Chapter 1 - Life Contingent Financial Instruments

The purpose of this course is to explore the mathematical principles

that underly life contingent insurance products such as

Life Insurance

Pensions
Lifetime Annuities

Section 1.2 - Some Important Terms

Premium - a payment from the policyholder to the insurance
company These are often periodic payments.
Benefit - a payment from the insurance company to the policyholder
or that person’s beneficiaries (person or persons designated by the
policyholder to receive the payment) This payment may be in the
form of a lump sum or the policy could alternatively designate
periodic payments.
Section 1.3 - Life Insurance
Life insurance is an attempt to indemnify (compensate for loss) the
hardship created by the death of the policyholder. The policyholder
pays a premium and this person’s beneficiaries receive a lump sum
payment upon the policyholder’s death or upon survival of the
policyholder to a predetermined maturity date.

Term Insurance - a lump sum benefit is paid upon the death of the
policy holder provided it occurs before the end of a specific term.
(a) Decreasing Term - the sum insured (benefit) and (typically) the
premium decrease over time.
(b) Level Term - the sum insured (benefit) and the premium stay
the same over time.
(c) Renewable Term - the policyholder has the option to renew the
policy at the end of the term without undergoing a health check.
Whole Life Insurance - a lump sum benefit is paid upon the death of
the policy holder with premiums payable until death or until the
policyholder reaches some maximum age, for example age 65.
Endowment Insurance - a lump sum benefit is paid upon the death
of the policy holder or at the end of a specified term, whichever
comes first.
Universal Life Insurance - Some of the premium is used to fund life
insurance (either whole life or term depending on structure) while
the remaining part of the premium is applied to an investment fund
that grows the policy’s cash value.
A "Participating" Insurance Policy (with profit) - for this policy, profits
earned on invested premiums are shared with policyholders in the
form of reduced premiums or reversionary bonuses (increases in the
benefits promised).

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Equity Linked Insurance
(a) Variable Annuity - premiums are deposited in an investment
account. The benefit at maturity is the accumulated
value of the premiums, but there is a minimum death benefit
if the policyholder dies before maturity.
(b) Equity Indexed Annuity - premiums earn a guaranteed
minimum return. At maturity the policyholder receives a
portion of the return on a stock index if that exceeds
the guaranteed minimum.

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Underwriting
The health status of a policy applicant is important in determining
the person’s insurability and/or an appropriate premium amount.
The process of collecting and evaluating the health information of
prospective policyholders is called underwriting. Based on health
information, applicants for insurance are classified in one of the
following categories:
(a) preferred - low mortality risk due to lifestyle habits and family
history
(b) normal (standard) - a few, but typical risk factors are present.
(c) rated - some significant risk factors are present. These must
be taken into account when an appropriate premium is
set (often an individual decision).
(d) uninsurable - strong risk factors make an insurance contract
unwise at any price

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Section 1.4 - Life Annuities

An annuity contract is an agreement designed to produce a series of

payments.
Whole Life Annuity - payments continue from the start of the
contract until the death of the annuitant (the policyholder) - whole life
annuities are often purchased by persons entering retirement as a
way to provide steady retirement income
Term Life Annuity - payments continue from the start of the
contract until the death of the annuitant, but stops if the annuitant
survives beyond a fixed time beyond the contract’s start (called the
term of the contract)

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Some Classifications of Annuities:

Single Premium Deferred Annuity (SPDA) - Policyholder pays a

single premium and benefit payments begin at some future specified
date. If the policyholder dies before benefit payments begin, there is
a death benefit. There may also be a guarantee period, a minimum
benefit payment period with payments going to the estate of the
annuitant if the annuitant does not survive this period.

Single Premium Immediate Annuity (SPIA) - This is like the SPDA,

except the benefit payments begin when the contract begins.

Regular Premium Deferred Annuity (RPDA) - This is like the SPDA,

except that instead of making just one premium payment, premiums
are paid periodically throughout the deferral period.

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Life Annuities often have the following structures:

(a) Joint Life Annuity - based on two lives, the annuity benefit
payments continue as long as both individuals survive.

(b) Last Survivor Annuity - based on two lives, the annuity

benefit payments continue as long as at least one of the
individuals survive

(c) Reversionary Annuity - based on two lives (one designated the

annuitant and the other the insured), the annuity only
begins paying benefits in the event that the annuitant out
lives the insured life. These payments then continue as long
as the annuitant survives.

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Section 1.5 - Pension Plans

Defined Contribution Plan (DC) - Both the employer and the

employee contribute while the employee is working (usually a fixed
percent of salary). These contributions grow in an investment fund
over time and the accumulated funds are then available to provide
income for the employee upon retirement. The funds are often used
to purchase a SPIA. The 401K accounts work in this manner.

Defined Benefit Plan (DB) - Offers retirement income based on a

defined formula which incorporates the number of years of service to
this employer ( a fixed percent of salary per year of employment) and
the salary level of the individual (using the average salary during the
last three [five] years of employment). The employer (and typically
the employee) pay into this fund during the employed years. These
contributions must be sufficient to provided the stated benefits
promised to the employee which may also depend on the age of the
employee.
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Section 1.6 - Insurance Companies

A mutual insurance company is one that is owned by its

policyholders. It has no shareholders. Profits are distributed to
policyholders through dividends or bonuses.

A proprietary insurance company has shareholders. Profits of the

company are distributed to shareholders and with-profit
policyholders through a predetermined formula.

Insurance is sold not bought through the use of:

(a) Agents or financial advisors
(b) Direct Marketing - television advertising, call-in centers, internet
websites.

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Appendix 1 - Probability
Conditional Probability
The conditional probability of event B given event A occurs, is the
fraction of the probability in A that is also in B.

P A∩B
P B|A =

P A

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Multiplicative Law of Probability
The probability that both events A and B occur, is the probability of
event A times the conditional probability of event B given that event
A occurs.

P A ∩ B = P A P B|A

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Law of Total Probability

P B = P A ∩ B + P Ac ∩ B

P B = P A P B | A + P Ac P B | Ac

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More generally, if

Ai ∩ Aj = φ and ∪i Ai = S

then

X


P B = P Ai P B | Ai .
i

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Appendix 2 - Random Variables
Expected Values
 P
h i  h(y ) p(y ) in discrete case
E h( Y ) =
 R
h(y ) f (y ) dy in continuous case

It is the average value of the function h(·) when evaluated at a

random value Y .

Mean
h i Z X
E Y = y f (y ) dy or y p(y ).

It is the average (balance point) of the distribution of the random

variable Y .

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Variance
h i h i h i 
2 2
Var Y = Y − E[ Y ] = E Y 2 − E[ Y ] .

It is the average squared distance between the value of the random

variable Y and its mean.

Standard Deviation
h i r h i
StDev Y = Var Y .

It is a measure of variability of the random variable Y . It has the

same unit of measurement as the values of Y .

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Application to a Linear Function (Here a and b are constants.)
h i h i
E a + bY = a + bE Y

h i h i
Var a + b Y = b2 Var Y

h i h i
StDev a + b Y = | b |StDev Y

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