Table of Contents Authors’ Biographies Authors’ Introductions and Guide to Study Introduction to First Edition .. Introduction to Second Edition Guide to Study ....... 1. The Economics of Insurance ...... 1.1 Introduction .... 12. Utility Theory ....... 1.3 Insurance and Utility 1.4. Elements of Insurance Seren 15 1.5 Optimal Insurance .. 16 1.6 Notes and References 18 Appendix 19 5 Exercises 20 i 2. Individual Risk Models for a Short Term sesssssseeescee 27 i 2.1 Introduction : 7 22 Models for Individual Claim Random Variables .......ss0ssesseeee 28 { 23. Sums of Independent Random Variables . cee OF 24 Approximations for the Distribution of the Sum 39 25 Applications to Insurance 2.6 Notes and References Exercises 3. Survival Distributions and Life Tables..... e 51 BAL Introduction ...seesssssssssseseeeeeeeessssenee 51 3.2. Probability for the Age-at-Death . sevens 52 3.2.1 The Survival Function .....se.cccsseceessess 52 3.2.2 Time-until-Death for a Person Age x evsesnsese 52 3.2.3 Curtate-Future-Lifetimes ......0..c00 . 54 3.2.4 Force of Mortality .. 55 Contents viiarea ener ree ete ee cece cc ct 33 34 35 36 37 38 39 Exercises 4 ‘Life Insurance 4d 42 Life Tables cs 33.1 Relation of Life Table Functions to the Survival Function ... 332. Life Table Example 58 The Deterministic Survivorship Group 66 Other Life Table Characteristics 68 3.5.1. Characteristics 68 3.5.2 Recursion Formulas 73 Assumptions for Fractional Ages 74 Some Analytical Laws of Mortality 7 Select and Ultimate Tables 79 Notes and References 83 84 Introduction Insurances Payable at the Moment of Death 421 Level Benefit Insurance 4.2.2 Endowment Insurance 101 4.2.3. Deferred Insurance - 103, 4.2.4 Varying Benefit Insurance 105 4.3 Insurances Payable at the End of the Year of Death 108 44 Relationships between Insurances Payable at the Moment of Death and the End of the Year of Death 119 45. Differential Equations for Insurances Payable at the Moment of Death 125 4.6 Notes and References 126 Exercises 126 5. Life Annuities 133 5:1 Introduction .- 133 5.2. Continuous Life Annuities 134 53. Discrete Life Annuities 143 3.4 Life Annuities with m-thly Payments 149 55 Apportionable Annuities-Due and Complete Annuities-Immediate . 154 5.6 Notes and References 157 Exercises 158 6 Benefit Premiums ...... 167 6.1 Introduction 167 62. Fully Continuous Premiums .. 170 63 Fully Discrete Premiums .. 180 64 True m-thly Payment Premiums .. 188 65. Apportionable Premiums 191 66 Accumulation-Type Benefits .... 194 67 Notes and References oo 197 Exercises 197 Contents7 Benefit Reserves 7.1 Introduction .. 72. Fully Continuous Benefit Reserves 73. Other Formulas for Fully Continuous Benefit Reserves 74 Fully Discrete Benefit Reserves 75. Benefit Reserves on a Semicontinuous Basis 7.6 Benefit Reserves Based on True m-thly Benefit Premiums 77 Benefit Reserves on an Apportionable or Discounted. Continuous Basis 7.8 Notes and References Exercises 8 Analysis of Benefit Reserves 8.1 Introduction 82. Benefit Reserves for General Insurances 83. Recursion Relations for Fully Discrete Benefit Reserves. 84 Benefit Reserves at Fractional Durations 85 Allocation of the Risk to Insurance Years ... 86 Differential Equations for Fully Continuous Benefit Reserves 87 Notes and References Exercises 9 Multiple Life Functions 9.1 Introduction 9.2 Joint Distributions of Future Lifetimes 9.3. The Joint-Life Status 9.4 + The Last-Survivor Status . 9.5 More Probabilities and Expectations. 9.6 Dependent Lifetime Models 9.6.1 Common Shock 9.6.2 Copulas . 97 Insurance and Annuity Benefits 97.1 Survival Statuses ... 9.7.2. Special Two-Life Annuities 9.7.3. Reversionary Annuities ... . 98 Evaluation—Special Mortality Assumptions ..... 9.8.1 Gompertz and Makeham Laws 98.2 Uniform Distribution 9.9 Simple Contingent Functions ... 9.10 Evaluation—Simple Contingent Functions 9.11 Notes and References . Exercises 10 Multiple Decrement Models 10.1 Introduction 10.2 Two Random Variables . 10.3. Random Survivorship Group . .. 203 203 -- 206 212 215 221 221 224 -- 225 +. 225 229 - 229 230 233 238 241 soos 248 -- 250 ++ 250 257 257 258 +. 263 -- 268 21 274 274 27 279 279) 284 285 287 - 287 - 288 291 295 - 297 298 307 - 308 316 Contents_ u 2 B 104 Deterministic Survivorship Group seccoees B18 105 Associated Single Decrement Tables ......++0+++0+++ ceceseeeeee BID 105.1 Basic Relationships seseseeseeeeeees 320 Central Rates of Multiple Decrement 321 Constant Force Assumption for Multiple Decrements . 322 1054. Uniform Distribution Assumption for Multiple Decrements ...... 323 10.55 Estimation Issues ....... 324 10.6 Construction of a Multiple Decrement Table 37 107 Notes and References Exercises Applications of Multiple Decrement Theory 11.1 Introduction .. 341 112. Actuarial Present Values and Their Numerical Evaluation 342 113. Benefit Premiums and Reserves . 345, 114 Withdrawal Benefit Patterns That Can Be Ignored Evaluating Premiums and Reserves ...... : 346 115. Valuation of Pension Plans 350 11.5.1 Demographic Assumptions cocoons 350 1132. Projecting Benefit Payment and Contribution Rates 351 1153. Defined-Benefit Plans ........ ceoeeneee 354 11.54 Defined-Contribution Plans .. ee ooo 356 116 Disability Benefits with Individual Life Insurance .......+.++.s11+++:++ 358 11.6.1 Disability Income Benefits ... 358 11.62 Waiver-of-Premium Benefits . 359 11.63 Benefit Premiums and Reserves . 360 117 Notes and References 361 Exercises 362 Collective Risk Models for a Single Period sey 12.1 Introduction ... 367 12.2. The Distribution of Aggregate Claims = 368 123 Selection of Basic Distributions Bee 372 123.1 The Distribution of N ao - 372 1232 The Individual Claim Amount Distribution ...... 377 12.4 Properties of Certain Compound Distributions ....... 378 125 Approximations to the Distribution of Aggregate Claims eee 385 12.6 Notes and References soe eeeee 390 Appendix eee 301 Exercises ..... eeseee cocoa 398 Collective Risk Models over an Extended Period 399 13.1 Introduction 399 132. A Discrete Time Model . 401 133 A Continuous Time Model 406 Contents13.4 Ruin Probabilities and the Claim Amount Distribution .. 13.5. The First Surplus below the Initial Level 13.6 The Maximal Aggregate Loss .. 13.7 Notes and References ...... Appendix Exercises 14 Applications of Risk Theory 14.1 Introduction 14.2 Claim Amount Distributions 14.3 Approximating the Individual Model 14.4 Stop-Loss Reinsurance .. 145 Analysis of Reinsurance Using Ruin Theory .. 