Further Topics in Actuarial Mathematics:

Premium Reserves
Matthew Mikola
April 26, 2007

Contents
1 Introduction
1.1 Expected Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2 An Overview of the Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1
2
3

2 Net Premium Reserves

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . .
2.2 The Net Premium Reserve for Various Life Insurance
2.2.1 Whole Life Insurance Policy . . . . . . . . . .
2.2.2 Term Insurance . . . . . . . . . . . . . . . . .
2.2.3 Endowment . . . . . . . . . . . . . . . . . . .
2.2.4 Examples . . . . . . . . . . . . . . . . . . . .
2.3 Other Forms of the Net Premium Reserve Equation
2.4 Recursive Formulae . . . . . . . . . . . . . . . . . . .
2.5 Savings and Risk Premium . . . . . . . . . . . . . .
2.6 Retrospective Reserves . . . . . . . . . . . . . . . . .
2.7 The Expected Value and Variance of Loss Variables
2.7.1 Prospective Loss . . . . . . . . . . . . . . . .
2.7.2 The Insurers Net Cash Loss . . . . . . . . .
2.7.3 Allocation of the Risk . . . . . . . . . . . . .
2.8 Expense Loadings . . . . . . . . . . . . . . . . . . .
2.8.1 Expense-Loaded Premium Reserves . . . . .

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24

3 Uses of Reserves
3.1 Introduction . . . . . . . . . . . . .
3.2 Alterations and Conversions . . . .
3.3 With-profits policies . . . . . . . .
3.3.1 The Net Premium Method
3.3.2 The Bonus Reserve Method
3.3.3 Asset Share Method . . . .

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26
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28
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29

4 Applications of Reserves Beyond Life Insurance

4.1 Insurance . . . . . . . . . . . . . . . . . . . . . .
4.2 Actuaries . . . . . . . . . . . . . . . . . . . . . .
4.3 Uses of Reserves . . . . . . . . . . . . . . . . . .
4.3.1 The Balance Sheet . . . . . . . . . . . . .
4.3.2 The Income Statement . . . . . . . . . . .
4.3.3 Loss Reserves . . . . . . . . . . . . . . . .
4.3.4 Adequacy Testing . . . . . . . . . . . . .
4.3.5 Reinsurance . . . . . . . . . . . . . . . . .

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30
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32
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34
34

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5 Conclusion

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36

A Notation
A.1 Lifetime Models .
A.2 Life Insurance . .
A.3 Endowments . .
A.4 Life Annuities . .

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i
i
ii
iii
iii

B Useful Equations
B.1 Proofs of Equations used in Section 2.3 . . . . . . . . . . . . . . . . . . . . . . . .
B.2 Proofs of Equations used in Section 2.6 . . . . . . . . . . . . . . . . . . . . . . . .
B.3 Proofs of Equations used in Section 2.8.1 . . . . . . . . . . . . . . . . . . . . . . .

iv
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C Life Tables

vi

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Chapter 1

Introduction
Actuarial Mathematics is a very interesting area of mathematics for me, as it has such a large
impact in the real world. The concepts that have been developed are used daily by insurance
companies in the calculations of their insurance policies and also when a monetary value is required
for any choice that involves risk. Insurance mathematics relies heavily on probability theory, as the
lifetime of a person or the occurrence of an event is unpredictable. Insurers calculate the expected
probability that these events occur, so they can price their insurance policies correspondingly and
also so no large unexpected losses occur.
In this project, I am going to explore the topic of net premium reserves with regards to life
insurance policies. This project assumes that the reader has understood the concepts covered in
the 2nd year mathematics course Actuarial Mathematics II, Appendix A contains explanations
and formulae for most of the theory covered for the readers benefit. I am only going to consider
discrete life insurance policies and the corresponding reserve formulae. Variants of the formulae
for the continual policies can be used in most cases, this simply involves using the appropriate
continuous net single premium formulae and lifetime probability distributions covered in the 2nd
year course.
Premium reserves, also known as benefit reserves, are of great interest to insurers as it enables
them to work out their liability, this is how much money they should put aside, reserve, each year
to cover the benefit payment to the insured in case of their death. The insurers take into account
the premiums already paid by the insured and the investment return they can receive on these
payments and the insureds expected future lifetime. Premium reserves look at the obligations
of the insurer and the insured, at a time later than policy issue, as either party may still have
financial duties that need settling at that time.
In the next section I will look at one of the most useful concepts for calculating premium
reserves, the expected loss of the insurer, which was covered in the course Actuarial Mathematics.
This has particular significance for the formulation of net premium reserves as the expected loss
to the insurer is used in its definition.

1.1

Expected Loss

In this section I have used my notes from the 2nd year mathematics course Actuarial Mathematics
II which, were based on concepts covered in [Gerber].
In this section I am going to recap the relevant actuarial concepts covered in the 2nd year
mathematics course Actuarial Mathematics II.
One of the important ideas developed near the end of the course was calculating the expected
loss to the insurer. For an insurance policy we define the prospective loss to the insurer, L, to
be the difference between the present value of future premium payments (paid by the insured) and
the present value of future benefit payments (paid by the insurer). The prospective loss is a really
important concept for the derivation of the formulae for the net premium reserve, as we shall see
later.
Premiums can be paid in a variety of different ways to suit the preferences of the insured, three
of these ways are:
1. One single premium.
2. Periodic premiums of a constant amount, also known as level premiums.
3. Periodic premiums of varying amounts.
In the case of the periodic premiums the frequency and the duration of the payments needs to
be specified as well as the premium amount, commonly the premiums are paid annually and while
the insured is still alive.
A premium is called a net premium if it satisfies the following equivalence principle:
E(L) = 0

(1.1.1)

If the policy is financed by a single premium, then the premium used is the net single premium,
the formulae for the different policies can be found in Appendix A.2. As the net single premium is
used to calculate the benefit payment as well, then the premium payment and the benefit payment
are equal in value so they satisfy (1.1.1). If periodic premiums of constant amount are used to
finance the policy, then we use (1.1.1) to calculate the net premiums. We cannot use (1.1.1) to
calculate the net premiums for periodic premiums of varying amounts though.
(1.1.1) is called an equivalence relation, this is because the present value of the benefit
payments exactly equals the present value of the premium payments, so the expected loss to the
insurer is zero. In practice this is rarely true because the insurance company would not make any
money, but we use this assumption in our calculations for simplicity.
The prospective loss is very important in the formulation of premium reserves as we shall see
in the next chapter.
If we now consider the more realistic case where the insurer wants to make sure a profit is
made, we can change (1.1.1) so that the difference between the premium payments and the benefit
payments is a positive value. If the insurer wants to make a profit of then in (1.1.1) we would
want the loss to the insurer to be :
E(L) =
The insurer could then use this variation, instead of (1.1.1), in their calculation of the net premiums.
We shall look later at another way the insurer can factor profit and the costs of setting-up and
running an insurance policy, by using expense loadings in the premiums.

1.2

An Overview of the Project

In chapter 2, I shall derive the formula for the net premium reserve for various life insurance
policies. I will then proceed to look at some of the interesting properties of reserves and why they
are useful to insurers. Near the end of the chapter I look at expected value and variance of the
loss to the insurer, which is very interesting as it gives an indication of the risk associated with the
policy. I also consider expense loadings, which are extra amounts added to the premium payments,
to cover various expenses of the insurer. This part gives an insight into how, in the real world,
insurance companies have to factor their overheads and profit margins into their policies.
In chapter 3, I will look at some of the uses of reserves for life insurance policies. I examine
how the reserves are used when the insured may want to make alterations to his existing policy
and I also look at how reserves can be used to determine the level of extra bonuses, added to the
benefit payment, in with-profit policies.
In chapter 4, I look at why insurance is so important to society as a whole and how specialists
known as actuaries work in insurance companies to ensure financial stability. I also look at some
of the uses of reserves outside of life insurance. In writing this chapter I looked at papers written
by researchers, who are looking at ways to apply reserves and various actuarial methods to real life
situations and problems. They look at ways of using different types of reserves to try to estimate
the amount of money an insurance company sets aside to cover their overall losses and expenses.
Other forms of reserves are used by the Financial Services Authority (F.S.A.), who regulate all
providers of financial services to make sure they are making reasonable levels of profit and have
enough reserves to cover their policies and actions. Finally I look at when reserves are used by
insurers to see if large risky policies are worth reinsuring, this is when an insurer looks to another
insurance company to cover all or part of the risk of one of their policies or group of policies.
In this project I have used information from the sources listed in the bibliography. At the
beginning of each section I have noted where I have directly used equations or text from a source
and what is my own work. All examples demonstrated in this project are my own work and have
been calculated by myself.

Chapter 2

Net Premium Reserves

2.1

Introduction

As we found in section 1.1, the expected loss to the insurer at the time of policy issue is zero
(1.1.1), this is because the expected value of future premium payments equals the expected value
of future benefit payments.
In this chapter we look at the expected loss at a later time than policy issue. We therefore
define a random variable t L as the difference at time t between the present value of future premium
payments and the present value of future benefit payments. According to [Gerber, p.59] the net
premium reserve at time t is defined as the conditional expectation of t L, given that T > t.
This is the conditional expectation of the difference between the present value of future benefit
payments and the present value of future premium payments at time t, given that the insured
survives to t. It is denoted by the symbol t V . The standard convention for reserves is to calculate
them just before the payment of the premium due at time t.
The net premium reserve can be seen as the present value of the liability for the insurer at time
t, i.e. the expected extra amount of money the insurer needs to set aside each year, to cover the
benefit payment taking into account the premium payments already paid by the insured. More
specifically, they are reserves that are calculated without the allowance for expenses and where
the reserve basis and the premium basis agree. The reserve basis is the mortality, interest and
expense assumptions used to calculate t V and the premium basis is a set of similar assumptions
applied to the premium payments. The net premium reserve is often positive to give the insured
some incentive to stay in the scheme, this also means that the insured will not have any additional
payments to pay to the insurer, if they leave the scheme.
Typically the premiums that the insured pays each year in the early years of the policy, are
more than the insurer needs in order to cover the benefit payment, but this margin decreases as
time progresses. At some point later in time, the future premiums will not be sufficient to cover
the remaining benefit payment, therefore the excess collected in the early years, which is invested
to gain interest, will be used to cover this deficit; this is another reason why net premium reserves
are often positive. Negative reserves can occur on policies where the benefit payment decreases
each year or the premium payments increase each year.
Some of the uses of reserves are for when the insured wants to leave the insurance policy before
a claim is made and so would want some compensation amount, this is known as the surrender
value of the policy. Also the insured, if they were part of their employers pension scheme, may
change jobs and so may want to transfer their existing pension to their new employers pension
scheme. Most modern insurance policies are quite flexible and allow the insured to make changes to
their policy (within reasonable boundaries, so the insurer still makes a profit), knowing the reserve
makes this possible. Reserves can also be used to determine the bonus rates of with-profits
policies and for the distribution of profits to shareholders. With-profits contracts are life insurance

policies where the insured has the right to share in the profits of the company, usually in the form
of bonuses added to the benefit payment.

2.2

The Net Premium Reserve for Various Life Insurance

Policies

In this section equations (2.2.3) and (2.2.4) are based on equations found in [Bowers, p.206], but
the derivation of (2.2.4) has been extended by me to provide clearer explanation.
Using the definition of the net premium reserve given in the Introduction I am now going to
find the net premium reserve for various life insurance policies.

