Module 6 Profit Testing - Exercises

Cash-flow projection of conventional products

1. Dickson et al. (2009a) Exercise 11.3 (a) (Exercise 12.6 (a) - Dickson et al., 2013a)

Cash-flow projection for unit-linked products

2. A life office issues a 4-year unit linked endowment policy to a life aged 50 exact under which level
premiums of $2, 000 per annum are payable in advance. In the first year, 25% of the premium is
allocated to units and 102.5% in the second and subsequent years. There is a bid/offer spread in the
prices of the units of 5% of the offer price. A management charge of 0.5% per annum of the bid value
of the units is deducted at the end of each year.
If the policyholder dies during the term of the policy, the death benefit of $5, 000 or the bid value of
the units after the deduction of the management charge, whichever is higher, is payable at the end of
the year of death. On surrender or on survival to the end of the term, the bid value of the units is
payable at the end of the year of exit.
The company uses the following assumptions in its profit test of this contract:

Rate of interest on unit investments: 8% per annum

Rate of interest on non-unit fund cashflows: 6% per annum
Independent rates of mortality: AM92 Select
Independent rates of withdrawal: 10% of all policies still in force at the end
of the first and subsequent years
Initial expenses: $150 plus 20% of first premium
Renewal expenses: $50 per annum on the second and
subsequent premium dates
Initial commission: 25% of first year premium
Renewal commission: 2.5% of the second and
subsequent premiums
Risk discount rate: 12% per annum

Project end-of-the-year unit funds and non-unit fund cash flows.

3. A three-year unit-linked policy is issued on the following terms:

premiums of $1, 000 are payable annually in advance;

the allocation proportion is 50% in the first year and 100% in the following two years;
the bid/offer spread is 5%;
the management charge, which is deducted at the end of the year before payment of the death
benefit, is 0.5% of the bid price of the unit fund;
the death benefit, which is payable at the end of the year of death, is the bid price of the units or
$1, 500, whichever is greater; and
the maturity proceeds are the value of the bid price of the units.

The company issuing the policy estimates the profit signature on the following (conservative) assump-
tions:

the units will grow at 3% p.a.;

the interest rate for reserves is 3% p.a.;
there are no withdrawals and the probability of death in any given year is 0.008; and

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 the expenses are $400 at the start of the first year and $100 at the start of each of the following
two years.

Project end-of-the-year unit funds and non-unit fund cash flows.

Profit measures
4. Dickson et al. (2009a) Exercise 11.3 (b), (c), (d) (Exercise 12.6 (b), (c), (d) - Dickson et al., 2013a)
5. A life insurance issues an endowment insurance with a term of five years to a life aged exactly 55. The
sum insured is $100, 000, payable at the end of the five years, or at the end of the year of death, if
earlier. Premiums are payable annually in advance throughout the term of the policy.
The insurer assumes that initial expenses will be $300 and renewal expenses, which are incurred at the
beginning of the second and subsequent years of the policy, will be $30 plus 2.5% of the premium. The
funds invested for the policy are expected to earn 7.5% p.a., and mortality is expected to follow the
AM92 Select life table. The company holds net premium reserves, calculated using AM92 Ultimate
mortality and interest of 4% p.a.
The insurer sets premiums so that the net present value of the profit on the contract is 15% of the
annual premium, using a risk discount rate of 12% p.a.

(a) Calculate the annual premium.

(b) Without carrying out any further calculations, state with brief reasons what the effect on the
premium would be in each of the following cases:
(i) The reserves are calculated using a lower rate of interest;
(ii) The insurer uses a risk discount rate of 15%; and
(iii) Mortality is assumed to be AM92 Ultimate.

6. A life insurance company issues a 4-year unit-linked policy to a life aged 50 exact under which level
premiums of $2,000 per annum are payable in advance. The following non-unit cash flows, NUCFk (k
= 1,2,3,4), are obtained at the end of each year k per policy in force at the start of the year k:

Year k 1 2 3 4
N U CFk 497.659 -43.199 -25.777 13.205
The company uses the following assumptions in its profit test of this contract:

Independent rates of mortality: AM92 Select

Independent rates of withdrawal: 10% of all policies still in force at the end
of the first and subsequent years
Risk discount rate: 12% per annum
Calculate the profit margin on the assumption that the company does not zeroize future negative
cashflows and that decrements are uniformly distributed over the year.

