ANUx Introduction to Actuarial Science

Lesson 7

Modelling a Life Insurance Company 2

In Lesson 6, we looked at the investigation of the financial condition of a life insurance company
through the use of simulations. In this Lesson we will continue to do this, whilst looking at further
modifications to the structure of the insurer that we considered in Lesson 6. You are encouraged to
refer back to the structure of the insurer that we considered in Lesson 6 as a starting point to the
material for this Lesson.
Before we look at these modifications, however, we wish to look further at the concept of reserves.
In Lesson 6 we projected the values of the Actual Reserves over the simulation process. In this
Lesson we will look at how an actuary measures the sufficiency of the Actual Reserves over time
after the product has been sold.

Expected Reserves
As we saw in Lesson 6, in a whole of life policy the premiums are much higher than the claim
amounts in the early years of the policy, resulting in the accumulation of Actual Reserves over the
duration of the policy. But how much should these reserves be? An actuary is very interested in the
answer to this question, as an insurer that does not hold sufficient reserves will be at risk of financial
collapse towards the end of the policy when claims tend to exceed premiums.
In order to determine an appropriate level for the reserves, we need to return to the techniques we
learned in Lesson 5 that we used to calculate the premium for a life insurance policy.
Recall that we set the risk premium by equating the expected present value (EPV) of the incomes
and outgoes of the insurer:

EPV income

EPV outgo

We can rewrite this as follows:

EPV income

EPV outgo

Essentially what this is telling us is that the EPV of all cash flows of the insurer is zero. Remember
that we have previously stated that we can calculate the value or EPV of a series of cash flows at any
time by knowing the value or EPV at one time and discounting or accumulating accordingly.

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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

The most obvious result of this is that, if the EPV of all cash flows at the commencement of the
policy is zero, then we would expect the Actual Reserves to be zero at the conclusion of the policy
when no further cash flows remain. (That the Actual Reserves are not zero is because the
experience of the insurer is stochastic and doesnt match the assumptions made in calculating the
EPVs exactly). But we can also use this result to calculate the Expected Reserves (also known as the
actuarial reserves or the required reserves) at a point in time during the policy. Lets place this on a
timeline for a policyholder who took up a whole of life policy at age 40:

Year

s+1
P

Premium
Probability

p40
C

Probability

1 40 s

n-1

Claim

n s 1

p40

n s 2|1 40 s

n s 1|1 40 s

We would like to calculate the expected reserves for a single policyholder who is still alive at Year s .
Note that all cash flows up until, and including, that year have already happened and so they are not
placed on the timeline. In addition, since the policyholder is alive at Year s (there would be no
further cash flows if they were dead) then all probabilities are expressed in terms of them being
alive at age 40 s .
So what should the expected reserves be at Year s ? We still wish to work with the equation
EPV income = EPV outgo , but we now have an additional cash flow that exists at Year s ; the
Expected Reserves at Year s . This has been built up by the premium and claim cash flows that have
accumulated before Year s . Hence we can re-express this equation at Year s as follows:

Expected Reserves at Year s

EPV income at Year s

EPV outgo at Year s

We would like to solve this equation for the Expected Reserves as thus rearrange it as:

Expected Reserves at Year s

EPV outgo at Year s

EPV income at Year s

This equation works for any form of life insurance product. Using the whole of life example above,
we can calculate the Expected Reserves at Year s as follows:

Expected Reserves at Year s

n 1

t s 1|1 40 s

t s 1

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P
t s 1

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t s

p40

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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Note that, like in Lesson 5, we have deliberately not put a border around this formula because the
EPV of the cash flows will be dependent upon the exact structure of the product.

Practice Question 7.1

Using a spreadsheet tool, calculate the Expected Reserves at Year 20 for a single alive policyholder
who purchased a whole of life product at age 40 which requires a premium equal to the premium
calculated in Assessment Question 6.2 and provides a claim of $400,000 at the end of the year of
death of the policyholder. Assume an interest rate of 6% per annum (i.e. the mean interest rate in
the scenario) and that mortality rates follow the Australian Life Tables 2010-12 (female rates) and
available for download in the relevant Courseware of the edX version of the course.