2.2.1

Whole Life Insurance Policy

The present value of a whole life insurance policy for a life aged x, which covers the insured until
death, with a benefit payment of 1 unit payable at the end of year of death, is given by:
Z = v K+1

K0

(2.2.1)

Where K(x) is the curtate future lifetime of the insured and v is the discount factor, with
1
where i is the Annual Equivalent Rate of interest (see the end of A.1 for further details).
v = 1+i
A whole life insurance is financed by level annual premiums Px , payable at the beginning of
each year whilst the insured is still alive. An equivalent way of describing this mathematically is
setting up a whole life annuity with benefit payment Px , this is because the payments are made at
the start of every year whilst the insured is still alive. The present value of this is given by:
Y = Px a
K+1

K0

(2.2.2)

The prospective loss to the insurer, as described in section 1.1, is the difference between the
present value of future premium payments and future present value of the benefit payments. For
the whole life insurance policy we just appropriately combine the two present value formulae (2.2.1)
and (2.2.2) to get:
L = v K+1 Px a
K+1
K0
If we now consider the prospective loss k years later than policy issue, this is given by the
symbol k L and is defined in exactly the same way as before but we have just adjusted which point
in time we are looking at. If the insureds curtate future lifetime is K(x) years, then if we look k
years later than policy issue, we only need to consider the remaining K k years of the insureds
life, so the index K in (2.2.1) and (2.2.2) changes to K k.
For example if the insured was 50 when the policy was issued and we expect them to die at 80
(in reality this is a random event as we dont know when someone is going to die, but for simplicity
assume we can for this case), then K = 30 and if we now look at the person k = 10 years later
when they are 60, we now only need to consider the remaining K k = 30 10 = 20 years.
Therefore the present value of the prospective loss for a whole life insurance is:
kL

= v K+1k Px a
K+1k

K(x) k

(2.2.3)

For the formulation of the net premium reserve we need the expected value of (2.2.1) and (2.2.2)
and these are shown by :

X
E(Z) = Ax =
v k+1 k px qx+k
k=0

and
E(Y ) = a
x =

a
k+1 k px qx+k .

k=0

as shown by (A.2.3) and (A.4.2) respectively.

The net premium reserve; the conditional expectation of the prospective loss, for a whole life
insurance policy, is given by:
kV

= E[k L|K(x) > k]

= E[v K+1k |K(x) > k] Px E[
aK+1k |K(x) > k]

X
X
=
aK+1k |K(x) > k]
v j+1 Pr[v K+1k |K(x) > k] Px
a
j+1 Pr[
j=0

j=0

v j+1 j px+k qx+j+k Px

j=0

a
j+1 j px+k qx+j+k

j=0

= Ax+k Px a
x+k
(2.2.4)

2.2.2

Term Insurance

1
Similarly the net premium reserve at the end of year k of a term insurance is denoted by k V x:n
.
A term life insurance pays 1 unit benefit payment at the end of year of death, if the insured dies
within n years and is financed by premiums payable at the beginning of each year the insured is
alive, up to the start of year n. Using the expected values for the term life insurance and the
n year temporary life annuity due, which can be found in (A.2.4) and (A.4.4), its net premium
reserve is given by:
1
k V x:n

2.2.3

1
1
= Ax+k:nk
P x:n
a
x+k:nk

k = 0, 1, . . . , n 1

(2.2.5)

Endowment

The net premium reserve for an n year endowment is denoted by k Vx:n . An n year endowment
pays 1 unit benefit payment at the end of the year of death if the insured dies within n years, or if
the insured survives n years the benefit payment is at the end of the nth year. Using the expected
values for the n year endowment and the n year temporary life annuity due can be found in (A.3.3)
and (A.4.4), it is given by:
k Vx:n

2.2.4

= Ax+k:nk Px:n a
x+k:nk

k = 0, 1, . . . , n 1

(2.2.6)

Examples

I will now look at a numerical illustration of the reserves for a term insurance and a n year
endowment. I will assume a sum insured of 100 units, the initial age of the insured as x = 50 years
old and a duration of n = 10 years. We will use the life tables found in appendix C and i = 5%.
As a first step we work out the net annual premiums for each policy. As the premiums are
constant we can use the equivalence relation. This is calculated in a very similar way to the method
used in the whole life insurance policy example above. This process is shown below:

E(L)

1
P 50:10

= 0
1
1
= 100 Ax:n
P x:n
a
x:n
1
100 A50:10
=
a
50:10
100(M50 M60 )
=
N50 N60
= 0.8166

Similarly:
P50:10 = 7.9512
Using (2.2.5), (A.2.5) and (A.4.5):
1
k V 50:10

1
100(M50+k M60 ) P 50:10
(N50+k N60 )

D50+k

k = 0, 1, . . . , 9

(2.2.7)

and using (2.2.6), (A.3.4) and (A.4.5):

k V50:10

100(M50+k M60 + D60 ) P50:10 (N50+k N60 )

D50+k

k = 0, 1, . . . , 9

(2.2.8)

Using these equations we can produce the following table which will enable us to directly
compare the net premium reserves for the term insurance with the endowment.
Table 2.1: The net premium reserves for a term insurance and an endowment
k
0
1
2
3
4
5
6
7
8
9

1
100(A50+k:10k
)
6.4
6.2
5.9
5.5
5.0
4.5
3.9
3.1
2.2
1.2

a
50+k:10k
7.9
7.3
6.6
5.9
5.2
4.5
3.7
2.8
1.9
1.0

1
k V 50:10

0.00
0.26
0.49
0.67
0.81
0.88
0.89
0.82
0.66
0.39

100(A50+k:10k )
63
65
69
72
75
79
83
87
91
95

k V50:10

0.0
7.8
16.0
24.6
33.7
43.3
53.4
64.0
75.3
87.3

Things to notice from these results are:

The net premium reserve for the term insurance and the endowment at k = 0, i.e policy
issue, is 0 as expected. This follows directly from the net premium equivalence principle that
E(L) = 0 at policy issue.
The net single premium of the term insurance decreases (1st column), this is because the
probability of the insured surviving to the end of the term increases (see Table 2.2), and this
out weighs the decreasing time for interest to accumulate on the premium payment.

 The net single premium of the n year temporary life annuity due decreases (2nd column),
this is because fewer benefit payments have to be paid and therefore there is less time for
interest to accumulate, this out weighs the probability of the insured surviving to the end of
the term, which increases.
The net single premium of the endowment increases (4th column), this is because the decreasing time for interest to accumulate on the premium payment out weighs the decreasing
probability of the insured dying before the end of the term.
The net premium reserve of the term insurance is very small and does not change by much
(3rd column). It grows to start with since the premiums slightly exceed that of a corresponding 1 year term insurance. Near the end of the period the net premium reserve drops again
as the insurer does not pay the benefit payment if the insured survives and the probability
of that occurring increases.
The net premium reserve of the endowment increases over time (5th column), this reflects
the increasing net single premium of the endowment and this is due to the decreasing time
for the interest to accumulate. Note that the net premium reserve of 87.2869 at the end of
the 9th year, plus the last premium payment of 1 7.9512, plus interest of 5% on both, is
sufficient to cover the benefit payment of 100 at the end of the 10 years.
87.2869 1.05 + 7.9512 1.05 = 91.6512 + 8.3488 = 100.0000

Table 2.2: The probability of a life aged 50 surviving to 60 given they have survived k years.
k
0
1
2
3
4
5
6
7
8
9
10

2.3

lx
8950994
8898004
8840879
8779258
8712711
8640918
8563495
8480001
8389943
8292787
8188132

10k P50+k

0.915
0.920
0.926
0.933
0.940
0.948
0.956
0.966
0.976
0.987
1.000

Other Forms of the Net Premium Reserve Equation

In this section equations (2.3.1) and (2.3.2) can be found in [Gerber, p.63,64], but the derivations
of these have been extended by me for clearer explanation.
So far I have only used the prospective method to write formulae for the net premium
reserve, stating that the net premium reserve is defined as the difference between the present value
of future benefit payments and of future premium payments. We can use this method to develop
other formulae for the net premium reserve, in terms of the premiums paid by the insured.
These other formulae are of interest because they give us different interpretations of the net
premium reserve and therefore give us greater insight into their use to actuaries. This is useful
because the actuary can now consider the reserve in terms of the amount paid by the insured each
8

year and therefore if they wanted to reserve only a certain proportion of the premium, then they
can adjust other factors accordingly to take this into account. Also by having an alternative way to
look at the concept of the net premium reserve I hope it will aid the reader in their understanding.
If we consider the net premium reserve of a whole life insurance policy as defined in section 2.2.1:
kV

= Ax+k Px a
x+k

Using results derived in [Gerber, p.64], the premium difference formula for k V can be found
by using Ax+k = 1 d a
x+k (as shown in (B.1.3)) and 1 d a
x+k = Px+k a
x+k (from (B.1.5)),
giving:
kV

= Ax+k Px a
x+k
= (1 d a
x+k ) Px a
x+k
= 1 (Px + d)
ax+k
= (Px+k Px )
ax+k
(2.3.1)

As we can see from (2.3.1), if a whole life insurance, of 1 unit, was bought k years later than
the original, now costing Px+k a
x+k , the net premium reserve is the expected present value of the
deficit of the premiums. Another way to look at this is to think of Px+k as the amount that should
be charged, for a policy with the same benefits if issued at time k to a person aged x + k, in order
that the premium equals the benefit payment after k years. Then the quantity Px+k Px is the
difference between what should be charged and what is actually charged. This means that the
reserve at time k is the yearly deficit between these premium amounts.
Also using results derived in [Gerber, p.64], the paid up insurance formula for k V can be
found by using a
x+k = (1 Ax+k )/d (as shown in (B.1.3)) and d = (Px+k (1 Ax+k ))/Ax+k (as
shown in (B.1.6)), giving:
kV

= Ax+k Px a
x+k
1 Ax+k
)
= Ax+k Px (
d
Px
= Ax+k
(1 Ax+k )
d
Ax+k Px (1 Ax+k )
= Ax+k
Px+k (1 Ax+k )
Ax+k Px
= Ax+k
Px+k
Px
= (1
)Ax+k
Px+k
(2.3.2)

(2.3.2) shows the net premium reserve as the present value of a portion of the remaining future
benefit payments, the portion which is not funded by future premium payments. Px+k is the
premium required if the future benefit payments were to be funded from only the future premium
payments, but Px is the benefit payment actually paid. Therefore Px /Px+k is the portion of future
benefit payments actually funded by future premium payments. Alternatively, as mentioned before
in the early years of the policy the premium payments exceed what should be paid for the benefit
x
) must be the that portion
payment, but this changes later in the policy, so the amount (1 PPx+k
of future benefits that has already been provided for by the excess past premiums.

Example
If we now calculate the net premium reserve for our example in section 2.2.4 using the premium
difference formula and the paid up insurance formula. We can calculate the values of Px+k from
the equivalence relation:
A 1
1
= x+k:nk
(2.3.3)
P x+k:nk
a
x+k:nk
for the term insurance and
Px+k:nk =

Ax+k:nk
a
x+k:nk

for the endowment.

1
),
The results are shown below (see Table 2.1 for the unchanged values of 100(A50+k:10k
a
50+k:10k and 100(A50+k:10k )):
Table 2.3: The net premium reserve for the term life insurance and endowment calculated via the
premium difference and paid up formulae
k
0
1
2
3
4
5
6
7
8
9

1
P 50+k:10k
0.81
0.85
0.89
0.93
0.97
1.01
1.05
1.10
1.15
1.20

1
k V 50:10

P50+k:10k
8.0
9.0
10.4
12.1
14.4
17.6
22.5
30.6
46.7
95.2

0.00
0.26
0.49
0.67
0.81
0.88
0.89
0.82
0.66
0.39

k V50:10

0.0
7.8
16.0
24.6
33.7
43.3
53.4
64.0
75.3
87.3

Unsurprisingly we see that the values for the net premium reserve are the same as they were
when we performed the calculation the first time.