7. A life office issues a 5-year unit-linked policy to a life aged 60 exact with annual payment of $1, 500.
Assume a 100% allocation percentage in each year.
Policyholders purchase units from the office at the offer price and the life office buys back units at the
beginning of each years bid price in the case of earlier death or at maturity. Benefits are paid at the
end of the year of death or at maturity. Initial expenses are $1, 200 and renewal expenses are $100
excluding the first per annum.

Basis: AM92 Ultimate. Interest 4%. Annual management charge: $200. Bid/Offer spread 10%.
Assume that the unit offer price at entry is $2.

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 (a) Calculate the profit made at the end of each of the five years provided the unit trust is in force
at the beginning of the year, assuming that the unit fund grows at 10% per annum before the
deduction of management charge.
(b) Calculate the net present value of the profit for a 5-year unit trust using a risk discount rate of
15% per annum.
(c) Calculate the profit margin using a risk discount rate of 15% per annum.

Zeroisation
8. A life insurance company issues 4-year unit-linked contracts to a male aged 50 exact. The following
non-unit fund cash flows, NUCFk, (k = 1, 2, 3, 4) are obtained at the end of each year k per contract
in force at the start of the year k:

Year k 1 2 3 4
N U CFk 375.4 -152.0 -136.2 118.0
The rate of interest earned on non-unit reserves is 5.5% per annum and mortality follows the AM92
Select table. Calculate the reserves required at times k = 1, 2 and 3 in order to zeroise future negative
cash flows.
9. A three-year unit-linked policy is issued to a male under which premiums of $1, 000 are payable annu-
ally in advance; the interest rate is 3% p.a.; there are no withdrawals and the probability of death in
any given year is 0.008. The following non-unit cash flows, NUCFk (k = 1,2,3), are obtained at the
end of each year k per policy in force at the start of the year k:

Year k 1 2 3
N U CFk 123.091 -44.320 -39.024

(a) Calculate the profit signature of the policy, assuming that no reserves are held at the end of each
policy year.
(b) Find the zeroized profit signature.
(c) Giving reasons for your answer, state the effect on the zeroized profit signature of an increase in
the assumed rate of growth of unit prices.

Universal life insurance

10. Dickson et al. (2013a) Excercise 13.10
A life insurance company issues a four-year universal life policy to (65). The main features of the
contract are as follows:
Premiums: $3000 per year, payable yearly in advance.
Expense charges: 4% of premium is deducted at the start of the first year; $100 plus 0.4% of the
account value (before premium) is deducted at the start of each subsequent policy year.
CoI: $25 is deducted from the account value at the start of each year.
Death benefit: greater of $12 000 or 1.5 times the account value at year end.
Maturity benefit: 100% of the account value.
The company uses the following assumptions in carrying out a profit test of this contract.
Interest rate: 4.5% per year in year 1, 5.5% per year in year 2, and 6.5% per year in years 3 and
4.
Credited interest: Earned rate minus 1%, with a 4% minimum.

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 Survival model: Standard ultimate survival model.
Withdrawals: None.
Initial expenses: $200 pre-contract expenses.
Renewal expenses: payable annually at each premium date, initial cost (with first premium) $50,
increasing with inflation of 2% per year.
Risk discount rate: 8% per year.

There are no reserves held other than the account value.

(a) Calculate the profit signature and NPV of a newly issued contract.
(b) Calculate the profit signature and NPV for the policy given that the policyholder dies in the first
year of the contract.
(c) Calculate the profit signature and NPV for the policy given that the policyholder survives to the
contract end.
(d) Calculate the profit signature and NPV for the policy given that the policyholder surrenders at
the end of the second year, assuming
(i) that the cash value is 100% of the year end account value
(ii) that the cash value is 90% of the year end account value
(e) Calculate the surrender penalty at time 2, as a proportion of reserves at time 2, which gives
the same profit margin for surrendering policyholders as for policyholders who remain in force
throughout.
(f) Comment on your results

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 Module 6 Solutions

1. Dickson et al. (2009b) (Dickson et al., 2013b) Solutions Manual.

2. First, we need to convert the independent decrements to dependent decrements. From the AM92 Select
table and a 10% yearly withdrawal rate, we have

x qxd qxw
50 0.001971 0.10
51 0.002732 0.10
52 0.003152 0.10
53 0.003539 0.10

where decrement d refers to death and w withdrawal or surrender. Next, assuming uniform distribution
of decrement, we know that the corresponding dependent decrement gives
 
d d 1 w
(aq)x = qx 1 qx
2

and  
1 d
(aq)w
x = qx
w
1 q .
2 x
And so we have
(ap)x = 1 (aq)dx (aq)w
x

which gives the probability of survival (i.e. not death nor withdrawal) during the year. We thus have

x (aq)dx (aq)w
x (ap)x t1 (ap)x
50 0.001872 0.099901 0.898226 1.000000
51 0.002595 0.099863 0.897541 0.898226
52 0.002994 0.099842 0.897163 0.806195
53 0.003362 0.099823 0.896815 0.723288

