Transactions of Society of Actuaries: Edward W. Frees

TRANSACTIONS OF SOCIETY OF ACTUARIES
1 9 9 0 VOL. 4 2
S TOCHAS TI C LI FE CONTI NGENCI ES
WI TH S OLVENCY CONS I DERATI ONS
EDWARD W. FREES
ABSTRACT
The ext ensi on of the t heory of life cont i ngenci es to a stochastic interest
envi r onment and its appl i cat i on t o sol vency val uat i on are di scussed. Al -
t hough life cont i ngenci es are wi del y used in traditional actuarial val uat i ons
of life i nsurance cont ract s, certain compl i cat i ons arise in a stochastic interest
envi r onment t hat are not evi dent whe n usi ng traditional det ermi ni st i c interest
assumpt i ons. In particular, many i nsurance funct i ons can no l onger be ex-
pressed in a si mpl e f or m, resul t i ng in a loss of the i nt ui t i ve appeal of t hese
funct i ons. In this paper, a st ochast i c interest envi r onment is i nt roduced and
analyzed in t erms of its effect s on i nsurance f unct i ons. Al t hough t he model
is less general t han ot hers i nt roduced in the literature, it is suffi ci ent l y flex-
ible to handl e the vol at i l i t y and certain aut ocorrel at i on aspects of interest
series. Its mai n advant age is the si mpl e f or m of the resul t i ng i nsurance
funct i ons and, hence, its intuitive appeal .
To exami ne the performance of a bl ock of busi ness, the assets as wel l as
the liabilities are consi dered. For liabilities of a bl ock of busi ness under a
common st ochast i c interest envi r onment , limit t heor ems for approxi mat i ng
the behavi or of sums of policies are no l onger readi l y available. Even i f the
mort al i t y experi ences of the policies are i ndependent , the liabilities are not
i ndependent because of the c ommon interest envi r onment . By consi der i ng
assets as wel l as liabilities, mat chi ng of cash fl ows reduces the vol at i l i t y of
surplus, defi ned to be assets in excess of liabilities. In fact, under an ext r eme
t ype of mat chi ng, l i mi t laws for sums of homogeneous policies can be de-
scribed under more general interest environments than those described above.
OVERVIEW
Thi s paper addresses the stochastic t heory of the val uat i on of a ri sk-t aki ng
enterprise f r om a sol vency perspect i ve. For concret eness, the enterprise is
assumed to be a life i nsurance company. In the devel opment , the i ncorpo-
ration of el ement s of financial economi cs is emphasi zed wher e possi bl e.
However , it is not the intent of this paper to show how weU-devel oped
91
92 S T OC HAS T I C LI FE CONT I NGE NCI E S
valuation theories in fi nance, such as the capital asset pricing model , arbi-
trage pricing model , and so on, can be applied in an insurance context as
in Garven [15]. These models empl oy several assumptions such as friction-
less trading, perfectly i nformed market participants, and t he like, whi ch have
been questioned in the relatively efficient asset markets and are dubious in
an insurance liabilities context. In particular, the l ack of a broad secondary
market for trading life insurance liabilities makes the straightforward appli-
cation of these valuation model s to the insurance probl em hi ghl y suspect;
compare Ti l l ey [35] and Giaccotto [17].
The approach is to extend some of the traditional actuarial valuation tech-
niques to incorporate ideas from modem financial economi cs. To this end,
the paper comprises t wo parts, stochastic life contingencies and valuation
from a solvency perspective. Part I, stochastic life cont i ngenci es, reviews
and extends a literature that has appeared in actuarial circles since the mid-
1970s, that is, that not onl y the time of decrement but also the valuation
discount rate may be random. Stochastic life contingencies are useful in
pricing, but their true val ue is in the ability to det ermi ne a val ue for an
established contract at current and future times. Part II, sol vency valuation,
addresses broader questions concerni ng the use of stochastic interest ideas
developed in Part I. Here, many of the financial interpretations not explicitly
mentioned in Part I are provided. Further, at the expense of weaker results,
much weaker assumptions on the interest envi ronment are made.
An important goal of this study is to provide actuaries with at least a
partial response to the criticism of other financial analysts that valuation
models do not take into account the stochastic nature of interest rates. There
are many different levels to a complete response to this criticism. A basic
response, as noted by Hi ckman [18], is that life cont i ngency models tradi-
tionally use deterministic interest discounting, and these model s have been
successful for centuries. Anot her response is that the stochastic variability
of interest rates is not crucial in a world in whi ch assets and liabilities are
nearl y "i mmuni z e d. " Here, immunization refers to an asset management
system in whi ch an asset portfolio is constructed so that the asset cash inflows
occur at roughl y the same time and in the same amount as benefit payment
outflows. The objective is to reduce the risk of asset price fluctuations due
to changes in interest rates. See Bierwag [2] for an introduction to this area.
This response assumes, however, that total liabilities are nonstochastic or,
at least, can be predicted quite accurately. When total liabilities arise from
several policies with unrelated losses, the average loss can be estimated
STOCHASTI C LIFE CONTI NGENCI ES 93
wi t hi n a desirable level of accuracy. However , i n an envi r onment of sto-
chast i c liabilities, mat chi ng t echni ques may or ma y not be adequat e. It is
preci sel y the extent of this adequacy that I wi sh t o quant i fy. Perhaps the
mos t compl et e response is the i nt roduct i on of a model that i ncl udes annual
forecasts of liabilities, a st ochast i cal l y changi ng t er m structure of interest
rate and the st ochast i c rel at i onshi ps among di fferent t ypes of assets wi t hi n
a port fol i o. I hope that this st udy pr ovi des a step t owards const ruct i ng such
a model .
I. STOCHASTI C LIFE CONTI NGENCI ES
1. Introduction to Life Contingencies with Stochastic Discounting
For every i nsurance cont ract , the uncert ai n t i mi ng of cont i ngent event s is
a key feature in quant i fyi ng fi nanci al aspects of t hese aleatory agr eement s.
Thi s is particularly true in life cont i ngenci es, the financial st udy of cont ract s
in whi ch the benefi t payment and pr emi um structure are consi dered known
at contract initiation. Under t he traditional approach t o life cont i ngenci es,
as in Jordan [20], pr emi ums and reserves have been cal cul at ed by deter-
mi ni st i cal l y di scount i ng for t he effect of interest and vari ous decr ement s
i ncl udi ng mort al i t y, disability, and so on. Under the moder n appr oach the
decr ement s are assumed t o be st ochast i c. Thi s approach is descri bed i n t he
text by Bowers et al. [3]; see Wol t hi us and van Hock [41] for an alternative
descri pt i on. Thus, several s ummar y measur es of fi nanci al cont ract s can be
exami ned, i ncl udi ng the medi an, st andard devi at i on, 95th percent i l e, and so
on, i n lieu of usi ng onl y the mean di scount ed val ue. Thi s flexibility al l ows,
for exampl e, the fi nanci al analyst t o expl i ci t l y consi der t he extent of pot ent i al
adverse deviations f r om the mean. In this paper, I al l ow not onl y t he vari ous
decr ement s but also t he force of interest to be stochastic. St ochast i c interest
model s have been consi dered pr evi ousl y in several st udi es i ncl udi ng t hose
of Pollard [27], Boyl e [4], Wi l ki e [40], Wat ers [38], Panjer and Bel l house
[26], Bel l house and Panjer [1], West cot t [39], de Jong [11], Gi accot t o [17],
and Dhaene [12]. One goal of this st udy is to revi ew the cont ri but i ons of
these papers and recast the results in the not at i on of Bower s et al. [3], the
current standard not at i on used in t he Nort h Amer i can actuarial literature.
Fol l owi ng Pollard [27] and Boyl e [6], to model a stochastic interest en-
vi r onment we use the sequence {Ak}. Here, Ak is a capital Greek del t a t hat
represent s the r andom force of interest in t he k-th per i od. Section 5 argues
that A k can be interpreted as a one-peri od spot rate. It is conveni ent t o model
the force of interest as the r andom quant i t y, in lieu of t he effect i ve interest
94 s' rocriASrlC LIFE CONTINGENCIES
or di scount rate, due to the linear nature of correl at i on and aut oregressi ve
model s and the mul t i pl i cat i ve nat ure of compound i nt erest . In this paper
at t ent i on is restricted to discrete t i me model s, and for conveni ence, we refer
to t i me intervals as years. Cont i nuous t i me model s can be f or mul at ed (com-
pare Panjer and Bel l house [26] and Mar t i n- Lof [23]) but are mor e compl ex
and of less interest in actuarial pract i ce.
The fol l owi ng out l i nes the rest of this part of the paper. In Sect i on 2, I
consi der the case in whi ch {Ak} is i dent i cal l y and i ndependent l y distributed
( i .i .d.) . Wi t h the interpretation of {Ak} as one-peri od spot rates and the
assumpt i on that {Ak} as i .i .d., t he l ogari t hm of the accumul at i on of a one
dol l ar i nvest ment , A1 + Az + ... + Ak, fol l ows a r andom wal k. Thi s is de-
sirable f r om the vi ewpoi nt of fi nanci al economi cs t heory because the r andom
wal k is a special case of a discrete t i me mart i ngal e. See Gerber [16] for an
i nt roduct i on to mart i ngal es f r om an actuarial perspect i ve. In i nvest ment pric-
i ng t heory t he mart i ngal e st ruct ure does not permi t riskless arbitrage. In
Sect i on 2, I focus on s ummar y measur es, or paramet ers, of general i nsurance
and annui t y policies. For the mean and vari ance of ma ny basi c pol i ci es such
as whol e life, n-year t erm, life annui t y due, and so on, t he not at i on used in
Bowers et al. [3] extends to the mor e general model . Thi s represent s two
i mport ant di fferences bet ween t hi s st udy and those cited above. First, pre-
vi ous papers dealt pri mari l y wi t h t he whol e life and life annui t y due pol i ci es,
l eavi ng the ext ensi on to more compl ex policies as i mpl i ci t . Second, previ ous
st udi es dealt explicitly onl y wi t h net single pr emi ums, l eavi ng the ext ensi on
t o reserves as i mpl i ci t . In Sect i on 3, the Sect i on 2 results are ext ended to
an aut ocorrel at ed interest envi r onment . Aut ocorrel at ed model s for interest
rates have received a resurgence of popul ari t y under t he label of "me a n-
r ever t i ng" wal ks in the fi nanci al economi cs literature lately; compare
de Bondt and Thal er [10] for a recent over vi ew. By rest ri ct i ng the model to
a si mpl e movi ng average model of order one, tractable resul t s are achi eved.
The proofs of all the proposi t i ons are in t he Appendi x.
2. Single Policy-Independent Interest Case
In this section the notation f or a single generalized pol i cy is i nt roduced.
The mean and vari ance for the net si ngl e pr emi um, net level pr emi um and
reserves are devel oped. As in Waters [38] and West cot t [39], hi gher-order
moment s can be devel oped in a si mi l ar yet t edi ous f ashi on. As emphasi zed
by de Jong [11], the vari ance is an i mport ant component of t he error in
forecast i ng expect ed present val ues. As shown later i n t he paper, t he first
STOCHASTI C LI FE CONTI NGENCI ES 95
t wo mome nt s are suf f i ci ent t o use t he Tc h e b y c h e f f i nequal i t y t o get a cr ude
bound on t he ent i re di st r i but i on. Fur t her , it i s we l l - known, in t he speci al
case o f t he nor mal di st r i but i on, that the fi rst t wo mome nt s are suf f i ci ent t o
char act er i ze t he ent i re di st r i but i on.