2.4

Recursive Formulae

In this section I have used the theory covered in [Gerber, p.61], but the derivations of all the
equations have been extended by me for greater clarity.
In this section I am going to develop a relation between k V and k+h V which is the net premium
reserve h years after k. If we consider the net premium reserve for a whole life insurance, with
varying benefit payment cj , being the amount insured in the jth year after policy issued, financed
by varying premiums 0 , 1 , . . . , k , being the premium due at time k. Then the net premium
reserve at the end of year k is:
kV =

ck+j+1 v j+1 j px+k qx+k+j

j=0

k+j a
j+1 j px+k qx+k+j

j=0

If we re-write a
j+1 as:
j

a
j+1 = 1 + v + + v =

X
k=0

10

v j I{J=j}

(2.4.1)

Where I{J=j} is an indicator function:


I{J=j} =

1
0

if J = j
elsewhere

Then:
E(I{J=j} ) = P r(J = j) = j px
So:

x = E(
aj+1 ) =
a
j+1 j px+k qx+k+j = a

v j j px

(2.4.2)

j=0

j=0

Now using (2.4.2) in (2.4.1) we get:

kV

ck+j+1 v j+1 j px+k qx+k+j

j=0

k+j v j j px+k

(2.4.3)

j=0

If we then use (A.1.5) with s = h, t = j h and x = x + k and rearrange we have:

j px+k

= h px+k jh px+k+h

(2.4.4)

Then substitute (2.4.4) in all except the first h terms of (2.4.3) then we have:
kV

h1
X

ck+j+1 v j+1 j px+k qx+k+j

j=0

j=h

h1
X

k+j v j j px+k

j=0

ck+j+1 v j+1 h px+k jh px+k+h qx+k+j

k+j v j h px+k jh px+k+h

j=h

(2.4.5)
If we then use j 0 = j h as a summation index in the second and third lines of (2.4.5) then
this part becomes:

ck+j 0 +h+1 v j

+h+1

h px+k j 0 px+k+h qx+k+j 0 +h

j 0 =0

k+j 0 +h v j

+h

h px+k j 0 px+k+h

(2.4.6)

j 0 =0

There is a common term of v h h px+k in (2.4.6), if this is taken out as a factor we are left with:

k+j 0 +h+1

j 0 +1

j0

px+k+h q

x+k+j 0 +h

j 0 =0

k+j 0 +h v j

j 0 px+k+h

j 0 =0

Which is the net single premium of k+h V . If we then combine (2.4.6) and the first line of (2.4.5)
and rearrange, we get:
kV

h1
X
j=0

k+j v

j px+k

h1
X

ck+j+1 v j+1 j px+k qx+k+j + h px+k v h k+h V

(2.4.7)

j=0

If we look at (2.4.7) we can see that if the insured survived to the end of year k, then the net
premium reserve plus the expected present value of the premium payments for the next h years is

11

just sufficient to cover a life insurance for those years, plus a pure endowment of k+h V , at the end
of year k + h.
A recursive equation for the net premium reserve can be achieved by letting h = 1:
kV

+ k = v[ck+1 qx+k + k+1 V px+k ]

(2.4.8)

We can therefore calculate the net premium reserve recursively in 2 ways:

1. We can calculate 1 V, 2 V, . . . successively by starting with the initial value 0 V = 0, by rearranging (2.4.8) to make k+1 V the subject.
2. Or if the duration of the insurance is of finite duration n, then we may calculate n1 V, n2 V, . . .
from a known value of n V , by letting k + 1 = n
The recursive formula is really useful for actuaries as it enables the insured to have greater
flexibility with their insurance policies. By being able to work out the net premium reserve each
year from the previous value can allow the insured to change the policy and use the current value
of the net premium reserve to begin a new policy.
An example may be when the insured wants to convert the insurance policy to a policy which
has no further premium payments, know as a paid-up insurance policy. The actuary can then
use the value of the last net premium reserve to calculate the net single premium for the paid up
insurance.
There is a type of insurance known as universal life or flexible life, which offers the
maximum degree of flexibility to the insured. The insured can change any two of the following
parameters:
k , the next premium to be paid,
ck+1 , the benefit paid in case of death in the next year,

k+1 V

, the net premium reserve for next year, this can be seen as the target value of the
insureds savings in the next year (see the savings premium in Section 2.5 for further
details on the consideration of the net premium reserve as a saving).

We calculate the value of k+1 V from the recursive formula (2.4.8), so we can see how useful it
is for actuaries when they are helping the insured modify their insurance policy. There are usually
some restrictions applied as to how much these values can be changed, so as not to leave the insurer
out of pocket, but yet still allow flexibility.

2.5

Savings and Risk Premium

All the equations from this section are from [Gerber, p.61,62]
If we examine (2.4.8) more closely we can see that the net premium reserve at time k plus the
premium payment equals the expected present value of the funds needed by the insurer at the end
of that year, ck+1 if the insured dies, or k+1 V otherwise. As px+k = 1 qx+k then (2.4.8) can be
rewritten as:
(2.5.1)
k V + k = v[k+1 V + (ck+1 k+1 V ) qx+k ]
(2.5.1) can be interpreted as; k+1 V is needed whatever happens to the insured and an additional
amount of ck+1 k+1 V if the insured dies. According to [Gerber, p.61], ck+1 k+1 V is known as the
net amount at risk. (2.5.1) can be rearranged to decompose the premium into two components,
k = sk + rk , where
sk = k+1 V v k V
(2.5.2)
12

and
rk = (ck+1 k+1 V )v qx+k
sk

is known as the savings premium and

rk

(2.5.3)

is known as the risk premium.

We can see in (2.5.2) that the savings premium is the part of the premium used to increase the
net premium reserve and cover the change in liability for the insurer. It is known as the savings
premium as it is the extra amount the insurer has to save each year to be able to cover any future
benefit payment. This part can also be seen as a savings account, with the premium accumulating
interest only, which can be used by the insurer in later years to cover the deficit between the
premium payments and the benefit payment. Some financial advisers suggest that people should
not buy whole life or endowment policies, but instead should purchase term life insurance. That
way the premiums are less and the insured can choose where to invest this extra money and so has
greater control of a portion of the savings premium and can make money from this. This led to
the insurance companies introducing the universal life policy, mentioned at the end of section 2.4,
in an attempt to offer the policyholder more flexibility with regards to the levels of the risk and
savings premium.
In (2.5.3) we see that the risk premium is the part used to fund a one-year term insurance,
of amount ck+1 k+1 V , to cover the net amount at risk to the insurer, which is the benefit
payment. This part of the policy has no reserves, since the risk premium is just sufficient to
purchase appropriate coverage for the net amount at risk for that 1 year.
If we multiply (2.5.2) by (1 + i)jk and just consider the first j years, then sum over k =
0, 1, . . . , j 1, we get:
j1
X
(1 + i)jk sk
jV =
k=0

We can see from this equation that the net premium reserve is the total value of the savings
premiums since the beginning of the policy.
Also we can re-write (2.4.8) by using d = i/(1 + i), where d is the discount rate covered in
the Actuarial Mathematics II course, which gives us v = 1 d, resulting in:
k + d k+1 V = (k+1 V k V ) + rk
We can see that the premium plus the interest received on the net premium reserve, is used to
change (increase or decrease) the net premium reserve and to cover the risk premium.

Example
The decomposition of the net annual premium into the savings premiums and the risk premiums
for the same example of section 2.2.4 is tabulated below:
We can see from these results that:
The savings premium for the term insurance decreases steadily and becomes negative from
year 5 onwards, this is because the net premium reserve decreases from year 6 and once the
net single premium in year 6 has been discounted it is less than the value for year 5.
The risk premium for the term insurance increases steadily this is because the probability of
the insured dying each year increases (See Table 2.5), which out weighs the increasing net
premium reserve during the first five years. After that the net premium reserve decreases
and the probability of the insured dying each year continues to increase, so an increasing risk
premium is expected.
The savings premium for the endowment increases slowly, this is because the net premium
reserve increases at roughly the same rate.
13

Table 2.4: Decomposition into savings premium and risk premium

k
0
1
2
3
4
5
6
7
8
9

Term insurance
sk
rk
0.25
0.56
0.20
0.61
0.15
0.66
0.10
0.72
0.03
0.78
-0.03
0.85
-0.11
0.92
-0.19
1.00
-0.29
1.10
-0.39
1.20

Endowment
sk
rk
7.43 0.52
7.44 0.51
7.45 0.50
7.47 0.48
7.51 0.45
7.55 0.40
7.62 0.33
7.70 0.25
7.81 0.14
7.95 0.00

The risk premium for the endowment decreases to zero, this is because the net premium
reserve increases as does the probability of the insured dying each year. The risk premium in
year 9 is zero because the net premium reserve in year 10 is 100 which is equal to the benefit
payment in year 10.

Table 2.5: The probability of the insured dying each year

k
0
1
2
3
4
5
6
7
8
9

2.6

lx
8950994
8898004
8840879
8779258
8712711
8640918
8563495
8480001
8389943
8292787

qx+k
0.0059
0.0064
0.0070
0.0076
0.0082
0.0090
0.0097
0.0106
0.0116
0.0126

Retrospective Reserves

In this section the definition of retrospective reserves is from [Scott, p.102]. Equations (2.6.1) and
(2.6.2) can be found in [Scott, p.103], but their derivations have been extended by me for further
clarity.
As mentioned in section 2.1 one of the uses of reserves is calculating the surrender value of the
policy, in this section I will find formulae to achieve this. If the insured decides to surrender the
contract before a claim is made, he will probably expect in the early of the years of the policy, to
receive a surrender value related to the accumulation of the premiums he has paid, less expenses
and the cost of the life insurance cover, since he hasnt received any benefit payment. Such a
surrender value is related to the retrospective reserve of the contract, which is defined to be
the total of the premiums paid, less expenses and the cost of the benefit payment, of a hypothetical
large group of identical policies whose mortality exactly follows a set life table and then dividing
the hypothetical funds amongst the survivors.
14

If we now consider the whole life insurance policy defined in section 2.2.1, the retrospective
reserve is found by collecting together the funds of say lx identical policies until time k and then
sharing the accumulated money out among the survivors. If we use standard notation used for life
tables, there are dx deaths in the first policy year, dx+1 deaths in the second policy year and lx+k
survivors at time k. The total accumulated premiums paid by the survivors is given by:
lx Px (1 + i)k + lx+1 Px (1 + i)k1 + + lx+k1 Px (1 + i)
= lx Px (1 + i)k [1 +

1
1+i

+ +

1
]
(1+i)k1

= lx Px (1 + i)k [1 + v + + v k1 ]
= lx Px (1 + i)k a
x:k
The first line can be simply explained: all the lx people pay premium Px at policy issue (k = 0),
which gains k years of interest, then at the start of the next year the surviving lx+1 people again
pay premium Px , which can gain k 1 years of interest, until at the start of the k th year the
surviving Lx+k1 people pay premium Px which only has that one year to accumulate interest.
The total of the benefit payments, of 1 unit, that need to be paid out to the people that died
each year is given by (we use the fact that dx+k = lx k px qx+k which is proved in section B.2):
dx (1 + i)k1 + dx+1 (1 + i)k2 + + dx+k1
= lx 0 px qx+0 v(1 + i)k + lx 1 px qx+1 v 2 (1 + i)k + + lx k1 px qx+k1 v t (1 + i)k
= lx (1 + i)k [v 0 px qx+0 + v 2 1 px qx+1 + + v k k1 px qx+k1 ]
Pk1
= lx (1 + i)k [ j=0 v j+1 j px qx+j ]
1
= lx (1 + i)k Ax:k

The first line can be simply explained: at the end of the first year the dx people that died that
year need to get the benefit payment of 1 unit, but they receive it at the end of year k, so it has
k 1 years to gain interest. This carries on till the end of year k when the dx+k1 people that
died receive the benefit payment of 1 unit, but with no years of interest as this is the end of the
final year.
We now need to work out the difference between these quantities to work out the loss to the
insurer, which can simply be written as:
1
Px a
x:k ]
lx (1 + i)k [Ax:k

(2.6.1)

As we said before we now share this total accumulated amount amongst the lx+k survivors at
time k by dividing (2.6.1) by lx+k to find the
retrospective reserve at time k, which is given by the
v x lx
x
symbol k VR (we also use the fact that vx+k
= DDx+k
).
lx+k
k Vx R

=
=
=
=

lx

1
(1 + i)k [Ax:k
Px a
x:k ]
lx+k
lx 1 1
[A
Px a
x:k ]
lx+k v k x:k
lx
vx
1
[Ax:k
Px a
x:k ]
x+k
lx+k v
Dx
[A1 Px a
x:k ]
Dx+k x:k

(2.6.2)
15

Example
I shall now find the retrospective reserves for the term insurance and the endowment policies
we considered in section 2.2.4. The equations for the respective reserves for the term insurance
and the endowment policies are respectively given by:
1
k Vx:n R

Vx:n

Dx
1
a
x:k ]
[A1 P x:n
Dx+k x:k

Dx
[A1 Px:n a
x:k ]
Dx+k x:k

The retrospective reserves for each year are shown below, included is the prospective reserves
calculated earlier for comparison.
Table 2.6: Retrospective Reserves
k
0
1
2
3
4
5
6
7
8
9

1
k Vx:n R

1
k Vx:n

0.00
0.28
0.54
0.79
1.01
1.17
1.25
1.22
1.04
0.65

0.00
0.26
0.49
0.67
0.81
0.88
0.89
0.82
0.66
0.39

Vx:n R
0
8
18
29
42
57
75
95
119
146

Vx:n
0
8
16
25
34
43
53
64
75
87

We can see from these results that:

The retrospective reserve for the term insurance (1st column) matches quite closely to the
prospective reserve (2nd column) for the first 3 years, which is what the retrospective reserve
set out to accomplish. After that the retrospective reserve increases faster than the prospective reserve and the difference between the two widens. This shows that the retrospective
reserve is not beneficial to the insurer later into the contract and so surrendering the contract
would probably not be possible.
A similar trend can be seen between the retrospective reserve (3rd column) and prospective
reserve (4th column) for the endowment policy.

