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Dr Sanjeewa Perera Department of Mathematics University of Colombo

FM 2002 ACTUARIAL MATHEMATICS I

FM 2002 ACTUARIAL MATHEMATICS I

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FM 2002 ACTUARIAL MATHEMATICS I

CHAPTER 4

Net Premiums

FM 2002 ACTUARIAL MATHEMATICS I

The techniques developed for analyzing the value of benefit payments and premium payments are now combined to compute the size of the premium payment needed to pay for the benefit. Actuarial present value of premium payments should be greater than or at lest equal to actuarial present value of benefit payments. Fully discrete: the benefit is to be paid at the end of the year of death and the premiums are to paid on a discrete basis as well.

Equivalence Principle

FM 2002 ACTUARIAL MATHEMATICS I

The premium should be set so that actuarial present value of the benefits paid is equal to the actuarial present value of the premiums received. Fully discrete whole life policy

Px

Semi-Continuous

FM 2002 ACTUARIAL MATHEMATICS I

The most common type of insurance policy is one issued on a semi-continuous basis. Here the benefit is paid at the time of death, but the premiums are paid on a discrete basis. The notation for the net annual premium in the case of a whole life policy is

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FM 2002 ACTUARIAL MATHEMATICS I

Fully Continuous
Pay the benefit amount at the time of death and collect premiums in the form of a continuous annuity. Theoretical interest only.

Loss Random Variable

FM 2002 ACTUARIAL MATHEMATICS I

Different view of equivalence principle. More useful for a probabilistic analysis of the insurance process. Denote by PVFB0 the present value, at time of issue, of future benefits to be paid by the insurer. Denote by PVFP0 the present value, at time of issue, of future premiums to be paid by the insured. The insurers net random future loss is defined by L = PVFB0 PVFP0.

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FM 2002 ACTUARIAL MATHEMATICS I

The equivalence principle

The equivalence principle sets the premium P so that E[L] = 0, that is, the expected loss on the policy is zero. A more detailed probabilistic analysis of the policy can be made by studying how the random variable L deviates from its mean.

E[L]=0

FM 2002 ACTUARIAL MATHEMATICS I

The expected value of the insurers net random future loss is equal to zero. This is then equivalent to setting E(PVFB0) =E(PVFP0). In words, we have APV(Future Premiums) = APV(Future Benefits).
For example, for a unit of benefit payment, let Z be the PV r.v. associated with the life insurance benefits and Y is the PV r.v. associated with the life annuity premium payments, with the premium payable annually, then L = Z Y so that

= E (Z) /E (Y ) .

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Fully discrete annual premiums - whole life insurance

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By the principle of equivalence, we have

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Other Cases
The loss function in this case is

FM 2002 ACTUARIAL MATHEMATICS I

Applying the principle of equivalence, we have

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Other Plan

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Fully Continuous Whole life

FM 2002 ACTUARIAL MATHEMATICS I

Consider a fully continuous level annual premiums for a unit whole life insurance payable immediately upon death of (x). Here, the loss function is expressed as

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Other Plans

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Other premium calculation principles

FM 2002 ACTUARIAL MATHEMATICS I

Besides the equivalence principle, there are other premium principles that are sometimes considered:
Percentile premiums: premium large enough is assessed to ensure the company suffers financial loss with sufficiently low probability. The premium charged is a percentile from the insurers loss distribution. Exponential premiums: premium is assessed using an exponential utility of wealth function u () = exp( ) for some risk aversion ; the insurer is indifferent between accepting and not accepting the risk.

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If we denote the insurers loss random variable by L, then the percentile premium is the smallest premium so that P (L > 0) for some predetermined (0, 1).

FM 2002 ACTUARIAL MATHEMATICS I

For the exponential premium, it is the premium solution to the certainty equivalent equation E(exp(L))=1.

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Types of Life insurance contract expenses

Investment-related expenses (e.g. analysis, cost of buying, selling, servicing). Insurance-related expenses:
acquisition (agents commission, underwriting, preparing new records) maintenance (premium collection, policyholder correspondence) general (research, actuarial, accounting, taxes) settlement (claim investigation, legal defense, disbursement)

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First year vs. renewal expenses

FM 2002 ACTUARIAL MATHEMATICS I

Most life insurance contracts incur large losses in the first year because of large first year expenses:

These large losses are hopefully recovered in later years. How then do these first year expenses spread over the policy life? Anything not first year expense is called renewal expense (used for maintaining and continuing the policy).

agents commission preparing new policies and records administration

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Gross premium calculations

FM 2002 ACTUARIAL MATHEMATICS I

Gross premium calculations can be done using the principle of equivalence:

APV(Future Gross Premiums)=APV(Future Benefits+ Expenses) To illustrate, consider a 5-year endowment policy issued to (60) with the following characteristics:
benefit is $100 payable at the end of the year of death or on maturity; renewal expense, including the first, of $1.50 per policy; assume you are given the following:

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Denote by G the gross premium payable annually in advance. Thus, we have

FM 2002 ACTUARIAL MATHEMATICS I

Notice that the first term is indeed the net annual premium (ignoring expenses):

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Gross premiums with large first year expense

Consider the same illustrative example, except this time assume there is an additional first year expense of $4.50. Denote by G* the gross annual premium so that according to equivalence principle:

FM 2002 ACTUARIAL MATHEMATICS I