For c o n v e n i e n c e , I f i r st d e s c r i b e s o me not at i on t o b e us e d t hr oughout
t he pa pe r . As s u me i ni t i al l y t hat {Ak} i s an i . i . d, s e qu e n c e s uc h t hat , f or
pos i t i ve c ons t a nt s ~ and cx, E(e -a) = e -~ and E( e -2zx) = e - " . Si nc e
0 < Va r ( e - a ) = e - " - e- z8
we k n o w that oL<25. I f x=25, t he f or ce o f i nt erest is a degener at e r andom
var i abl e and the t echni ques in Bowe r s et al. [3] appl y. At time 0, t he r andom
pr esent va l ue o f $1 payabl e at t i me k is
vk = e x p ( - A , ) = exp - As ,
and t hus, the l ogar i t hm o f vk is a r andom wa l k. ( See Sect i on 5 f or mor e
i nt erpret at i ons o f {vk}.) The f ol l owi ng exampl e i s cent ral t o ma n y di s cus s i ons
in the l i t erat ure.
Example 1.1. Lognormal Distribution
As s u me A1 = A - N ( ~ , 0 2 ) ; t hat i s, A i s di st r i but ed nor mal l y wi t h me a n
and var i ance 02. In t hi s case, e x p ( - A) is sai d t o b e l ognor maUy di st ri b-
ut ed wi t h par amet er s - F z and 02; t hat i s, c x p ( - A ) - l o g N ( - V . , 0 2 ) . The
mome nt gener at i ng f unct i on o f A is E(e ~) = e x p ( l a + 02t2/2). Thus , wi t h
t = - 1, we have
e - ~ = E e - " = e x p ( - ~ + 02/2) or 5 = ~ - 02/ 2.
Wi t h t = - 2 , we have
e - " = e x p ( - 2 l ~ + 202) o r e~ = 2( ~ - 02).
Fi nal l y, wi t h {Ak} i .i .d.,
k
A - N(k~, k02),
and t hus
vk - l og N ( - k l x , k02).
96 S T O C H A S T I C L I F E C O N T I N G E N C I E S
Note that the i .i .d, normal i t y assumption will r ar el y be satisfied in prac-
tice; compare the discussion in Section 3 below. However, it does serve as
a useful benchmark. For exampl e, in this example t he force of interest used
in expected value calculations can be interpreted as a mean force minus
~ / 2 , that is, a price paid for volatility.:l:
Assume initially that there is onl y one decrement and that, as in Bowers
et al. [3], K is the curtate time of decrement . Use the notation P( K=k) =k[qx
and P(K>k)=k+~Px, k = 0 , 1, 2, . . . , for the mass and survival function,
respectively. Also assume initially that K is independent of {Ak}. Two types
of general contracts are considered, insurance and annui t y contracts. Under
the general insurance contract, a benefit bk+ ~ is payabl e at the end of t he
year of loss. The present val ue of this benefit is
Z~+I = vk+l bk+i. (2.1)
Under the general annuity contract, payment s a, are payable at the beginning
of each year up to and including the year of loss. The present value of t he
benefits is
k
a(k) = ~, v, as. (2.2)
s ~ O
wher e v0 = 1. In principle, both insurance and annui t y payment s, bk+ ~ and
a~, respectively, may be positive, negative or zero.
Summar y measures for the insurance benefit are easy to evaluate because
there is onl y one benefit payment . By the law of iterated expectations, we
have
E (ZK+,) = E [E(vx+, bK+,IK = k)]
= E [e -~(K+') bK+,] = Z e- ~( k' ) b, , ,Iq.- (2.3)
k ~ 0
Similarly,
E (Z~+,) = E [e -'~K') b2+1]. (2.4)
For example, in the case of whol e life insurance, bk+ l = 1 for each k. Then,
from (2.3) and (2.4), we have
E ZK+ , = E [e -~(K+''] = ~A~, = Ax
and
Var(ZK.I) = ~'A,, - (Ax) z.
Compared to the results in Bowers et al. [3], the results are the same except
we use o~ in lieu of 28 in the variance calculation. Indeed, this holds true
more general l y in instances wher e : _ bK a - bx 1 as in Theorem 4.1 of Bowers
et al. [3, p. 85]. As pointed out there, this is convenient for computations.
Finally, note that, when a specific distribution for {Ak} is assumed, it is
straightforward to calculate the distribution of ZK ~. We have the following.
Exampl e 1.1 (continued)
Assume that A - N ( p , o -2) and use ~( y) for the distribution function of a
standard normal random variable, that is, for Y- N( 0, 1) , we have ~ ( y ) =
P(Y<_y). To calculate the distribution function of ZK. ~ = v~:+ ~ b, :. ~, we have
e( z , , +, <_ y ) = e [ P (v,,+, b, , +, _< y l K = k)]

= E P(vk+, <- f i b, +, ) k]q,,
k=O
= E a , {[logO,/t,~+O + ( k + 1 ) ~ ]
k = O
/ [o-(k + 1)an]} *lq,,- (2.5)
Consider the specific case of whol e life insurance. The quantity in (2.5) is
easy to comput e. A graph can be found in Figure 1 for a life age 30,
i x=4.5%, o- =7% and using the 1979--81 U.S. Male Life Tables for the
mortality decrement (compare Bowers et al. [3, pp. 55-58]). It is instructive
to approximate the medi an from this graph, whi ch turns out to be roughl y
0.12. With 8= p . - o a / 2= 0. 04 255, this can be compared to the mean A3o,
whi ch turns out to be 0.16744. The fact that the medi an is less that the mean
is one indication that the distribution is skewed to t he right.:~
Summar y measures for annui t y benefits are mor e compl ex because of the
multiplicities of payment s. Si mi l arl y to (2.3) and (2.4), with (2.2) we have
K
9 8 S T OCHAS T I C LI FE CONT I NGE NCI E S
FI GURE 1
DISTRIBUTION FUNCTION OF THE NET SINGLE PREMIUM FOR WHOLE LIFE INSURANCE
- - i t i t i t i t i t l k i t i t
Ik I t i t i t * i t i t i t ~ * i t i t i t t ~
0 . 9 0 + * * * *
I t t ; k
m / I f
0 . 6 0 + * *
0 . 3 0 ; I t
- - i
o o + +* _ . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . Y
o .
0 . 0 0 0 . 2 0 0 . 4 0 0 . 6 0 0 . 8 0 1 . 0 0
and
E[a( K) 2] = E e - ' ~ a~ + 2 ~ e -Ss e -('~-~" ar as ( 2.7)
s = 0 r = l s = 0
The der i vat i on o f ( 2.7) t akes sever al l i nes o f al gebr a.
For exampl e, s uppos e as = 1 f or each s . Then a ( K) i s t he r andom var i abl e
associ at ed wi t h a life annui t y due. Her e, aft er s o me al gebr a, f r om (2.6) and
( 2.7) , we get
and
( , } o)
E vs = E e - ~ = ~dx = ax ( 2.8)
X=O
E ( \~=o = ~'a,, + 2(//x - '~ax)/[1 - e-(' ~-~)]. ( 2.9)
Suppos e in addi t i on t hat K = n - 1 wi t h pr obabi l i t y one. Then a( K) is t he
r andom var i abl e associ at ed wi t h an n- year cert ai n annui t y due and (2.8) and
( 2.9) r educe to
E v s = a ~ =
\ s ~ O
STOCHASTIC L I F E C O N T I N G E N C I E S 99
and
2
I n - I X
E { ~ ] v s } = ' ~ , q + 2 ( ~ - a ~ ) / [ 1 - e - ( a - B) ] .
- ] \ s = 0
The i mport ant poi nt is that even in special cases, such as Exampl e 1.1, there
is a si mpl e expressi on for the distribution of 2~.o As and thus vx. Thi s is
not t he case for Z~z; vk. Thi s is easy t o see si nce v, , v2, ..., v,,_, depend
on A1 and hence are dependent r andom vari abl es.
Net l evel pr emi ums can be const ruct ed by usi ng the equi val ence pri nci pl e,
as in Bowers et al. [3, p. 162]. To this end, consi der an i nsurance cont ract
wi t h pr emi ums Pa~ payabl e at the begi nni ng of each year, at t i mes s = 0, 1,
2 . . . . . Benefits bk+, are payabl e at the end of the year of loss, at t i me k + 1.
At cont ract initiation, wi t h Z~,+, and a(k) defi ned in (2.1) and (2.2), respec-
tively, let
oL(K,P) = Z r+, - P a(K)
be the l oss at t i me 0 for a generi c pr emi um l evel P. The net l evel pr emi um
PN is defi ned to be the sol ut i on of E[ o L( / ~ P) ] = 0; that is, Pu=E(Z g+~)/
E[a(K)]. Thi s is st rai ght forward t o comput e f r om (2.3) and (2.6). See Frees
[14] for some alternative defi ni t i ons of a net l evel pr emi um. Wat ers [37]
consi ders the loss at t i me zero f or an endowment pol i cy and remarks on the
di ffi cul t y of calculating its di st ri but i on.
The ext ensi on to reserves is similar. Fol l owi ng Bowers et al. [3, Chapt er
7], for durat i on k, defi ne J = K - k and Ek t o be t he expect at i on condi t i onal
of the event {K>-k}. Let
J
kL(J,P) = Vj+ I b~+j+, - P 2 v, ak+~ (2.10)
be t he loss at t i me k. The reserves are defi ned t o be
, v =
= Ek [ e-~' +' ) bk+s+,] - P Ek ( s ~ oe - ~ a~+s).
(2.11)
100 STOCHASTI C LIFE CONTINGENCIES
Hencef or t h, when the cont ext is clear, use E for Ek. To cal cul at e the vari ance
associated wi t h the loss f unct i on, we have
bk+~+l) + p2 E vs ak+,
- 2P E e -~cJ+l) bk+j+~ ~ e - ~ - ~ ak+s
Here, the second t erm on the ri ght -hand side is calculated si mi l arl y to (2.7).
3. Singl e Pol i cy- - Aut ocorrel at ed Interest Case
The assumpt i on that the interest envi r onment , represent ed by t he sequence
{A~}, is i .i .d, is a useful modi f i cat i on of the traditional assumpt i on that {Ak}
is det ermi ni st i c. Thi s modi fi cat i on permi t s vol at i l i t y of interest rates in the
model . In this section the results of Sect i on 2 are ext ended by assumi ng that
{A~} can be represent ed as a movi ng average model of or der one, that is,
MA(1). Thi s model account s for certain autocorrelation aspects of the se-
quence {Ak} and is particularly tractable in the calculation of i nsurance func-
tions. I believe this tractability will help actuaries develop the proper intuition
concer ni ng the behavi or of i nsurance funct i ons in an aut ocorrel at ed environ-
ment . Al t hough the MA(1) model is not known t o prohi bi t riskless arbitrage,
fi nanci al economi st s have l at el y shown a wi l l i ngness t o i nvest i gat e model s
that cannot be reduced t o a mart i ngal e. The argument is t hat when exami ni ng
the mi crost ruct ure of i nvest ment s, returns wi l l fol l ow a mar t i ngal epl us some
corrupt i ng i nfl uences. It is posi t ed that the corrupt i ng i nf l uences account for
the obser ved autocorrelations of returns. Cho and Frees [7] exami ne one
such corrupting influence: the discreteness of prices. Cohen, Maier, Schwartz
and Whi t comb [8] give addi t i onal backgr ound on the mi crost ruct ure of se-
curity returns.
