Académique Documents
Professionnel Documents
Culture Documents
Mathematics of Finance
Instructor:
Dr. Alexandre Karassev
COURSE OUTLINE
• Theory of Interest
1. Interest: the basic theory
2. Interest: basic applications
3. Annuities
4. Amortization and sinking funds
5. Bonds
• Life Insurance
6. Preparation for life contingencies
7. Life tables and population problems
8. Life annuities
9. Life insurance
Chapter 1
INTEREST: THE BASIC THEORY
• Accumulation Function
• Simple Interest
• Compound Interest
• Present Value and Discount
• Nominal Rate of Interest
• Force of Interest
1.1 ACCUMULATION FUNCTION
Definitions
• The amount of money initially invested is
called the principal.
• The amount of money principal has grown to
after the time period is called the
accumulated value and is denoted by
A(t) – amount function.
t ≥0 is measured in years (for the moment)
• Define Accumulation function a(t)=A(t)/A(0)
• A(0)=principal
• a(0)=1
• A(t)=A(0)∙a(t)
Natural assumptions on a(t)
• increasing
• (piece-wise) continuous
a(t) a(t)
a(t)
Note: a(0)=1
Definition of Interest
and
Rate of Interest
• Interest = Accumulated Value – Principal:
Interest = A(t) – A(0)
• Effective rate of interest i (per year):
a(1) a(0) A(1) A(0)
i a(1) 1
a(0) A(0)
(since A(t) A(0) a(t))
a(t) =1+it
1+i
•Amount function:
(0,1) A(t)=A(0) ∙a(t)=A(0)(1+it)
t
1
•Effective rate is i
•Effective rate in nth year:
i
in
1 i (n 1)
a(t)=1+it
Example (p. 5)
Jack borrows 1000 from the bank on
January 1, 1996 at a rate of 15% simple
interest per year. How much does he owe
on January 17, 1996?
Solution
A(0)=1000 i=0.15
A(t)=A(0)(1+it)=1000(1+0.15t)
t=?
How to calculate t in practice?
1 t 2
Example (p. 8)
Jack borrows 1000 at 15% a(t)=(1+i)t
compound interest.
a) How much does he owe after 2 years?
b) How much does he owe after 57 days, A(t)=A(0)(1+i)t
assuming compound interest between
integral durations?
c) How much does he owe after 1 year and 57 A(0)=1000, i=0.15
days, under the same assumptions as
in (b)?
d) How much does he owe after 1 year and 57
days, assuming linear interpolation A(t)=1000(1+0.15)t
between integral durations
e) In how many years will his principal have
accumulated to 2000?
1.4 PRESENT VALUE AND
DISCOUNT
Definition
The amount of money that will accumulate to
the principal over t years is called the
present value t years in the past.
(0,1)
t
If principal is not equal to 1…
Solution a(t)=(1+i)t
= 68,725.29
If simple interest is assumed…
• a (t) = 1 + it
• Let x denote the
present value of one
NOTE:
unit t years in the
past
In the last formula,
• x ∙a (t) = x (1 + it) =1 t is positive
• x = 1 / (1 + it) t>0
Thus, unlikely to the case of compound interest,
we cannot use the same formula for present
value and accumulated value in the case of
simple interest
1 1
1 / (1 + it) 1 / (1 - it)
t t
Discount
Alternatively:
Recall:
accumulated value after 1 year – principal a(1) – 1
i= principal
=
a(0)
In n th year…
a(n) a(n 1)
dn
a ( n)
Identities relating d to i and v
a (1) a (0) (1 i ) 1 i
d
a (1) 1 i 1 i
i d
d i Note: d < i
1 i 1 d
i (1 i ) i 1
1 d 1 v
1 i 1 i 1 i
Present and accumulated values in
terms of d:
1
1 d v
1 i
• Present value = principal * (1-d)t
• Accumulated value = principal * [1/(1-d)t]
If we consider positive and negative values of t then:
a(t) = (1 - d)-t
Examples (p. 13)
1. 1000 is to be accumulated by January 1,
1995 at a compound rate of discount of 9%
per year.
a) Find the present value on January 1, 1992
b) Find the value of i corresponding to d
2. Jane deposits 1000 in a bank account on
August 1, 1996. If the rate of compound
interest is 7% per year, find the value of
this deposit on August 1, 1994.
1.5 NOMINAL RATE OF INTEREST
Example (p. 13)
A man borrows 1000 at an effective rate
of interest of 2% per month. How much
does he owe after 3 years?