14.6 Notes and References Appendix Exercises 15 Insurance Models Including Expenses ...... 15.1 Introduction 15.2. Expense Augmented Models 15.2.1 Premiums and Reserves 15.22 Accounting 15.3 Withdrawal Benefits 153.1 Premiums and Reserves 15.3.2 Accounting . 15.4 Types of Expenses 155. Algebraic Foundations of Accounting: Single t Decrement Model 15.6 Asset Shares 156.1 Recursion Relations 15.6.2 Accounting . 15,7 Expenses, Reserves, and General Insurances 15.8 Notes and References Exercises 16 Business and Regulatory Considerations 16.1 Introduction 16.2 Cash Values 163. Insurance Options . 16.3.1 Paid-up Insurance ... 163.2 Extended Term = 163.3 Automatic Premium Loan 16.4 Premiums and Economic Considerations .. 164.1 Natural Premiums 1642 Fund Objective .. : 1643 Rate of Return Objective 1644 Risk-Based Objectives 165 Experience Adjustments - 466 409 415 a7 423 425 430 435 435 436 441 445 451 459) 460 461 465 465 466 469 472 472 we 476 476 481 485 485 487 489 491 492 499 499 499 evo 502 . 502 504 - 506 507 508 508 509 511 312 Contents16.6 Modified Reserve Methods 167 Full Preliminary Term 16.8 Modified Preliminary Term 16.9 Nonlevel Premiums or Benefits .. 169.1 Valuation 169.2. Cash Values 16.10 Notes and References Exercises 17 Special Annuities and Insurances ... 17.1 Introduction 172 Special Types of Annuity Benefits 17.3. Family Income Insurances 174. Variable Products ... 17.4.1 Variable Annuity 1742. Fully Variable Life Insurance 1743. Fixed Premium Variable Life Insurance... 17.4.4 Paid-up Insurance Increments 175. Flexible Plan Products ...... 175.1 Flexible Plan Mlustration 1752 An Alternative Design 176 Accelerated Benefits 176.1 Lump Sum Benefits 1762. Income Benefits 17.7 Notes and References Exercises 18 Advanced Multiple Life Theory 18.1 Introduction 18.2. More General Statuses 183 Compound Statuses 184. Contingent Probabilities and Insurances ... cece 564 185 Compount Contingent Functions .. eee 566 18.6 More Reversionary Annuities ..... 570 18.7 Benefit Premiums and Reserves ... seseeeeee STB 188 Notes and References ....+:+..0000++ 575 Appendix Exercises 19 Population Theory 585 19.1 Introduction 585 192. The Lexis Diagram. - 585 19.3 A Continuous Model 587 194 Stationary and Stable Populations | 6.593 195. Actuarial Applications coo : 595 196 Population Dynamics ...... a 599 19.7 Notes and References : . : 603 Exercises 603 Contents20. Theory of Pension Funding ....s.scsssssseecsssssseeeeeeseeee 607 20.1 Introduction Seer : seceesesseseees 607 20.2 The Model . + 608 20.3 Terminal Funding ......... : - 609 20.4 Basic Functions for Retired Lives .. S él 204.1 Actuarial Present Value of Future Benefits, (fA eee OIL 204.2 Benefit Payment Rate, B,. -. 611 204.3. The Allocation Equation . 612 20.5 Accrual of Actuarial Liability 614 20.6 Basic Functions for Active Lives 615 206.1 Actuarial Present Value of Future Benefits, (A), 615 20.6.2 Normal Cost Rate, P, - enees 616 20.63 Actuarial Accrued Liability, (@V), 618 20.64 Actuarial Present Value of Future Normal Costs, (Pa), eovseessssseeesessssstseeeesessnssssnnnenseees 619 20.7 Individual Actuarial Cost Methods ......... ese 622 20.8 Group Actuarial Cost Methods . -- 624 20.9 Basic Functions for Active and Retired Members Combined «oo... sescesnsssnestesseessnnsnsnsssereessees 628 20.10 Notes and References . cesses 630 Exercises ccc referent 630 21. Interest as a Random Value soos 6385 21.1 Introduction . . ceceessnssssees 635, 21L.1 Incorporating Variability of Interest ..... + 636 21.1.2 Notation and Preliminaries .- 637 21.2 Scenari 638 21.2.1 Deterministic Scenarios 638 21.22. Random Scenarios: Deterministic Interest Rates «..-...-..--- 641 213. Independent Interest Rates ......... a oo 6B 214 Dependent Interest Rates : 649 214.1 Moving Average Model secon 649 214.2 Implementation ee oon 654 i 215. Financial Economics Models 655 21.5.1 Information in Prices and Maturities 655 21.5.2 Stochastic Models .... — ooo 659 21.6 Management of Interest Risk ooo 663 21.6.1 Immunization . ane -- 663 2162 General Stochastic Model 665 21.7. Notes and References = renee on 666 Exercises, — 667 Appendix 1 Normal Distribution Table .. oo 673 Appendix 2A. Illustrative Life Table anne 65 Appendix 2B Illustrative Service Table .. c 685 Appendix 3 Symbol Index soo 687 Appendix 4 General Rules for Symbols of Actuarial Functions . 693 ContentsSIs ee rater etna eet Appendix 5 Some Mathematical Formulas Useful in Actuarial Mathematics 701 Appendix 6 Bibliography -- 705 Appendix 7 Answers to Exercises. 719 Index 749 xiv ContentsAUTHORS’ BIOGRAPHIES NEWTON L. BOWERS, JR, Ph.D, FS.A, M.A.A.A, received a BS. from Yale University and a Ph.D. from the University of Minnesota. After his graduate stud- ies, he joined the faculty at the University of Michigan and later moved to Drake University. He held the position of Ellis and Nelle Levitt Professor of Actuarial Science until his retirement in 1996. HANS U. GERBER, Ph.D, A.S.A,, received the Ph.D. degree from the Swiss Fed- eral Institute of Technology. He has been a member of the faculty at the Universities of Michigan and Rochester. Since 1981 he has been on the faculty at the Business School, University of Lausanne, where he is currently head of the Institute of Ac- tuarial Science.* JAMES C. HICKMAN, Ph.D., S.A, A.CAS, M.AA.A, received a B.A. from Simpson College and a Ph.D. from the University of lowa. He was a member of the faculty at the University of lowa and at the University of Wisconsin, Madison, until his retirement in 1993. For five years he was Dean of the School of Business at Wisconsin. DONALD A. JONES, Ph.D., FS.A, EA, MAA.A, received a BS. from Towa State University and MS. and Ph.D. degrees from the University of Iowa. He was a member of the actuarial faculty at the University of Michigan and a working partner of Ann Arbor Actuaries until 1990 when he became Director of the Actu- arial Science Program at Oregon State University. CECIL J. NESBITT, Ph.D, FS.A,, M.A.A.A, received his mathematical education at the University of Toronto and the Institute for Advanced Study in Princeton. He taught actuarial mathematics at the University of Michigan from 1938 to 1980. He served the Society of Actuaries from 1985 to 1987 as Vice-President for Research and Studies." “Professors Gerber and Nesbitt were involved as consultants with the revisions incorporated in the second edition Authors’ Biographies xvAUTHORS’ INTRODUCTIONS AND GUIDE TO STUDY Introduction to First Edition* This text represents a first step in communicating the revolution in the actuarial profession that is taking place in this age of high-speed computers. During the short period of time since the invention of the microchip, actuaries have been freed from numerous constraints of primitive computing devices in designing and man- aging insurance systems. They are now able to focus more of their attention on creative solutions to society's demands for financial security. To provide an educational basis for this focus, the major objectives of this work are to integrate life contingencies into a full risk theory framework and to dem- onstrate the wide variety of constructs that are then possible to build from basic models at the foundation of actuarial science. Actuarial science is ever evolving, and the procedures for model building in risk theory are at its forefront. Therefore, we examine the nature of models before proceeding with a more detailed discus- sion of the text. Intell into a comprehensive and coherent theory or to enable us to simulate, in a labo- ratory or a computer system, the operation of the corresponding full-scale entity. Models are absolutely essential in science, engineering, and the management of large organizations. One must, however, always keep in mind the sharp distinction between a model and the reality it represents. A satisfactory model captures enough of reality to give insights into the successful operation of the system it represents. tual and physical models are constructed either to organize observations The insurance models developed in this text have proved useful and have deep- ened our insights about insurance systems. Nevertheless, we need to always keep *Chapter references and nomenclature have been changed to be in accord with the second edition, These changes are indicated by italics. ‘Authors Introductions and Guide to Studybefore us the idea that real insurance systems operate in an environment that is ‘more complex and dynamic than the models studied here. Because models are only approximations of reality, the work of model building is never done; approxima- tions can be improved and reality may shift. It is a continuing endeavor of any scientific discipline to revise and update its basic models, Actuarial science is no exception Actuarial science developed at a time when mathematical tools (probability and calculus, in particular), the necessary data (especially mortality data in the form of life tables), and the socially perceived need (to protect families and businesses from the financial consequences of untimely death) coexisted. The models constructed at the genesis of actuarial science are still useful. However, the general environment in which actuarial science exists continues to change, and it is necessary to peri- odically restate the fundamentals of actuarial science in response to these changes. We illustrate this with three examples: 1. The insurance needs of modern societies are evolving, and, in response, new systems of employee benefits and social insurance have developed. New mod- els for these systems have been needed and constructed. 2. Mathematics has also evolved, and some concepts that were not available for use in building the original foundations of actuarial science are now part of a general mathematics education. If actuarial science is to remain in the main- stream of the applied sciences, it is necessary to recast basic models in the language of contemporary mathematics 3. Finally, as previously stated, the development of high-speed computing equip- ment has greatly increased the ability to manipulate complex models. This has far-reaching consequences for the degree of completeness that can be incor- porated into actuarial models. This work features models that are fundamental to the current practice of actu- arial science. They are explored with tools acquired in the study of mathematics, in particular, undergraduate level calculus and probability. The proposition guid- ing Chapters 1-14 is that there is a set of basic models at the heart of actuarial science that should be studied by all students aspiring to practice within any of the various actuarial specialities. These models are constructed using only a limited number of ideas. We will find many relationships among those models that lead to a unity in the foundations of actuarial science. These basic models are followed, in Chapters 15-21, by some more elaborate models particularly appropriate to life insurance and pensions. While this book is intended to be comprehensive, it is not meant to be exhaustive. In order to avoid any misunderstanding, we will indicate the limitations of the text: + Mathematical ideas that could unify and, in some cases, simplify the ideas presented, but which are not included in typical undergraduate courses, are not used. For example, moment generating functions, but not characteristic functions, are used in developments regarding probability distributions. Stieltjes integrals, which could be used in some cases to unify the presentation xvii Introduction to First Editionof discrete and continuous cases, are not used because of this basic decision on mathematical prerequisites. * The chapters devoted to life insurance stress the randomness of the time at which a claim payment must be made. In the same chapters, the interest rates used to convert future payments to a present value are considered deterministic and are usually taken as constants. In view of the high volatility possible in interest rates, it is natural to ask why probability models for interest rates were not incorporated. Our answer is that the mathematics of life contingencies on a probabilistic foundation (except for interest) does not involve ideas beyond those covered in an undergraduate program. On the other hand, the modeling of interest rates requires ideas from economics and statistics that are not in- cluded in the prerequisites of this volume. In addition, there are some technical problems in building models to combine random interest and random time of claim that are in the process of being solved. + Methods for estimating the parameters of basic actuarial models from obser- vations are not covered. For example, the construction of life tables is not discussed. + This is not a text on computing, The issues involved in optimizing the orga- nization