Previ ous studies that devel op i nsurance funct i ons i n an autocorrelated
envi r onment include Pollard [27], Panjer and Bel l house [26], Bel l house and
Panjer [1], Giaccotto [17], and Dhaene [12]. All t hese studies dealt onl y
wi t h autoregressive (AR) model s except Giaccotto [17] and Dhaene [12].
Gi accot t o and Dhaene consi dered ARI MA, aut oregressi ve integrated movi ng
average, model s, whi ch, al t hough mor e general , lack t he interpretability of
this sect i on.
There is not yet a consensus in the literature on the sel ect i on of a particular
model to represent {Ak}. As not ed by the Institute of Act uar i es' Mat uri t y
STOCHASTIC LIFE CONTINGENCIES 101
Guarantees Working Party [28], the long-term nature of actuaries' concerns
may engender model selection criteria substantially different than those of
other financial analysts. There is a general, although not unanimous, agree-
ment among financial data analysts that the ARI MA class of model s is a
good starting point based on the principle of parsimony. Statisticians tend
to prefer AR models because simple transforms enable one to analyze a
multiple linear regression model wi t h AR errors easily. Probabilists tend to
prefer AR models because of the ni ce duality bet ween continuous and dis-
crete time stochastic process models; compare Shiu and Beckman [33].
However, there is a duality bet ween AR and MA model s described in, for
exampl e, Miller and Wichern [24]. An important corollary of this result is
that it is often difficult, i f not impossible, to distinguish an AR(1) model
with a small lag one autocorrelation from a MA(1) model. Some model
extensions are discussed bri efl y at the end of this section.
Now consider the MA(1) model ,
Ak = Ix + ek -- 0 ek-1, k = 1, 2 . . . . (3.1)
where {ek}7,-o is a mean zero, i .i .d, sequence with variance o a. The case
0 = 0 reduces to the i .i .d, structure discussed in Section 2. Often 0 is re-
stricted to be in the interval ( - 1,1) so that the model is invertible; that is,
it can be expressed as an autoregressive model . The following simple prop-
osition is a driving force behind this section. To simplify notation, defi ne
M( t ) = E e '~ to be the moment generat i ng function of ~, which is assumed to
exist throughout the paper.
Proposi t i on 1
Consider the MA(1) sequence defi ned in (3.1) and recall
Then, for k = 1, 2 . . . .
v . =
E (Vk) = C, e -ks' , (3.2)
where ~1 = ~ - logM(0 - 1) and Cx =M( 0) M( - 1)/M(0 - 1).
Note, in the special case of 0 = 0, that 81 = 8 and C1--1. The above
proposition is useful because we can easily calculate net single premi ums
using the law of iterated expectations. As in (2.3) and (2.6), we have
E (Z r+~) = CI E [e -s'(~+~) bx+~] (3.3)
102 STOCHASTI C LI FE CONTI NGENCI ES
and
E[a( hO] = C~ E ( ~ e-~" a' )
Thus, even when 0 g~ 0 we have
(3.4)
PN = E [e-S,<Kl~ bk+l] / E e-S," as .
To be precise, the above equation and (3.4) are approximate equalities. This
is pointed out by Dufresne is the subsequent discussion. Net premiums are
calculated as in Section 2, except we use ~ in lieu of ~. Thus, it is of interest
to compare 8~ and 5, and this can be done in the context of the following
example.
Example 3.1
Use the conditions of Exampl e 1.1 and assume ~-N(0, O2). In the case
0 = 0, from Section 2 we have 8 = V. - 0"2/2. With 0 ~ 0 and by the moment
generating function properties of the normal distribution,
M ( O - 1) = e x p [ o 2( 1 - 0) 2/ 2] .
Thus, 81 = I~ - o2(1 - 0)2/2- The increase in the force of interest by assuming
an autocorrelated interest environment is
8 , - 8 = ( 1 - 0 / 2 ) 0 o 2 .
To interpret this, recall that the lag 1 autocorrelation for the MA(1) model
defined in (3.1) is pl = - 0/ ( 1 + 0~ ) . Thus, for a positively autocorrelated
environment with p~ > 0, this yi el ds 0 <0 and 8~ < 8. This indicates that the
actuary should use a hi gher interest assumption than in the corresponding
i .i .d, environment.
Second moment ideas are similar but more compl ex. The main ideas are
summarized below.
Proposition 2
Under the assumptions of Proposition 1, for k = 1, 2 . . . .
E (Vk 2) = Cz e - k' ' ,
and for s <r ,
E (vsvr) = C3 e -s~' e-~r-s)~
( 3. 5)
(3.6)
wher e tx~ = 2Ix - logM(20 - 2),
C2 = M( 20) M( - 2)/M(20 - 2),
and
C3 = M( 0 - 2) M( 20) M( - 1)/{M(0 - 1)34(20 - 2)}.
As bef or e, i f 0 = 0, t hen a~ = ct and C2 = Ca = 1.
Reserve consi derat i ons are si mi l ar , but , unl i ke net pr emi ums, the con-
stants do not vani sh. As in (2.11), f r om Pr oposi t i on 1, one can check t hat
kVl ~-- E[d.,(J,P)]
= Cl { E (e-~J +' ) bk+,+,) - P E(,~oe-~" ak ,) } . (3.7)
Si mi l ar t o ( 2.10) , we have
Ek[L(J,P)I 2 = E (vs+, bx+, +a) 2 + p2 E v, a,+~
wher e
( , )
- 2 P E Vs+l bk+s+l ~ v~ ak+~ (3.8)
s~O
E ( v, + ~ b , , + , ) 2 = c 2 e [ e , , ' + , b ~ , + 11,
(3.9)
E vsak+s = E C2 e -"'~a~+~
s - O
J r - 1 }
+ 2 C3 E E e-S~ e-~"~-~~ ak+r ak+s (3.10)
r - 1 s- O
and
( " / { }
E vi+1 bk+j+l ~ v , ak+s = C3 E bk+1+l e -~I' e -~'+l-s)s~ ak+s (3.11)
s =O s =O
A special case is a f ul l y di scret e whol e l i f e pol i cy i ssued t o (x) at dur at i on
k. In t hi s case, f r om (2.9),
~v~ = c , g ~ + ~ - e , , ~ + ~ } ( 3 . 1 2 )
104 STOCHASTI C LIFE CONTI NGENCI ES
and
E ( ~ ) 2 = C~' A.+k
+ P~. {C~" '~+k + 2 C3(d.+k - '~'~.+k)/[1 - e-~'~'-~'~]}
- 2 C3 Px(Ax+k - ~"Ax+k)/[1 -- e-~'~'-~')]. (3.13)
The notation '~'a means use the force of interest eq in calculating a and
similarly for A. I f no force of interest is specified, use 51. Some numeri cal
examples of (3.12) and (3.13) appear in Section 4.
Thus, it is of interest to establish relationships between the pairs (C1, 51)
and (1,5) under general conditions. Naturally, for specific distributions such
as in Example 3.1, C1 and 8~ can be computed exactly. More generally, we
have the following.
Proposition 3
Consider the MA(1) in (3.1) and assume 0-2>0. Then, i f - 1 < 0 < 0 ,
51 < 5, oq < ~x and Ci < 1, i = 1 , 2 , 3 . (3.14)
I f 0< 0_<1, then (3.14) holds wi t h the inequalities reversed. Furt her, i f
0 = 0, then the inequalities in (3.14) are equalities.
The interpretation is that in the case of reserves we have offsetting factors.
For exampl e, in a positively autocorrelated interest environment, 0 < 0, and
thus C1<1 and 81<8. Now, in general, a l ower interest factor (St) means
that the reserve is higher. However, this is slightly offset in the calculation
of kV~ in (3.8), because we multiply by C1, a factor less than one.
We close this section with the following.
Exampl e 3. 2. Bond Index Returns
Consider the annual returns of the Salomon Brothers Bond Index f or the
period 1926-85, inclusive. The data can be found in Ibbotson and Sinque-
field [19]. For each return Ri, i = 1, ..., 60, let Di = log(1 +Ri ) be the corre-
sponding force of interest. For this series, the average force of interest is
= 0.04676, and the standard deviation is so = 0.07363. Using maxi mum
likelihood (with a normal model ), the estimated force of interest is
= D - s ~ 2 = 0.04405,
and the second moment paramet er estimate is
& = 2(D - s~) = 0.08268.
An examination of the histogram in Figure 2 indicates that the assumption
of normal i t y ma y be acceptable, although one or two observations could be
considered to be too far away t o be generated by a normal distribution.
HGURE 2
HISTOGRAM OF THE SALOMON BROTHERS BOND INDEX r:Oa 1926--1985
(DATA ARE IN NATURAL LOOARrn~MS)
N = 6 0
M i d p o i n t C o u n t
- 0 . 1 0 1 *
- 0 . 0 5 6 * * * * * *
0 . 0 0 1 4 * * * * * * * * * * * * * *
0 . 0 5 2 4 * * * * * * * * * * * * * * * * * * * * * * * *
0 . i0 8 * * * * * * * *
0 . 1 5 5 * * * * *
0 . 2 0 0
0 . 2 5 1 *
0 . 3 0 0
0 . 3 5 1 *
The time series plot in Figure 3 shows the temporal aspects of these data.
Some summar y statistics are r l = 0.144 and r2 = 0.078, the first- and second-
order autocorrelations, respectively. Aft er considerable examination of the
data, it was decided that the MA(1) and AR(1) model s were the best fitting
model s of the ARI MA class. For the MA(1) model , the estimated parameters
were
12 = 0.04731, 0 = - 0. 1 4 6 5, and 6" = 0.07346.
Hence, under a normal model ,
gx = 0.04376 and &l = 0.08043.
While the Box-Pierce statistic (compare Miller and Wichern [24, page 391,
equation (10.27)]) indicated model adequacy, in each case the autocorrela-
tion parameter estimates were onl y about one standard deviation away from
zero. This low significance was somewhat disappointing, and a careful in-
spection of the time series in Figure 3 provides some insights. Not e that,
although the series is stationary in the mean, it appears to be more volatile
106 STOCHASTIC LIFE CONTINGENCIES
in t he later year s than in the earl y years. Indeed, the largest observation is
in 1982, whi ch corresponds to an annual return of 42.5 percent! To get an
idea of the effect on the model of this large outlying observation, I arbitrarily
truncated the observation to 22.5 percent (still 2.5 standard deviations above
the average) and reran the MA(1) model. The absolute t-statistic for 0 jumped
from 1.07 to 1.60, an increase of 60 percent. This illustrates the large effect
of one observation on the model fitting exercise. It also reminds us that the
task of model i ng interest rates for valuation purposes is by no means com-
plete. Models that allow the volatility parameter to change over time ma y
be a useful next step. See Tsay [36] for a recent overvi ew of this developing
met hodol ogy.