(m)
i
[1 i ]
1/ m
1
m
Examples (p. 15)
1. Find the accumulated value of 1000 after
three years at a rate of interest of 24 %
per year convertible monthly
1 d 1 1 i 1
n m
1
1 d
1 i i (m) m
d (n) n
1 1
m n
1
1 i (1 d )
Example
• Find the nominal rate of discount
convertible semiannualy which is
equivalent to a nominal rate of interest
of 12% convertible monthly
m n
i (m)
d (n)
1 1
m n
1.6 FORCE OF INTEREST
[(1 i ) ] a(t )
t
(1 i ) t
a (t )
a(t )
t
a (t )
Note:
1) in general case,
force of interest depends on t
2) it does not depend on t ↔ a(t)= (1+i)t !
Example (p. 19)
a(t ) (1 it ) i
t
a(t ) 1 it 1 it
How to find a(t)
if we are given by δt ?
a(t )
We have: t
a (t )
d d (m)
d ( m 1)
i ( m 1)
i (m)
i
• and formulas:
1 1 1 1 1
1 and (m)
d i d i (m) m
Chapter 2
INTEREST: BASIC APPLICATIONS
• Equation of Value
• Unknown Rate of Interest
• Time-Weighted Rate of Return
2.1 Equation of Value
• Four numbers:
• principal A(0)
• accumulated value A(t) = A(0) ∙ a(t)
• period of investment t (determine
effective period in order to compute t)
• rate of interest i
• Time diagram
• Bring all entries of the diagram to the
same point in time and set
equation of value
Examples
1. Find the accumulated value of 500 after 173 months
at a rate of compound interest of 14% convertible
quarterly (p. 30)
2. Alice borrows 500 from FF Company at a rate of
interest 18% per year convertible semi-annually.
Two years later she pays the company 3000. Three
years after that she pays the company 2000. How
much does she owe seven years after the loan is
taken out? (p. 31)
3. Eric deposits 8000 on Jan 1, 1995 and 6000 on
Jan 1, 1997 and withdraws 12000 on Jan 1, 2001.
Find the amount in Eric’s account on Jan 1, 2004 if
the rate of compound interest is 15% per year (p. 31)
More Examples…
4. (Unknown time) John borrows 3000
from FFC. Two years later he borrows
another 4000. Two years after that he
borrows an additional 5000. At what
point in time would a single loan of
1200 be equivalent if i = 0.18 ? (p. 32)
5. (Unknown rate of interest) Find the rate
of interest such that an amount of
money will triple itself over 15 years
(p. 32)
2.2 UNKNOWN RATE OF INTEREST
0 1 2 3 ….. n
an v v 2 v 3 v n
1 vn sn (1 i ) n an
an
i
(1 i ) n 1
sn
i
Examples (p. 46)
1. (Loan) John borrows 1500 and wishes to pay it
back with equal annual payments at the end of
each of the next ten years. If i = 17% determine the
size of annual payment
2. (Mortgage) Jacinta takes out 50,000 mortgage. If
the mortgage rate is 13% convertible semiannually,
what should her monthly payment be to pay off the
mortgage in 20 years?
3. (Investments) Eileen deposits 2000 in a bank
account every year for 11 years. If i = 6 % how
much has she accumulated at the time of the last
deposit?
One more example… (p. 47)
• Elroy takes out a loan of 5000 to buy a
car. No payments are due for the first 8
months, but beginning with the end of
9th month, he must make 60 equal
monthly payments. If i = 18%, find:
a) the amount of each payment
b) the amount of each payment if there
is no payment-free period
Annuity-immediate and Annuity-due
an| Annuity-immediate sn|
(payments made at the end)
1 1 1 1
0 1 2 3 ….. n
än|
Annuity-due ..
(payments made at the beginning) sn|
1 1 1 1
1 2 3 ….. n n+1
an an (1 i) 1 vn 1 vn 1 vn
an an (1 i) (1 i) i
i 1 i
d
sn sn (1 i) 1 vn (1 i ) n 1
an sn
d d
Example (p. 50)
1 1 1
0 1 2 3 …..