of input data and computation in actuarial models are not discussed. This is a rapidly changing area, seemingly best left for readers to resolve as they choose in light of their own resources. + Many important actuarial problems created by long-term practice and insur- ance regulation are not discussed. This is true in sections treating topies such as premiums actually charged for life insurance policies, costs reported for pen- sions, restrictions on benefit provisions, and financial reporting as required by regulators. Ideas that lead to interesting puzzles, but which do not appear in basic actuarial models, are avoided. Average age at death problems for a stationary population do not appear for this reason. ‘This text has a number of features that distinguish it from previous fine textbooks on life contingencies. A number of these features represent decisions by the authors on material to be included and will be discussed under headings suggestive of the topics involved Probability Approach [As indicated earlier, the sharpest break between the approach taken here and that taken in earlier English language textbooks on actuarial mathematics is the much fuller use of a probabilistic approach in the treatment of the mathematics of life contingencies. Actuaries have usually written and spoken of applying proba- bilities in their models, but their results could be, and often were, obtained by a deterministic rate approach. In this work, the treatment of life contingen: is based on the assumption that time-until-death is a continuous-type random vari- able. This admits a rich field of random variable concepts such as distribution function, probability density function, expected value, variance, and moment generating function. This approach is timely, based on the availability of high-speed Authors’ introductions and Guide to Studycomputers, and is called for, based on the observation that the economic role of life insurance and pensions can be best seen when the random value of time-until- death is stressed. Also, these probability ideas are now part of general education in mathematics, and a fuller realization thereof relates life contingencies to other fields of applied probability, for example, reliability theory in engineering, Additionally, the deterministic rate approach is described for completeness and is a tool in some developments. However, the results obtained from using a deter- ministic model usually can be obtained as expected values in a probabilistic model. Integration with Risk Theory Risk theory is defined as the study of deviations of financial results from those expected and methods of avoiding inconvenient consequences from such devia- tions. The probabilistic approach to life contingencies makes it easy to incorporate long-term contracts into risk theory models and, in fact, makes life contingencies only a part, but a very important one, of risk theory. Ruin theory, another important part of risk theory, is included as it provides insight into one source, the insurance claims, of adverse long-term financial deviations. This source is the most unique aspect of models for insurance enterprises. Utility Theory This text contains topics on the economics of insurance. The goal is to provide a motivation, based on a normative theory of individual behavior in the face of un- certainty, for the study of insurance models. Although the models used are highly simplified, they lead to insights into the economic role of insurance, and to an appreciation of some of the issues that arise in making insurance decisions. Consistent Assumptions The assumption of a uniform distribution of deaths in each year of age is con- sistently used to evaluate actuarial functions at nonintegral ages. This eliminates some of the anomalies that have been observed when inconsistent assumptions are applied in situations involving high interest rates Newton L. Bowers Hans U. Gerber James C. Hickman Donald A. Jones Cecil J. Nesbitt x Introduction to First EditionIntroduction to Second Edition Actuarial science is not static. In the time since the publication of the first edition of Actuarial Mathematics, actuarial science has absorbed additional ideas from economics and the mathematical sciences. At the same time, computing and communications have become cheaper and faster, and this has helped to make feasible more complex actuarial models. During this period the financial risks that modem societies seek to manage have also altered as a result of the globalization of business, technological advances, and political shifts that have changed public policies. It would be impossible to capture the full effect of all these changes in the re- vision of a basic textbook. Our objective is more modest, but we hope that it is realistic. This edition is a step in an ongoing process of adaptation designed to keep the fundamentals of actuarial science current with changing realities. In the second edition, changes in notation and nomenclature appear in almost every section. There are also basic changes from the first edition that should be listed 1. Commutation functions, a classic tool in actuarial calculations, are not used. This is in response to the declining advantages of these functions in an age when interest rates are often viewed as random variables, or as varying deter- ministically, and the probability distribution of time until decrement may de- pend on variables other than attained age. Starting in Chapter 3, exercises that illustrate actuarial calculations using recursion formulas that can be imple- mented with current software are introduced. It is logically necessary that the challenge of implementing tomorrow's software is left to the reader. 2. Utility theory is no longer confined to the first chapter. Examples are given that illustrate how utility theory can be employed to construct consistent models for premiums and reserves that differ from the conventional model that im- plicitly depends on linear utility of wealth. 3. In the first edition readers were seldom asked to consider more than the first and second moments of Joss random variables. In this edition, following the intellectual path used earlier in physics and statistics, the distribution functions and probability density functions of loss variables are illustrated 4. The basic material on reserves is now presented in two chapters. This facilitates a more complete development of the theory of reserves for general life insur- ances with varying premiums and benefits In recent years considerable actuarial research has been done on joint distri- butions for several future lifetime random variables where mutual indepen- dence is not assumed. This work influences the chapters on multiple life ac- tuarial functions and multiple decrement theory. 