FIGURE 3
TIME SERIES PLOT OF THE SALOMON BROTHERS BOND INDEX FOR 1926-1985
(DATA ARE m NATURAL LOGARrrHMS)
0. 300~
: /
o.zso;
o.ooo; 5~
=
- 0 . 1 5 0 ~
+ . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . +
0 10 20 30 40 50 60
Y e a r
II. SOLVENCY VALUATION
In this part I address various aspects of how to val ue a life insurance
company when sol vency considerations drive the choi ce of valuation tech-
niques. In the development, Section 4 is a direct extension of Section 3 to
the case of several policies, with two important differences. First, a more
general interest environment is considered, and second, the notion of a vect or
of cash fl ows, in lieu of discounting everything back to an arbitrary valuation
date, is actively used. I interpret Section 4 to be a discussion of valuation
model s in whi ch all assets are val ued at market. This type of valuation is
useful in considering the liquidation or sale of a block of business, that is,
the liabilities and assets of a group of contracts, of a company or a division
of a company. In Section 5 begins the real discussion of matching asset and
liability cash flows. Here, certain portions of the asset portfolio are not
val ued at market . Bringing assets explicitly into the picture allows us to give
a financial interpretation to the discounting mechani sm. The introduction of
assets also permits us to discuss various central limit theorems for surplus
in Section 6.
4. Liabilities for a Block of Business
Now consider the case in whi ch several policies share a common interest
environment. The policies constitute a block of business that is supported
by the same pool of assets. As such, the policies are not necessarily identical
and may be of different duration, age at issue, benefit structure, etc. Con-
ditional on the interest envi ronment , the events of loss are assumed to be
mut ual l y independent. As noted by Waters [38], i f a common interest en-
vi ronment is assumed for the policies, central limit t heorems to approximate
the distribution of the sum of losses are no longer available. I present two
useful alternatives, both available for any sequence {Ak}. First, I propose a
technique for calculating the vari ance of the sum by using expect ed cash
flows. Second, I establish an approximation to the distribution of the sum
by the distribution of a simpler random variable. These results quantify, at
least in one sense, the folklore opinion that interest variability dominates
mortality variability. Anot her useful corollary of the second result is that,
under the i .i .d, assumption, the entire distribution of the sum can be recur-
sively calculated. This idea seems to be new even for certain annuities.
Specifically, assume there are n policies in this block of business. For the
i-th policy, the age at issue is x~, the duration is ki, and the random time
until loss is Ji" Assume J1, ---, Jn are independent. The benefit structure is
b { ~.s}s=l and the present val ue of future benefits is
z , ( J i ) = v j, +l
Premiums payable at the begi nni ng of each year are (Pfl~s} and the present
value of such premi ums is
Jr
P, ai(Ji) = Pi ~ v, a~+, .
smO
Thus, each policy incurs the random loss
Li ( J i~ei) -~- Z i ( J i) - e i ai (J i)
and the sum of such losses is denoted by
SL = ~ L, (J, , e, ).
i = l
Since
e(sL) = El L,
i ~ l
(4.1)
( 4.2)
it is straightforward to calculate the expected loss by using, for example,
(3.7) in the MA(1) environment.
In order to apply curve fitting techniques to the distribution, it is crucial
to also calculate Var(SL). For example, Tchebycheff' s inequality guarantees
that the probability that SL is less than E ( S L ) + 3 ~ is a conservative
11.1 percent. With a normal approximation of SL, this probability is close
to 0.0001. In an actuarial context, Waters [38] provides a discussion of
curve fitting using the Pearson fami l y of curves when hi gher moments of SL
are known. In the present context, computation of Var(SL) is tractable via
examination of projected cash flows arising from liabilities. To this end,
consider the i-th policy wi t h fl ow of cash at time point s + 1 defined by
{
- P i a t ~ ~ + l i f J i > s
F~s.l = bgk,+,+x i f J i = s
0 if./,. < s.
(4.3)
With the convention Fi.o = - P i ai.kl , the loss in (2.10) or (4.1) can be ex-
pressed as the sum of discounted net cash flows, that is,
L, (J~, P,) = ~ vs F~s (4.4)
Thus, SL is a sum of discounted benefit payments in excess of premium
i ncome.
S T OC HAS T I C L I F E C ONT I NGE NC I E S 109
The project ed (expected) cash f l ow at t i me s + 1 is
f l ; s + l = E ( F i . s+ l ) = b / . , ~ + s + l s l qx, +k, - P i ai, ki+s+ l s+ l Pxi +ki.
Wi t h the convent i on f~.o = --Pa~ki, the reserve is
E [L,(J,, P,)] = X E (v~ f~.,).
s ~ O
Now consi der the bl ock of busi ness. Defi ne
F s=~F ~s
i = l
to be the total r andom cash f l ow at t i me poi nt s and let f~ = E( F, ) be its
project ed (expect ed) val ue. Defi ne .9 t o be t he col l ect i on of interest infor-
mat i on generat ed by {Ak}. Not e that i n this sect i on I no longer requi re {Ak}
to be i .i .d, or even stationary. The cal cul at i on of E(S~) is summar i zed in
the fol l owi ng.
Proposition 4
As s ume J~ . . . . . J,, to be i ndependent of .9. Then,
E ( S ~ ) = i.1 ~ E[Var(Li[.9)]+ E (~=ov~ f~
wher e
(4.5)
E [ Wa r ( L/ [ .9) ] = E[L i (Ji, p, )z] _ E Y. vs f,.s (4.6)
\ s = O
Not e that comput at i on of t he second t er m in (4.5),
E v, f, = E(v~) f~ + 2 ~, E(vr v,) fr f, (4.7)
$- - 0 r < $
is straightforward in, for example, an MA(1) envi ronment from Proposition 2.
Example 4. I. Block of Whole Life Policies
To illustrate the appl i cat i on of Proposi t i on 4, consi der a bl ock of whol e
life busi ness. For si mpl i ci t y, pol i ci es are cat egori zed into three gr oups of
size N so the total size is n = 3N. Assume, for each cat egor y, that ages at
issue are x = 3 0 , 30, 40 and durations are k = 5 , 10, 5, respectively. Also
assume the MA(1) envi ronment of Example 3.2, and thus ~ = 0.04376 and
a l = 0.08043. The mortality decrement s are the 1979-81 U.S. Male Life
Tables.
The reserve, or E( SL) , calculation follows directly from (3.12). Thus,
E( SL) = N{ CI[ ( A3s - P30/~33) + (A, o - P30 ii,o) + (A45 - e, o/ i 45 ) ] }
= N(0.18458).
Here, for C1, I used a normal approximation in Example 3.1, whi ch resulted
in
C1 = exp (62 0~/2) exp (62/2)/exp [(&(0 - 1)2/2] -= 0.99919.
Similarly, it turns out that C2=0.99677 and C3--- 0.99757. By using (3.13),
similar calculations establish that
E ( L3 z = N (0.14918).
From (4.4), the projected cash fl ow at time s + 1 is
f~s+l = ,Iqx,+~ - Pi ,*tPx,+k,.
ThUS, as in (4.7), straightforward calculations yi el ded
Y._ E[ Var(L,I,~)] __. ~,,_ 2 _ E v, f ~ ,
i =1 i * l
= N(0.14918) - N(0.01538) = N(0.13380).
Finally, with (4.7), further tedious calculations establish
E( S~) = N(0.13380) + N2(0.04268).
Thus,
Var SL = Ar2(0.00861) + N(0.13380).
In Figure 4 is a graph of E [ S z J ~ ] compared to N. Because the
limiting value of the ratio does not tend to zero, this is one indication that
the usual limit laws for sums of policies do not h o l d . ,
FIGURE 4
PLOT OF TIIE EXPECTED LIABmlTIES AS A PROPORTION OF THE
COR~SPONDING STANDARD DEVtA'nON COMPARED TO THE SA-~WLE SIZE IN EXAMPLE 4.1
(THE LIMrr~G VALtm IS 1.989)
1 . 7 5 ~ * * * * * *
w * * * * * *
1 . 4 0 ~ * * *
1 . 0 5 ~ *
0. 70~ *
+ . . . . . . . . . . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . N
0 1 0 2 0 30 4 0 50
Because the central limit theorem is no longer available, it is desirable to
have other approximations for the distribution of SL. I assume that the bl ock
of business is homogeneous. Thus, for simplicity, the following result is
stated onl y for identical policies (losses).
Proposition 5
Assume ./1, - .., J,, to be independent of $. Assume Li(J , P)=L(J , P), de-
fined in (2.10), are identical loss functions and define Y=E[ L(J ,P)I,~ ]. If
E[ L(J ,P) 2] < , then
limit in (SL/n) = Y.
distribution
n ~
In the Appendix, I actually establish the order of the limiting approxi-
mation. It is important that the result holds by using any random sequence
{Ak}. This includes not onl y the autocorrelated sequences used as examples
but also applications to interest rate scenarios. Proposition 5 is useful because
often the distribution of SL is compl ex and can be approximated by the
distribution of nY, whi ch is simpler to comput e. For any sequence {Ak} and
loss function L, the distribution of Y can be approximated via simulation.
As demonstrated bel ow, in certain important special cases, the distribution
of Y can be comput ed exactly.
Example 4. 2. n-year Annuities
Consi der a modi f i ed i mmedi at e life annui t y wi t h C dollars payable at the
end of each year , up t o n year s, and F dollars payabl e at the end of n years
wher e payment s are made i f the annui t ant (x) is al i ve. As s umi ng we are at
contract initiation and the pol i cy is pai d up, f r om (2.2) the loss associated
wi t h the pol i cy is
n - 1
= c I(K_> k) + V v . I ( K > n) .
k - I
Now, define
n - 1
Y,,:m = Y = E(LI.~) = C Z v~ ,,p,, + F v, d9~.
k - 1
Assumi ng that {Ak} is i .i .d, , we have
n - 1 k
Yx:~ = C ~, 1-I [(vs/v~-l)(~p,,/s-uo,,)] + F v, ,Px
k ~ l s ~ l
n - 1 k
= C E 17[ [ e x p ( - A, ) P~ +s - z ] + e e x p [ - ( A z + ... + A, ) ] ,,px
k = l s ~ l
n - 2 k
= e x p ( - A1 ) p ~ C + C ~ 1-I e xp( - A, +~) px+~
k = l s ~ l
+ F e x p [ - ( A2 + ... + A.) ] ._dTx+,}
= e x p ( - A1 ) p ~ (C + ~+, :, _a~) , (4.8)
wher e Y*~+s~_---~ is i ndependent A~ and has t he same distribution as
Yx+l:,---~. Thi s suggest s an efficient way to recursively comput e the distri-
but i on of Yx:~- Let G~,, and g ~ , be the di st ri but i on f unct i on and probabi l i t y
densi t y funct i on, respect i vel y, of Y~,:,,7. Then f r om (4.8), we have
G, J y ) = I G~+,,,_~(Fy/u - C) gx.,(u) du (4.9)
and
g~.,,O') = f (F /u) gx+ a.,,-l(Fy/u - C) g,,.l(u) du. (4.10)
As in Exampl e 1.1, the normal distribution is the i mport ant benchmar k
choi ce of distributions, and thus we take A- N( l ~, oa ) . In this case, to start
either recursi on (4.9) or (4.10), we have
Yx:~ = F e x p ( - A1)p, , - I o g n o r ma l [ - ~ + l og( Fpx) , ~ ]
and thus
g~a(Y) = (2wY 2 '2) -l ' z e x p { - [ l o g y - ( - I ~ + l og F px)]2/(2o2)}.
