Lecture Notes

on
Actuarial Mathematics
Jerry Alan Veeh
May 9, 2003

§0. Introduction
The objective of these notes is to present the basic aspects of the theory of in
surance, concentrating on the part of this theory related to life insurance. An
understanding of the basic principles underlying this part of the subject will f
orm a solid foundation for further study of the theory in a more general setting
.
Throughout these notes are various exercises and problems. The reader should
attempt to work all of these.
A calculator, such as the one allowed on the Society of Actuaries examinations,
will be useful in solving some of the problems here. The problems contained here
are not all amenable to solution using only this simple calculator. A computer
equipped with spreadsheet software will sometimes be useful, especially for the
laboratory exercises.
§1. Overview
The central theme of these notes is embodied in the question, “What is the value t
oday of a random sum of money which will be paid at a random time in the future?”
Such a random payment is called a contingent payment.
The theory of insurance can be viewed as the theory of contingent payments. The
insurance company makes payments to its insureds contingent upon the oc- currenc
e of some event, such as the death of the insured, an auto accident by an insure
d, and so on. The insured makes premium payments to the insurance company contin
gent upon being alive, having suf cient funds, and so on. A natural way to model t
hese contingencies mathematically is to use probability theory. Probabilistic co
nsiderations will, therefore, play an important role in the discussion that foll
ows.
The other central consideration in the theory of insurance is the time value of
money. Both claims and premium payments occur at various, possibly random, poin
ts of time in the future. Since the value of a sum of money depends on the point
in time at which the funds are available, a method of comparing the value of su
ms of money which become available at different points of time is needed. This m
ethodology is provided by the theory of interest. The theory of interest will be
studied rst in a non-random setting in which all payments are assumed to be sure
to be made. Then the theory will be developed in a random environment, and will
be seen to provide a complete framework for the understanding of contingent pay
ments.
§2. Elements of the Theory of Interest
A typical part of most insurance contracts is that the insured pays the insurer
a xed premium on a periodic (usually annual or semi–annual) basis. Money has time v
alue, that is, $1 in hand today is more valuable than $1 to be received one year
hence. A careful analysis of insurance problems must take this effect into acco
unt. The purpose of this section is to examine the basic aspects of the theory o
f interest. A thorough understanding of the concepts discussed here is essential
.
To begin, remember the way in which compound interest works. Suppose an amountA
is invested at interest ratei per year and this interest is compounded annually.
Aftern years the amount will beA(1 +i)n. The factor (1 +i)nis sometimes called
theaccumulation factor. If interest is compounded daily after the samen years th
e amount will beA(1 +i
365)365n. In this discussion the interest ratei is called
thenominal annual rate of interest. Theeffective rate of interest in the example
in which interest is compounded daily is (1 +i
365)365− 1. This is the rate of interest
which compounded annually would provide the same return.
Exercise 2–1.What is the effective rate of interest corresponding to an interest r
ate
of 5% compounded quarterly?
It is possible that two different investment schemes with two different nominal
annual rates of interest may in fact beequivalent, that is, may have equal doll
ar value at any xed date in the future. This possibility is illustrated by means
of an example.
Example 2–1.Suppose I have the opportunity to invest $1 in Bank A which pays
5% interest compounded monthly. What interest rate does Bank B have to pay,
compounded daily, to provide an equivalent investment? At any timet in years the
amount in the two banks is given by
365t
respectively. It is now an easy exercise to nd the nominal interest ratei which m
akes these two functions equal.
Exercise 2–2.Find the interest ratei. What is the effective rate of interest?
Situations in which interest is compounded more often than annually will arise f
requently. Some notation will be needed to discuss these situations conveniently
. Denote byi(m)the nominal annual interest rate compoundedm times per year which
is equivalent to the interest ratei compounded annually. This means that

1+i(m)
m
m
= 1+i.
Exercise 2–3.Compute 0.05(12)
§2: Elements of the Theory of Interest5
An important abstraction of the idea of compound interest is the idea of con
tinuous compounding. If interest is compoundedn times per year the amount after
tyears is given by
nt
. Lettingn→ ∞ in this expression produceseit, and this corresponds to the notion of
instantaneous compounding

of interest. In this context denote byδthe rate
of insta
ntaneous compoun ing which is equivalent to interest ratei. Hereδis calle theforc
e of
interest.