16

2.7

The Expected Value and Variance of Loss Variables

In this section equation (2.7.1) is from [Bowers, p.230]. Equations (2.7.2), (2.7.3), (2.7.4), (2.7.5)
are from [Bowers, p.233-235], but the derivations of (2.7.3), (2.7.4) have been extended by me for
greater clarity. Table 2.7 is from [Bowers, p.233]. Equations (2.7.6), (2.7.8), (2.7.9) and (2.7.10)
are from [Bowers, p.242-244], but (2.7.8), (2.7.9) and (2.7.10) have been extended by me for greater
clarity. Table 2.8 is from [Bowers, p.242].
In this section I am going to find formulae for the expected value and variance of different loss
variables.

2.7.1

Prospective Loss

The first loss variable I am going to look at is the prospective loss, touched on in section 1.1.
I shall consider a general discrete whole life insurance where:
1. The benefit payment is payable at the end of year of death.
2. The benefit payment in the jth year is cj , j = 1, 2, . . ..
3. The premium payments are paid annually at the beginning of the year.
4. The premium payment in the jth year is j1 , j = 1, 2, . . ..
Similar to before, the prospective loss in year k, k L, is the present value of future benefit
payments less the present value of future premium payments. Expressed as a function of k this is:

0
K = 0, 1, . . . , k 1
PK
L
=
(2.7.1)
k
K+1k
jk
cK+1 v
j=k j v
K = k, k + 1, . . .
The expected value of the prospective loss, E(k L|K k) is by definition the net premium
reserve k V . I will leave Var(k L|K k) until later when we have seen the other loss variables.

2.7.2

The Insurers Net Cash Loss

The next loss variable I am going to look at is the insurers net cash loss within each insurance
year for the general discrete life insurance defined above. Table 2.7 is a time diagram that illustrates
the annual cash income and expenses for the insurer.
Table 2.7: The Insurers Annual Cash Income and Expenses
Year
Expenses
Income

0
0

1
0
1

2
0
2

K 1
0
K1

K
0
K

K +1
cK+1
0

K +2
0
0

K +3
0
0

etc. . .

Let Ck be the present value, at the beginning of year k, of the net cash loss during the year
(k, k + 1).
If (k, k + 1) is after the year of death (i.e. K(x) < k) then, the insured has already died and so
no premium payments are made and the benefit payment has already been paid, so Ck = 0.
If (k, k + 1) is the year of death (i.e. K(x) = k) then the premium payment, k , was paid at
the start of the year and the benefit payment, ck+1 , is paid by the insurer at the end of the year,
so Ck = ck+1 v k .
If (k, k + 1) is before the year of death (i.e. K(x) > k) then, the insured is still alive and has to
pay the premium k at the start of the year, so Ck = k . The explicit function of K is shown
below:
17


0
ck+1 v k
Ck =

K = 0, 1, . . . , k 1
K=k
K = k + 1, k + 2, . . .

(2.7.2)

For the conditional distribution of Ck , given that K k, we see that:

Ck = v ck+1 I k
where I is again an indicator function but this time:

1 with probability qx+k
I=
0 with probability px+k
This is the case since Ck only takes the value v ck+1 in year k when the insured dies and that
occurs with probability qx+k .
Therefore the expectation of Ck is:
E(Ck |K k) = v ck+1 qx+k k

(2.7.3)

Using that:
Var(x) = E(x2 ) [E(x)]2
then the variance is:
Var(Ck |K k)

=
=
=
=
=
=
=
=

E[(Ck )2 |K k] [E(Ck |K k)]2

E[(v ck+1 I k )2 ] (v ck+1 qx+k k )2
2
E(v 2 c2k+1 I 2 2v k ck+1 I + 2k ) v 2 c2k+1 qx+k
+ 2v k ck+1 qx+k 2k
2 2
2
2 2
2
E(v ck+1 I) 2v k ck+1 qx+k + k v ck+1 qx+k + 2v k ck+1 qx+k 2k
2
v 2 c2k+1 qx+k v 2 c2k+1 qx+k
v 2 c2k+1 qx+k v 2 c2k+1 qx+k (1 px+k )
v 2 c2k+1 qx+k v 2 c2k+1 qx+k + v 2 c2k+1 qx+k px+k
v 2 c2k+1 qx+k px+k
(2.7.4)

By rearranging the terms in the definition of the prospective loss in (2.7.1), we find an equivalent
one that states k L as the sum of the present value of the insurers future net annual losses at year
k. This gives us:

X
v jk Cj
(2.7.5)
kL =
j=k

We can verify (2.7.5) for K k by substituting in (2.7.2), this is shown explicitly below:

kL

v jk Cj

j=k

= v Kk (v cK+1 k )

K1
X

v jk j

j=k

= cK+1 v K+1k

K
X
j=k

Obviously we get (2.7.1) as expected.

18

j v jk

2.7.3

Allocation of the Risk

The next loss variable I am going to look at explores the allocation of the risk within each year of
the insurance policy. It is very similar to the net cash loss looked at previously, but now it also
includes the change in liability for the insurer each year. The change in liability, as mentioned
before, is basically the change in the net premium reserve over each year, this can be thought of
as the extra money the insurer needs to set aside each year to cover the premium payment.
I will now look at the risk to the insurer within each insurance year for the general discrete
life insurance defined above, Table 2.8 is a time diagram that illustrates the annual cash income,
expenses and change in liability for the insurer.
Table 2.8: The Insurers Annual Cash Income, Expenses and Change in Liability
Year
Expenses
Income
Liability

0
0

1
0
1
1V

2
0
2
2 V (1 + i)1 V

K
0
K
K V (1 + i)K1 V

K +1
cK+1
0
K V

K +2
0
0
0

etc. . .

Let k be the present value, at the beginning of year k, of the net cash loss and change in
liability during the year (k, k + 1).
If (k, k + 1) is after the year of death (i.e. K(x) < k) then, the insured has already died and
the benefit payment has already been paid, so the insurer has no liability and as before Ck = 0 so
k = 0.
If (k, k + 1) is the year of death (i.e. K(x) = k) then the insurer has the reserve from the
beginning of the year, k V , as the premium payment was paid by the insured, but there is no
reserve needed at the end of the year for next year as the benefit payment has already been made,
so Liability = k V . Ck = ck+1 v k for the reasons described previously. The change in
liability has to be discounted back to the start of the year so k = ck+1 v k v k V .
If (k, k + 1) is before the year of death (i.e. K(x) > k) then, the insured is still alive and the
insurer has the reserve k V at the beginning of the year, as the premium payment was paid by the
insured. It is also paid at the beginning of next year as the insured will survive to at least that
point so the insurer now has reserve k+1 V . The insurers change in liability for the year (k, k + 1),
with discounting, is therefore Liability= v k+1 V k V . Ck = k for the reasons described
previously. This gives us k = v k+1 V k V k .
The explicit function of K is shown below:

K = 0, 1, . . . , k 1
0
(ck+1 v k ) + (k V )
K=k
k =
(2.7.6)

(k ) + (v k+1 V k V ) K = k + 1, k + 2, . . .
We can write (2.7.6) in terms of the risk and savings premiums from (2.5.3) and (2.5.2):

K = 0, 1, . . . , k 1
0
rk + (ck+1 k+1 V )v K = k
k =

rk
K = k + 1, k + 2, . . .
The conditional distribution of k , given that K k, we see that:
k = v ck+1 I + v k+1 V J k k V
where I is again an indicator function :

1 with probability qx+k
I=
0 with probability px+k

19

(2.7.7)

As is J but this is:


J=

1 with probability px+k

0 with probability qx+k

This is the case as k takes:

v ck+1 in year k when the insured dies and that occurs with probability qx+k
v k+1 V if the insured survives year k and that occurs with probability px+k .
The expectation of k is given by:
E(k |K k)

= v ck+1 qx+k + v k+1 V px+k k k V

= 0 from (2.4.8)
(2.7.8)

The variance of k is given by:

Var(k |K k)

E[(k )2 |K k] [E(k |K k)]2

E[(v ck+1 I + v k+1 V J k k V )2 ] (v ck+1 qx+k + v k+1 V px+k k k V )2

E[v 2 c2k+1 I + 2v 2 ck+1 k + 1V IJ 2v ck+1 k I 2v ck+1 k V I + v 2 k+1 V 2 J

2v k+1 V k J 2v k+1 V k V J + 2k + 2k k V + k V 2 ] [E(k |K k)]2

= v 2 c2k+1 qx+k + 0 2v ck+1 k qx+k 2v ck+1 k V qx+k + v 2 k+1 V 2 px+k

2v k+1 V k px+k 2v k+1 V k V px+k + 2k + 2k k V + k V 2
2
v 2 c2k+1 qx+k
2v 2 ck+1 k+1 V px+k qx+k + 2v ck+1 k qx+k + 2v ck+1 k V qx+k
2
2 2
v k+1 V px+k + 2v k+1 V k px+k + 2v k+1 V k V px+k 2k 2k k V k V 2
2
= v 2 c2k+1 qx+k + v 2 k+1 V 2 px+k v 2 c2k+1 qx+k
2v 2 ck+1 k+1 V px+k qx+k
v 2 k+1 V 2 p2x+k

= v 2 c2k+1 qx+k v 2 c2k+1 qx+k + v 2 c2k+1 qx+k px+k + v 2 k+1 V 2 px+k

v 2 k+1 V 2 px+k + v 2 k+1 V 2 px+k qx+k 2v 2 ck+1 k+1 V px+k qx+k
= v 2 c2k+1 px+k qx+k + v 2 k+1 V 2 px+k qx+k 2v 2 ck+1 k+1 V px+k qx+k
= v 2 (ck+1 k+1 V )2 px+k qx+k
(2.7.9)
We can now express the prospective loss variable k L in terms of k using the definition of the
k s and (2.7.5):

v jk k

j=k

v jk [Ck + v Liability(k, k + 1)]

j=k

kL

v jk+1 Liability(k, k + 1)

j=k

If we look at Table 2.8 we can see that for the sum of all the discounted change in liabilities,
most of the terms cancel each other out and we are simply left with 0 k V for the year (k, k + 1)

20

with all the years after this obviously having no change in liability. Using this deduction and
rearranging the above formula we have the relationship:

0P
K<k

kL =
jk
v

+
V
Kk
j
k
j=k
We can now find Var(k L) using the simple identity:
Var(k |K j) = Var(k |K k) kj px+j

for j k

this can be simply explained as kj px+j is just the probability that the insured survives to the
year k, given that he has survived j years. We also need:
Var(aX + b) = a2 Var(X)
Using these identities, the arrangement of k L above and (2.7.9) we get:
Var(k L|K k)

X
Var[
v jk j + k V |K k]
j=k

X
j=k

Var[v jk j + k V |K k]
v 2(jk) Var[j |K k]

j=k

v 2(jk) jk px+k Var[k |K k]

j=k

v 2(jk) jk px+k [v 2 (ck+1 k+1 V )2 px+k qx+k ]

j=k

(2.7.10)

Example
These quantities for the term insurance and endowment example from section 2.2.4 are shown
in table 2.9 below:
We can see from these results that:
The expected net cash loss for the insurer for the term insurance (1st column) is negative,
showing that the insurer expects to make money each year (as a negative loss is a profit),
but the amount increases each year as more needs to be set aside just in case the insured
dies.
The variance of the net cash loss is the same for both the term insurance (2nd column) and
the endowment (6th column) as it only depends on the sum insured and the probabilities of
surviving the period, which are the same for each. We can see that the variance increases
over time showing that the risk of the insurer losing money each year increases.
The variance of the allocation of the risk (3rd column) increases each year showing that the
term insurance becomes more risky each year as there is more at stake should the insured
die, as the insurer would lose a lot of the money he could have been able to keep, in order to
pay the benefit payment.
The variance of the prospective loss (4th column) increases each year again showing that the
term insurance becomes more risky.
21

Table 2.9: The Expected Value and Variance of Loss Variables for the Term Insurance and Endowment
k
0
1
2
3
4
5
6
7
8
9