Equat i ons (4.9) and (4.10) become great l y si mpl i fi ed in the case of an
annui t y certain in l i eu of a life annui t y. For the annui t y certain case, take
Px = 1 for all x and drop t he x variable in Equat i ons (4.9) and (4.10). In this
case, the annui t y reduces t o an ordi nary bond wi t hout call provi si ons, and
i ndeed, the not at i on C is for coupons, whi l e F is for face val ue. To get an
idea of the distribution of the present val ue of a bond, consi der a $1000
( = F ) 10-year bond wi t h $50 ( = C) coupons payable annual l y. As s ume
A- N( 0. 05, o a) wher e t r = 0. 01 , 0.05, 0.10 and recall that ~ = 0. 05 -0"2/ 2 is
the mean force of interest. In Fi gure 5 are graphs that emphasi ze t he effect
of the vol at i l i t y paramet er tr on t he distribution of Y_m. The di st ri but i on was
approxi mat ed by si mul at i on t echni ques. See Kahn [21] for an earl y discus-
sion of the use of si mul at i on t echni ques t o val ue i nsurance benefits under a
stochastic interest envi r onment . Not e that for each graph, the means are
close (they turn out t o be 1005, 972 and 961) whi l e the standard devi at i ons
are dramatically di fferent (260, 126 and 25). Ext ensi ve literature in financial
economi es pr ovi des pricing, strategies for a bond, but t he not i on of the
distribution of the present val ue of a bond has not been emphasi zed in that
literature. The f ol l owi ng sect i on i ncl udes some interpretations of the se-
quence {Ak} that are mor e traditional in fi nanci al economi es.
5. Matching Stochastic Assets and Liabilities
There is a wi despr ead bel i ef that t he val uat i on act uary mus t exami ne t he
port fol i o of assets t hat suppor t the liabilities of a bl ock of busi ness (compare
Tullis and Pol ki nghom [37, Chapt er 8]). Al t hough this is particularly true
for interest-sensitive pr oduct s, si mi l ar argument s can be made for all lines
of busi ness. In this sect i on I consi der a si mpl e port fol i o of assets that support
F I G U R E 5
COMPARI SON OF DI STRI BUTI ONS FOR SI GMA - - 0 . 1 , 0 . 0 5 AND 0 . 0 1 , RESPECTI VELY
EACH DOTPLOT I S GENERATED FROM 2 , 0 0 0 S I MUL A~ ONS .
T H E U N I T S O N T I l E A XI S WE R E KE P T T H E S A M E F O R C O M P A R I S O N P U R P O S E S .
E a c h d o t r e p r e s e n t s 7 p o i n t s
* . o . . , . . . . . . .
. . . . . . . . . . . . , . . . . ,
o . . . . . . . . . . . . . . . * o
. . . . . . . . , . . . . . . . . . . . o
. . . . . . . . . . . . . . . . . . . . . . o
. . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . , . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . , . . . . . . . . . . . . . . . . . . . . .
+ . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . s i g m a . i
E a c h d o t r e p r e s e n t s 1 4 p o i n t s
. . o . . . . .
, . o o . * . 0
. . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . ,
+ . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . s i f f m a . 0 5
E a c h d o t represents 57 p o i n t s
: ::
+ . . . . . . . . . + . . . . / l _ i l ~ . . . . . . . . . + . . . . . . . . . + . . . . . . . . . + . . . . . . . s l g l a . 0 1
3 5 0 . 0 0 7 0 0 . 0 0 1 0 5 0 . 0 0 1 4 0 0 . 0 0 1 7 5 0 . 0 0 2 1 0 0 . 0 0
F I G U R E 6
MORE DETAI LED VERSI ON OF THE DO' I - PLOT FOR THE SI GMA = 0 . 0 1 CAS E
E a c h d o t r e p r e s e n t s 9 p o i n t s
~ .
. . . . . . . . . . . . . . . . . 0 . .
. . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
. . . . ; + L L ~ L L ; L t L i L L L L L L L ; L $L L ; ; L L L ; L ; L ~ ; L L L L L - ~ _ L - - - L - _ - + _ s i g m a . O 1
8 8 0 . 0 0 9 2 0 . 0 0 9 6 0 . 0 0 1 0 0 0 . 0 0 1 0 4 0 . 0 0 1 0 8 0 . 0 0
1 1 4
STOCHASTIC LIFE CONTINGENCIES
115
the liabilities of t he bl ock of busi ness descri bed in Sect i on 4. The port fol i o
compri ses t wo part s, those assets subject to net rei nvest ment risks and those
assets subject t o asset price as wel l as net rei nvest ment risk. The assets
subject t o onl y net rei nvest ment risk can be t hought of as hi gh-qual i t y bonds
wi t hout call provi si ons. Thi s asset subport fol i o yi el ds an i ncome stream of
ck at t i me k. Here, use c for coupon i ncome associated wi t h assets even
t hough the asset st ream consists of coupons pl us bond mat uri t i es. Al so, make
the si mpl i f yi ng assumpt i on that t hese assets are defaul t -free. Al l ot her assets
are assumed t o be val ued on a market basis wi t h current asset val ue Ao.
As s ume that the f und earns interest gover ned by the st ochast i c envi r onment
{Ak}. Furt her, make t he si mpl i fyi ng assumpt i on that the net rei nvest ment
rate associated wi t h amort i zed securities is also gover ned by {Ak}. With
these assumpt i ons, t he present val ue of assets is
Sa = Ao + ~ vk ck. (5.1)
k - 1
Define the surpl us as t he excess of assets over liabilities, that is,
S = SA - SL (5.2)
wher e SL is defi ned in (4.2).
In this paper, vect or s of asset- and liability-generated cash fl ows are com-
pared and summar i zed by bei ng di scount ed back t o an arbitrary ori gi n date.
Assets are det er mi ned t hrough effi ci ent mar ket s, and hence their wor t h is
assumed to be known at the val uat i on dat e. The secondary market for lia-
bilities is rel at i vel y i neffi ci ent , and hence the vect or of liabilities is model ed
stochastically. ( A recent except i on is the sale of a bl ock of Pr udent i al ' s
pol i eyhol der ' s l oans; compar e Shant e et al. [31].) The di scount i ng factors
can be i nt erpret ed in t he mor e general f r amewor k of t he t erm st ruct ure of
interest rates, as f ol l ows (see also Bi er wag [2] for additional backgr ound
i nformat i on).
At t i me 0, the val uat i on dat e, let ho(O,t) be the t -peri od spot rate. That
is, the price of a t -year $1 pure di scount bond is exp[- t ho( O, t ) ]. Equi va-
lently, we t hi nk of a f und of $1 at t i me 0 bei ng wor t h exp[ tho(O,t)] in t
years. The set of spot rat es, ho(0, 1), ho(0,2) . . . . is known as the t er m struc-
ture of interest rates. It is wel l - known, di sal l owi ng arbitrage opport uni t i es,
that the t er m structure al so det ermi nes ho(s, t). Di sal l owi ng arbitrage oppor-
tunities is equi val ent to all i nvest ment strategies yi el di ng equi val ent returns
for all s, t. Int erpret exp[ ( t - s) ho( s, t ) ] as the val ue at t i me t of an initial fund
of $1 invested at t i me s . Here, the val uat i on is done at t i me 0, and at this
t i me, the t erm st ruct ure is consi dered known. The t erm structure is general l y
calculated f r om t he yi el d curve whi ch, in t ur n, is cal cul at ed vi a least squares
regression. See Si egel and Nel son [25] for a recent over vi ew of these
t echni ques.
At subsequent val uat i on dates, j = 1, 2 . . . . . asset and liability val ues are
subject to ent i r el y new term structures [hj(0,1), hi(0, 2), ...]. A var i et y of
model s have been pr oposed for devel opi ng rel at i onshi ps bet ween t he current
and subsequent t erm structures (compare Bi er wag [2, Chapt er 11]). Perhaps
the most wel l - known model is f r om t he i mmuni zat i on st udy of Fi sher and
Weil [13]. The y posi t ed that the i nst ant aneous movement of the t er m struc-
ture does not depend on t he spot peri od, that i s, hj(O,t) = hi_ l(O,t) + 8 i , wher e
~j does not depend on t. Thi s model for changi ng t erm structures ma y be
appropriate for some val uat i ons. However , for sol vency val uat i ons, I adopt
the pri nci pl e that requi red surplus shoul d not depend on fut ure i nvest ment
strategies except wi t hi n broad classes of assets. In this paper onl y t wo classes
of assets, based on asset pri ce risk charact eri st i cs, are used, al t hough this
classification scheme can and shoul d be event ual l y refi ned. For ma ny val-
uat i ons, it is appropri at e t o recogni ze t er m structure and ot her effect s. How-
ever, i f one consi ders a st at ut ory val uat i on, it seems that uni form st andards
wi t h broad cl asses of assets shoul d appl y. Whi l e t erm effects of the current
port fol i o can be somewhat recogni zed wi t h t he t wo classes of assets, recog-
ni zi ng term effect s of rei nvest ment s made in the fut ure woul d not al l ow
enough st ruct ure in the model to hope t hat one val uat i on act uary coul d
i ndependent l y affi rm the wor k of anot her. Thus, furt her restrictions are re-
quired. In this paper the one - pe r i ods pot rat es, hs(s, s + 1 ) = As+w, s = 0, 1,
2 . . . . are used for di scount i ng asset and liability fl ows. Use of t hese rates
can be just i f i ed under a risk-neutral expect at i ons model in financial econom-
ics (see Cox, Ingersol l , and Ross [9, Appendi x]) . Thi s model admi t s an
AR(1) model , among ot hers, as a model for rates.
The key poi nt is that, in a st ochast i c interest envi ronment , it is the dis-
tribution of S and not SL that is i mpor t ant . The not i on of mat chi ng assets
and liabilities is t he mai n poi nt of the i mmuni zat i on literature. See Boyl e
[5], [6] and Shi u [32] for some cont ri but i ons to this literature f r om an ac-
tuarial perspect i ve. The pri mary i nnovat i on of this paper is that t he liabilities
are consi dered to be st ochast i c in lieu of det ermi ni st i c. The mai n result of
this sect i on is summar i zed in Proposi t i on 6 bel ow. As in Sect i on 4, not e
that there is no speci fi c assumpt i on regardi ng the distribution of {Ak} here.
Proposition 6
Consi der the surplus S defi ned in (5.2) and assume E(S 2) is fi ni t e. Then
Var(S) = Var(SL) + Var(SA) - 2 Cov[E(SLI,~), Sa]. (5.3)
Furt her, Var S is mi ni mi zed by choosi ng {c~}7,.i so that
E(ScI~) = Sa + So (5.4)
wher e So, the initial surplus, is an arbitrary const ant . In this case,
Var (S) = Var(SL) - Var(S4). (5.5)
The relation (5.4) suggests a new index of matching, M= Var[SA-E(SL{~)].
