AS 2427 Long Term Actuarial Math I

Lecture Notes

Instructor: Shu Li

Department of Statistical and Actuarial Sciences

Western University

Winter 2025
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1 Chapter 1: Introduction
• Text looks at “combining models of mortality with models in finance to develop a framework
for pricing and risk management for long-term policies in life insurance and life annuities"

– Techniques can be used for other modeling as well (e.g., pension mathematics, other
insurance types)

• AS 2427 focuses on the determination of EPV (1st moment) & 2nd moments for different
products of life insurance and life annuities (Chapters 4 and 5), as well as the basic premium
calculation (Chapter 6).
This requires a good understanding of

– basis calculation of Probability Theory (review in Chapter 1)

– survival modeling and life tables (Chapters 2 and 3)

Insurance is a means of protection from financial loss. It is a form of risk management, primarily
used to hedge against the risk of a contingent or uncertain loss.

1.1 Life insurance introduction

Life insurance is a contract between the insurance buyer and an insurer (insurance company), where
the insurer agrees to pay certain amount of benefits upon the occurrence of an individual’s or some
individuals’ death or survival. In return, the buyer agrees to pay a stipulated amount of money to
the insurer.

1. Terminology:

• Policy: such a contract is called a policy.

• Policyholder: the buyer, who pays the premiums.
• Insured: the person whose life status is used to determine whether the benefits should
be paid or not; often coincide with the policyholder (we assume it is the case throughout
the course).

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• Beneficiary: the person who receive the insurance benefits.

• Sum insured: the predetermined lump sum, delivered to the beneficiary upon the
occurrence of the death or survival stipulated in the policy.
• Premiums: the amount of money paid by the buyer (policyholder) to the insurer; paid
at regular intervals or in a lump sum.

*In UK, it is common to use the term assurance for insurance contracts involving lives, and
‘insurance’ for contracts involving property.

2. Insurable interest

• A person has an insurable interest in something when loss or damage to it would cause
that person to suffer a financial loss or a substantial harm.
– your own house versus your neighbor’s
• It is disallowed by law to buy a life insurance on some stranger, or public figure.
• Basic requirements in all types of insurance
– The buyer has an insurable interest in subject of the insurance
– The benefit is no larger than the potential financial loss

3. Underwriting (will be discussed more in AS 4426)

• Underwriting is the process of collecting and evaluating the risk of an applicant (person
to be insured) on relevant rating factors (e.g., mortality risk for life insurance/annuity)
• Different underwriting methods are used for different policies (ranging from question-
naires, to a few tests to a full medical)
• Applicant’s rating will be determined from the underwriting process
• Their rating will affect the premium (cost) of their policy
– The poorer their health, the higher the expected mortality and the higher the cost of
a life insurance policy
– Different classifications used but along the lines of preferred, normal, rated and
uninsured where this list is in increasing order of mortality risk
• Mortality rates that are used to price of value and insurance policy reflect the underwrit-
ing results

4. Premiums: Always paid in advance.

• Single premium insurance policies: The buyer makes a single payment to the insurer.
• Regular premium insurance policies
– The policyholder pays at regular intervals, e.g. annually, monthly, etc.
– Dependent on the insured’s surviving to the payment date.
– Usually level, sometimes decreasing or increasing in certain patten.
• Variable premium policies

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– It is a policy that allows premium payments to vary, within certain limits, at the
option of the policyholder. In return, the insurance benefits for the policyholder
also vary with the premium payments.
Note: Net premium determination is covered in AS 2427, while the gross premium
determination is covered in AS 3429 LTAM II.

1.2 Life insurance and annuity contracts

1. Introduction:

• Product designs have become more complex in recent years

– More produces offering a savings and insurance component
– Enhanced technology (computer capabilities) enables more complex products to be
modeled
– Increased sophistication of policyholders
– Increased competition
– Guarantee features (requires more sophisticated risk management measures)
• Contract types
– Life insurance: the benefit is paid as a single lump sum either on the death or
survival of the insured.
– Life annuity: the benefit is in term of a regular series of payments. Usually
contingent on survival, but could be other contingency, e.g., Disability annuity

2. Traditional life insurance contracts (Chapter 4)

(a) Term insurance

• Death benefit (DB) paid if death occurs within a specified term. DB is typically
level but can be varying (e.g., decreasing DB for mortgage protection)
(b) Whole life insurance
• DB paid whenever death occurs.
• Often limit as to how long premium can be paid (e.g., only up to age 80)
(c) Pure endowment insurance
• paying survival benefit at the end of the term (if living)
(d) Endowment insurance
• DB paid at death if death occurs within the given tern, otherwise benefit paid out at
the end of the term (if living)

3. Life Annuities (Chapter 5)

Benefit is periodic payments that are contingent on survival (v.s. annuities certain in AS 2553)

(a) Whole Life Annuity: Periodic payments made as long as the insured is still living
(retirement annuities, defined benefit pension plans)

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(b) Temporary or Term Life Annuity: Periodic payments for a maximum period (e.g., n
years), each payment contingent upon survival
(c) Deferred Life Annuity: Payments contingent upon survival but first payment deferred
n years
(d) Guaranteed Annuity: A guaranteed annutiy is paid for a minimum period, regardless
of the survival or death of the annuitant

- The following types are covered in AS 3431 LTAM III, not in AS2427.

4. Joint Life and Last Survivor benefits

Insurance benefits are dependent on the joint mortality of two lives.