Step 1: Project the unit funds:

Year 1 Year 2 Year 3 Year 4

value of units at
start of the year 0.000 510.435 2,641.297 4,931.121

premium received 2,000 2,000 2,000 2,000

premium allocated 500 2,050 2,050 2,050

B/O spread 25 102.5 102.5 102.5

interest 38.000 196.635 367.104 550.290

mngt charge 2.565 13.273 24.780 37.145

value of units at
end of the year 510.435 2,641.297 4,931.121 7,391.766

Note that management charges are imposed after crediting of interest.

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 Step 2: Project the non-unit cashflows:

Year 1 Year 2 Year 3 Year 4

premium unallocated (+) 1,500 -50 -50 -50

B/O spread (+) 25 102.5 102.5 102.5

expenses (-) 1,050 100 100 100

interest (+) 28.50 -2.85 -2.85 -2.85

mngt charge (+) 2.565 13.273 24.780 37.145

extra mortality cost (-) 8.406 6.122 0.206 0.000

end of the year

cash flow 497.659 -43.199 -25.777 -13.205

Note that management charges is positive because this is an (addition) cash flow to the insurer. The
extra mortality costs were computed as

max (0, 5000 ut ) (aq)dx+t1

which provides for the shortfall of the units to provide for the minimum death benefit guaranteed.

3. Step 1: Project the unit funds:

Year 1 Year 2 Year 3

value of units at
start of the year 0.000 486.804 1,472.508

premium received 1,000 1,000 1,000

premium allocated 500 1,000 1,000

B/O spread 25 50 50

interest 14.250 43.104 72.675

mngt charge 2.446 7.400 12.476

value of units at
end of the year 486.804 1,472.508 2,482.708

Note that management charges are imposed after crediting of interest.

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 Step 2: Project the non-unit cashflows:

Year 1 Year 2 Year 3

premium unallocated (+) 500 0 0

B/O spread (+) 25 50 50

expenses (-) 400 100 100

interest (+) 3.750 -1.500 -1.500

mngt charge (+) 2.446 7.400 12.476

extra mortality cost (-) 8.106 0.220 0

end of the year

cash flow 123.091 -44.320 -39.024

Note that management charges is positive because this is an (addition) cash flow to the insurer. The
extra mortality costs were computed as

max (0, 1500 ut ) (aq)dx+t1

which provides for the shortfall of the units to provide for the minimum death benefit guaranteed.

4. Dickson et al. (2009b) (Dickson et al., 2013b) Solutions Manual

5. One can use Solver in Excel, for example, to find the desired annual premium, by varying the annual
premium and seeking a 15% profit margin.

(a) In the end, the result is an annual premium of $19, 847.84. The details of the resulting emerging
cash flows with this annual premium is summarized below:

Year 1 Year 2 Year 3 Year 4 Year 5

Premium 19,847.84 19,847.84 19,847.84 19,847.84 19,847.84

Expenses 300.00 526.20 526.20 526.20 526.20

Interest on (Prem-Expns) 1,466.09 1,449.12 1,449.12 1,449.12 1,449.12

Interest on reserves 0.00 1,374.05 2,805.34 4,302.07 5,864.23
Total interest income 1,466.09 2,823.17 4,254.47 5,751.19 7,313.35

Death claims (expected) 335.80 490.30 565.00 635.20 714.00

Surrenders - - - - -

Increase in reserves 18,259.09 18,900.57 19,632.29 20,332.13 21,096.25

E.O.Y. profits 2,419.03 2,753.93 3,378.82 4,105.51 4,824.74

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 Therefore, in computing the resulting profit margin, we have:

Year 1 Year 2 Year 3 Year 4 Year 5

Probability in force 1.000000 0.996642 0.991755 0.986152 0.979888

Discount factor 0.8928571 0.7971939 0.7117802 0.6355181 0.5674269

Expected PV profits 2,159.85 2,188.05 2,385.15 2,572.99 2,682.63

Expected PV premiums 19,847.84 17,661.77 15,692.12 13,931.66 12,359.97

One can then easily verify that the resulting profit margin will be around the neighborhood of
15%.
(b) If reserves were calculated using a lower interest rate, this increases the necessary value of reserves
to hold in each year because the reserve fund will be expected to be earning less. There will then
be larger increases in reserves expected in each year, thereby emerging of lower profits. To achieve
the 15% profit margin, one will have to increase the annual premium. If risk discount rate of 15%
were used instead of 12%, this decreases the present value of the profits, thereby requiring higher
annual premium to achieve the same profit goal. Lastly, if the AM92 ultimate table were used
instead of AM92 Select, then mortality cost will be higher than expected which reduces profit in
turn. Thereby higher premium is required.

