health status of the policyholder.
Hence this lesson, Lesson 5, is a pivotal lesson in the course. It is the lesson where how an actuary
thinks about the world starts to become apparent.

Expected Present Value

In Lesson 1, we introduced the concept of the present value of a cash flow or series of cash flows.
The expected present value (EPV, sometimes called the actuarial present value) of a cash flow or
series of cash flows takes into account the probability that the cash flow(s) will be paid.
Lets now look at a simple example. Imagine that an individual knew that they had a payment of
$1,000 to make in future, but were unsure exactly what time that payment would need to be made.
There is a 40% chance the payment will need to be made in 5 years and a 60% chance the payment
will need to be made in 7 years. Putting this information on a timeline:

Year

Cash Flow

1,000

1,000

Probability

40%

60%

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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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:

Cash Flow Pr(Cash Flow) v t

EPV
t

Assessment Question 5.1

Your parents have promised to reward you with a cash payment at the exact time you become an
actuary. They will pay you $100,000 if you become an actuary within the next 7 years, or $50,000 if
you become an actuary in 7 years or greater. You estimate that there is a 30% probability that you
will become an actuary in exactly 6 years, a 40% probability that you will become an actuary in
exactly 8 years, and a 30% probability that you will not become an actuary at all.
Calculate the expected present value of the payment from your parents, assuming an interest rate of
3% per annum.

Linking EPV to the Life Table

Premiums
The concept of EPV is very relevant to life insurance and can be especially useful when used in
conjunction with the Life Table that we looked at in Lesson 4. Imagine now that an insurer was
selling a product that required the policyholder to pay a premium of $500 at the start of every year
in which they were alive. Lets place these premium cash flows on a timeline for a policyholder who
took up the policy at age 30, with the probability that a policyholder pays a premium being t p30 :

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

ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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.

Practice Question 5.1

A life insurance company sells a product where policyholders pay a premium of $2,000 at the start of
each year they are alive for a maximum of 25 premium payments. Use a spreadsheet tool to
calculate the EPV of the premium payments for a policyholder who takes out the policy at age 40.
Assume mortality follows the ELT16 rates described in Lesson 4 and available for download in the
relevant Courseware of the edX version of the course, and that interest rates are 4.5% per annum.

Assessment Question 5.2

A life insurance company sells a product where policyholders pay a premium of $5,000 at the start of
each year they are alive, with no maximum number of premium payments. Use a spreadsheet tool
to calculate the EPV of the premium payments for a policyholder who takes out the policy at age 55.
Assume mortality follows the rates described in Assessment Question 4.7 and available for
download in the relevant Courseware of the edX version of the course, and that interest rates are
6% per annum.

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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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

50,000 50,000 50,000 50,000

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.

Practice Question 5.2

A life insurance company sells a product where policyholders receive a claim amount of $200,000 at
the end of the year of death (death can occur at any time with no maximum time limit). Use a
spreadsheet tool to calculate the EPV of the claim amounts for a policyholder who takes out the
policy at age 65. Assume mortality follows the ELT16 rates described in Lesson 4 and available for
download in the relevant Courseware of the edX version of the course, and that interest rates are
5% per annum.

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Assessment Question 5.3

A life insurance company sells a product where policyholders receive a claim amount of $500,000 at
the end of the year of death, or if death does not occur in the next 30 years then the claim amount
of $500,000 is paid in exactly 30 years and the policy ceases immediately. Use a spreadsheet tool to
calculate the EPV of the claim amounts for a policyholder who takes out the policy at age 35.
Assume mortality follows the rates described in Assessment Question 4.7 and available for
download in the relevant Courseware of the edX version of the course, and that interest rates are
2.5% per annum.

Assessment Question 5.4

In Assessment Question 5.3, what impact would doubling all the mortality rates have on the EPV of
the claim amounts?
A) The EPV will be decreased
B) The EPV will be unchanged
C) The EPV will be increased

Linking EPV to Equations of Value

In Lesson 2, we introduced the concept of an equation of value and noted its usefulness in
calculating unknown income values when the outgo values were known, or vice versa.
The same concept is readily applicable to EPVs as well, as per the following formula:

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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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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.

Practice Question 5.3

Returning to Practice Question 5.1, the same life insurance company is now wishing to revise its
premium on the product it sells where policyholders pay a premium of $X (previously $2,000) at
the start of each year they are alive for a maximum of 25 premium payments. If claim payments are
$100,000 at the end of the year of death (and zero if the policyholder survives until age 65), use a
spreadsheet tool to calculate the appropriate risk premium $X for a policyholder who takes out the
policy at age 40. Again assume mortality follows the ELT16 rates described in Lesson 4 and available
for download in the relevant Courseware of the edX version of the course, and that interest rates are
4.5% per annum.
Hint set the premium initially to $1 and then solve the equation:

$X

EPV $1 Premiums = EPV Claims

Assessment Question 5.5

We return to Assessment Question 5.3, with the life insurance company selling a product where
policyholders receive a claim amount of $500,000 at the end of the year of death, or if death does
not occur in the next 30 years then the claim amount of $500,000 is paid in exactly 30 years and the
policy ceases immediately. Use a spreadsheet tool to calculate the risk premium for a policyholder
who takes out the policy at age 35 and pays the premium at the start of each year they are alive until
a final premium payment at age 64. Again assume mortality follows the rates described in
Assessment Question 4.7 and available for download in the relevant Courseware of the edX version
of the course, and that interest rates are 2.5% per annum.