6. There are potentially serious estimation and interpretation problems in multiple decrement theory when the random times until decrement for competing causes of decrement are not independent. Those problems are illustrated in the second edition, Authors’ Introductions and Guide to Study 1‘The applications of multiple decrement theory have been consolidated. No at- tempt is made to illustrate in this basic textbook the variations in benefit for- mulas driven by rapid changes in pension practice and regulation 8. The confluence of new research and computing capabilities has increased the use of recursive formulas in calculating the distribution of total losses derived from risk theory models. This development has influenced Chapter 12 9. The material on pricing life insurance with death and withdrawal benefits and accounting for life insurance operations has been reorganized. Business and regulatory considerations have been concentrated in one chapter, and the foun- dations of accounting and provisions for expenses in an earlier chapter. The discussion of regulation has been limited to general issues and options for addressing these issues. No attempt has been made to present a definitive in- terpretation of regulation for any nation, province, or state. 10. The models for some insurance products that are no longer important in the market have been deleted. Models for new products, such as accelerated ben- efits for terminal illness or long-term care, are introduced 11, The final chapter contains a brief introduction to simple models in which in- terest rates are random variables. In addition, ideas for managing interest rate risk are discussed. It is hoped that this chapter will provide a bridge to recent developments within the intersection of actuarial mathematics and financial economics. ‘As the project of writing this second edition ends, it is clear that a significant new development is under way. This new endeavor is centered on the creation of general models for managing the risks to individuals and organizations created by uncertain future cash flows when the uncertainty derives from any source. This blending of the actuarial/ statistical approach to building models for financial se- curity systems with the approach taken in financial economics is a worthy assign- ment for the next cohort of actuarial students. Newton L. Bowers James C. Hickman Donald A. Jones Guide to Study The reader can consider this text as covering the two branches of risk theory. Individual risk theory views each policy as a unit and allows construction of a model for a group of policies by adding the financial results for the separate policies in the group. Collective risk theory uses a probabilistic model for total claims that avoids the step of adding the results for individual policies. This distinction is sometimes difficult to maintain in practice. The chapters, however, can be classified as illustrated below xxii Guide to Study12, 13, 14, 19, 20 It is also possible to divide insurance models into those appropriate for short- term insurance, where investment income is not a significant factor, and long-term insurance, where investment income is important, The following classification scheme provides this division of chapters along with an additional division of long- term models between those for life insurance and those for pensions. Short-Term Insurances Life Insurance 1,2, 12, 13, 14 3,45, 67, 8,9, 10, Wis 16 i718 aL ‘The selection of topics and their organization do not follow a traditional pattern. ‘As stated previously, the new organization arose from the goal to first cover ma- terial considered basic for all actuarial students (Chapters 1-14) and then to include a more in-depth treatment of selected topics for students specializing in life insur- ance and pensions (Chapters 15-21), ‘The discussion in Chapter 1 is devoted to two ideas: that random events can disrupt the plans of decision makers and that insurance systems are designed to reduce the adverse financial effects of these events. To illustrate the latter, single insurance policies are discussed and convenient, if not necessarily realistic, distri- butions of the loss random variable are used. In subsequent chapters, more detailed models are constructed for use with insurance systems. In Chapter 2, the individual risk model is developed, first in regard to single policies, then in regard to a portfolio of policies. In this model, a random variable, 5, the total claims in a single period, is the sum of a fixed number of independent random variables, each of which is associated with a single policy. Each component of the sum $ can take either the value 0 or a random claim amount in the course of a single period, From the viewpoint of risk theory, the ideas developed in Chapters 3 through 11 can be seen as extending the ideas of Chapter 2. Instead of considering the potential claims in a short period from an individual policy, we consider loss var~ iables that take into account the financial results of several periods. Since such random variables are no longer restricted to a short time period, they reflect the time value of money. For groups of individuals, we can then proceed, as in Authors" introductions and Guide to StudyChapter 2, to use an approximation, such as the normal approximation, to make probability statements about the sum of the random variables that are associated with the individual members. In Chapter 3, time-of-death is treated as a continuous random variable, and, after defining the probability density function, several features of the probability distribution are introduced and explored. In Chapters 4 and 5, life insurances and annuities are introduced, and the present values of the benefits are expressed as functions of the time-of-death. Several characteristics of the distributions of the present value of future benefits are examined. In Chapter 6, the equivalence prin- ciple is introduced andl used to define and evaluate periodic benefit premiums. In Chapters 7 and 8, the prospective future