6. Calculate the expected p.v. of profits, premiums and then the profit margin (without zeroizing future
negative cash flows).

Year 1 Year 2 Year 3 Year 4

probability
in force 1.000000 0.898226 0.806195 0.723288

discount factor 0.892857143 0.797193878 0.711780248 0.635518078

expected p.v. of profits 444.338 -30.933 -14.792 -6.070

sum = 392.543

expected p.v. of premiums 2,000.000 1,603.975 1,285.387 1,029.645

(annual premium*discount factor*probability in force)
expected p.v. premiums 5,919.007

profit margin 6.63%

7. We skip the details as they are exactly similar to the last question, as well as those illustrated in the
lecture.
Note that the price of one unit at entry itself is not important. What matters are the bid/offer spread
and the growth rate of the unit fund. The death benefit and maturity benefit are same as the balance
of the unit fund. So there will be no extra mortality and withdraw cost in the non-unit fund for any
year.

(a) One can verify that the profit vector turns out to be

PRO = (892, 252, 252, 252, 252) .

(b) The NPV of the profits is equal to 163.007.

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 (c) This gives a profit margin of 2.86%.

8.
118.0
3V = = 111.85
1.055
2 V 1.055 p52 3 V = 136.2 2 V = 234.78

1V 1.055 p[50]+1 2 V = 152.0 1 V = 366.01

where

Year k q[50]+t1 p[50]+t1

1 0.001971 0.998029
2 0.002732 0.997268
3 0.003152 0.996848
4 0.003539 0.996461

9. (a) Calculation of the profit signature without reserves held.

Year 1 Year 2 Year 3

probability
in force 1.000000 0.992000 0.984064

profit vector 123.091 -44.320 -39.024

profit signature 123.091 -43.966 -38.402

(b) If reserves were held by zeroizing future negative cash flows, one can easily verify that the resulting
profit signature will be
(44.208, 0, 0) .
(c) It is expected that the zeroized profit signature will increase with increased rate of growth in the
unit funds primarily for two reasons: (1) this increases the value of the unit funds which will in
turn increase management charges since it is a rate applied to the unit funds; and (2) this increases
the value of the unit funds thereby decreasing the probability that there will be a shortfall from
the minimum guarantee.

10. Dickson et al. (2013b) Solutions Manual - Exercise 13.10.

(a) First, project the account values and the death benefit, assuming the policy remains in force for
four years. In general,

AVt = (AVt1 + P EC CoI)(1 + iC

t )

and

DBt = max(12000, 1.5Vt ).

The calculations are set out in the following table.

t AVt1 P EC CoI ic AVt DBt

1 0.00 3 000 120.00 25 4.0% 2 960.20 12 000.00
2 2 969.20 3 000 111.88 25 4.5% 6 094.78 12 000.00
3 6 094.78 3 000 124.38 25 5.5% 9 437.40 14 156.09
4 9 437.40 3 000 137.75 25 5.5% 12 949.75 19 424.63

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 Next, use AVt and DBt from this projection to profit test the insurers cash flows. At time t = 0,
we have the pre-premium expenses of $200, giving P r0 = 200. For t = 1, 2, 3, 4, the emerging
profit at the year end for a policy in force at the start of the year is
P rt = (AVt1 + P E)(1 + it ) q65+t1 DBt p65+t1 AVt
The full profit vector calculation is tabulated below:

t AVt1 P E I EDBt EAVt P rt

0 200.00 -200.00
1 0.00 3 000 50.00 132.75 70.98 2 951.64 60.14
2 2 969.20 3 000 51.00 325.50 79.42 6 054.44 109.84
3 6 094.78 3 000 52.02 587.78 104.88 9 367.47 158.18
4 9 437.40 3 000 53.06 804.98 161.16 12 842.31 185.84

The profit signature, , is the vector of emerging profits per policy issued, where t =t1 p65 P rt
for t = 1, 2, 3, 4, and 0 = P r0 . So
= (200.00, 60.14, 109.19, 156.20, 182.16)0
and
4
X
t
N P V = 0 + t v8% = 207.19
t=1

(b) Given that the policyholder dies in the first year, the profit signature is
= (200.00, 8917.15, 0, 0, 0)0
Note that the profit signature and profit vector are the same when there is no uncertainty about
the year of death.