E(Ck )
-0.25
-0.24
-0.22
-0.20
-0.18
-0.16
-0.13
-0.09
-0.05
0.00

Term Insurance
Var(Ck ) Var(k )
0.53
53.4
0.58
57.6
0.63
62.2
0.68
67.3
0.74
72.9
0.81
79.1
0.88
86.0
0.95
93.7
1.04
102.5
1.13
112.1

Var(k L)
500
595
709
847
1013
1214
1457
1754
2118
2562

E(Ck )
-7.4
-8.4
-9.7
-11.4
-13.6
-16.8
-21.6
-29.6
-45.6
-94.0

Endowment
Var(Ck ) Var(k )
0.53
53.4
0.58
49.2
0.63
44.3
0.68
38.8
0.74
32.6
0.81
25.9
0.88
19.0
0.95
12.3
1.04
6.3
1.13
1.8

Var(k L)
427
424
408
378
332
269
192
108
34
0

The expected net cash loss for the insurer for the endowment (5th column) is negative and
increases, showing that the insurer expects to make money each year (as a negative loss is
a profit), and the amount decreases each year, showing that more profit is expected to be
made.
The variance of the allocation of risk (7th column) decreases each year showing that the
endowment becomes less risky for the insurer each year because the insurer is more likely
to have to make the benefit payment at the end of the period and so get the profit he was
expecting.
The variance of the prospective cash loss (8th column) decreases each year again showing
that the endowment becomes less risky for the insurer.
The expected value is of use to the insurer as it enables them to see statistically how much
profit they are likely to make. The variance is probably more useful as it is a measure of the risk
of the policy for the insurer as it shows the variability in the expected value. The insurer may
not want to take on a policy with a high variance because, if something were to go wrong, i.e.
the insured dies early into the contract, then there could be large losses for the insurer. We can
therefore see that from the insurers point of view, being able to calculate the expected value and
variance each year for the different loss variables is really useful.

2.8

Expense Loadings

In this section I have used my notes from Actuarial Mathematics II which are based on [Gerber,
p.103-105].
As discussed in chapter 1.1, if the insurer wants to make a profit and cover the setup and
running costs of the policy, they will have to take this into account when calculating the premium
amounts for the insured to pay. The reason for looking at the expense loadings is that the resulting
premiums and reserves will closely resemble the net premiums and reserves calculated earlier, so
this is a basic extension of what has already been looked at. It also enables us to see what happens
more often in the real world, where the insurer is looking to make a profit, rather than allowing
the premiums to be net premiums, but also how they strive to be competitive with other insurance
companies.

22

There are 3 main groups of expenses:

Acquisition Expenses
This expense takes into account all the costs associated with the setup of the policy e.g. policy
writing, agents commission, medical exam and advertising. The expenses are proportional
to the sum insured and are charged as a single amount. The equivalent premium rate, due
every year, is given by .
Collection Expenses
This expense is charged at the beginning of every year in which a premium is to be collected,
it can be thought of as the expenses for an agent to travel to the insured for the annual
payments, or in case of an electronic transfer a handling fee. The expenses are proportional
to the expense-loaded premium, which is the net annual premium, when all the expenses
have been taken into account. The equivalent premium rate, due every year, is given by .
Administration Expenses
All other expenses are included in this group, such as data processing costs, wages, taxes and
license fees. These expenses are charges at the beginning of each year for the entire length
of the contract while the insured is still alive and is usually proportional to the sum insured.
The equivalent premium rate, due every year, is given by .
The expense-loaded premium (or adequate premium, hence the a in the superscript in
the symbol, see later) is the overall amount of premium to be paid at the beginning of each year,
taking into account both the sum insured and the expense loadings. Its expected present value
should be just sufficient to cover the total of these amounts. The symbol P a is used to denote
the expense-loaded premium and we denote the expected present value of the net annual premium
and the premiums for acquisition expenses, collection expenses and administration expenses by
P, P , P , P respectively. As the total of P, P , P , P equals the expense-loaded premium by
definition then we get:
Pa = P + P + P + P
(2.8.1)

Example
If we now try and find the expense loaded premiums for the term insurance and endowment
from section 2.2.4.
As the expense-loaded premium is payable at the start of each year the insured is alive for the
n year period, then it must have a factor of an n year temporary life annuity due, like the original
premium payments did.
1
, can be written as
The original premium for the term insurance,P x:n
1
1
P x:n = Ax:n /
ax:n by using the equivalence relation, see (2.3.3).
The acquisition expense is a one off payment and as mentioned before the premium rate due
each year is .
The collection expenses as mentioned before are proportional to P a and are due at the start
of every year like the original premium so it also must have the factor of an n year temporary life
annuity due.
The administration expenses are proportional to the sum insured and is also due at the start
of every year the insured is alive and as the contract ends after n years it is capped here too, so
also has a factor of an n year temporary life annuity due.
Taking all this into account we can write the expense-loaded premium for the term insurance
1
as (N.b. I have written this as P a (Ax:n
) purely for aesthetic purposes):
1
1
1
P a (Ax:n
)a
x:n = Ax:n
+ + P a (Ax:n
)a
x:n + a
x:n

23

giving us:
1
)=
P a (Ax:n

1
Ax:n
++a
x:n
(1 )
ax:n

similarly for the endowment:

a
Px:n
=

Ax:n + + a
x:n
(1 )
ax:n

Let the insured be 50 years old, the duration of the policy be n = 10 years and the sum insured
1
be 100 units as before. The net annual premiums were calculated before and are P 50:10
= 0.8166
and P50:10 = 7.9512 for the term insurance and endowment respectively. If we have an acquisition
expense of 0.5% of the 100 units, a collection expense of 10% of each expense-loaded premium
and an administration expense of 0.8% of the 100 units, for both policies then we get for the term
insurance.

1
)
P a (A50:10

=
=
=

100(A50:10 ) + 0.5 + 0.8(

a50:10 )
(1 0.1)
a50:10
6.38 + 0.5 + 6.29
7.08
1.86

Similarly for the endowment:

a
Px:n
=

62.54 + 0.5 + 0.8 7.87

= 9.79
0.9 7.87

We can see that the expense-loaded premiums are higher than the standard premiums for both
policies, as expected, since the insurer is charging more to take into account the expenses.

2.8.1

Expense-Loaded Premium Reserves

In this section (2.8.2) is from [Gerber, p.105] but its derivation has been extended by me for greater
clarity.
The expense-loaded premium reserve is similarly given by k V a . Unsurprisingly it is defined
similarly to how the net premium reserve was, but it also takes into account the expense-loaded
premiums. Its definition is therefore given by: the difference between the expected present value of
future benefits and the expected present value of future expense-loaded premium reserves. Using
this definition we can find the expense-loaded premium reserve for the whole life insurance policy
used in section 2.2.1 and substitute (2.8.1) for the expense-loaded premium Pxa , which replaces the
normal premium Px :
a
k Vx

= Ax+k Pxa a
x+k
= Ax+k (Px + Px + Px + Px ) a
x+k

= Ax+k Px a
x+k Px a
x+k Px a
x+k Px a
x+k

= k V x + k V x + k V x + k Vx

Where k Vx is the reserve for the acquisition expense, k Vx is the reserve for the collection expense
and k Vx is the reserve for the administration expense.

24

We can find expressions for each of the expense-loaded premium reserves in terms of the
expense-loaded premiums:

k Vx

= Px a
x+k
a
x+k
=
a
x
= (1 k Vx )
(2.8.2)

Proof of

a
x+k
a
x

= 1 k Vx can be found in (B.3.1).

k Vx

k Vx

= Px a
x+k
= Pxa a
x+k
= Px a
x+k
= a
x+k

Example
Using the above formulae we can now find the expense-loaded premium reserves for the term
insurance and endowment from section 2.2.4. As before, if we have an acquisition expense of 0.5%
of the 100 units, a collection expense of 10% of each expense-loaded premium and an administration
expense of 0.8%, for both policies. The results are shown in table 2.10 below:
Table 2.10: Expense-Loaded Premium Reserves

k
0
1
2
3
4
5
6
7
8
9

1
k Vx:n

0.00
0.26
0.49
0.67
0.81
0.88
0.89
0.82
0.66
0.39

Term Insurance
1
1
k Vx:n
k Vx:n
-0.50
-1.5
-6.3
-0.37
-1.3
-5.8
-0.26
-1.2
-5.3
-0.16
-1.1
-4.7
-0.10
-1.0
-4.2
-0.06
-0.8
-3.6
-0.05
-0.7
-2.9
-0.09
-0.5
-2.3
-0.17
-0.4
-1.6
-0.30
-0.2
-0.8

1
k Vx:n

1a
k Vx:n

k Vx:n

-8.3
-7.3
-6.3
-5.3
-4.4
-3.6
-2.8
-2.1
-1.4
-0.9

0
8
16
25
34
43
53
64
75
87

Endowment

k Vx:n
k Vx:n
-0.50
-7.7
-6.3
-0.46
-7.1
-5.8
-0.42
-6.5
-5.3
-0.38
-5.8
-4.7
-0.33
-5.1
-4.2
-0.28
-4.4
-3.6
-0.23
-3.6
-2.9
-0.18
-2.8
-2.3
-0.12
-1.9
-1.6
-0.06
-1.0
-0.8

k Vx:n

a
k Vx:n

-14
-6
4
14
24
35
47
59
72
85

We can see from the results that:

The expense-loaded premium reserve for the term insurance (5th column) is less than the
standard premium reserve (1st column) as expected, since the insurer is now receiving more
money from the insured, so consequently needs to reserve less. What this example fails to
take into account though, is that the insurer will not be able to keep all of this extra premium
amount purely as profit, he will have to use some of it to pay the expenses incurred. This
means that the reserves will need to be slightly higher than indicated by the expense-loaded
premium reserve, to take this into account.
The expense-loaded premium reserve for the endowment (10th column) is also less than the
standard premium reserve (6th column) for the same reasons.

25

Chapter 3

Uses of Reserves
3.1

Introduction

At the end of section 2.1 I gave some of the uses of reserves. I have already covered the surrender
value, which is related to the retrospective reserves in section 2.6. I will now look at altering one
part of an existing policy or converting a policy from one form to another. Also I will look at the
reserves for with-profits policies.

3.2

Alterations and Conversions

In this section the general principle is based on information from [Scott, p.126-127], but the illustrating example is my own.
If insurance companies want to stay competitive they need to offer policies that are flexible and
allow the insured person to make changes to the policy, if their financial standing changes. Such
alterations that are possible include: altering the amount of the premium payments, the duration
of the premium payments, maturity time of endowment policies and completely changing from one
form of insurance to another. Such changes often involve reducing the benefit payment in order to
make sure that the remains fair for both the insurer and the insured.
According to [Scott, p.126] the usual rule for carrying out these calculations is to equate the
reserves before and after the conversion. If V1 and V2 are the reserves before and after the conversion
respectively, then we get the following equality:
V1 = V 2
If there are expenses of F for the conversion itself, then the formula becomes:
V1 F = V2
This is indeed correct because at the date of conversion, the insureds policy is worth V1 on its
immediate surrender. Then imagine that the amount V1 is used as a net single premium to purchase
the new contract, thus the equation of value of the new contract is:
V1 + expected value of future premiums = expected value of future benefits + F
Rearranging this gives:
V1 F = expected value of future benefits expected value of future premiums
26

We notice that the right-hand side of this equation is in fact the net premium reserve formula, so
is equal to V2 as required. We can use this equation to solve for the unknown quantity, which is
usually the new benefit payment or premium payments.

