Stochastic Modeling of Actuarial Reserve: A Heavy Traffic

Approach
Jose Blanchet and Henry Lam

In life insurance modeling, actuarial reserve constitutes the amount of capital that is required
for an insurance company to face future contingent claims. This quantity, which by law must be
declared on the company’s balance sheet (see below), is naturally of great importance for risk man-
agement purposes. Prevailing life insurance literature, both in academia and industry, calculates
reserve based on the mathematical expectation of cash flows on individual basis (i.e. holding an
individual contract fixed). One classical method for doing this calculation is the so-called net level
premium reserve (see, for example, Bowers et. al. (1986), Gerber (1997) and Panjer (1985)). The
basic principle in this method is to first price the contract’s premium according to the so-called
equivalence principle, which sets zero expected net cash flow at the beginning of the contract (i.e.
the premium so that the actuarial net present value of the benefits equals the actuarial net present
value of the premium paid according to a given payment schedule specified by contract). Assuming
fixed interest rates, this level of premium would then guarantee the equality between two quan-
tities at any time point t: the actuarial accumulated value of the net cash flow from 0 to time t
and the actuarial present value of the net cash flow from time t up until the end of the contract’s
duration. The actuarial reserve at any time point is then calculated using either the former or the
latter. The former is known as retrospective method and the latter known as prospective method.
The retrospective calculation is reflected as an asset on the balance sheet, whereas the prospective
evaluation is reflected as a liability.
In practice, however, the actual accumulated net cash flow at time t of an insurance company is
different from its expected value. From a statistical point of view, the retro / prospective equivalence
arises in real terms only approximately, when the number of policyholders in a system is large
enough due to the Law of Large Numbers. Statistical fluctuations (present due to the fact that
there are finitely many policyholders) give rise to solvency risk to the insurance company when
the size of its assets undermatches the statutory reserve requirement. In this regard, substantial
literature has focused on more sophisticated modeling techniques with emphasis in aspects such as
mortality, interest rate and operational costs. Steffensen (2000), Olivieri (2001) and Marocco and
Pitacco (1998) proposed stochastic mortality assumptions. Milevsky and Promislow (2001) took
into account both stochastic mortality and interest rate. Dahl (2004) and Norberg (1999) studied
reserving under both mortality and market uncertainty. A modern reserving methodology that
uses market bidding price as proxy for the classical prospective reserve arises due to an uplift of
unit-linked insurance contracts. Moller and Steffensen (2007) surveyed such reserving methods.
In this paper we take a complementary approach in view of previous studies. Contrary to treating
reserve as a fixed-time individually calculated quantity, we look at the sum of all individual reserve
and treat the aggregation as a stochastic process that exhibits some statistical regularity. This
is a model of the reserve quantity itself rather than the exogenous assumptions as were studied
prominently in the literature. We aim to capture the fluctuation of both the asset accumulation
process and the statutory reserve liability, and formulate solvency risk as a mismatch of these two

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processes. For instance, we envision the results that we discuss below as useful tool to evaluate
if the difference between assets and liabilities on the balance sheet is within normal statistical
error. The results can also be used to evaluate ruin probabilities and related performance measures
in aggregated life insurance portfolios. For purpose of illustration we shall consider only whole
life insurance with only initial arrivals in this work (see below), but we plan to generalize our
methodology to more realistic models and sophisticated contracts in future work; we describe these
future directions at the end. It is remarkable that even in the simple model that we consider here,
features such as temporal correlation and reserve-triggered ruin problem formulation arise and to
our knowledge they have never been discussed in the literature.
The approach that we take is a diffusion approximation under heavy traffic. We assume a large
numbers of policyholders in the system and derive functional Law of Large Numbers and Central
Limit Theorem for the accumulated asset and statutory liability as processes. The techniques
that we use are largely borrowed from statistics and queueing literature (see the standard surveys
of Whitt (2002) and Billingsley (1999) for instance). More precisely, assume a large numbers,
n, of policyholders in an insurance company at the beginning. For simplicity we assume whole-life
insurance with continuous level premium payment and identical profiles for all these n policyholders.
We use the following notations:

• x: age of policyholders at the start of the contract

• b: amount of benefit paid at the death time for an individual policyholder

• p: rate of premium payment until death

• δ: constant rate of interest (continuous compounding)

• T : upper limit of the support for the time until death of an individual with age x at the start
of contract

• Xi : the time until death of the i-th policyholder (the Xi ’s are independent and identically
distributed (iid))

• fx (t), Fx (t), F̄x (t): density, distribution and survival functions of Xi (note the dependence on
the initial age x).