When M = 0 , liabilities are "f u l l y ma t c h e d " on a project ed basis. The con-
dition that M = 0 is more restrictive t han t he usual not i on of mat chi ng du-
ration moment s . However , t he condi t i on also yi el ds mor e i nformat i ve
properties; see Sect i on 6. A suffi ci ent condi t i on for (5.4) is that for each
peri od the asset i ncome, ck, equals fk, t he expect ed benefi t out f l ow, condi -
tional on the interest i nformat i on. It is not hard to check that this is also a
necessary condi t i on under mi l d assumpt i ons on t he distribution of {Ak}, for
exampl e, {Ak} is i .i .d, normal . In the case of full mat chi ng, Var(S) is easy
to comput e si nce, by (4.5),
Var(S) = ~ E[Var(Lil~)].
i - 1
In the special case of i .i .d, pol i ci es, we see that t he vari ance of S is pro-
portional to n in lieu of n 2. Thi s suggest s t hat a central limit t heor em ap-
proxi mat i on ma y be available. Furt her, it woul d suggest a way t o cal cul at e
the asympt ot i c distribution of S even when full mat chi ng is not achi eved.
Thi s line of t hought is pursued furt her i n Sect i on 6. Fr om an i nvest ment
manager ' s perspect i ve, this asset posi t i on ma y be nei t her feasible nor desir-
able ( compar e, Lei bowi t z and Wei nberger [22]).
The above model for the vari ance of surpl us is si mpl i st i c f r om bot h an
asset and a liability perspect i ve. Furt her r ef i nement s of the liabilities, or loss
r andom vari abl es, are di scussed in the f ol l owi ng sect i on, so here I di scuss
some of the drawbacks f r om the asset side. As ment i oned above, the risk
of asset default is i gnored in the above anal ysi s. Thi s coul d be addressed by
creat i ng special subcategories of assets and usi ng est i mat es of default prob-
abilities for each subcat egory, t he probabi l i t i es pr esumabl y bei ng interest-
sensitive. A deeper probl em is that all interest-sensitive assets are assumed
118 S T OCHAS T I C LI FE CONT I NGE NCI E S
to be val ued at market , and hence all the stochastic characteristics of the
asset are summarized by a single quantity at the valuation date. The mai n
advantage of this approach is that it relies on efficient asset markets for
pricing and thus avoids a host of problems that arise in developing consistent
asset-pricing models. The mai n disadvantage of this approach is that it treats
all interest-sensitive products equally. For exampl e, once market val ues are
established, there is no real recognition of the many different risk charac-
teristics of a high-quality bond with a mild call provision as compared to a
mortgage-backed securi t y, whi ch is heavi l y influenced by prevailing interest
rates. Presumably, future enhancement of valuation model s will involve
projecting asset vect ors of cash streams for subcategories of assets, condi -
tional on an interest environment. The sum of these projected vect ors over
asset subcategories woul d be compared wi t h the corresponding project ed
vect or liabilities. The difference could then be discounted back to an arbitrary
valuation date and the resulting random variable summarized via means,
variances, or percentiles.
A third drawback is that examination of onl y the random variable S ignores
the event of a shortfall of cash flows. Because of the experience suffered
by the savings and loan industry in the U.S. in the 1980s, one can argue
that consideration of this event is not mer el y an academi c exercise. The
event of shortfall could reasonably be ignored i f the valuation is for a line
of business, and it is assumed that other lines of business have available
funds that could be lent in the event of a shortfall. Analogously, at a company
level, it may be presumed that a parent company or other lender woul d be
available to provide surplus rel i ef on a short-term basis. Alternatively, the
probability of shortfall could be quantified by using classical risk t heory
ideas, as follows.
Formal l y define the event of shortfall of cash flows to occur i f surplus at
time k is less than some predetermined threshold level, say Tk, for each k.
To define surplus at time k, let ik = exp(Ak) - 1 = v k - ~/vk - 1 be t he random
interest rate for year k. Interpret 1 + i k to be the value at time k of $1 invested
at time k - 1. Surplus at time k, Sk, is defi ned recursively by
Sk = Sk - t ( 1 + i k ) + ck - ~ F ~ k , k = 1 , 2 , . . .
i = l
where
So = A o - ~ , o -
- 1
Wi t h this not at i on, the probabi l i t y of shortfall is
1 - P (Sk -> T, , for each k = 0, 1, 2 . . . . ).
Thi s, of course, is just the i ndi vi dual model versi on of the classical rui n
probl em in risk t heory; compar e Bowers et al. [3, Chapt er 12]. Col l ect i ve
model ruin pr obl ems wi t h st ochast i c interest have been di scussed by Schni e-
per [29].
6. Central Limit Theorems for Surplus
In this section, l i mi t approxi mat i ons for surpl us suggest ed in Sect i on 5
are mor e ful l y devel oped. To si mpl i f y t he di scussi on, onl y the ful l y mat ched
case is present ed expl i ci t l y, al t hough some ext ensi ons to the general ease
are i ndi cat ed. To ext end t he arena of pot ent i al appl i cat i ons, this sect i on
consi ders bot h the mul t i decr ement model and the si t uat i on in whi ch loss
r andom variables ma y depend on the interest envi r onment . As in Sect i ons
4 and 5, no particular assumpt i ons about t he interest envi r onment , such as
i .i .d., are made in this sect i on.
Speci fi cal l y, there are t wo i mport ant ways in whi ch the interest envi ron-
ment , $, can affect each loss r andom vari abl e. First, cash fl ows, ei t her
t hrough the benefi t amount or pr emi um payment , may be det er mi ned by
whi l e the t i me of loss r andom variable remai ns unaffect ed. Exampl es of this
are the vari abl e annui t y or f ul l y vari abl e life i nsurance policies descri bed i n,
for exampl e, Bowers et al. [3, pp. 465- 67]. Second, the t i me of l oss r andom
variable ma y be affect ed by $. An exampl e of this is a whol e life pol i cy
wi t h the lapse rate i nf l uenced by $. To i ncorporat e the latter exampl e in t he
analysis, I consi der the mul t i decr ement model ; compar e Bower s et al. [3,
Chapt er 9]. For t he i-th pol i cy, let j~0~ be t he cause of loss due t o t he j - t h
cause, j = 1, ..., m, wher e m is a fi xed, known number . Defi ne Jj = rain
[an~ .... J/"~] to be the r andom t i me of pol i cy cessat i on. Let b~,O3 be t he
benefi t amount payabl e f or loss due t o t h e j - t h cause, i = 1 . . . . , m. Si mi l ar
to (4.3), the f l ow of cash at t i me poi nt s + 1 is defi ned by
- P ~ a ~ , ~ + s + l (~)
F~s+1(~) = ~ + ~ + x (~)
i f J~ (~) > s
i f Y , q ) ( , ~ ) = s , j = 1 , . . . , m
i f J , (~) < s.
(6.1)
Here, the notation (.9) is added to emphasize the fact that a, b, J , and F
may all depend on the interest environment ,9. The argument (.9) is hence-
forth omitted in F to simplify notation.
With {Fts} as in (6.1), define Li as in (4.4). Let
f,~ = E(F ,,[ #)
be the projected cash fl ow for a given interest environment #. Let Seu be
the surplus arising from n homogeneous policies under full mat chi ng, that
is,
S m = N v,(fts - Ft , ) = Sa - SL. (6.2)
i ~ I $ - 0
The fol l owi ng result quantifies the probability of achieving a specified re-
quired surplus l evel , K, =K n v~, whi ch may depend on #.
Proposition 7
Conditional on .9, assume {Li~=l are i .i .d, loss functions wi t h E(L2)< .
Then
limit P ( Sm + Kn 1/2 -> 0) = limit P(SL <- Sa + Kn ~c2)
= E ~{K/[Var(L[.~)] 1~}. (6.3)
Recall that dp is the standard normal distribution function. Applications
of Proposition 7 may involve the unmat ched surplus in (5.2),
s = + - f ,)
$ = 0
where
f , = ~ fi., = nfl,, and Co = Ao.
i - 1
From Proposition 7, the probability that S exceeds a required surplus level,
Kt , may be approximated by using
p( S+KI>O) _~E dp n - vz K, + E v~ ( cs- fs) [Var(Ll#)],f 2 (6.4)
$ = 0
The ri ght -hand sides of (6.3) and (6.4) are t aken over vari ous pat hs of interest
rates. These quantities are st rai ght forward to evaluate expl i ci t l y by usi ng
interest rate scenarios. For exampl e, f o r j = 1 . . . . . m, let
S~j = (1, vl ; , v2, . . . . )
represent the j - t h interest rate scenari o, whi ch occurs wi t h probabi l i t y pj.
Then, the ri ght -hand side of (6.4) is
] }
pj e; n-, r2 g l + ~ vsj (c, - fsj) / [Var(Llgj)] 1/2 .
j = l s = O
Not e t hat the expect ed cash f l ows, fsj, ma y depend on the interest envi ron-
ment . I f instead one uses a st ochast i c model for {As} such as in Sect i on 2
or 3, t hese quantities can be eval uat ed numer i cal l y vi a Mont e Carlo or
si mul at i on met hods.
Example 6.1. Block of Whole Life Policies
Consi der a bl ock of n = 100 whol e life pol i ci es, each issued to a life aged
x = 30. Use the ful l y discrete model wi t h benefi t = $1 payable at t he end of
the year of deat h and pr emi um P3o payabl e at t he begi nni ng of each year .
Under the MA(1) envi r onment of Exampl es 3.2 and 4.1, it t urns out that
/ 30 = 0.00816. As s umi ng t he i nsurer has the l uxury of purchasi ng assets that
ful l y mat ch expected benef i t fl ows, how much extra initial surplus is required
t o assure that t he bl ock wi l l suppor t i t sel f wi t h a reasonabl y hi gh probabi l i t y?
Fr om Proposi t i on 7 and Table 1, one answer is that K,, = $2.50 wi l l purchase
prot ect i on at the 96.18 percent l evel ; that i s, P(SL <-SA + 2.5)----96.18%. Ot her
val ues o f Kn are also pr ovi ded in Table 1, whi ch was comput ed by usi ng
100 si mul at i on trials. Mor e trials coul d have easi l y been used, but t he es-
t i mat ed standard error i ndi cat ed that 100 trials gi ves accurate results to t hree
deci mal places.
Tabl e 1 underscores t he i mpact of full mat chi ng, or i mmuni zat i on, con-
cept s on sol vency probabilities. There is little movement in sol vency prob-
abilities bet ween t he MA(1) envi r onment of Exampl e 3.2, t he cor r espondi ng
i .i .d, est i mat es (0 = 0) and the det ermi ni st i c interest envi r onment (o-= 0 = 0).
The latter envi r onment is t he one present ed in Bower s et al. [3]. For com-
parison purposes, to see t he effect of a much mor e volatile envi r onment ,
0.1 was added to the st andard devi at i on in the MA(1) model , and t he result
is report ed in the bot t om of Tabl e 1. Al t hough this causes t he largest shi ft
in sol vency probabilities, the shi ft was not as large as one mi ght have con-
ject ured. The sol vency probabilities are stable under the di fferent val ues,
especially when compared t o the unmat ched distributions i n Exampl e 4.2.
It is possi bl e that these disparities are due to product di fferences or the central
limit t heor em approxi mat i on in Exampl e 6.1. However , t he si mul at i on sug-
gests t hat a great deal of the st abi l i t y can be attributed to t he mat chi ng of
assets and liabilities.