Example
Suppose a man aged 40 takes out a whole life insurance policy, with benefit payment of 1000
units paid at the end of year of death, and paid for by level annual premiums. After 10 years
he wants to change the policy to a 10 year endowment policy with the same annual premium
payments. We shall now work out the benefit payment, C, of the endowment policy.
First we work out the annual premium payment for the whole life insurance policy, P. Using
that the expected loss to the insurer at policy issue is 0 we get:
0 = 1000 A40 P a
40
Now rearranging this, using the commutation functions for the whole life and insurance and whole
life annuity, which are given by (A.2.2) and (A.4.3) respectively and using the life tables found in
appendix C we get:
P

1000 A40
a
40
1000 M40 D40
=
D40 N40
1000 M40
=
N40
= 12.50
=

Now we work out the reserve just before the conversion:

V1

10 V40

1000 A50 12.50 a

50

1000 M50
D50

120.02

12.50 N50
D50

We now use this amount as the reserve for the 10 year endowment policy, which has the same
premium payments as before and benefit payment C, which we have to calculate. Again we use
the commutation functions for the endowment policy and the n year temporary annuity due, which
are given by (A.3.4) and (A.4.5) respectively:
120.02

= C A50:10 12.50 a
50:10
C(M50 M60 + D60 ) 12.50 (N50 N60 )
=
D50
120.02 D50 + 12.50 (N50 N60 )
=
M50 M60 + D60
= 349.17

27

3.3

With-profits policies

In this section the general principle is based on information from [Scott, p.114-117].
With-profit policies are life insurance policies where the insured has the right to share in the
profits of the company, usually in the form of bonuses added to the benefit payment. As the
benefit payments from these policies are usually higher than normal non-profit policies, especially
if the company makes a lot of money from its investments, then the premium payments for these
policies are also higher. According to [Scott, p.46], the bonuses come typically in two forms,
reversionary bonuses, which are usually added annually and are not subsequently reduced, or
terminal bonuses, which are paid only upon death and are not guaranteed to continue. Here I
will only deal with reversionary bonuses only, as terminal bonuses are a lot more complicated to
calculate since the bonuses are not guaranteed.
Let us consider the whole life insurance policy used in section 2.2.1, but with benefit payment
of C, which is paid with the total bonuses accumulated at the end of year of death. Again the
policy is paid for by level annual premiums Px due at the start of each year. Each year reversionary
bonuses are added to the benefit payment when the corresponding premium has been paid and we
denote the total bonuses added to date by B. This gives a total benefit payment of C + B at the
end of each year.
According to [Scott, p.114], there are 3 main ways used to calculate the reserves for with-profit
policies are:
1. The net premium method.
2. The bonus reserve (or gross premium) method.
3. The asset share method.

3.3.1

The Net Premium Method

According to [Scott, p.115], the reserve is taken to be the net premium reserve for the corresponding
non-profit policy, plus the mean present value of the bonuses already declared. For our whole life
insurance policy considered above, the reserve is given by the formula:
kV

WP

= C k Vx + B Ax+k
= (C + B)Ax+k C Px a
x+k

The explanation for this method is that the additional premium amount (relative to the corresponding non-profit policy) is considered to have earned the bonus B so far, so an extra reserve
is required to cover the value of these bonuses.

3.3.2

The Bonus Reserve Method

In this section I have also used information from [Scott, p.48].

For this method the benefits and bonuses gain interest each year at a bonus rate b, which is
known as compound bonuses, instead of the usual Annual Equivalent Rate of i. This means
that the benefits, for our whole life insurance policy considered above, will be:

28

(C + B)(1 + b)

in year 1

(C + B)(1 + b)

in year 2

(C + B)(1 + b)k

in year k

and
This means that the net single premium is given by:
(C + B)

(1 + b)k+1 v k+1 k px qx+k

(C + B)

k=0

(C +

k+1

X
1+b

k=0
B)Ax

1+i

k px qx+k

(3.3.1)
Where Ax is at rate of interest:

This can be shown by using i =

ib
1+b

ib
1+b

1
ib
1 + 1+b

in v =
=
=

1
1+i :

1
1+b+ib
1+b

1+b
1+i

As required in (3.3.1)

The reserve for our whole life insurance policy is now found exactly as in the net premium method,
but obviously using the bonus rate of interest, this gives us:
kV

3.3.3

WP

= (C + B)Ax+k C Px a
x+k

Asset Share Method

The asset share of a life insurance according to [Scott, p.106] is a retrospective gross premium
reserve calculated on the basis of the mortality, interest and expenses actually experienced by the
office. A retrospective gross premium reserve is a reserve calculated by a retrospective accumulation
of premiums (as shown in Section 2.6) less expenses and the cost of the benefit payment. We also
allow for the possibility of expenses in the premium and reserving bases.
The calculation of the asset share is quite complicated and so we can simplify this method by
using the retrospective reserve without expenses, this was given by:
k Vx R

Dx
1
[P a
x:k Ax:k
]
Dx+k

The with-profit reserve can now be simply calculated as before, by using the retrospective
reserve and the mean present value of the bonuses already declared:
kV

WP

= C k Vx R + B Ax+k

These three methods vary in their approach to calculating the reserves for the with-profit
policies, to match the variety of ways there are of adding the different types of bonuses, giving the
insured the widest scope of choice for their policy.

29

Chapter 4

Applications of Reserves Beyond

Life Insurance
4.1

Insurance

Insurance has always been important to a developing society, as communal interest is crucial to
the furthering of civilization and insurance basically involves financially sharing lifes risks. The
basic principle for insurance is that the company, known as the insurer agrees to pay out money,
which is known as benefits, upon the occurrence of a specified event, which usually results in
financial loss for a person. The person buying the insurance is known as the insured and they
agree to pay amounts of money known as premiums for this cover. The contract between the two
parties is known as an insurance policy. The purpose of insurance is to reduce the financial cost
to individuals that arise from the occurrence of, usually negative, events. An insurance company
will cover the insured for all or part of the financial losses that may occur due to these events.
The pooling of liabilities by the insurance company makes the total losses more predictable, than
they would be for each of the insured individuals separately, so reducing the overall risk. Also, as
the insurance company has lots of resources and money to draw upon, they are able to take on
more risky operations, which increases creativity, competition and efficiency in the marketplace.
Insurance has been required by a variety of different people throughout time, for example: travelling
merchants, who had the risk of having their goods stolen, needed insurance. Property owners
needed insurance as they have the risk of fire and burglary. The main provider in any family
always has the risk of dying prematurely, disability or infirmity leaving their dependents without
a source of income. Also people sometimes live too long, use up all their savings and then become
a burden to their family or society.

4.2

Actuaries

As society develops, people and companies take more complicated risks and so businesses and
people need a greater variety of insurance policies to protect their money. Professionals called
actuaries now work with insurance companies to help them manage the financial implications of
risk and uncertainty. They help evaluate the probability of events occurring and try to quantify the
outcomes in order to minimise the financial losses associated with certain undesirable events. Since
many events, such as death cannot totally be avoided, it is helpful to take measures to minimise
their financial impact when they do occur. They also need to make sure that the premiums and
investment earnings of these policies are adequate to provide for the payment of the benefits. The
difficulty for actuaries is that there are many areas of uncertainty, the amount and timing of when
the benefits need to be paid, along with the investment earnings, are unknown and are subject to

30

random fluctuations. Another complication is that the actuaries need to make sure that the rates
they charge for a policy are perceived as being fair in order to attract business, but also make a
profit for the insurer.
Actuaries working in the life insurance sector deal with life insurance, health insurance and
pensions. They look at mortality and try to construct models that accurately predict the life
expectancy of a person given certain lifestyle details about them. They also have to take into
account medical advances, inflation, politics and living costs when designing their models and the
insurance policies, as these also have an influence on the risk.
Casualty actuaries work in the general insurance field and deal with catastrophic, unnatural
risks that can occur to people or their property. They design policies for car insurance, house
insurance and liability insurance. Their analysis involves calculating the probability of a loss,
called the frequency and the size of the event, called the severity. Also it is useful for them to
calculate the expected time of the loss, as it will give the insurer a good indication of how long
they have to generate the required benefit payment.
Actuaries dont just work in insurance, their understanding of uncertainty and finance is very
valuable to companies and so they are also employed by professional services companies to give
advice on investments, mergers and pension schemes. They also are involved in reporting the
companies assets and liabilities to the government to make sure the company is making a profit,
but is doing so fairly.
For both life and casualty actuaries their main role is to calculate the premiums and reserves
for insurance policies so that they cover the various risks. Premiums, as mentioned before, are the
amount of money the insurer needs to collect from the insured to cover the expected loss, expenses
and a margin for profit.

4.3

Uses of Reserves

In this section I have used information from [Wiser], any direct quotation from the text is given
in quotation marks.
Reserves are very important to actuaries as they indicate how much money should be set aside
to cover future benefit payments. Actuaries have lots of different types of reserves to calculate,
depending on the nature of the insurance dealt with by the insurer. Before exploring some of these
types of reserves, I am going to cover some basic accounting principles to illustrate the importance
of reserves and how they show the financial strength and stability of an insurance company.

4.3.1

The Balance Sheet

The balance sheet reports on the financial position of the company at a specific point in time.
It shows the level of assets and liabilities and the status of the shareholders equity.
Assets are any economic resource that is held by the company, they could be cash, stocks,
bonds or real estate for example.
Liabilities are claims on the resources of the company and that need to be paid to satisfy the
obligations to their clients. They could be mortgages, bank debt and benefits that need paying for
example.
Owners equity is the owners claim on the assets of the firm and they are always lower than
all other liabilities of the company. Owners equity is also called the surplus of the insurer. For a
publicly owned company the stockholders are the owners, but for a mutual insurer owned by its
members, the policyholders are the owners and this surplus belongs to them.
These three are related by the following equation, which is given on the balance sheet:
Assets = Liabilities + Owners0 Equity
31

(4.3.1)

If liabilities exceed the assets available then the value of the owners equity is negative and the
company is in a state known as insolvency.

4.3.2

The Income Statement

The income statement measures changes in the owners equity during a stated period of time.
The income statement measures the companys performance in this period as follows:
Income = Revenue Expense
Revenue measures the gaining of assets from the companys products or services.
The expense measures the loss of assets that used up in order to provide those products or
services.
The owners equity can be divided into 2 parts; the capital contributed by the owners and any
earnings retained by the company from past periods. This gives us:
Owners0 Equity = Contributed Capital + Retained Earnings

(4.3.2)

The income can be used either to increase the owners equity (i.e. increase retained earnings)
or be given out to the owners as dividends. This can be written as:
Income = Change in Retained Earnings + Dividends to Owners

(4.3.3)

By rearranging and combining (4.3.1), (4.3.2) and (4.3.3) we get:

Income

4.3.3

= Change in Assets Change in Liabilities

Change in Contributed Capital + Dividends to Owners

Loss Reserves

One of the types of reserves actuaries need to be able to calculate is called loss reserves. Loss
reserves are the actuarial process of estimating an insurance companys liabilities for loss and their
loss adjustment expenses, which are used in the balance sheet and income statements above. Loss
reserves are challenging for causality actuaries to calculate because, the process involves complex
technical calculations and important judgment too, as no single formula will provide the correct
answer.
According to [Wiser], there are five parts to a loss reserve:
1. Case reserves assigned to specific claims.
2. A provision for future development on known claims.
3. A provision for claims that re-open after they have been closed.
4. A provision for claims that have occurred but have not yet been reported to the insurer.
5. A provision for claims that have been reported to the insurer but have not yet been recorded.
One of the reasons why loss reserves need to be estimated is due to the delay that occurs
from when a loss occurs, to when it is reported and when it is finally settled. This has not been
accounted for in the calculation of my net premiums reserves for simplicity, but the reader should
be aware this happens. Dates therefore are very important in keeping track of the loss reserve
estimation process.

32

According to [Wiser], five key dates are:

1. Accident date: the date on which the loss occurred.
2. Report date: the date on which the loss is first reported to an insurer.
3. Recorded date: the date on which the loss is first recorded in the insurers statistical information.
4. Accounting date: the date used to define when the group of claims is to be included in the
liability estimate. A loss reserve is an estimate of the liability for unpaid claims as of a given
date, called the accounting date. An accounting date may be any date and is generally a date
for which a financial statement is prepared, such as a month end, quarter end or year-end.
5. Valuation date: the date as of which the evaluation of the loss liability is made. The valuation
date defines the point in time through which all the transactions are to be included for a
group of claims. The valuation date can be before, after or at the same time as the accounting
date.
As the loss reserve is only an estimate and as the date of its calculation is important, since its
value will change depending when it is calculated, there is some conventional terminology used to
distinguish between the results of the loss reserve process, which according to [Wiser] is:
The required loss reserve as of a given accounting date is the amount that must ultimately
be paid to settle all claim liabilities. The value of the required loss reserve can only be known
when all claims have been settled. Thus, the required loss reserve as of a given accounting
date is a fixed number that does not change at a different valuation date. However, the value
of the required loss reserve is generally unknown for an extremely long period of time.
The indicated loss reserve is the result of the actuarial analysis of a reserve inventory
as of a given accounting date conducted as of a certain valuation date. The indicated loss
reserve is the analysts opinion of the amount of the required loss reserve. This estimate will
change with successive valuation dates and will converge to the required loss reserve as the
time between valuation date and the accounting date of the inventory increases.
The carried loss reserve is the amount of unpaid claim liability shown on external or
internal financial statements.
The loss reserve margin is the difference between the carried reserve and the required
loss reserve. Since the required reserve is an unknown quantity we only have an indicated
margin. The indicated loss reserve margin is defined to be the carried loss reserve minus the
indicated loss reserve. One should not generally expect the margin to be zero, since for any
subset of an entitys business it is unlikely that the carries loss reserve will be identical to
either the indicated or required loss reserve.
As the process of estimating the loss reserve is complicated and involves using lots of actuarial
and accounting methods that have not been explored in this project, the details of how the estimate
can be found will be excluded. For further details see [Wiser].