If we use equivalence principle to calculate premium, then p = bAx /ax , where Ax = Ee−δXi and
ax = E[(1 − e−δXi )/δ] (the notations Ax and ax are standard in the actuarial science literature; see
Bowers et. al. (1986)). According to the prospective approach, the net level benefit reserve at time
t is V (t) = bax+t − pAx+t .
Now let Nn (t) to be the number of deaths before time t. Recall that we denote Xi , i = 1, 2, . . .
as the death times, so we can write
n
X
Nn (t) = I(Xi ≤ t).
i=1

Suppose a policyholder dies at time t. The benefit payment from the insurance company discounted
at time 0 is B(t) := be−δt , while the discounted premium collected by the insurance company is
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Rt
P (t) := 0 pe−δs ds = p(1 − e−δt )/t. Therefore, assuming a zero initial cash level, the net and
accumulated cash level of the insurance company at time t will be
n
X
eδt [(P (Xi ) − B(Xi ))I(Xi ≤ t) + P (t)I(Xi > t)]
i=1

which we can write more neatly as

Z t
δt
e (P (s) − B(s))dNn (s) + P (t)N̄n (t)
0

where N̄n (t) = Nn (T ) − Nn (t) = n − Nn (t) is the number of surviving policyholders at time t. The
accumulated cash flow per survival is equal to
Rt
eδt 0 (P (s) − B(s))dNn (s) + P (t)N̄n (t)
Vn (t) := .
N̄n (t)

Note that Vn (t) is precisely the contribution to the asset of the balance sheet of a single individual
who is still part of the portfolio.
The following theorem states that V (t) is the limit of the average accumulated cash flow Vn (t)
and hence it provides a link between our stochastic formulation and the classical reserve evaluation
V (t) for a large pool of policyholders.
Theorem 1. Regarding Vn (·) as elements of D[0, T ] equipped with Skorokhod topology, we have

Vn (t) ⇒ V (t)

and
t
√ eδt
Z 
V (t)
n(Vn (t) − V (t)) ⇒ (P (s) − B(s))dW0 (F (s)) − P (t)W0 (F (t)) + W0 (F (t))
0 F̄ (t) F̄ (t)
R
on D[0, T − ] for any 0 <  < T , where · dW0 (F (s)) is the Ito’s integral with respect to the
time-changed Brownian bridge W0 (F (t)).

The previous result provides a clear refinement to the classical individual reserve evaluation and,
as mentioned before, we envision it as a tool to evaluate if the difference between assets and liabilities
on the balance sheet is within statistical error. Next we obtain a diffusion approximation for the
aggregate accumulated cash flow and the total prospective reserve under heavy traffic. Let Cn (t)
be the actual (not average) aggregate accumulated cash flow, and C̄n (t) be the actual aggregate
prospective reserve. We can write
Z t 
δt
Cn (t) = e (P (s) − B(s))dNn (s) + P (t)N̄n (t)
0

and Z T
δt
C̄n (t) = N̄n (t)e (B(s) − (P (s) − P (t)))fx+t (s)ds
t
where fx+t (s) := fx (s|Xi > t) = fx (s)/F̄x (t) for s > t. The following theorem describes the joint
limit of Cn (t) and C̄n (t):
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Theorem 2. Regarding (Cn (t), C̄n (t)) as elements in D[0, T ] × D[0, T ] equipped with the product
Skorokhod topology, we have  
Cn (t) C̄n (t)
, ⇒ (y(t), ȳ(t))
n n
where
Z t 
δt
y(t) = e (P (s) − B(s))fx (s)ds + P (t)F̄x (t)
0
Z T 
ȳ(t) = eδt (B(s) − P (s))fx (s)ds + P (t)F̄x (t)
t

Also,

√ √
    
Cn (t) C̄n (t)
n − y(t) , n − ȳ(t)
n n
 Z t  Z T 
⇒ eδt (P (s) − B(s))dW0 (Fx (s)) − P (t)W0 (Fx (t)) , W0 (Fx (t))eδt (P (s) − B(s))fx+t (s)ds − P (t)
0 t

We illustrate the implications of Theorem 2 by formulating a new ruin problem in contrast to

the classical Cramer-Lundberg model. In the classical Cramer-Lundberg risk model, one assumes a
constant premium rate and claims follow a compound Poisson process. Ruin occurs when the cash
amount ever falls below zero, given an initial surplus. Here we would instead model ruin as the
event that the accumulated asset ever falls short of statutory reserve requirement. In other words,
this corresponds to the probability that Cn (t) is ever less than C̄n (t) on the time horizon [0, T ],
given an initial surplus Un . With appropriate scaling, one can write
!
P (ruin) = P (Un + Cn (t) − C̄n (t) < 0 for some t ∈ [0, T ]) = P sup X(t) > u
0≤t≤T

where
Z t Z T 
δt
X(t) = e (P (s) − B(s))dW0 (Fx (s)) − W0 (Fx (t)) (P (s) − B(s))fx+t (s)ds
0 t

Analytical and simulation techniques for Gaussian processes are employed to approximate this
probability (using for example Mandjes (2007) and Blanchet and Li (2009)).
Finally, we emphasize that the current work serves as a first attempt to introduce heavy traffic
approach in modeling life insurance reserves as a time-varying stochastic process. Many directions
of extensions can be pursued. A few possible and important extensions are: (1) modeling the
arrival process, which leads to more sophisticated measure-valued description of individual statuses
(2) assuming a distribution of profiles, or ages, for the policyholders (3) exploring different policy
structures e.g. term life insurance, unit-linked products etc. (4) modeling the interest rate as a
market risk (5) exploring different premium rules and initial surplus (6) incorporating operational
cost and other expenses. Lastly, one can also take into account time-varying correlation among
policyholders e.g. Markov-modulated arrival rate and death distribution.
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