We see that there is no impact on P r0 , as the value was not dependent on survival in any
case. The second term is from the year 1 cash flows, given that the death benefit is paid in the
first year:
1 = 1.045(3000 50) 12000 = 8917.25
The NPV is -$8 456.71
(c) The calculations are are similar to those in part (a), but assuming the policyholder survives the
term. For example,
1 = 1.045(3000 50) AV1 = 113.55
2 = 1.055(AV1 + 3000 51) AV2 = 148.92
The profit signature, given survival to the end of the term, is
= (200, 113.55, 148.92, 193.14, 239.57)0
and the NPV is $362.23.
(d) (i) The calculations are similar to those in part (c), but assuming the policyholder survives to
time 2, and then receives the full account value, AV2 , and there are no further cash flows.
Using part (c), we have
= (200, 113.55, 148.92, 0, 0)0
and the NPV is $32.82.
1. Assuming the policyholder survives to time 2, and then receives 90% of the account value,
we have
2 = 1.055(AV1 + 3000 51) 0.9AV2 = 758.40
giving
= (200, 113.55, 758.40, 0, 0)0
and the NPV is $555.35.

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(e) The profit margin, denoted pm for policyholders who remain in force throughout the contract is

NPV
pm = given survival to the contract end
P V P remiums
NPV 362.23
= = = 3.38%
3000a4|8% 10731.29

The profit margin for a policyholder who surrenders at time 2 is

NPV
pm = given surrender at time 2
P V premiums
NPV NPV
= =
3000(1 + v8% ) 5777.78

Setting this profit margin equal to 3.38% gives

N P V = 0.0338 5777.78 = 195.02

P2 k
and so, since we also have N P V = k=0 k v8% ,
2
195.02 = 200 + 113.55v8% + 2 v8% ,

giving 2 = 338.12. Then if represents the surrender penalty,

338.12 = 1.055(2969.20 + 3000 51) (1 )AV2

giving = 3.1%. so a cash value of 96.9% of the account value would generate 3.38% profit
margin required from policyholders surrendering during the second policy year.
(f) We see from part (a) that, ignoring surrenders, there will be a profit for the insurer, at the 8%
discount rate, of $207.19 per policy. (The profit margin is 1.95%.) However, part (b) shows that
early death is quite costly, as we would expect from a policy with a term insurance component.
On the other hand, survivals generate a small profit in NPV terms, of $362.23 each. The mix of
more severe losses from death benefit claims, which are assumed to be relatively rare, and smaller
gains from survivals, which are more common, gives the average results found in part (a).

If the policyholder surrenders at time 2, we see from part (d) that the cash value determina-
tion is significant. If there is no surrender penalty, so policyholders take the full account value on
early exit, the NPV is really small, at $32.82; the profit margin (which is a useful measure as it
adjusts for fewer premiums) is 0.6% in this case, compared with 1.96% overall.

If the cash value is reduced to 90% of the account value, the NPV is much stronger, at $555.35,
representing a profit margin if 9.61%. At this level of penalty, the insurer gains an NPV greater
than that earned from the full term survivors in part (c). It is not ideal to have surrenders gener-
ating significantly higher returns than those who stay - it creates perverse incentives for insurers
to stimulate higher withdrawal rates, and indicates a lack of equitable treatment for leavers com-
pared with stayers.

From part (e) we see that a cash value of 96.9% of the account value for the time 2 surrenders
would generate the same profit margin for leaving policyholders as for those who stay throughout
the term. This would appear to be more equitable. The NPV generated by the surrendering
policyholders is less than for those staying for the full term, but is slightly more than the overall
expected NPV, which allows for mortality but not for surrenders.

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References
Dickson, D. C. M., Hardy, M. R., Waters, H. R., 2009a. Actuarial Mathematics for Life Contingent Risks,
1st Edition. Cambridge University Press.
Dickson, D. C. M., Hardy, M. R., Waters, H. R., 2009b. Solutions Manual for Actuarial Mathematics for
Life Contingent Risks, 1st Edition. Cambridge University Press.
Dickson, D. C. M., Hardy, M. R., Waters, H. R., 2013a. Actuarial Mathematics for Life Contingent Risks,
2nd Edition. Cambridge University Press.

Dickson, D. C. M., Hardy, M. R., Waters, H. R., 2013b. Solutions Manual for Actuarial Mathematics for
Life Contingent Risks, 2nd Edition. Cambridge University Press.

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