loss on a contract already in force is investigated. The distribution of future loss is examined, and the benefit reserve is defined as the expected value of this loss. In Chapter 9, annuity and insurance contracts involving two lives are studied. (Discussion of more advanced multiple life theory is deferred until Chapter 18.) The discussion in Chapters 10 and 11 investigates a more realistic model in which several causes of decrement are pos- sible. In Chapter 10, basic theory is examined, whereas in Chapter 11 the theory is applied to calculating actuarial present values for a variety of insurance and pen- sion benefits. In Chapter 12, the collective risk model is developed with respect to single-period considerations of a portfolio of policies. The distribution of total claims for the period is developed by postulating the characteristics of the portfolio in the aggre- gate rather than as a sum of individual policies. In Chapter 13, these ideas are extended to a continuous-time model that can be used to study solvency require- ments over a long time period. Applications of risk theory to insurance models are given an overview in Chapter 14. Elaboration of the individual model to incorporate operational constraints such as acquisition and administrative expenses, accounting requirements, and the ef- fects of contract terminations is treated in Chapters 15 and 16. In Chapter 17, in- dividual risk theory models are used to obtain actuarial present values, benefit and contract premiums, and benefit reserves for selected special plans including life annuities with certain periods that depend on the contract premium, variable and flexible products, and accelerated benefits. In Chapter 18, the elementary models for plans involving two lives are extended to incorporate contingencies based on a larger number of lives and more complicated benefits. In Chapter 19, concepts of population theory are introduced. These concepts are then applied to tracing the progress of life insurance benefits provided on a group, or population, basis. The tools from population theory are applied to tracing the progress of retirement income benefits provided on a group basis in Chapter 20. Chapter 21 is a step into the future. Interest rates are assumed to be random variables. Several stochastic models are introduced and then integrated into models for basic insurance and annuity contracts. xxiv Guide to StudyThe following diagram illustrates the prerequisite structure of the chapters. The arrows indicate the direction of the flow. For any chapter, the chapters that are upstream are prerequisite. For example, Chapter 6 has as prerequisites Chapters 1, 2, 3, 4, and 5. 2 13, oT We have a couple of hints for the reader, particularly for one for whom the material is new, The exercises are an important part of the text and include material not covered in the main discussion. In some cases, hints will be offered to aid in the solution. Answers to all exercises are provided except where the answer is given in the formulation of the problem. Writing computer programs and using electronic spreadsheets or mathematical software for the evaluation of basic formulas are excellent ways of enhancing the level of understanding of the material, The student is encouraged to use these tools to work through the computing exercises. We conclude these introductory comments with some miscellaneous information on the format of the text. First, each chapter concludes with a reference section that provides guidance to those who wish to pursue further study of the topics covered in the chapter. These sections also contain comments that relate the ideas used in insurance models to those used in other areas. Second, Chapters 1, 12, 13, 14, and 18 contain some theorems with their proofs included as chapter appendices. These proofs are included for completeness, but Authors Introductions and Guide to Study 7reer nn reer are not essential to an understanding of the material. They may be excluded from study at the reader's discretion. Exercises associated with these appendices should also be considered optional. Third, general appendices appear at the end of the text. Included here are nu- merical tables for computations for examples and exercises, an index to notation, a discussion of general rules for writing actuarial symbols, reference citations, answers to exercises, a subject index, and supplemental mathematical formulas that are not assumed to be a part of the mathematical prerequisites. Fourth, we observe two notational conventions. A referenced random variable, X, for example, is designated with a capital letter. This notational convention is not used in older texts on probability theory. It will be our practice, in order to indicate the correspondence, to use the appropriate random variable symbol as a subscript on functions and operators that depend on the random variable. We will use the general abbrevii ion [og to refer to natural (base ¢) logarithms, because a distinction between natural and common logarithms is unnecessary in the examples and ex- ercises. We assume the natural logarithm in our computations. Fifth, currencies such as dollar, pound, lira, or yen are not specified in the examples and exercises due to the international character of the required computations. Finally, since we have discussed prerequisites to this work, some major theorems from undergraduate calculus and probability theory will be used without review or restatement in the discussions and exercises, tow Guide (0 Studya THE ECONOMICS OF INSURANCE Introduction Each of us makes plans and has expectations about the path his or her life will follow. However, experience teaches that plans will not unfold with certainty and sometimes expectations will not be realized. Occasionally plans are frustrated be- cause they are built on unrealistic assumptions. In other situations, fortuitous cir- cumstances interfere. Insurance is designed to protect against serious financial re- versals that result from random events intruding on the plans of individuals. We should understand certain basic limitations on insurance protection. First, it is restricted to reducing those consequences of random events that can be measured in monetary terms. Other types of losses may be important, but not amenable to reduction through insurance. For example, pain and suffering may be caused by a random event. However, insurance