• Joint Life Annuity: payments stop on the first death

• Last Survivor Annuity: payments continue until the second death
• Reversionary Annuity: one designated as annuitant, the other as the insured. If insured
dies & annuitant alive, they get an annuity for the rest of their life
• Joint Life Insurance: death benefit paid on the first death
• Last Survivor Insurance: death benefit paid on the second death

5. Participating insurance

• ‘With profit insurance’ better known as participating insurance (or par insurance)
• Policyholders share in profits through dividends in North America or bonuses else-
where. We use the term ‘dividend’ when the profit share is distributed in the form of
cash (or cash equivalent), and ‘bonus’ when the profti share is distributed in the form of
additional insurance.

6. Modern life insurance

• Universal Life insurance

– Combines life insurance and investment (solid understanding of traditional products
is required to work with UL)
– Flexibility in premium paid and DB amount
– Very popular in North America
• Equity-linked insurance
– benefit linked to the performance of an investment fund in a separated account
(other than the insurer’s general account)
– there may be a guarantee, e.g., Guaranteed Minimum Death Benefits (GMDB)
– Also called ‘variable annuity’ in US,‘segregated fund policies’ in Canada or ‘unit-
linked policies’ in UK

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1.3 Long-term coverages in health insurance

This includes contracts that are contingent on morbidity risk (incident of ill heath) not on death or
survival. Examples:
• Income protection insurance: replacement of income for individuals who cannot work due to
sickness or disability. Benefit ends at normal retirement age.
• Long-term care insurance: pays a series of payments to cover the costs of care in old age
(when the insured cannot live independently)
• Critical illness insurance: pays fixed lump sum benefits on diagnosis of specified serious
illness
Life contingency concepts covered in LTAM courses can be modified and applied to these products.

1.4 Pension benefits

(covered in AS 3431 LTAM III)
Life contingency concepts can also be applied to pension plan design, valuation and risk manage-
ment.
• Offers lump sum and annuity benefits (or a combination of these) to the employee in retirement.
• A typical employer sponsored pension plan
• Two designs:
– Defined Benefit Plans: provide lifetime retirement income, where the benefits are
certain based on service and salary, e.g.,
Benefit = Average Salary × # of years of service × accrual rate
– Defined Contribution Plans: employee and employer pay a pre-determined contribu-
tion into a fund and fund earns interest.
∗ The contributions are certain, but the benefits may be uncertain.
∗ Proceeds at retirement depend investment performance.

1.5 Actuaries’ Role

• Maintain solvency and manage risk for policies
• Determine adequate premiums
• Oversee appropriate investment strategy
• Determine appropriate level of capital required for the uncertain future liabilities (e.g. reserve)
• Develop new insurance products
• Calculate fair surrender values: The surrender value is the cash amount offered to the policy-
holder by the issuing life carrier upon cancellation of the contract.
• ...

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1.6 Review on Probability Theory

1. Random variable (r.v.)

• X is a discrete r.v. if X takes a countable number of values

• X is a continuous r.v. if X takes values in some interval of real numbers

2. Cumulative distribution function (c.d.f.)

F (x) = P(X ≤ x)
for x ∈ R. Properties:

(a) F (x) is non-decreasing

(b) F (x) is right-continuous
(c) limx→−∞ F (x) = 0 and limx→∞ F (x) = 1

3. Survival function (s.f.)

S(x) = P(X > x) = 1 − F (x)
for x ∈ R. Properties:

(a) S(x) is non-increasing

(b) S(x) is right-continuous
(c) limx→−∞ S(x) = 1 and limx→∞ S(x) = 0

4. Probability density function (p.d.f.)

• defined only for continuous r.v.’s.

d d
f (x) = F (x) = − S (x)
dx dx
Ra
• F (a) = P(X ≤ a) = −∞
f (x)dx

5. Probability mass function (p.m.f.)

• defined only for discrete r.v.’s.

p(k) = P(X = k)

• F (a) = P(X ≤ a) =
P
k≤a p(k) for a discrete r.v. X.

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6. Moments

The kth moment of a r.v. X is defined by

Z ∞
k
E[X ] = xk · f (x)dx, if X is continuous.
−∞
X
E[X k ] = xk · p(x), if X is discrete.
all x

• E[X] is called the expectation (or mean) of X.

• Var(X) = E (X − EX)2 = E[X 2 ] − (EX)2 is called the variance of X.
 

• E[kX] = kE[X] and Var[kX] = k 2 Var[X] for any constant k.

One useful equation:

• Suppose X is non-negative r.v. with s.f. S(x), we have

Z ∞
E[X] = S(x)dx,
0

Using integration by parts,

Z ∞ ∞
Z ∞ Z ∞
E[X] = x · f (x) dx = x · (−S(x)) + S(x)dx = S(x)dx.
0 x=0 0 0

7. Conditional probability

• The conditional probability of event A, given event B, is given by

P(AB)
P(A|B) = ,
P(B)

• Similarly, P(B|A) = P(AB)

P(A)
.
• Combining the above two formulae, we obtain the well-known Bayes’ formula

P(B|A)P(A)
P(A|B) = .
P(B)

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Example 1.1 Given a discrete r.v. X

x 0 2 5
P(X = x) 0.5 0.4 0.1

(a) Find the c.d.f. of X for x ∈ (−∞, ∞), and draw it out.
(b) Find the mean and variance of X.

Example 1.2 A continuous r.v. X with p.d.f.

f (x) = 0.1e−0.1x , x > 0.

(a) Identify the name of this distribution.

(b) Find the c.d.f. of X for x ∈ (0, ∞), and draw it out.
(c) Find the mean and variance of X.

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