III. SUMMARY AND CONCLUSIONS
AS r emar ked by Hi ckman [18], "I nt er es t rate vari at i on and resul t i ng ri sk
is a fact of busi ness l i f e ." To enhance their credibility wi t h managers and
other fi nanci al analysts, actuaries shoul d explicitly allow f or interest rate
vari abi l i t y in their model i ng endeavor s and their resulting r ecommendat i ons.
Thi s paper is split into t wo part s. In t he first part, st ochast i c life cont i n-
genci es, interest effects as wel l as decr ement s are assumed t o be stochastic.
By assumi ng one-peri od spot rates are i ndependent or f ol l ow a si mpl e mov-
ing average model , vol at i l i t y and aut ocorrel at i on effects of t he interest en-
vi r onment can be i nt roduced i nt o t he model . Al t hough mor e general
assumpt i ons have appeared in t he literature, these assumpt i ons allow the
act uary t o use the traditional i nsurance funct i ons in a numbe r of cases of
i mport ance wi t h onl y a change i n t he interpretation of t he f or ce of interest.
The appropri at e model for interest rates has been much debat ed in the lit-
erature, but no real consensus has been achi eved. The l ong- t er m nature of
act uari es' concerns may engender model sel ect i on criteria subst ant i al l y dif-
ferent t han t hose of other fi nanci al analysts.
In the second part, val uat i on of a bl ock of busi ness is di scussed in the
cont ext of st ochast i c life cont i ngenci es. When the policies share a c ommon
interest envi r onment , the associ at ed losses are no l onger i ndependent and
the usual l i mi t i ng distribution results for sums of i ndependent r andom var-
iables no longer hol d. When all assets are val ued at mar ket and their val ue
is assumed known at val uat i on dat e, the vari ance of the l osses is cal cul at ed
by us i ng expect ed cash f l ows and the distribution is approxi mat ed by usi ng
si mpl er r andom variables. These results quant i fy the fol kl ore opi ni on that
interest vari abi l i t y domi nat es mort al i t y variability. To compar e cash fl ows
in di fferent peri ods, one-peri od spot rates are used in lieu o f t he mor e general
t erm structure. Thi s is done so that val uat i on model s do not depend on
i nvest ment strategies and any concomi t ant arbitrage possi bi l i t i es. Bri ngi ng
assets i nt o the val uat i on model al l ows for some mat chi ng of the interest rate
ri sk and a resul t i ng reduct i on of vol at i l i t y of surplus. Br ought to the logical
S T OC HAS T I C LI FE CONT I NGE NCI E S
T A B L E I
SOLVENCY PROBABILITIES WITH ESTIMATED STANDARD ERRORS
FOR A BLOCK OF 100 WHOLE LIFE POLICIES EACH ISSUED AT AGE 30.
I~, ~r AND 0 ARE PARAMETERS IN THE MA(1) MODEL.
NUMBER OF SIMULATIONS IS 100.
Mean Solvency [ Simulation
K,, , Probability Standard Error
= 0.04731; ~ = 0.07346; 0 : - 0 . 1 4 6 5
0. 0000
0.5000
1 . 0 0 0 0
1.5000
2.0000
2.5000
3.0000
5.0000
0.5000
0.6385
0.7608
0.8561
0.9218
0.9618
0.9832
0.9998
= 0.04676; ~ = 0.07363; = 0. 0
0.0000
0.0001
0.0002
0.0003
0.0002
0.0002
0.0001
0.0000
0. 0000
0. 5000
1.0000
1.5000
2. 0000
2. 5000
3. 0000
5. 0000
0.5000
0.6378
0.7596
0.8549
0.9208
0.9610
0.9828
0.9998
0.0000
0.0002
0.0003
0.0003
0.0003
0.0002
0.0001
0.0000
= 0.04676; ~ = 0.0; 0 = 0. 0
0.0000
0.5000
1 . 0 0 0 0
1.5000
2.0000
2.5000
3.0000
5.0000
0.5000
0.6399
0.7631
0.8587
0.9240
0.9633
0.9842
0.9998
0.0000
0.0000
0.0000
0.0000
0.0000
0.0000
0. 0000
0.0000
Ix = 0.04731; o- = 0.17346; 0 --- - 0 . 1 4 6 5
0.0000
0.5000
1.0000
1.5000
2.0000
2.5000
3.0000
5.0000
0.5000
0.6275
0.7423
0.8353
0.9032
0.9478
0.9743
0.9994
0. 0000
0.0004
0.0007
0.0008
0. 0007
0. 0006
0. 0004
0. 0000
123
extreme of "f ul l mat chi ng" of assets and projected liabilities, limiting dis-
tributions can be established to approximate the behavi or of the surplus.
Under a ful l y mat ched environment, surplus requirements are not sensitive
to the choi ce of the interest model , at least for the simple bl ock of whol e
life policies exami ned.
ACKNOWLEDGMENTS
Thi s r esear ch wa s f unde d b y t he Gr aduat e School o f Busi ness o f t he
Uni ver s i t y o f Wi s c ons i n. Thanks go t o my act uar i al col l eagues at t he Uni -
ver s i t y o f Wi s c ons i n, J i m Hi c kma n, Ji m Robi ns on, and Don Schuet t e, and
to Sam Cox o f Mi c hi ga n St at e Uni ver s i t y, f o r t hei r st i mul at i ng c omme nt s
on t hi s pr oject .
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APPENDIX
Th e appendi x cont ai ns t he pr oof s o f t he r esul t s o f Sect i ons 3 t hr ough 6.
Proof of Proposition 1
Def i ne the par t i al s um, Tk = ck + ek- 1 + ... + el , and f r om ( 3.1) , not e t hat ,
k
As = k p. + ek - 0 eo + (1 - O) Tk_,. ( A.1)
s = l
By t he i .i .d, pr ope r t y o f {ek}, we have
E(vk) = E { e x p [ - k p . - Gk + 0 Go -- (1 -- O) Tk- , ]}
{
- - e [ e x p ( - G ~ + o G o) e - k ~ ] E { e x p [ - ( 1 - O) e ] }
= M ( - 1 ) M ( O ) e - - k~ [ M ( O - 1 ) ] k - L
Thi s is s uf f i ci ent f or ( 3.2) . :]:
The pr oof o f ( 3.5) is si mi l ar t o the p r o o f o f Pr oposi t i on 1 and is omi t t ed.
To pr ove ( 3.6) , f r om ( A.1) we have
= E { e ~ - [ s ~ + ~ , - o ~ + ( 1 - o ) L - d
- [ r ~ + ~ r - - 0 ~ 0 + ( 1 - - O ) r ~ - , ] } }
= E ( e x p [ - 2(s - 1)B - 2(1 - 0) T~_I] }
E { e x p [ - ( r - s - - ( 1 - o ) -
E { e x p [ - e , - (1 - 0) % + 20e o - e,. - 31~1}
= e -(~-1)'' e- { . . . . 1)s, e-3~, E{exp[(0 - 2) e 2 + 20el - e3]}.
No w, si nce e - s l = e - ~ E(e-O-o~,) and e - " l = e -2~ E( e- 2O- ~' ) , we get
t he resul t b y di rect subst i t ut i on. :1:
We fi rst i nvest i gat e t he or der s f or t he const ant s C1, C2, C3. Fi rst , not e
that i f 0 = 0, st r ai ght f or war d cal cul at i ons yi el d Cl = C2 = C3 = 1.
Now, i f 0 > 0, we have Cov[exp( 0e) , e x p ( - e ) ] < 0. Thi s i mmedi at el y yi el ds
M( 0 - 1) = E{exp[( 0 - 1)e]} < E[e xp( 0 e)] E [ e x p ( - e ) ]
= M( 0) M( - 1) ( A.2)
and t hus 1 <C~. I f 0< 0, t hen the i nequal i t y in ( A.2) is r ever s ed, and t hus
1 > C~. Si mi l ar ar gument s est abl i sh that 1 < Cz i f and onl y i f 0 > 0.
To est abl i sh 1 < C3, we s h o w
E{exp[( 0 - 1) e]} E{exp[2( 0 - 1) e]}
< E{exp[( 0 - 2) el} E{exp( 20 e)} E { e x p ( - e)}. ( A.3)
Si mi l ar t o ( A.2) f or 0 < 0 < 1, C o v [ e x p ( 0 - 2) e, exp( 0e) ] < 0 and t hus
E{exp[2( 0 - 1) e]} < E{exp( 0 e)} E{exp[( 0 - 2) el}.
Put t i ng t hi s wi t h ( A.2) , and t he f act t hat E{exp( 20e) }>{E[exp( 0e) ]} 2, is suf -
f i ci ent f or ( A.3) . The cas e - 1 < 0 < 0 is si mi l ar.
As not ed be f or e , it i s t ri vi al t hat ~ I = B and c q = a f or the cas e 0 = 0 .
Fur t her , wi t hout l oss o f gener al i t y, a s s ume ~ = 0 . For 0<0_<1, we have
Co v { e x p [ ( 0- 1 ) e ] , e x p ( - 0 ~) }>0 and t hus
e - s = E { e x p ( - e ) } > E{exp[( 0 - 1) e]} E { e x p ( - 0 e)}
= e - ~ E { e x p ( - 0 e)} > e -~'
si nce E{exp( - 0e)} > exp[E( - 0k)] = 1 b y J e ns e n' s i nequal i t y. Thus ~ < ~1.
The cas e o f - 1 < 0 < 0 is si mi l ar except t hat it us es t he r ever s e i nequal i t y i n
( A.2) . The p r o o f f or ct, ax is si mi l ar and is omi t t ed. :]:
128 S T OC HAS T I C LI FE C ONT I NGE NC I E S
Fr om (4.4) and the i ndependence of J1 . . . . . J , and .~ not e that
and
e(L,la) = E v f.
S=O
Thi s is suffi ci ent for (4.6).
Now, f r om some basi c identities,
E(S, 9 = [E(SL)] 2 + Var(SL)
= [E(SL)] z + E[Var(SLI~)] + Var[E(SlJ~)]
:
= ~ E Var Lil~ + E vsf~ .
i ~ l
(A.4)
(n.5)
The fourt h equal i t y is true si nce, condi t i onal on .~, the losses L~, .... L, are
i ndependent . Thi s is suffi ci ent for the result. :1:
For the pr oof of Proposi t i on 5, we i nt end to show
Theorem A. 1
Under t he condi t i ons of Proposi t i on 5, t here exists a posi t i ve const ant C
so that
n E (SL/n - I") 2 < C, for all n. (A.6)
Remarks: An i mmedi at e consequence of (A.6) is that
limit E ( SJ n - y)2 = 0. (A.7)
Furt her, it is wel l - known that conver gence in mean square i mpl i es conver-
gence in distribution (see, for exampl e, Serfl i ng [30, page 10]), and thus
(A.7) i mpl i es Proposi t i on 5. The advant age of (A.6) over Proposi t i on 5 is
that not onl y do we know the l i mi t i ng distribution of SUn but also how
qui ckl y SL/n approaches the l i mi t i ng di st ri but i on.
