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ACTL1101 Wk 9-12

Johnny Wong

Wk 9 Life Insurance
Types of policies:
Endowment Always pays, whether at death before a certain
term, or at survival to term
Pure endowment Only pays if survival to specified term
Term Insurance Pays on death within specified term
Life Annuities Regular payment until death

Look in International Actuarial Notation tab of orange book

Endowment = pure endowment + Term insurance

Notation used to calculate stuf

S = sum paid as benefit
X = age at death
T(x) = a continuous r.v. denoting future lifetime
Normal actuarial notation:
px = probability of a life aged x living another year
qx = probability of a life aged x dying within a year

PV of claim payments for Term

If death occurs between k and k+1 years. The benefit
will be paid at the end, so we need to discount k+1
Expected PV of payments
Consider the customer dies after k years:
This has a probability kpxqx = k|qx
Payment will be made k+1 periods from now so need to
discount by vk+1
Benefit will have payment of S.
Thus the expected PV of a term insurance policy is

EPV of premiums
Suppose there are annual premium payments of P
Premiums are only paid if the person is alive (duh)
They are paid upfront (in case they die during the year)
Thus we have:
Probability of paying premium = probability they are still alive
= kpx
We need to discount by vk

Principle of equivalence
Equate EPV of premiums with EPV of benefit payments
In a perfect world, the company will make no profit or
Generally though, the principle of equivalence is not
adhered to:
Companies want to profit
Companies need leeway for unfavourable events (solvency)

Probability of ruin
Often you will be given information about an insurance
companies policies and asked to compute how much
reserves they have to maintain a low risk of insolvency.
Almost always:
Use binomial distribution to find mean and variance
Use CLT to approximate to normal
Use orange book to find normal probabilities

S = 100,000
Benefit if claim
Number of policies
Probability of claim
Premium income
X = number of claims
X ~ Bin(10,000 0.00489)
C = Capital required

X ~ Bin(10,000, 0.00489)
E[X] = 10,000x0.00489 = 48.8
Var[X] = 10,000 x 0.00489 x (1-0.00489) = 48.66
We want:
Pr(100,000X > 10,000x500 + K) = 0.001


Looking at pg 162 of orange book, you will see that
Pr(z > 3.0902)=0.001
The company needs at least 2,045,622 for them to have
less than 0.001 chance of insolvency

Valuation of Policy Liabilities

EPV of future claims and expenses EPV of future
Basically, your expected outflows minus expected

If your Policy Liability is negative, then the policy is

essentially an asset, you are expected to make more
money than you lose.

Recurrence relation
At time t, a premium P will be received by the company
At time t, two things can happen in the space of one
Person dies and you pay the Benefit, after that there are no
more premiums of benefits. This happens with probability qx+t
Person survives and you still have policy liability at t+1, this
has a probability of px+t

Thus the recurrence relation is

Calculating Policy Liability

If the premiums were calculated on the principle of
equivalence, policy liability will be 0 by definition
At the end of the term, there is nothing left to pay or
receive, s othe policy liability is 0
If using the recurrence relation, start at the end because
its easier to compute.

Investment policy
In insurance, your inflows and outflows are very
mismatched. Customers pay early on, but you have to
pay them back later (when they claim)
You cant just leave the money sitting around because
you can invest and make more money.
However, you cant invest too much money because
then you wont be able to pay the customer back when
they claim.
Thus you must have a balance of when and how much
to invest in.

Wk 10 - Non life insurance


Log normal

All distributions are in your orange book

Most often modelled by Poisson distribution:

Poisson distribution
Why is Poisson favoured over say Binomial?
One reason is that Poisson doesnt have a limit on how
many events can occur over a given time period.
Can be Thinned
If you change the time period, you can change the
parameter by the same scale
So if something is Poi(2) over one year, it is Poi(1) over
half a year

Related to frequency
Exponential distribution models the time until the next
Poisson event
If an even has frequency modelled by Poisson(), then
the time between events is exponentially distributed
with parameter

e.g. let X be the number of car

accidents in a year
X~ Poi(0.5)
Find the probability of having a car accident over the
next 6 months
Method 1 (probably easier)
Let T = time until next accident
T ~ Exp(0.5)
Probability of accident over next six months = Pr (T <

Method 2 (uses thinning)

If X = number of accidents over 6 months,
X ~ Poi (0.25)
Probability of accident over next 6 months = Pr (X > 0)
=1 - Pr(X = 0)

See how both methods give the same answer?