1
a v v v v ... v
2 3 n k
a
k 1
i
1 vn 1
a lim an lim
n n i i
1 1 i 1 1
a a (1 i ) (1 i ) a
i i d d
3.4 Unknown Time and Unknown
Rate of Interest
Examples – Unknown Time
1. A fund of 5000 is used to award scholarships of amount 500, one
per year, at the end of each year for as long as possible. If i=9%
find the number of scholarships which can be awarded, and the
amount left in the fund one year after the last scholarship has
been awarded
2. A trust fund is to be built by means of deposits of amount 5000 at
the end of each year, with a terminal deposit, as small as
possible, at the end of the final year. The purpose of this fund is to
establish monthly payments of amount 300 into perpetuity, the
first payment coming one month after the final deposit. If the rate
of interest is 12% per year convertible quarterly, find the number
of deposits required and the size of the final deposit
Example – Unknown Rate of Interest
(m) ( m)
a s
n| 1/m 1/m 1/m 1/m n|
1 v n
(1 i ) 1 n
a sn|
n|
3.6 Varying Annuities
• Arithmetic annuities
– increasing
– decreasing
• Arithmetic increasing perpetuities
Arithmetic annuity
• Definition: Arithmetic annuity is a series
of payments made at regular intervals
such that
– the first payment equals P
– payments increase by Q every year
• Thus payments form arithmetic
progression P, P+Q, P+2Q, …, P+(n-1)Q
Formulas
Series of n payments
k-th payment = P+ (k-1)Q
k=1,2,…, n accumulated value
present value S
A
P P+Q P+2Q P+(n-1)Q
0 1 2 3 ….. n
an nvn sn n
A Pan Q S Psn Q
i i
1) Increasing annuity with P = 1, Q = 1
Series of n payments
k-th payment = k accumulated value
present value
k=1,2,…, n
(Ia)n| (Is)n|
1 2 3 n
0 1 2 3 ….. n
an nvn sn n
We have: A Pan Q S Psn Q
i i
P=1 an nvn sn n
Q=1 ( Ia ) n an ( Is ) n sn
i i
2) Decreasing annuity with P = n, Q = -1
Series of n payments
k-th payment = n – k + 1 accumulated value
present value
k=1,2,…, n
(Da)n| (Ds)n|
n n-1 n-2 1
0 1 2 3 ….. n
an nvn sn n
We have: A Pan Q S Psn Q
i i
P=n an nvn sn n
Q = -1 ( Da) n nan ( Ds) n nsn
i i
Two Special Cases
n an n(1 i) sn
n
( Da ) n ( Ds) n
i i
Increasing perpetuity
present value k-th payment = k
continues forever
(Ia)∞|
1 2 3
0 1 2 3 …..
1 v n
an nv n nv n
1 1
( Ia ) 2
i i
Examples (p. 62 - 65)
1. Find the value, one year before the first payment, of a
series of payments 200, 500, 800,… if i = 8% and the
payments continue for 19 years
2. Find the present value of an increasing perpetuity
which pays 1 at the end of the 4th year, 2 at the end of
the 8th year, 3 at the end of the 12th year, and so on, if i
= 0.06
3. Find the value one year before the first payment of an
annuity where payments start at 1, increase by annual
amounts of 1 to a payment of n, and then decrease by
annual amounts of 1 to a final payment of 1
4. Show both algebraically and verbally that
(Da)n| = (n+1)an| - (Ia)n|
More examples: Geometric annuities
1. (Geometric annuity) An annuity provides for 15 annual
payments. The first is 200, each subsequent is 5% less
than the one preceding it. Find the accumulated value
of annuity at the time of the final payment if i = 0.9
2. (Inflation and real rate of interest) In settlement of a
lawsuit, the provincial court ordered Frank to make 8
annual payments to Fred. The firs payment of 10,000 is
made immediately, and future payments are to increase
according to an assumed rate of inflation of 0.04 per
year. Find the present value of these payments
assuming
i = .07
Chapter 4
AMORTIZATION AND
SINKING FUNDS
• Amortization
• Amortization Schedule
• Sinking Funds
• Yield Rates
4.1 Amortization
• Amortization method: repay a loan by means of
installment payments at periodic intervals
• This is an example of annuity
• We already know how to calculate the amount
of each payment
• Our goal: find the outstanding principal
• Two methods to compute it:
– prospective
– retrospective
Two Methods
• Prospective method:
outstanding principal at any point in time is equal
to the present value at that date of all remaining
payments
• Retrospective method:
outstanding principal is equal to the original
principal accumulated to that point in time minus
the accumulated value of all payments previously
made
• Note: of course, this two methods are equivalent.
However, sometimes one is more convenient than
the other
Examples (p. 75-76)
• (prospective) A loan is being paid off with
payments of 500 at the end of each year for the
next 10 years. If i = .14, find the outstanding
principal, P, immediately after the payment at the
end of year 6.
• (retrospective) A 7000 loan is being paid of with
payments of 1000 at the end of each year for as
long as necessary, plus a smaller payment one
year after the last regular payment. If i = 0.11
and the first payment is due one year after the
loan is taken out, find the outstanding principal,
P, immediately after the 9th payment.
One more example… (p. 77)
Example
A 1000 loan is repaid by annual payments of 150, plus a
smaller final payment. If i = .11, and the first payment is made
one year after the time of the loan, find the amount of principal
and interest contained in the third payment
General method
outstanding principal at t
present value = outst.
principal at 0 an-t|
an|
1 1 1 1 1
….. …..