coverages designed to compensate for pain and suffering often have been troubled by the difficulty of measuring the loss in monetary units. On the other hand, economic losses can be caused by events such as property set on fire by its, owner. Whereas the monetary terms of such losses may be easy to define, the events are not insurable because of the nonrandom nature of creating the losses. ‘A second basic limitation is that insurance does not directly reduce the proba- bility of loss. The existence of windstorm insurance will not alter the probability of a destructive storm. However, a well-designed insurance system often provides financial incentives for loss prevention activities. An insurance product that en- couraged the destruction of property or the withdrawal of a productive person from the labor force would affect the probability of these economically adverse events. Such insurance would not be in the public interest. Several examples of situations where random events may cause financial losses are the following: + The destruction of property by fire or storm is usually considered a random event in which the loss can be measured in monetary terms. Chapter 1 The Economics of Insurance+ A damage award imposed by a court as a result of a negligent act is often considered a random event with resulting monetary loss. + Prolonged illness may strike at an unexpected time and result in financial losses. These losses will be due to extra health care expenses and reduced eamed income. + The death of a young adult may occur while long-term commitments to family or business remain unfulfilled. Or, if the individual survives to an advanced age, resources for meeting the costs of living may be depleted. ‘These examples are designed to illustrate the definition: ‘An insurance system is a mechanism for reducing the adverse financial impact of random events that prevent the fulfillment of reasonable expectations. It is helpful to make certain distinctions between insurance and related systems. Banking institutions were developed for the purpose of receiving, investing, and dispensing the savings of individuals and corporations. The cash flows in and out of a savings institution do not follow deterministic paths. However, unlike insur- ance systems, savings institutions do not make payments based on the size of a financial loss occurring from an event outside the control of the person suffering the loss. Another system that does make payments based on the occurrence of random events is gambling. Gambling or wagering, however, stands in contrast to an in- surance system in that an insurance system is designed to protect against the ec- onomic impact of risks that exist independently of, and are largely beyond the control of, the insured. The typical gambling arrangement is established by defining, payoff rules about the occurrence of a contrived event, and the risk is voluntarily sought by the participants. Like insurance, a gambling arrangement typically re- distributes wealth, but it is there that the similarity ends. Our definition of an insurance system is purposefully broad. It encompasses sys- tems that cover losses in both property and human-life values. It is intended to cover insurance systems based on individual decisions to participate as well as, systems where participation is a condition of employment or residence. These ideas are discussed in Section 14. ‘The economic justification for an insurance system is that it contributes to general welfare by improving the prospect that plans will not be frustrated by random, events. Such systems may also increase total production by encouraging individuals and corporations to embark on ventures where the possibility of large losses would inhibit such projects in the absence of insurance. The development of marine in- surance, for reducing the financial impact of the perils of the sea, is an example of this point. Foreign trade permitted specialization and more efficient production, yet mutually advantageous trading activity might be too hazardous for some potential trading partners without an insurance system to cover possible losses at sea, Section 1.7 Introduction1.2 Utility Theory If people could foretell the consequences of their decisions, their lives would be simpler but less interesting. We would all make decisions on the basis of prefer- ences for certain consequences. However, we do not possess perfect foresight, At, best, we can select an action that will lead to one set of uncertainties rather than. another. An elaborate theory has.been developed that provides insights into deci- ig in the face of uncertainty. This body of knowledge is called utility \e to insuranée systems, {ts main points will be out- ‘One solution to the problem of decision making in the face of uncertainty is to define the value of an economic project, with a random outcome to be its expected value. By this expected value principle/the distribution of possible outcomes may be replaced for decision purposes by a single number, the expected value of the random monetary outcomes. By this principle, a decision maker would be indif- ferent between assuming the random loss_X and paying amount E[X] in order to be relieved of the possible loss, Similarly, a decision maker would be willing to pay up to E[Y] to participate in a gamble with random payoff Y. In economics he} expected value of tandom prospects with monstary paymenté is frequently called the fair or actuarial value of the prospect. Many decision makers do not adopt the expected value principle. For them, their wealth level and other aspects of the distribution of outcomes influence their decisions. Below is an illustration designed to show the inadequacy of the expected value principle for a decision maker considering the value of accident insurance. In all cases, it is assumed that the probability of an accident is 0.01 and the probability of no accident is 0.99. Three cases are considered according to the amount of loss arising from an accident; the expected loss is tabulated for each Case Possible Losses __ Expected Loss a 0 1 O01 2 0 1.000 10.00 3 1.000.000 10 000.00 A loss of 1 might be of little concern to the decision maker who then might be unwilling to pay more than the expected loss to obtain insurance. However, the loss of 1,000,000, which may exceed his net worth, could be catastrophic. In this case, the decision maker might well be willing