Modelling of severity
Given a claim has occurred, how much is the customer
Often modelled by log normal or Weibull

Log Normal

Note how and are NOT the mean and variance

If you log a log normal, it becomes normal

That is, suppose
X ~ LN( ,)
Ln(X) ~ N(, )
Alternatively, if
X ~ N(, )

We will use this property more later in superannuation

Note that in the orange book, the mean and variance
arent given to you, youll have to compute them from
the Moments

That is, if you want to find the mean, you want E[X1] so
you set k=1
If you want variance, Var[X] = E[X2]-(E[X])2


The () is the Gamma function, and is also in the orange

book (pg 5)
You probably wont get asked about this function as
much as log normal because its harder to find the
mean and variance etc.

Premium rating
Lets consider a simple one year insurance policy.
End of policy
Benefits are

Start of

There are 2 random variables: the NUMBER of accidents

The SIZE of the loss (X)

Assuming X
are iid

Very intuitive: Expected aggregate loss equals expected number of claims

multiplied by the expected loss per claim
But still important to understand the principles behind each step

Always assume principle of equivalence unless otherwise stated.

Remember to discount

Unearned premiums
Same logic as unearned revenue in ACCT
For insurance companies, revenue=premiums
When premiums are paid, they cover a certain time
period (usually 1 year)
Start of



End of


For January: By the time 31 December, there will only be

half a month left unearned, thus
For April: At 31 December, there will be 3 and a half
months left unearned, thus

Earned premiums
If you look at this equation long enough, it makes sense

Outstanding claims
When a customer makes a claim, it is not paid
immediately, there is a delay between the accident and
the claim settlement
Up until now, we have assumed that a claim during the
year will be settled (benefits paid) at the end of the
In general insurance, the delays can be longer.
When a claim needs to be settled, it is called an
outstanding claim.
It is important to accurately forecast claims so the
insurance companies know how much to keep in their

Run-of triangle - dont need to

know how to calculate estimates.

Profit and Loss

Everything is done on ACCRUAL assumption

If you think long enough, these make sense. They are

diferent versions of each other.

Customer pays the deductible, insurance company pays
the rest.
E.g. if your claim is $300 and the excess is $200, you
pay $200 and the insurance companies pays $100
Prevents people doing stupid stuf just to get money.
If S is the aggregate loss, and D is the deductible:

Finding E[Y]
The amount
insurance company
will pay given loss is

over all S
that would
that the loss

Lower limit of
integral is D because
below the
deductible, the
company pays

Defined benefits
Defined contributions
Salary growth
Retirement, injury, death

Salary scales
As you work, your salary will increase:
Response to inflation
Industry awards

Index of expected increase is known as the salary scale

Sx = Salary at age x
sx = Salary scale

Inflation rate denoted by f p.a.

compounding salary
growth rate

Salary growth

This assumes that the growth rate is the same each

year, in reality they are probably diferent.

Distribution of Salary growth

We can assume the growths rate to be a random
In this course,

Sum of Normal random variables are normally distributed with

mean equal to sum of the means and variance equal to the sum
of the variances

DONT memorise these, they arent that hard to derive.
From here, you can work out the expected value and variance of
the growth rate.
(Using orange book to find the mean and variance of log-normally
distributed random variables)

Defined benefits

Salary at 65 is $250,000
And you have been with the fund for 30 years, (n=30)
Benefit at retirement will be

EPV of future benefits

Probability of surviving to retirement
x expected Salary at retirement
= Expected benefit at retirement
x discounting factor

Probability of surviving will t(ap)x

We have already talked about how to find expected
Salary at retirement
Discounting factor is as usual

EPV of future contributions

Contributions are usually a percentage of salary.
Expected contribution at age x+t =
Expected Salary at age x+t
x Probability of survival to age x+t
x Percentage to pay to super
x discount to present

EPV of all future contributions

Simply find the EPV of a contribution at a specific age
and sum up for all ages


Dont do illegal stuf

Just dont

Exam tips
Break down questions
Use your orange book (remember, unannotated, no
Know your orange book
Understand, dont memorise
MC can be done quicker, maybe leave towards the end?
Linear interpolation should be used when calculating
normal probabilities.
i.e. (1.013)=0.7x (1.01)+0.3x (1.02)

Good Luck!