0 1 2 t t+1 n
I. Take the entry from “Outs. Principal” of the previous row, multiply it by
i, and enter the result in “Interest”
II. “Payment” – “Interest” = “Principal Repaid”
III. “Outs. Principal” of prev. row - “Principal Repaid” = “Outs. Principal”
IV. Continue
Example (p. 80)
• A 1000 loan is repaid by annual payments of 150, plus a smaller
final payment. The first payment is made one year after the time
of the loan and i = .11. Construct an amortization schedule
interest
iL iL iL
…..
0 1 2 n
Loan L
• Lump-sum payment L is accumulated by periodic
deposits into a separate fund, called the sinking fund
• Sinking fund has rate of interest j usually different from
(and usually smaller than) i
• If (and only if) j is greater than i then sinking fund method
is better (for borrower) than amortization method
Examples (p. 82)
• John borrows 15,000 at 17% effective annually. He agrees to
pay the interest annually, and to build up a sinking fund which
will repay the loan at the end of 15 years. If the sinking fund
accumulates at 12% annually, find
– the annual interest payment
– the annual sinking fund payment
– his total annual outlay
– the annual amortization payment which would pay off this
loan in 15 years
• Helen wishes to borrow 7000. One lender offers a loan in
which the principal is to be repaid at the end of 5 years. In the
mean-time, interest at 11% effective is to be paid on the loan,
and the borrower is to accumulate her principal by means of
annual payments into a sinking fund earning 8% effective.
Another lender offers a loan for 5 years in which the
amortization method will be used to repay the loan, with the
first of the annual payments due in one year. Find the rate of
interest, i, that this second lender can charge in order that
Helen finds the two offers equally attractive.
4.4 Yield Rates
• Investor:
– makes a number of payments at various points in
time
– receives other payments in return
• There is (at least) one rate of interest for which the
value of his expenditures will equal the value of the
payments he received (at the same point in time)
• This rate is called the yield rate he earns on his
investment
• In other words, yield rate is the rate of interest which
makes two sequences of payments equivalent
• Note: to determine yield rate of a certain investor, we
should consider only payments made directly to, or
directly by, this investor
Examples (p. 83 – p. 85)
• Herman borrows 5000 from George and
agrees to repay it in 10 equal annual
instalments at 11%, with first payment
due in one year. After 4 years, George
sells his right to future payments to Ruth,
at a price which will yield Ruth 12%
effective
– Find the price Ruth pays.
– Find George’s overall yield rate.
• At what yield rate are payments of 500
now and 600 at the end of 2 years
equivalent to a payment of 1098 at the
end of 1 year?
• Henri buys a 15-year annuity with a
present value of 5000 at 9% at a price
which will allow him to accumulate a 15-
year sinking fund to replace his capital at
7%, and will produce an overall yield rate
of 10%. Find the purchase price of the
annuity.
Chapter 5
BONDS
• Price of a Bond
• Book Value
• Bond Amortization Schedule
• Other Topics
5.1 Price of a Bond
• Bonds
• certificates issued by a corporation or government
• are sold to investors
• in return, the borrower (i.e. corporation or government) agrees:
– to pay interest at a specified rate (the coupon rate) until a specified
date (the maturity date)
– and, at that time, to pay a fixed sum (the redemption value)
• Usually:
– the coupon rate is a nominal rate convertible semiannually and is
applied to the face (or par) value stated on the front of the bond
– the face and redemption values are equal (not always)
• Thus we have:
– regular interest payments
– lump-sum payment at the end
Example of a bond
• Face amount = 500
• Redemption value = 500
• Redeemable in 10 years with semiannual coupons
at rate 11%, compounded semiannually
• Then in return investor receives:
• 20 half-yearly payments of (.055)(500) = 27.50 interest
• a lump-sum payment of 500 at the end of the 10 years
Notations
• F = the face value (or the par value)
• r = the coupon rate per interest period (we assume
that the quoted rate will be a nominal rate 2r
convertible semiannually)
• Note: the amount of each interest payment (coupon)
is Fr
• C = the redemption value (often C = F, i.e. bond
“redeemable at par”)
• i = the yield rate per interest period
• n = the number of interest periods until the
redemption date (maturity date)
• P = the purchase price of a bond to obtain yield rate i
redemption value C
coupon
(interest)
Note: time is
Fr Fr Fr measured in
…..
half-years
0 1 2 n
purchase price P
Example
Find the book value exactly 2 months after the 14th
coupon is paid of a 10-year 1,000 par-value bond
with semiannual coupons, if r =.05 and the yield rate
is 12% convertible semiannually.
Alternative approach
• Since Bt+1 = Bt (1+i) – Fr we can view Bt (1+i) as the book value just
before next (i.e. (t+1)th) coupon is paid
• Book value calculated using simple interest between coupon dates
is called the flat price of a bond
• Using linear interpolation between Bt+1 and Bt we obtain the market
price (or the amortized value) of the bond
• Clearly market price ≤ flat price at any given moment
(1+i) Bt
Fr
Bt Bt+1
t t+1
Example (p. 98)
Find the market price exactly 2 months
after the 14th coupon is paid of a
10-year 1,000 par-value bond with
semiannual coupons, if r =.05 and the
yield rate is 12% convertible
semiannually.