Assessment Question 7.1

For the same product and assumptions as Practice Question 7.1, use a spreadsheet tool to calculate
the Expected Reserves at Year 30 for a single alive policyholder.

Practice Question 7.2

For the insurer scenario outlined in Lesson 6 and the questions above, use a spreadsheet tool to
calculate the probability that the Actual Reserves will be greater than the Expected Reserves at Year
20.
Note that the Expected Reserves for all policyholders is simply the Expected Reserves for a single
policyholder multiplied by the number of policyholders alive at that point in time.

Adam Butt
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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Extension Question 7.1 (Hard)

If the premium is calculated as a risk premium (see Lesson 5), an alternative approach to calculating
Expected Reserves is to calculate the expected accumulated value of the cash flows at Year s , which
for the example above would give you:
s

Expected Reserves at Year s

p40

i)s

(1

t 0

t 1|1 40

(1

i)s

t
s

p40

t 1

Show mathematically that the two different calculations of Expected Reserves give the same results;
i.e. that:
s

t p40

(1

i )s

t 0
n

t 1|1 40

i )s

(1

t
s

p40

t 1
n 1

t s 1|1 40 s

t s 1

vt

t s

p40

vt

t s 1

Note that the division by s p40 is to reflect the fact that the above calculation without the
denominator is the Expected Reserves at Year s for a policyholder who is alive at Year 0; the division
adjusts this to be the Expected Reserves at Year s for a policyholder who is alive at Year s , in order
to be consistent with the original calculation of Expected Reserves.

We would now like to incorporate the Expected Reserves for each year of each simulation for the
insurer scenario outlined in Lesson 6 into the simulation work, which is available for download in the
relevant Courseware of the edX version of the course. We will use the premium which was
calculated in Assessment Question 6.2.
If you are feeling confident you should attempt to do this yourself right now without going any
further. Those who are feeling less confident can look at the final version, which is available for
download in the relevant Courseware of the edX version of the course, and the video which
demonstrates this from scratch.

Assessment Question 7.2

In the updated solution file to the simulations (including Expected Reserves), which is available for
download in the relevant Courseware of the edX version of the course, calculate the probability that,
in a random future year (except Year 0), the Actual Reserves will be greater than the Expected
Reserves.

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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Adjustments to Actual Reserves

Whilst the premium charged and investment strategy chosen are the primary factors that will affect
the financial position of an insurance company, it is possible for an insurer to make adjustments by
taking money from, or adding money to, the Actual Reserves. These adjustments will typically be
linked to a comparison between the values of the Expected Reserves and the Actual Reserves.

Practice Question 7.3

For the insurer scenario outlined above, the insurer now wishes to take money from the Actual
Reserves whenever the Actual Reserves exceeded the Expected Reserves by more than 50%. From
Year 1 up until and including Year 30 of the policy, the insurer will take away any money in the
Actual Reserves that is greater than 1.5 x Expected Reserves, except where the Expected Reserves
are negative, in which case the Actual Reserves are set to zero.
Using the updated solution file to the simulations (including Expected Reserves), which is available
for download in the relevant Courseware of the edX version of the course, calculate the revised
probability that the premium charged will be sufficient to cover the claims cash flows for the
following premium amounts:

the value calculated in Assessment Question 6.2

$2,000
$2,500

Assessment Question 7.3

For the insurer scenario outlined above, instead of removing money from the reserves, the insurer
now wishes to add money to the Actual Reserves whenever the Actual Reserves are more than 20%
less than the Expected Reserves. From Year 1 onwards, whenever the Actual Reserves are more
than 20% less than the Expected Reserves, the insurer will add money to the Actual Reserves equal
to the lessor of:
o
o

The amount required to increase the Actual Reserves to 80% of the Expected Reserves; or
30% of the premium income received at the time the adjustment is being made.