to pay more than the expected loss of 10,000 in order to obtain insurance. The fact that the amount/a decision maker would pay for protection against a random loss may differ from the expected value’ suggests that the expected value principle is inadequate to model behavior. Chapter 1 The Economics of InsuranceWe now study another approach to explain why a decision maker may be willing to pay more than the expected value. At first we simply assume that the, valig2or utility that a particular decision maker attaches to wealth of amount agymeasured in monetary units, can be specified in the form of a function u(w), called a utility function. We demonstrate a procedure by which § few valtieS of such a function ‘can be determined. For this we assume that our decision maker has wealth equal to 20,000. A linear transformation, an ut(w) = auw) +b a >0, yields §-furiction u"(w), which is essentially equivalent.t0 u(io), It then follows by choice of a and b that we can determine arbitrarily the 0 point and one additional point of an individual's utility function. Therefore, we fix u(0) = ~1 and 1(20,000) 0. These values are plotted on the solid fine in Figure 1.2.1 Determination of a Utility Function (wo) wealth in thousands ‘We now ask a question of our decision maker: Suppose you face a loss of 20,000 with probability 0.5, and will remain at your current level of wealth with proba- bility 0.5. What is the maximum amount* G you would be willing to pay for =Premium quantities, by convention in insurance literature, are capitalized although they are not random variables. Section 12 Utity Theorycomplete insurance protection against this random loss? We can express this ques- tion in the following way: For what value of G does 1u(20,000 ~ G) = 0.5 u(20,000) + 0.5 u(0) = (0.5(0) + (0.5)(-1) = -05? If he pays amount G, his wealth will certainly remain at 20,000 — G. The equal sign indicates that the decision maker is indifferent between paying G with cer- tainty and accepting the expected utility of wealth expressed on the right-hand le Suppose the decision maker's answer is G = 12,000. Therefore, 14(20,000 ~ 12,000) = u(8,000) = -0.5. This result is plotted on the dashed line in Figure 1.2.1. Perhaps the most important aspect of the decision maker's response is that he is willing to pay an amount for insurance that is greater than (0.5)(0) + (0.5)(20,000) = 10,000, the expected value of the loss, This procedure can be used to add as many points [w, u(w)], for 0 = w = 20,000, as needed to obtain a satisfactory approximation to the decision maker's utility of wealth function. Once a utility value has been assigned to wealth levels w, and w, where 0 = w, < w, = 20,000, we can determine an additional point by asking the decision maker the following question: What is the maximum amount you would pay for complete insurance against a situation that could leave you with wealth w, with specified probability p, or at reduced wealth level w, with probability 1 ~ p? We are asking the decision maker to fix a value G such that ute ~ G) = (1 = p)u(toy) + p u(y). (121) Once the value w, — G = w, is available, the point [w,, (1 — p)u(w,) + p u(w,)) is determined as another point of the utility function, Such a process has been used to assign a fourth point (12,500, -0.25) in Figure 1.2.1. Such solicitation of prefer- ences leads to a set of points on the decision maker's utility function. A smooth function with a second derivative may be fitted to these points to provide for a utility function everywhere. After a decision maker has determined his utility of wealth function by. the. method outlined, the function can be used to compare two random economic pros- pects. The prospects are denoted by the random variables X and Y. We seek a decision rule that is consistent with the preferences already elicited in the deter- ‘mination of the utility of wealth function, Thus, if the decision maker has wealth w, and must compare the random prospects X and Y, the decision maker selects X if Efu(we + X)] > Elu@e + YL and the decision maker is indifferent between X and Y if Chapter 1 The Economics of InsuranceFe Elu(w + X)] = Eluw + Y)) Although the method of eliciting and using a utility function may seem plausible, it is clear that our informal development must be augmented by a more rigorous chain of reasoning if utility theory is to provide a coherent and comprehensive framework for decision making in the face of uncertainty: If we are to understand the economic role of insurance, such a framework is needed. An outline of this more rigorous theory follows ‘The theory starts with the assumption that a rational decision maker, when faced with two distributions of outcomes affecting wealth, is able to express a preference for one of the distributions or indifference between them. Furthermore, the pref- cerences must satisfy certain consistency requirements, The theory culminates in a theorem stating that if preferences satisfy the consistency requirements, there is a utility function u(to) such that if the distribution of X is preferred to the distribution of Y, E{u(X)] > E{u(Y)), and if the decision maker is indifferent between the two distributions, E[u(X)] = Elu(Y)] That is, the qualitative preference or indifference yelation may be replaced by a consistent numerical comparison. In Section 1.6, references are given for the detailed development of this theory. Before turning to applications of utility theory for insights into insurance, we record some observations about utility. Observations: 1. Utility theory is built on the assumed existence and consistency of preferences for probability distributions of outcomes. A utility function should reveal no surprises. It is a numerical description of existing preferences 2. Autility function need not, in fact, cannot, be determined uniquely. For example, if uw) = au(w) +b a>, then Elu(X)] > EW) is equivalent to Epu'(X)] > Eur) “That is, preferences are preserved when the utility function is an increasing linear transformation of the original form. This fact was used in the Figure 1.2.1 illus- tration where two points were chosen arbitrarily. 3. Suppose the utility function is linear with a positive slope; that is, uo) =aw+b a>0. ‘Then, if E[X] = wy and E[Y] = By, we have E[u(X)] = apy + b> Elu(Y)] = apy +b if and only if py > py- That is, for increasing linear utility functions, preferences é Section 1.2 Utility Theory