5.3 Bond Amortization Schedule
• Goal: trace changes of the book value
• Bond amortization schedule – table, containing the following
columns:
Time Coupon Interest Principal Book Value
– time adjustment
– coupon 0 1037.17
– interest
1 40 31.12 8.88 1028.29
– principal adjustment
2 40 30.85 9.15 1019.14
– book value 3 40 30.57 9.43 1009.71
4 40 30.29 9.71 1000.00
Example
1000 par value two-year bond which pays interest at 8%
convertible semiannually; yield rate is 6% convertible
semiannually
Algorithm
• Book value at time t is Bt
• Amount of coupon at time t+1 is Fr
• The amount of interest contained in this coupon is iBt
• Fr – iBt represents the change in the book value
between these dates
possible
redemption
• Find
– the probability that a newborn will live to age 3
– the probability that a newborn will die between
age 1 and age 3
• Find an expression for each of the following:
– the probability that an 18-year-old lives to age 65
– the probability that a 25-year-old dies between ages
40 and 45
– the probability that a 25-year-old does not die
between ages 40 and 45
– the probability that a 30-year-old dies before age 60
• There are four persons, now aged 40, 50, 60 and 70.
Find an expression for the probability that both the 40-
year-old and the 50-year-old will die within the five-year
period starting ten years from now, but neither the 60-
year-old nor the 70-year-old will die during that five-year
period
Note:
• If we are already given by probabilities qx and
starting population l0 we can construct the
whole life table step-by-step since dx = qx lx
and lx+1 = lx - dx
Example
Given the following probabilities of deaths
q q q q
0 = .40, 1 = .20, 2 = .30, 3 = .70, q4 = 1 and
l
starting with 0 = 100 construct a life table
More notations…
• qx = dx / lx – probability that x – year-old will not
survive to age x + 1
• px = 1- qx – probability that x – year-old will survive to
age x + 1
• Note: qx = (lx – lx+1) / lx and px = lx+1 / lx
• nqx – probability that x – year-old will not survive to age
x+n
• npx = 1- nqx – probability that x – year-old will survive to
age x + n
• Note: nqx = (lx – lx+n) / lx and n px = lx+n / lx
• Formulas:
lx – lx+n = dx + dx+1 + …+ dx+n
n+mpx = mpx ∙ npx+m
What is mPx when m is not integer?
l x td x l x t (l x l x 1 ) (1 t )l x tlx 1
t px
lx lx lx
Examples (p. 132 – p. 133)
• 30% of those who die between ages 25 and 75 die
before age 50. The probability of a person aged 25 dying
before age 50 is 20%. Find 25P50
• Using the following life table and assuming a uniform
distribution of deaths over each year, find:
– 4/3P1
– The probability that a newborn will survive the first year but die in
the first two months thereafter
Age lx dx 1000 qx
0 1,000,000 1580 1.58
1 998,420 680 .68
2 997,740 485 .49
3 997,255 435 .44
7.3 Analytic Formulas for lx
• Properties of lx
• de Moivre’s Law
• Force of mortality
• Gompertz and Makeham formulas
Properties of lx and S(x) = lx / l0
• Decreasing
• Vanishes after terminal age of the
population ω
• Decreases more rapidly near 0 and
ω-∆ (population-dependant, e.g. 65-70)
lx
l0
ω-∆ ω
de Moivre’s Law
• First approximation – linear
x
l x a1
• Derivative is constant
• Hence, the function does not satisfy the
last property
• However, is reasonable in the middle
range of ages
Examples
• Find probabilities of survival tPx and of
dying tqx for de Moivre’s law
• Let
lx x
S ( x) S ( x x)
P( x X x x | X x)
S ( x)
• Dividing by ∆x and letting ∆x → 0 we get the force of mortality, that can
be interpreted as conditional density of dying at age x given that
person survived to age x
S ( x) S ( x x)
lim
P( x X x x | X x) x0 x
x lim
x 0 x S ( x)
S ( x x) S ( x)
lim
x 0 x
S 'x
ln l x
l 'x d
S ( x) Sx lx dx
Force of mortality
• Unconditional density of dying at age x is
μx Sx = - S’x
(recall: Sx is the probability of surviving to age x)
• Indeed, if a random variable X denotes age, then
Sx = P(X ≥ x ) = 1 – P(X < x) = 1 – F(x)
and therefore
-S’x = F’(x), the density of dying
x ln l x
d x
lx r dr
dx S ( x) e 0
x l0
dr ln l
0
r x ln l0
Gompertz formula (age-dependant)
x Bc x
x x
r dr Bc r dr
l x l0 S ( x ) l0 e 0
l0 e 0
x
Bc ln c B ln c c
l0 e l0 e l0 g
x
cx
l x l0 g , 0 g 1
cx
Makeham formula
(introduces age-independent term)
x A Bc x
x x
r dr A Bc r dr
l x l0 S ( x ) l0 e 0
l0 e 0
e
x
( Ax Bc ln c ) Ax B ln c c
l0 e l0 e l0 s g
x
x cx
l x l0 s g , 0 g 1
x cx
Exercise
• Check whether Gompertz and
Makeham formulas satisfy properties of
survival function. Which requirements
should we impose on the constants in
theses formulas (A, B, c, g, etc.)?