Extension Question 5.1

The insurer in Assessment Question 5.5 now wants to allow for expenses in determining the risk
premium. It costs the insurer $5,000 to set up the policy (i.e. at Year 0), $100 to receive any
premium, and $2,000 to pay any claim. Calculate the revised risk premium, using the same product
design and assumptions from Assessment Question 5.5.
Hint Expenses can be considered to be an additional outgo for the insurer and can hence be treated
that way in the equation of value.

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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

Uncertainty & Accumulated Value

The same techniques described above could be used to calculate an expected accumulated value
of say, an Actual Reserve, although in practice an expected accumulated value is not particularly
useful as it can be determined by simply taking the EPV and accumulating it forward for the relevant
number of time periods.
What is more useful is looking at the uncertainty in an accumulated value due to the factors
affecting the accumulated value that are variable in nature. In the insurance examples considered in
this course the primary factors that are likely to be variable in nature are interest rates and mortality
rates. However, before we consider these we need to give a short introduction to the concept of
random variables.

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.

Interest Rates & The Normal Distribution

Lets now think about the distribution that the interest rates could take. A common distribution
used for these sorts of variables is a normal distribution. The following graph gives a representation
of the normal distribution:

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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

and the standard deviation

. In the

3% . The mean represents the position of the centre of the random

above graph,
5% and
variable (i.e. the peak of the curve), whilst the standard deviation represents the spread of the
random variable. The following graph gives a representation of two normal distributions with
different means and standard deviations:

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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.

Generating random interest rates from the normal distribution

Now we have investigated the normal distribution, we need to know how to generate a random
interest rate from a normal distribution with given parameters. A demonstration of this process
using the above spreadsheet tool will be provided in the video material for this Lesson in the
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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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.

Practice Question 5.4

The random number generator used by Excel (which generates random numbers between 0 and 1)
gives a random number of 0.7498. Using this random number, and the tool described above,
calculate the interest rate from a normal distribution with a mean of 7% and a standard deviation of
8%.

Assessment Question 5.6

The random number generator used by Excel (which generates random numbers between 0 and 1)
gives a random number of 0.3923. Using the tool described above, calculate the interest rate from a
normal distribution with a mean of 9% and a standard deviation of 15%.

Mortality Rates & The Binomial Distribution

Lets now think about the distribution that the mortality rates could take. In order to understand
this a little better, well start with a dice-based example.
Imagine you rolled a six-sided dice 600 times and you were interested in the number of 1s that you
rolled. Since there is a 1/6 chance of rolling a 1 in any given dice roll, you know that the expected
number of 1s you should roll is 100 (i.e. 1/6th of the 600 rolls). But are you guaranteed to roll 100
1s? Of course not! Despite knowing that the underlying probability of rolling a 1 is 1/6 you are still
not guaranteed to roll 100 1s. You might roll 95. You might roll 102. You might also roll 100. But
you are not guaranteed to roll 100.
A similar issue exists with mortality rates. You might have 600 individuals aged 30, with an
underlying mortality rate of 0.01. Hence you would expect 6 of them to die whilst aged 30. But
simply due to random chance it is possible that only 3 of them might die, or perhaps 10. The
number of people who die is therefore a random variable.
This random variable is not continuous, like it was for interest rates; it is actually discrete. For
example it would be impossible for 4.2781 of the 600 individuals to die in the example above. In fact
the distribution of the number of deaths actually follows what is called a binomial distribution.
However, for simplicity we are actually going to assume that mortality rates follow a normal
distribution, an assumption which is reasonable as long as the number of individuals is sufficiently
large.
The distribution of the number of deaths can 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.
Using the example above the number of deaths would have a normal distribution with a mean of

600 0.01
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6 and a standard deviation of

600 0.01 0.99

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2.4372 . When generating a

ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

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.

Assessment Question 5.7

The random number generator used by Excel (which generates random numbers between 0 and 1)
gives a random number of 0.9144. Using this random number, and the tool described above,
calculate the number of deaths to occur from a population of 10,000 people with an underlying
mortality rate of 0.015.

Extension Question 5.2

Return to the Life Table described in Assessment Question 4.7 and available for download in the
relevant Courseware of the edX version of the course. Using the techniques described above in
generating random numbers, project random population numbers for ages 60 90. Assume a
population at age 60 of 91,440 people (i.e. the same as is currently in the Life Table) and that
underlying mortality rates follow the distribution in this Life Table.
Note that we will need to do this next week when we project an insurance company youre just
getting a head start!

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.

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ANUx Introduction to Actuarial Studies Lesson 5 Valuing Uncertain Cash Flows

Summary of the Lesson 5 Material

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:

Cash Flow Pr(Cash Flow) v t

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.

We can look at uncertainty in accumulated values by allowing relevant inputs to become

stochastic rather than deterministic.

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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