33

4.3.4

Adequacy Testing

In this section I have used information from [Fisher], any direct quotation from the text is given
in quotation marks.
Following on from loss reserves, another requirement of causality actuaries in particular, as
their reserves are not usually given by set actuarial formulae but more often established by claims
adjusters on an individual case basis, is to test the adequacy of the reserves. These tests are very
important for assessing the financial solvency of the company and are carried out on a statistical
basis, reviewing a whole portfolio of cases at the same time. Government organizations like the
Financial Services Authority (F.S.A.), who regulate all providers of financial services, make sure
companies like insurers are making reasonable levels of profit and have enough reserves to cover
their policies and actions. Using the results of these tests the insurers can decide whether it
may be necessary to increase or decrease existing reserves, add special bulk reserves, or issue new
instructions redirecting the claims adjusters in the setting of reserves. One method now used,
called the report year approach, was developed more than 30 years ago and was based on an
approach known as the accident year method. It was designed to reveal whether the reserve is
adequate and to measure:
The extent of any redundancy or inadequacy.
The slippage or strengthening of the equity position of the reserve since last evaluation.
The contribution of various report years to the overall position.
The first two results are significant in the financial position of the company in that the first one
deals with solvency while the second deals with the possible distortions in the income statement.
The third result is of value in the administration of the claim department, in that it tells us whether
any redundancy is due to old or new cases. In other words, it indicates where corrective action is
needed and in latter evaluations it monitors that corrective action.

4.3.5

Reinsurance

In this section I have used information from [Patrik], any direct quotation from the text is given
in quotation marks.
Another important use for reserves is in the calculation of reinsurance. Reinsurance is a form
of insurance, where the an insurer looks to another insurance company to cover them for part or all
of the insurance policy they are offering their client. The terminology used is that the reinsurer
assumes the liability surrendered on the subject policies. The cession, or share of claims to be
paid by the reinsurer, may be defined on a proportional basis (a specified percentage of each
claim) or on an excess basis (part of each claim above some specified monetary amount). As
mentioned before for insurance, reinsurance further helps reduce the financial costs to insurance
companies arising from the possible claims and also helps to spread the risk. This promotes more
innovation, competition and efficiency in the marketplace.
More specific reasons for the insurer to take out reinsurance are to increase their capacity,
stability, financial management and for management advice.
Capacity: By having reinsurance cover, an insurer can offer insurance policies with larger
benefit payments while still maintaining a manageable risk level. By doing this the total net
loss exposure can be kept in line with the insurers surplus. This enables smaller insurance
companies to compete with larger insurers.
34

 Stabilisation: Reinsurance can help stabilise the insurers financial results over time and
shield them from large unexpected losses. Reinsurance can be written such that the insurer
has to pay the smaller predictable claims, but shares the cost of the larger more infrequent
claims, thus decreasing the insurers chance of financial ruin.
Financial results management: Reinsurance can be used to make a company look like it is
performing better, by altering the timing of income, enhancing surplus and improving the
various financial ratios by which insurers are judged. Insurers are able to use reinsurance
to give up part of their liability and make use of the reinsurers surplus. This can be seen
as a loan of surplus from the reinsurer to the insurer, which they could use to take on new
business or finance existing policies.
Management advice: When reinsurance is taken out, the reinsurer will have to critically
review the insurers operation to make sure that they are taking on something that they
can cope with. In this process the reinsurer may give the insurer advice and assistance on
pricing, loss prevention, claims handling, reserving and investment, to make sure that the
contract they make is viable for themselves. This enables smaller insurers to greatly benefit
from knowledge and advice from more experienced insurers.

35

Chapter 5

Conclusion
Reserves have many interesting properties and play a vital role in modern insurance. They are
one of the factors that ensure that insurance companies rarely go bankrupt and they also make
the whole process of insurance feasible. This is because they enable insurance companies to keep
track of extra amount of money they need to set aside, so that they can afford to pay the benefit
payment. We also saw that they enable insurance companies to offer a wide range of insurance
policies, they are important for assessing the financial position of a company and in reinsurance.
In chapter 2 I derived the formula for the net premium reserve and we saw that the net
premium reserve was basically the extra money the insurer needs that year, to ensure that the
benefit payment can be paid. I then looked at some of the interesting properties of reserves and
why they are useful to insurers. I studied various ways to express the reserve in terms of the
premiums, this was useful because the actuary could consider the reserve in terms of the amount
paid by the insured each year and therefore if they wanted to reserve only a certain proportion
of the premium, then they can adjust other factors accordingly to take this into account. It also
enabled us to see the portion of the benefit payment paid for by the premium payment that year
and the surplus/deficit between the premium payment and the benefit payment at that point in
time. I then looked at the recursive formula for the net premium reserve, which enables the insurer
to offer policies that are flexible and that can be changed from one form to another. After that I
examined the decomposition of the reserve and corresponding premium into the savings and risk
premium. The savings premium was the part of the premium that accumulated interest only and
is used by the insurer in later years to cover the deficit between the premium payments and the
benefit payment. The risk premium the part used to fund a one-year term insurance to cover the
net amount at risk, the benefit payment. This enables insurers to know how much of the premium
that they receive can be invested and how much needs to cover the benefit payment. I next looked
at retrospective reserves, which involved dividing the gains of the insurer each year between the
survivors of a hypothetical large group. This had uses in surrender values, which is when the
insured wants to leave an insurance policy and expects some compensation if they are in the early
years of the policy. I then studied the expected value and variance of various loss variables, which
enables insurers to have an indication of their expected loss/gain and the risk associated with
that amount. Finally I looked at a way of factoring the insurers expenses into the cost of the
policy, in the form of expense loading. I also examined the expense-loaded premium reserves for
completeness. This part gave an insight into how, in the real world, insurance companies have to
factor their overheads and profit margins into their policies.
In chapter 3 I looked at some of the uses of reserves for life insurance policies. I examined how
the reserves are used when the insured may want to make alterations to his existing policy and
I also looked at how reserves can be used to determine the level of extra bonuses, added to the
benefit payment, in with-profit policies. This chapter showed the variety of life insurance policies
that are available to people and the ways they are tailored to meet the requirements of a variety
of different customers.
36

In chapter 4 I looked at why insurance is so important to society as a whole, as it encourages

creativity, competition and efficiency in the marketplace. Also by pooling resources an insurance
company is able to reduce the risk relative to an individual. I then looked at how specialists known
as actuaries work in insurance companies to ensure financial stability. I also looked at some of
the uses of reserves outside of life insurance. We saw how loss reserves are the actuarial process
of estimating the amount of money an insurance company should set aside to cover their overall
losses and expenses. Adequacy testing, which uses reserves, are used to assess whether an insurance
company is making a reasonable level of profit and that they have enough reserves to cover their
policies and actions. Finally I looked at when reserves are used by insurers to see if large risky
policies are worth reinsuring, this is when an insurer looks to another insurance company to cover
all or part of one of their policies or group of policies.
In this project in order to make it accessible to 3H students and to explore the topic of reserves
in enough detail, I have had to use some simplified assumptions that could be extended for greater
accuracy and a closer fit to the actual events and occurrences of the real world. One such area is in
the use of the life tables. These are very useful for a quick estimation of the number of people dying
each year, but obviously these need to be updated each year, due to medical advances and the
fact that people are living longer. Also a continuous distribution of the survival of a population is
more realistic than the discrete distribution I have used, since a person can die at any time. There
are studies and research into methods of modeling the future lifetime as this is very important for
insurance and pension companies, because if people live longer than predicted then the company
is very likely to make a loss. Other models that are used for many random quantities are known
as deterministic and stochastic. In this project I have used deterministic models, which are
ones where the insurer pretends it knows exactly how much they will have to pay out in benefit
payments and then sets its premiums accordingly, to match this amount. This method is justified
by the concept of the law of large numbers, which states that if a large enough group of people
are insured, then the total number of losses is likely to be close to the predicted amount. The
more advanced stochastic model assigns probabilities to the occurrence of these losses, so that the
total loss can be more accurately predicted, especially for a smaller group. If you would like to
know more on how these models can be used in insurance, I would recommend reading [Bowers]
and [Promislow].

Acknowledgements
I would like to thank Prof. Frank Coolen for his guidance and advice throughout this project. I
would also like to thank Nicola Talbot for her guide LATEX for Complete Novices, which has
been invaluable to me in creating this project and understanding how to use LATEX.

37

Appendix A

Notation
Here I am going to cover the notation first introduced in the 2nd year mathematics course Actuarial Mathematics II with help from [Gerber].

A.1

Lifetime Models

The future lifetime of a person aged x is denoted by (X). As the time of death of the person is
random, the future lifetime of the person can be modeled by a probability distribution T (X). The
cumulative distribution of T (X) is given by:
Gx (t) = Pr(T t)

t0

(A.1.1)

Gx (t) can be interpreted as the probability of a life aged x dying within t years.
Further notation covered in the 2nd year course is given below:
t qx

= Gx (t)

(A.1.2)

Equation (A.1.2) denotes the probability that a life aged x dies within t years.
t px

= 1 Gx (t)

(A.1.3)

Equation(A.1.3) the probability that a life aged x survives at least t years.

s|t qx

= s+t qx s qx

(A.1.4)

Equation(A.1.4) denotes the probability that a life aged x will survive s years and then die in
the next t years.
t px+s

s+t px
s px

(A.1.5)

Equation(A.1.5) denotes the conditional probability that a person will survive t years, given
that they have attained the age x + s.
x+t =

g(t)
d
= ln[1 G(t)]
1 G(t)
dt

Equation(A.1.6) is the force of mortality of (x) at the age x + t.

(A.1.6)

The curtate future lifetime of X is defined as the number of completed years lived by x, and
has the symbol K(X).
Pr(K = k) = Pr(k T < k + 1) = k px qx+k

E(K(x)) = ex =

k Pr(K = k) =

k=1

A.2

k k px qx+k

(A.1.7)

(A.1.8)

k=1

Life Insurance

I will only give the net single premiums of the life insurance policies as the construction of these,
from the present value, was shown in the 2nd year course.
Whole life insurance: payment of 1 unit when death occurs.
Ax =

v k+1 k px qx+k

(A.2.1)

k=0

The commutation function for use with the life tables is:
Ax =
Ax =

Mx
Dx

(A.2.2)

v t t px x+t dt

(A.2.3)

(A.2.1) has the benefit payment at the end of year of death and (A.2.3) has its at the moment
of death.
Term life insurance: payment of 1 unit if death occurs within n years.
1
=
Ax:n

n1
X

v k+1 k px qx+k

(A.2.4)

k=0
1
Ax:n
=

Mx Mx+n
Dx

(A.2.5)

n year deferred whole life insurance: payment of 1 unit, if the insured survives n years,
at the end of year of death.
n| Ax

v k+1 k px qx+k

(A.2.6)

k=n
n| Ax

ii

Mx+n
Dx

(A.2.7)

A.3

Endowments

Pure endowment of n years: payment of 1 unit, if the insured survives n years, at the end of
year n.
Ax:n1 = v n n px

(A.3.1)

Dx+n
Dx

(A.3.2)

Ax:n1 =

n year endowment: payment of 1 unit if death occurs within first n years, else payment is
at the end of year n.
Ax:n =

n1
X

v k+1 k px qx+k + v n n px

(A.3.3)

k=0

Ax:n =

A.4

Mx Mx+n + Dx+n
Dx

(A.3.4)