The force
of interest is extremely important from a theoretical s
tan point an also provi es some useful quick approximations.
Exercise 2–4.Show
thatδ= log(1 +i).


Exercise

2–5.Fin the force of interest which is equivalent to 5% compoun e
aily.


The converse of the problem of n ing the amount aftern years at compoun interes
t is as follows. Suppose

the objective is to have an amountA


n years

hence.

If m
oney

can be investe at interest ratei, how

much shoul be eposite to ay

in or
er to achieve this objective? It
is rea ily seen that the amount require is
A(1 + i)−n. This quantity is calle thepresent value ofA. The factor (1 +i)−1is






often calle the iscount factor an is enote byv.
Example 2–2.Suppose the annual interest rate is 5%. What is the present value
of a payment of $2000 payable in the year 2014? The present value (in 2004) is
$2000(1 + 0.05)−10 = $1227.83.



The notion of present value is use to move payments of money through time in or
er to simplify the analysis of a complex
sequence of payments. In the simple ca
se of the last example the important i ea is this.
Suppose you were given the fo
llowing choice. You may either receive $1227.83 to ay or you

may receive $2000 i
n
the year

2014. If you can earn 5% on your money

(compoun e annually) you shou
l be in ifferent between these two choices. Un er the assumption

of an interest
rate
of 5%, the payment of $2000 in 2014 can be
replace by a payment of
$1227.
83 to ay. Thus the payment
of $2000 can be move
through time using

the i ea of
present value. A
visual ai that is often
use

is that of a time iagram which s
hows the time an amounts that

are pai . Un er the assumption of an interest rat
e of 5%, the following two iagrams are equivalent.
Two Equivalent Cash Flows
$2000 $1227.83
___________________________ __________________
2004 2014 2004 2014


The a vantage of moving amounts of money through time is that once all.

§2: Elements of the Theory of Interest7

Problems

Problem


2–1.Show that ifi> 0 then
< (2)< (3)< ⋅⋅⋅ <δ < ⋅⋅⋅ <i(3)<i(2)<i.


Problem 2–2.Show that limm→∞ (m) = limm→∞i(m) =δ .
Problem 2–3.Calculate the nominal rate of
interest convertible once every 4 years
that is equivalent to a nominal rate of iscount convertible quarterly.
Problem 2–4.Interest rates are not always the same throughout time. In theoretical




stu

ies
such scenarios
are usually mo elle by allowing the force
of interest to
epen on time. Consi er the situation in which $1 is investe at time 0 in an
account which pays interest at a constant force of interestδ. What is the
amount
A(t) in the account at time t? What is the relationship between A′(t) an A(t)? Mor
e
generally,

suppose the force
of interest at timet isδ(t). Argue thatA′(t) = δ(t)A(t),
an solve this equation
to n an explicit formula forA(t) in terms
ofδ(t) alone.
Problem 2–5.Show that
= 1−v. Is there a similar equation involving
(m)?

Problem 2–6.Show that =iv. Is there a similar equation involving (m)an i
§2: Elements of the Theory of Interest8
Solutions to Problems

Problem 2–1.An analytic argument is possible irectly from the formulas.


For example,

(1 +i(m)/m)m = 1+ i=
eδso

i(m)=m(eδ/m−

1). Consi erm as a continuous

vari
able an show that the right han si e is a ecreasing

function ofm for xe i. Can
you give a purely


verbal argument? Hint: How oes an investment with nominal ra

tei(2)compoun

e annually compare with an investment at nominal ratei(2)compoun
e twice a year?


Problem 2–2.Sincei(m)=m((1 +i)1/m−1) the limit can be
evaluate
irectly
using L’Hopitals rule, Maclaurin expansions, or the e nition of erivative.
Problem 2–3.The relevant equation is
1+ 4i(1/ 4)
1/ 4=


1− (4)/ 4
−4.

Problem 2–4.In the constant force settingA(t)

=eδt an A′(t) =δA(t). The
equationA′(t)
=δ (t)A(t) can be solve by separation of variables.
Problem 2–5.1−

(m)/m= v1/m.
Problem 2–6. (m)/m= v1/mi(m)/m(m)?