7.4 The Stationary Population
• Assume that in every given year (or, more precisely, in any
given 12-months period) the number of births and deaths is
the same and is equal to l0
• Then after a period of time the total population will remain
stationary and the age distribution will remain constant
• px and qx are defined as before
• lx denotes the number of people who reach their xth birthday
during any given year
• dx = qx lx represent the number of people who die before
reaching age x+1
• Also, dx represent the number of people who die during any
given year between ages x and x + 1
• Similarly lx – lx + n represent the number of people who die
during any given year between ages x and x + n
Number of people aged x
• Let Lx denote the number of people aged x
(last birthday) at any given moment
• Note: Lx ≠ lx
• More precisely:
Tx l x t dt
0
Example (p. 139)
• An organization has a constant total membership. Each
year 500 new members join at exact age 20.
20% leave after 10 years, 10% of those remaining
leave after 20 years, and the rest retire at age 65.
Express each of the following in terms of life table
functions:
– The number who leave at age 40 each year
– The size of the membership
– The number of retired people alive at any given time
– The number of members who die each year
7.5 Expectation of Life
• What is the average future life time ex of
a person aged x now?
• The answer is given by expected value
(or mathematical expectation) and is
called the curtate expectation:
ex t (t p x t 1 p x ) 1(1 p x 2 p x ) 2( 2 p x 3 p x ) 3( 3 p x 4 p x )
t 1
px 2 px 3 px t px
t 1
Complete Expectation
l x t
(1) ex t p x (2) Tx l x t dt (3) t px
t 1 0
lx
Tx
(2)&(3)&(4) imply: e x
lx
1
(since Tx 2 lx lx i )
1
Approximation: e x
ex
i 1
2
Remarks
Tx
e x
Tx l x e x
lx
Thus Tx can be interpreted
as the total number of years of future life
of those who form group lx
1 1 1
ax vpx v 2
2 px v 3 px v
3 n
n p x v t p x
t
t 1
Temporary life annuity
Series of n payments of 1 unit
(contingent on survival)
present value
last payment
ax:n|
1 1 1
n
ax:n| vpx v 2
2 px v 3 px v
3 n
n p x v t p x
t
t 1
n - years deferred life annuity
Series of payments of 1 unit as long as individual is alive
in which the first payment is at x + n + 1
n|ax 1 1
n2 n 3 n t
n | a x v n1
p
n 1 x v p
n2 x v p
n 3 x v n t p x
v n t n t p x s px
v s
t 1 s n 1
| a x a x a x:n|
Note: n
äx Life annuities-due
1 1 1 1
ax 1 ax 1 v t t px
x x+1 x+2 ….. x+n … t 1
1 1 1 1 n 1
ax:n| 1 ax:n1| 1 vt t px
x x+1 x+2 ….. x + n-1 x+n t 1
px 2px n-1px
n|äx
1 1 1
n | ax n 1 | a x
x x+1 x+2 … x+n x + n +1 x + n + 2 …
npx n+1px n+2px
Note
ax:n| 1 ax:n1| but ax:n| (1 i)ax:n|
n lxn xn
v lxn
n Ex v n px v
n
x
lx v lx
• Denote Dx = v xlx
• Then nEx = Dx+n / Dx
Life annuity and commutation function
a x v t p x t E x
t
E = Dx+n / Dx
Since n x
t 1 t 1 we have
ax
Dx t
1
Dx1 Dx2 Dx3
t 1 Dx Dx
N x Dx t v x t l x t
Define commutation function
Nx as follows: t 0 t 0
N x 1 Note:
Then: ax
Dx Dx N x 1 N x
Identities for other types of life annuities
we have N x 1 N x n1
sx:n|
Dx n
similarly for temporary life annuity-due:
a(m)x
1/m 1/m 1/m 1/m
1 1/ m
a v 1/ m p x v 2 / m 2 / m p x v i j / m i j / m p x
( m)
x
m
1 1/ m l x 1/ m 2 / m lx2 / m
l
i j / m x i j / m
v v v
m lx lx lx
1 v x 1/ ml x 1/ m v x 2 / ml x 2 / m
x i j / m
v l x i j / m
x
x
m v l x v lx v xl x
1 Dx 1/ m Dx 2 / m Dx i j / m
m Dx Dx Dx
Annuity payable every 1/m part of the year
a(m)x
1/m 1/m 1/m 1/m
1 Dx 1/ m Dx 2 / m Dx i j / m
a (m)
x
m Dx Dx Dx
1 Dx 1/ m Dx 2 / m Dx ( m 1) / m Dx 1
mDx Dx 11/ m Dx 1 2 / m Dx 1 ( m 1) / m Dx 2
1 m m 1 m
Dx 1 j / m Dx 1 j / m Dx i j / m
mDx j 1 j 1 mDx i 0 j 1
Using linear interpolation for Dx+i+j/m
Dx i j / m Dx i mj Dx i 1 Dx i
m m
D x i j / m Dx i mj Dx i 1 Dx i
j 1 j 1
m
m(m 1)
mDx i Dx i 1 Dx i mj mDx i Dx i 1 Dx i
j 1 2m
(m 1)
mDx i Dx i 1 Dx i
2
m
D
i 0 j 1
x i j / m
(m 1) (m 1) (m 1)
mDx Dx 1 Dx mDx 1 Dx 2 Dx 1 mDx 2 Dx 3 Dx 2
2 2 2
(m 1)
mDx 1 Dx 2 mDx Dx 1 Dx Dx 2 Dx1 Dx3 Dx 2
2
m 1
mN x 1 Dx
2
Using linear interpolation for Dx+i+j/m
m
m 1
D
i 0 j 1
x i j / m mN x 1
2
Dx
1 m 1 N x 1 m 1 m 1
a ( m)
x mN x 1 2 Dx D 2m a x 2m
mDx x
m 1
a (m)
x ax
2m
Continuous life annuity
m 1 1
a x lim a ( m)
x lim ax ax
m m
2m 2
a x lim a x( m )
m
1 1/ m
lim v 1/ m p x v 2 / m 2 / m p x v i j / m i j / m p x v t t p x dt
m m
0
1
a x ax a x v t p x dt
t
2 0
Annuity payable m-thly, deferred
n|a(m)x a(m)x+n
1/m 1/m 1/m 1/m
age x
… x+n x+ x+ ….. x +n+ x + n+1 …..
n+1/m n+2/m (m-1)/m
Dx n ( m )
na (m)
x v n
n px a (m)
xn axn
Dx
Dx n m 1 Dx n m 1
xn
a n a x
Dx 2m Dx 2 m
Dx n m 1
na (m)
x n ax
Dx 2m
Annuity payable m-thly, temporary
a(m)x:n|
1/m 1/m 1/m 1/m
m 1 Dx n m 1
a na ax n a x
(m) (m) (m)
a x:n | x x
2m Dx 2m
Dx n m 1 Dx n m 1
a x n a x 1 a x:n | 1
Dx 2m Dx 2m
Dx n m 1
a (m)
x:n | a x:n | 1
Dx 2 m
8.4 Varying Life Annuities
• Arithmetic increasing annuities
t 1 t 2 t 3
N x t 1
t | ax
t 0 t 0 Dx
S x N x t Ia x
S x 1
t 0 Dx
Arithmetic increasing annuity, temporary
(Ia)x:n|
1 2 n
S x 1 S x n1 nN x n1
Ia x:n|
Dx
Arithmetic decreasing annuity, temporary
(Da)x:n|
n n-1 1
(Da)x:n|
n n-1 1
• Two annuities are of equal value to Jim, aged 25. The first is
guaranteed and pays him 4000 per year for 10 years, with
the first payment in 6 years. The second is a life annuity with
the first payment of X in one year. Subsequent payments are
annual, increasing by .0187 each year.
If i = .09, and from the 7% -interest table, N26=930 and D25=
30, find X.
8.5 Annual Premiums and
Premium Reserves
• Paying for deferred life annuity with a series of payments
instead of a single payment
• Premium reserve is an analog of outstanding principal
• Premiums often include additional expenses and
administrative costs
• In such cases, the total payment is called
gross premium
• Loading = gross premium – net premium
• General approach: actuarial present values of two
sequences of payments must be the same (equation of
value)
Annual premiums P = tP(n|äx)
P P P 1 1 1
N xn
N xn
n ax t P( n a x )
P
Dx
N xn
ax:t | N x N x t N x N x t N x N x t
Dx
Example
• Arabella, aged 25, purchases a deferred life annuity of 500
per month, with the first benefit coming in exactly 20 years.