Using the updated solution file to the simulations (including Expected Reserves), which is available
for download in the relevant Courseware of the edX version of the course, calculate the revised
probability that the premium charged will be sufficient to cover the claims cash flows for the
following premium amounts:

the value calculated in Assessment Question 6.2

$2,000
$2,500

Adam Butt
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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Additional Questions
The final component of the learning material for the course is a series of questions that ask you to
make further adjustments to the insurance scenario outlined in Lesson 6 and expanded upon in this
Lesson. The questions will test your understanding of the simulation process we have looked at in
these two lessons, but in the context of a different type of life insurance product.

Practice Question 7.4

An insurance company wishes to sell a life annuity policy to policyholders aged 60. This policy will be
sold for a single premium at age 60 and will pay annual claims of $25,000 to policyholders at Year 1,
2, 3, until the death of the policyholder (i.e. claims are only paid to policyholders whilst they are
alive).
The insurer will sell 5,000 life annuity policies to policyholders aged exactly 60 at Year 0. Assume
that interest rates each year follow a normal distribution with a mean of 4% and a standard
deviation of 3%. Assume that mortality rates are equal to 90% of the Australian Life Tables 2010-12
(female rates), produced by the Australian Government Actuary, and available for download in the
relevant Courseware of the edX version of the course. Note that the final mortality rate should be
maintained at 1.
First calculate the risk premium for a single policyholder, assuming an interest rate of 4% per annum,
and mortality rates as described above.
Then, adjust the simulation file prepared in this Lesson, which is available for download in the
relevant Courseware of the edX version of the course, and update it for the revised policy design.
Calculate the probability that the premium charged will be sufficient to cover the claims cash flows
for the following premium amounts:

The risk premium calculated above

90% of the risk premium
110% of the risk premium

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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Assessment Question 7.4

Adjust the simulation spreadsheet produced for Practice Question 7.4, which is available for
download in the relevant Courseware of the edX version of the course, so that the life annuity is sold
to policyholders aged exactly 80 at Year 0.
First calculate the risk premium for a single policyholder, using the same assumptions as Practice
Question 7.4.
Calculate the probability that the premium charged will be sufficient to cover the claims cash flows
for the following premium amounts:

The risk premium calculated above

90% of the risk premium
110% of the risk premium

You may like to discuss the reason for the difference in probabilities compared to Practice Question
7.4 in the forum thread for this question.

Assessment Question 7.5

Adjust the simulation spreadsheet produced for Practice Question 7.4, which is available for
download in the relevant Courseware of the edX version of the course, so that the premium charged
is $450,000. Calculate the probability that this premium will be sufficient to cover the claims cash
flows.
The insurer now wishes to take money from the Actual Reserves whenever the Actual Reserves
exceed the Expected Reserves by more than Y % . From Year 1 up until and including Year 20 of the
policy, the insurer will take away any money in the Actual Reserves that is greater than (1 Y %)
Expected Reserves, except where the Expected Reserves are negative, in which case the Actual
Reserves are set to zero.
Calculate the value of Y % such that the revised probability that the premium of $450,000 will be
sufficient to cover the claims cash flows is 95%.

Adam Butt
Version 1 (2015)

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ANUx Introduction to Actuarial Studies Lesson 7 Modelling a Life Insurance Company 2

Summary of the Lesson 7 Material

Expected Reserves are the amount of Actual Reserves an insurer would hold to be equal to
the expected present value of the future cash flows.
Expected Reserves at Year s

EPV outgo at Year s

EPV income at Year s

It is possible for an insurer to make adjustments by taking money from, or adding money to,
the Actual Reserves. These adjustments are typically linked to a comparison between the
values of the Expected Reserves and the Actual Reserves.

Under a life annuity policy, a policyholder purchases the policy from the insurer for a single
premium and receives annual claims at Year 1, 2, 3, until the death of the policyholder (i.e.
claims are only paid to policyholders whilst they are alive).

Adam Butt
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