Life Annuities

Remember that the present value of an annuity-due with n annual payments of 1 unit is given
by:
a
n = 1 + v + v 2 + + v n1

(A.4.1)

Whole life annuity: annual payment of 1 unit as long as the beneficiary lives, paid at the
start of the year.
a
x =

a
k+1 k px qx+k

(A.4.2)

k=0

Nx
Dx

a
x =

(A.4.3)

n year temporary life annuity due: payment of 1 unit at the start of years 1,. . . ,n if the
beneficiary is alive.
a
x:n =

n1
X

a
k+1 k px qx+k

(A.4.4)

k=0

a
x:n =

Nx Nx+n
Dx

(A.4.5)

n year deferred life annuity due: payment of 1 unit at the start of the year as long as the
beneficiary lives, if they survived n years.
x =
n| a

a
k+1 k px qx+k

(A.4.6)

k=n

x
n| a

Nx+n
Dx

iii

(A.4.7)

Appendix B

Useful Equations
B.1

Proofs of Equations used in Section 2.3

Remember that the present value of a perpetuity due with annual payments of 1 unit is given
by:

X
1
1
vk =
a
= 1 + v + v 2 + =
=
(B.1.1)
1v
d
k=0

Then we can think of an annuity due as the difference between two perpetuities, 1 starting at
time 0, the other at time n, then:
a
n = a
(v n + v n+1 + v n+2 + ) = a
v n a
=

1
1 vn
1
vn =
d
d
d

(B.1.2)

If we then let n = k + 1 and take the expected value of both sides we get:
E(
ak+1 )

1 v k+1
)
d
E(1) E(v k+1 )
E(d)
1 Ax
d

= E(

a
x

a
x

(B.1.3)
Use the expected loss equation for a whole life insurance policy at policy issue for sum insured
1 (as given by (1.1.1)), we see that:
= Ax Px a
x
= Px a
x

0
Ax

(B.1.4)
If we then combine (B.1.3) and (B.1.4) with x = x + k we get:
d

Px+k + d

1 Ax+k
a
x+k
1
Px+k
a
x+k
1
a
x+k
(B.1.5)
iv

If we also combine rearranged versions of (B.1.3) and (B.1.4) with x = x + k then:

d

1 Ax+k
a
x+k
(1 Ax+k )Px+k
Ax+k
(B.1.6)

B.2

Proofs of Equations used in Section 2.6

We use the lifetime equations in conjunction with the life table notation to give us the following
identities:
lx+k
k px =
lx
qx+k

1 px+k
lx+k+1
= 1
lx+k
lx+k lx+k+1
=
lx+k
dx+k
=
lx+k
=

If we multiply these together and rearrange we get:

k px qx+k

dx+k

B.3

lx+k dx+k
lx lx+k
dx+k
=
lx
= lx k px qx+k
=

Proofs of Equations used in Section 2.8.1

a
x+k
= 1 k Vx
a
x

This can be shown by using Ax+k = d a

x+k 1 from (B.1.5) and d + Px =
(B.1.5).
1 k Vx

1
a
x

again from

= 1 Ax+k + Px a
x+k
= 1 1 + da
x+k + Px a
x+k
= a
x+k (d + Px )
a
x+k
=
a
x
(B.3.1)

Appendix C

Life Tables
These life tables are edited versions of the ones from [Gerber, Appendix E]. Since they contain all
the numbers I have used to complete my examples, they will enable the reader to try them for
themselves.
Table C.1: Illustrative Life Tables
Basic Functions and Net Single Premiums at i = 5%
x
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24

lx
10,000,000
9,795,800
9,782,674
9,770,739
9,759,796
9,749,646
9,740,091
9,731,033
9,722,372
9,713,914
9,705,657
9,697,407
9,689,164
9,680,831
9,672,409
9,663,801
9,655,007
9,646,028
9,636,864
9,627,516
9,617,888
9,607,982
9,597,798
9,587,240
9,576,311

dx
204,200
13,126
11,935
10,943
10,150
9,555
9,058
8,661
8,458
8,257
8,250
8,243
8,333
8,422
8,608
8,794
8,979
9,164
9,348
9,628
9,906
10,184
10,558
10,929
11,300

Dx
10,000,000.00
9,329,333.30
8,873,173.70
8,440,331.70
8,029,408.30
7,639,102.80
7,268,205.90
6,915,663.50
6,580,484.10
6,261,675.60
5,958,431.50
5,669,873.00
5,395,289.10
5,133,951.40
4,885,223.80
4,648,453.50
4,423,070.00
4,208,530.10
4,004,316.00
3,809,935.00
3,624,880.80
3,448,711.80
3,281,006.00
3,121,330.20
2,969,306.70

vi

Nx
196,427,244.20
186,427,244.20
177,097,910.90
168,224,737.20
159,784,405.50
151,754,997.20
144,115,894.40
136,847,688.50
129,932,025.00
123,351,540.90
117,089,865.30
111,131,433.80
105,461,560.80
100,066,271.70
94,932,320.30
90,047,096.50
85,398,643.00
80,975,573.00
76,767,042.90
72,762,726.90
68,952,791.90
65,327,911.10
61,879,199.30
58,598,193.30
55,476,863.10

Mx
646,321.73
451,845.54
439,939.87
429,629.96
420,627.13
412,674.34
405,544.25
399,106.90
393,244.80
387,792.69
382,723.61
377,900.01
373,310.00
368,890.83
364,637.15
360,496.55
356,467.92
352,550.41
348,742.58
345,043.26
341,414.57
337,858.88
334,377.48
330,940.10
327,551.37

x
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24

x
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64

lx
9,565,011
9,553,342
9,541,209
9,528,519
9,515,274
9,501,382
9,486,845
9,471,571
9,455,469
9,438,544
9,420,611
9,401,676
9,381,556
9,360,166
9,337,421
9,313,144
9,287,253
9,259,577
9,229,946
9,198,195
9,164,070
9,127,414
9,088,075
9,045,725
9,000,135
8,950,994
8,898,004
8,840,879
8,779,258
8,712,711
8,640,918
8,563,495
8,480,001
8,389,943
8,292,787
8,188,132
8,075,463
7,954,250
7,823,959
7,684,067

dx
11,669
12,133
12,690
13,245
13,892
14,537
15,274
16,102
16,925
17,933
18,935
20,120
21,390
22,745
24,277
25,891
27,676
29,631
31,751
34,125
36,656
39,339
42,350
45,590
49,141
52,990
57,125
61,621
66,547
71,793
77,423
83,494
90,058
97,156
104,655
112,669
121,213
130,291
139,892
149,993

Dx
2,824,574.30
2,686,788.90
2,555,596.80
2,430,664.60
2,311,700.80
2,198,405.50
2,090,516.20
1,987,762.30
1,889,888.60
1,796,672.20
1,707,865.30
1,623,269.10
1,542,662.10
1,465,852.20
1,392,657.40
1,322,891.90
1,256,394.50
1,193,000.40
1,132,555.00
1,074,913.30
1,019,929.00
967,475.50
917,434.00
869,675.10
824,087.60
780,560.00
738,989.60
699,281.30
661,340.30
625,073.60
590,402.80
557,250.30
525,540.10
495,198.90
466,156.60
438,355.90
411,737.30
386,244.80
361,826.80
338,435.60

vii

Nx
52,507,556.40
49,682,982.10
46,996,193.20
44,440,596.40
42,009,931.80
39,698,231.00
37,499,825.50
35,409,309.30
33,421,547.00
31,531,658.40
29,734,986.20
28,027,120.90
26,403,851.80
24,861,189.70
23,395,337.50
22,002,680.10
20,679,788.20
19,423,393.70
18,230,393.30
17,097,838.30
16,022,925.00
15,002,996.00
14,035,520.50
13,118,086.50
12,248,411.40
11,424,323.80
10,643,763.80
9,904,774.20
9,205,492.90
8,544,152.60
7,919,079.00
7,328,676.20
6,771,425.90
6,245,885.80
5,750,686.90
5,284,530.30
4,846,174.40
4,434,437.10
4,048,192.30
3,686,365.50

Mx
324,214.45
320,932.65
317,682.85
314,445.71
311,227.89
308,013.59
304,810.22
301,604.73
298,386.38
295,164.62
291,913.55
288,644.28
285,335.83
281,986.04
278,593.67
275,145.23
271,642.65
268,076.89
264,441.04
260,730.57
256,932.58
253,047.16
249,075.92
245,004.31
240,829.91
236,544.63
232,143.75
227,625.37
222,983.47
218,209.20
213,303.85
208,265.72
203,091.26
197,775.77
192,314.41
186,711.65
180,967.08
175,081.19
169,055.75
162,894.37

x
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64

x
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99

lx
7,534,074
7,373,448
7,201,720
7,018,508
6,823,464
6,616,235
6,396,708
6,164,763
5,920,515
5,664,157
5,396,186
5,117,257
4,828,285
4,530,476
4,225,258
3,914,448
3,600,118
3,284,604
2,970,563
2,660,793
2,358,287
2,066,119
1,787,317
1,524,778
1,281,103
1,058,511
858,696
682,723
530,974
403,084
297,988
213,982
139,088
73,021
23,732

dx
160,626
171,728
183,212
195,044
207,229
219,527
231,945
244,248
256,358
267,971
278,929
288,972
297,809
305,218
310,810
314,330
315,514
314,041
309,770
302,506
292,168
278,802
262,539
243,675
222,592
199,815
175,973
151,749
127,890
105,096
84,006
74,894
66,067
49,289
23,732

Dx
316,027.90
294,562.10
274,001.70
254,315.30
235,474.20
217,450.30
200,224.10
183,775.20
168,089.50
153,153.60
138,959.90
125,502.00
112,776.00
100,781.00
89,515.60
78,981.70
69,180.50
60,111.90
51,775.80
44,168.20
37,282.60
31,108.30
25,629.10
20,823.20
16,662.40
13,111.70
10,130.10
7,670.60
5,681.60
4,107.70
2,892.10
1,977.90
1,224.40
612.20
189.50

viii

Nx
3,347,929.90
3,031,902.00
2,737,339.90
2,463,338.20
2,209,022.90
1,973,548.70
1,756,098.40
1,555,874.30
1,372,099.10
1,204,009.60
1,050,856.00
911,896.10
786,394.10
673,618.10
572,837.10
483,321.50
404,339.80
335,159.30
275,047.40
223,271.60
179,103.40
141,820.80
110,712.50
85,083.40
64,260.20
47,597.80
34,486.10
24,356.00
16,685.40
11,003.80
6,896.10
4,004.00
2,026.10
801.70
189.50

Mx
156,602.69
150,185.84
143,652.16
137,013.48
130,282.61
123,471.79
116,600.35
109,685.94
102,751.48
95,819.80
88,919.14
82,078.34
75,328.72
68,703.92
62,237.62
55,966.42
49,926.20
44,151.94
38,678.32
33,536.25
28,753.88
24,354.89
20,357.03
16,771.65
13,602.35
10,845.12
8,487.89
6,510.78
4,887.03
3,583.73
2,563.73
1,787.23
1,127.93
574.03
180.47

x
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99

Bibliography
[Gerber]

Life Insurance Mathematics, Hans U. Gerber, with exercises contributed by Samuel

H Cox, Sprinjer, (1997).

[Bowers]

Actuarial Mathematics, Newton L. Bowers Jr [et all], 2nd edition, Schaumburg III:
Society of Actuaries, (1997).

[Scott]

Life Contingencies, W.F. Scott, Document used to support the lecture syllabus at
Herriot-Watt university, (1996).

[Wiser]

Loss Reserving, R.F. Wiser; J.E. Cockley and A. Gardner, Foundations of Casualty
Actuarial Science (Fourth Edition), Casualty Actuarial Society, Chapter 5, pp. 197285, (2001).

[Patrik]

Reinsurance, G.S. Patrik, Foundations of Casualty Actuarial Science (Fourth Edition), Casualty Actuarial Society, Chapter 7, pp. 434-464, (2001).

[Fisher]

Loss Reserve Testing: A Report Year Approach, W.H. Fisher and J.T. Lange,
PCAS LX, pp. 189-207, (1973).

[Slud]

Actuarial Mathematics and Life-Table Statistics, Eric V. Slud, Chapter 6: Commutation Functions, Reserves & Select Mortality (PDF), (2001).

[Promislow] Fundamentals of Life Insurance Mathematics,David S. Promislow, John Wiley &

Sons Ltd, (2006).

ix