She intends to pay for this annuity with a series of annual
payments at the beginning of each year for the next 20
years. Find her net annual premium if D25 = 9000, D 45 =
5000, ä25 = 15 and ä45 = 11.5
Reserves
P P P P 1 1 1
• Reserve
n V ( |ä ) = PV of all future benefits – PV of all future premiums
t n x
N x t
ax t , tn
Dx t
tV ( n a x )
n
N P( N x t N x n )
n t | ax t Pax t:n t| x n , tn
Dx t
Loading and Gross premiums
• Arabella, aged 25, purchases a deferred life annuity of 500
per month, with the first benefit coming in exactly 20 years.
She intends to pay for this annuity with a series of annual
payments at the beginning of each year for the next 20
years. Assume that 50% of her first premium is required for
initial underwriting expenses, and 10% of all subsequent
premiums are needed for administration costs. In addition,
100 must be paid for issue expenses. Find Arabella’s annual
gross premium, if D25 = 9000, D 45 = 5000, ä25 = 15,
and ä45 = 11.5
Chapter 9
LIFE INSURANCE
• Basic Concepts
• Commutation Functions and Basic Identities
• Insurance Payable at The Moment of Death
• Varying Insurance
• Annual Premiums and Premium Reserves
9.1 Basic Concepts
• Benefits are paid upon the death of the insured
• Types of insurance
– Term insurance
– Deferred insurance
– Endowment insurance
Whole life policy
• Benefit (the face value) is paid to the beneficiary
at the end of the year of death of inured person
Ax
1
Ax t px qx t v t 1
t 0
Ax
1
n 1
A 1
x:n | t p x q x t v t 1
t 0
Deferred insurance
• Does not come into force until age x+n
Ax A n | Ax
1
x:n | n | Ax Ax A 1
x:n |
n-year endowment insurance
• Benefit (the face value) is paid to the beneficiary at the end
of the year of death of inured person, if the death occurs
within n years
• If the insured is still alive at the age x+n, the face value is
paid at that time
Exercise:
Ax:n | A n Ex
1
x:n | A 1
x:n | Ax Ax:n |
Examples
• Rose is 38 years old. She wishes to purchase a life
insurance policy which will pay her estate 50,000 at the end
of the year of her death. If i=.12, find an expression for the
actuarial present value of this benefit and compute it,
assuming px = .94 for all x.
Dx n
Dx v lx x
n Ex
Dx
N x Dx t
t 0
Commutation Functions
• Recall: Ax t px qx t v t 1
t 0
• So we need:
x t 1
t 1 l xt d xt t 1 d x t t 1 d xt v
t p x q x t v v v x
l x l x t lx lxv
Cx d x v x 1 t 1 C x t
t p x q x t v
Dx
Whole life insurance
C x t 1
Ax t p x q x t v
t 1
C x t
t 0 t 0 Dx Dx t 0
M x C x t Ax
Mx
t 0 Dx
Term insurance
n 1
1
A
x:n | t p x q x t v t 1
t 0
n 1
C x t C x t C x t M x M x n
A1x:n |
t 0 Dx t 0 Dx t n Dx Dx Dx
M x M xn
1
A
x:n |
Dx
n-year endowment insurance
Ax:n | A n Ex
1
x:n |
M x M x n Dx n M x M x n Dx n
Ax:n |
Dx Dx Dx
Note
• We can represent insurance premiums
in terms of actuarial present values of
annuities, e.g. Ax = 1 – d äx
• Hence they also can be found using
“old” commutation functions
Examples
• Juan, aged 40, purchases an insurance policy paying
50,000 if death occurs within the next 20 years, 100,000 if
death occurs between ages 60 and 70, and 30,000 if death
occurs after that. Find the net single premium for this policy
in terms of commutation functions.
1 v1/ m
l '
x s ( 0 ,1) / m v 2/ m
l x s ( 0, 2 ) / m
'
i j / m '
ml x v l x s (i , j ) / m
1 m i j / m '
ml x i 0 j 1
v l x s (i , j ) / m
Taking the limit as m→∞ we get:
m
1
Ax lim A
m
(m)
x lim
m ml
v i j / m
i 0 j 1
l x s (i , j ) / m
'
x
'
l l l '
0 x t
0 lx lxt
x t
x t
dt v t t p x x t dt
t t
v dt v
lx 0
Premium for insurance payable at the moment of
death
• Term policy: n
A : n | v t t p x x t dt
0
Examples
• Find the net single premium for a 100,000 life insurance
policy, payable at the moment of death, purchased by a
person aged 30 if i = .06 and tp30 = (.98)t for all t
Āx = 1 – δ āx
• Approximate formula:
Āx ≈ (i/δ) Ax
A
lx
1 1/ m
v (l x l x 1/ m ) v 2 / m (l x 1/ m l x 2 / m ) v i j / m (l x i ( j 1) / m l x i j / m )