STOCHASTI C LIFE CONTI NOENCI ES 129
Proof of Theorem A. 1
To prove (A.6), we have
n E ( Sdn - y)2 = n E{ E[ (Sdn - Y)~19]}
= n E{Var (Sutn[9)}
= E{Var [L(J,P)Ig]} <
since E[ L(J , P) z] < . This is sufficient for (A.6) and hence the result. :~
Begin wi t h the standard relationship
Var(S) = Var[E(S[9)] + E[Var(S[9)] (A.8)
Now, note that Sa is a constant, gi ven 9. Thus, E( S] 9 ) =E( SLIg) - SA and
Var(SI9 ) =Var(SL]9). Putting this in ( A.8) yi el ds
Var(S) -- Var[E(SL[9) - SA] + E[Var(SL[9)]. (A.9)
Now, the second t erm on the right-hand side of (A.9) does not depend on
{ck}. Thus, to mi ni mi ze Var(S) over choices of {ck}, we mi ni mi ze the first
term on the right-hand side of (A.9). Clearly, (5.4) is such a choice. Now,
from (A.9),
Var(S) = Var[E(SL[~)] + Var(Sa) - 2 Cov[E(SL[9), S,~] + E Var(SL[~)
whi ch is sufficient for (5.3). Equation (5.5) follows from direct substitution
using (5.4).
Conditional on 9, by the usual central limit t heorem,
limit P( n -aa SFM < I~,9) = eP{K/[Var(Llg)lr2]}.
n ~ m
Taking expectations of both sides and applying the Bounded Convergence
Theorem yi el ds the result. ~:
DI SCUSSI ON OF PRECEDI NG PAPER
DANI EL DUFRESNE:
I found Dr. Fr ees' paper ver y i nt erest i ng. Af t er maki ng some general
comment s , I first describe the t echni que of t i me reversal, whi ch is ver y
useful when di scount rates are r andom, and t hen address some speci fi c as-
pect s of the paper.
Dr. Frees correct l y emphasi zes the tractability afforded by i .i .d, or movi ng
average (MA) rates of i nt erest . These processes al l ow explicit f or mul as for
moment s or, at the ver y l east , si mpl e al gori t hms to comput e t hem. An y l ack
of fi t wi t h actual data, as compar ed wi t h ARI MA model s, may wel l be mor e
t han compensat ed by t he si mpl i fi cat i ons t hey per mi t . See [3], [4], [7] and
[8] f or applications of r andom rates of return to pensi on f undi ng.
Dr. Frees is also right in poi nt i ng out t hat mos t (i f not all) pr evi ous aut hors
have not dealt wi t h reserves, but onl y wi t h l evel payment i nsurances or
annui t i es; in this respect I am as gui l t y as the others (see [5] and [6]). I t ry
to earn forgi veness bel ow.
For the most part I agree wi t h t he aut hor that discrete funct i ons have mor e
practical use t han cont i nuous ones. Nevert hel ess,
(a) Cont i nuous funct i ons do arise whe n payment s are made ve r y oft en, or
when cl ai ms are pai d at the mome nt of death;
(b) Cont i nuous funct i ons gi ve a di fferent intuitive underst andi ng of a prob-
l em, whi ch can somet i mes lead to the solution of the discrete counterpart.
An exampl e of the second poi nt above can be f ound in [6], wher e all the
moment s of ax are deri ved us i ng the same i dea t hat had pr evi ousl y wor ked
in cont i nuous t i me.
1. Time Reversal
In hi s paper, Dr. Frees deal s wi t h di scount ed val ues of r andom payment s ,
whe n the di scount rates are t hemsel ves r andom vari abl es. To f i nd t he dis-
t ri but i on of such "r a n d o ml y di scount ed present v a l u e s " is by no means an
easy quest i on, as the paper i t sel f shows. However , in many cases it is
possi bl e t o great l y si mpl i f y t he cal cul at i ons, by usi ng a t echni que cal l ed
"t i me r ever s al ." Thi s t echni que has a l ong hi st ory in probabi l i t y t heory. I
have appl i ed it to r andom present val ues in [5] and [6]. My goal here is t o
descri be, in si mpl e t erms, h o w t i me reversal can be used t o cal cul at e t he
mome nt s of r andom present val ues. No at t empt is made to treat the mos t
131
general case. The si mpl est case, that of i .i .d, rates of i nt erest and l evel
payment s, is dealt wi t h in part (a). Two ext ensi ons are t hen gi ven, one to
variable payment s, part (b), and the ot her t o MA rates of i nt erest , part (c).
(a) First, consi der accumul at ed val ues. Suppose one uni t is i nvest ed at
the end of each year , at i .i .d, rat es of interest I~ = Uk - 1, pr oduci ng a total
amount S k just after t he k-th payment is made. Then
Sk+l = Uk . l S k + 1, So = O. (A)
S~ onl y depends on Uj, j _< k, and is t hus i ndependent of Uk+l. The mean
val ues of {Sk} thus satisfy
ESk+~ = ul ESk + l , ul = EUk+t;
that is, t hey gr ow at constant rate i l = u t - 1 . Hence
ESk = s~i~
= C1 uk + C 2
where cl and c2 are const ant s. The first expressi on s~ is traditional in actuarial
sci ence, but the second one is mor e useful in the present cont ext (of course
ct = 1 / ( u l - 1) and c 2 = - 1 / ( u ~ - 1)). To obtain second mome nt s , square
equat i on (A) and take expect at i ons on bot h sides:
= uzE + 2utESk + 1
= + 2ut(ctu + c2) + 1,
wher e u2=EU~k+ t. Thus ES~k+I is the accumul at ed val ue, at const ant rate
i2 = u 2 - 1 , of annual payment s consi st i ng of t wo parts, one const ant (namel y,
2 u : 2 + 1) and the ot her gr owi ng at rate i t = u t - 1 ( namel y, 2ulctu~0. There
is no st andard actuarial not at i on for this accumul at ed val ue, but what can
' ' and c~, be said wi t h certainty is that f or some const ant s cl , c2
(this is a standard result in t he t heory of di fference equat i ons; see, for ex-
ampl e, [10, Sect i on 3.4]). In this fashi on all moment s of Sk can be calcu-
lated, ei t her recursi vel y or by expl i ci t l y f i ndi ng the pr oper const ant s Cmj in
ES7 = c,,,o + c,,,1 u~ + c,,,2 u~ + . . . + c,,,,,, u~.
The latter approach is used i n [6] and is also illustrated in Part 2 of this
di scussi on. Goi ng one step f ur t her , t he distribution of Sk can be calculated
DISCUSSION 133
numer i cal l y f r om Equat i on (A); this is essent i al l y what Dr. Frees does in
his Exampl e 4.2.
When the rate of interest is const ant , t here is a si mpl e relationship bet ween
accumul at i ng and di scount i ng: di scount i ng at rate i is the same as accumu-
lating at rate i ' = - / / ( 1 +i ) . As wi l l be shown present l y, t o some ext ent this
dual i t y is preserved when rates of interest are r andom.
Suppose V1, 1/'2 . . . . are i .i .d, annual di scount fact ors. The present val ue
of an n-year annui t y-cert ai n is
Y , = 1 + VI + 1111/2 + . . . + V~ . . . V~ _ ~ . (B)
(In Dr. Frees' not at i on, Vk =e - a* ) . T he progressi on of di scount ed val ues
111, Y2, . . . is di fferent f r om t hat of S~, $2 . . . . . Y , is obt ai ned by addi ng VI
... V,_~ to Y,_~, wher eas S, results f r om mul t i pl yi ng S, _I by/-In, and t hen
addi ng 1. Accumul at i ng is done by movi ng forward i n t i me, wher eas dis-
count i ng is usual l y t hought of as br i ngi ng back one uni t f r om t i me n to t i me
0. Because of t hi s di fference bet ween accumul at i ng and di scount i ng, the
moment s of Yn are a p r i or i a lot mor e di ffi cul t to cal cul at e than those of Sn;
the r andom vari abl es 111 ... 11,_ i and Y,_ i are cert ai nl y not i ndependent , and
even the cal cul at i on of second moment s get s messy; see Equat i on (2.7).
To r emedy this si t uat i on, consi der the f ol l owi ng ar gument : i magi ne your -
sel f at t i me n wi t h an initial amount of 0. Move back t o t i me n - 1, addi ng
the uni t i nvest ed at t i me n - 1 . The result is 1. Now move backwards to
t i me n - 2 , mul t i pl yi ng t he pr evi ous amount by V,_~, and t hen add 1. The
result is 1 + V,_ ~. Next move backwards one mor e per i od, mul t i pl yi ng by
V,_2 and again addi ng 1. The resul t is 1 + Vn - 2+ Vn- 2V, - ~. Movi ng back-
wards n - 3 mor e peri ods yi el ds Equat i on (B).
1 1 1 1
I ..o..
1 0
n - 3 n - 2 n - 1 n
Vl V.-a "--
The progressi on of di scount ed val ues, st art i ng f r om t i me n and t hen movi ng
backwards, is seen t o mi mi c the progressi on of accumul at ed val ues. The
1 3 4 S T O C H A S T I C L I F E CONT I NG ENCI ES
moment s and distributions of {Y.} can therefore be obtained in the same wa y
as those of {S,,}. More specifically, define a new process {B,,} by
Bk + l = Vk + l Bk + 1, Bo = 0.
( " B" stands f or "ba c kwa r ds . ") By iterating this equation, we fi nd
B . = t + v . + v . v . _ ~ + . . . + v . . . . v ~ .
B. is not equal to Y., because the discount factors are in reverse order.
Nonetheless, the fact that the discount factors are i .i .d, assures us that B.
and Y,, have t he same distribution. This implies EY". =EB". for any m. Pro-
ceedi ng as wi t h {S.}, we find
EYk+ , = dplEYi + 1,
E ~ + , = +2E~ + 2d&EY, + 1,
where ~,,. =EV' L All moment s of Yk can either be found recursively, or else
by determining the constants d, . in
E ~ = d , , o + d ,.~ + ~ + . . . + d , . , . + ~ .
(b) Now suppose payment Tik is made at time k, and let Y,, stand for the
discounted val ue of Tio, ---, Ti,,.
First, let t he payment s be deterministic. Define Po = ~ , , P1 =Ti , - 1, ....
P . = Tio a n d
8 ~ + , = v~ + , 8 ~ + P ~ + , , Bo = P o .
1,'1 V._, V.
Ti 0 q"l" 1 Ti n - 2 Ti n - 1 Ti n
I I ...... [ t I
(c)
0 1 n - 2 n - 1 n
P, P . - , P2 P~ Po
v. v~ v,
The moment s of { Bk} an be found recursively; this yields all the moment s
of
Y. = Tio + TIiV1 + ... + TI. VI . . . V. ,
D~SCtJSS~ON 135
since
B, = P , + P , - 1 V, + . . . +1: ' oi: , . . . 1/ ' 1
clearly has the same distribution as Y,.
When the payment s are random, but independent of the discount fact ors,
the same procedure can be applied. The onl y additional ingredients required
are the moment s
EPk, EPj P , , O <_ j, k <_ n.
Equation (C), raised to the powers 1 and 2, respectively, implies
EBk+I = dpl EBk + EPk+I,
EB~+ I = dOz EBb, + 2d01 EPk I Bj, + eIr~k 1.
The onl y unknown quantity on the right-hand side of these equations is EP~ I
x B~. This can be found recursi vel y from
EP~, + 1 Bo = EPj, + a Po
EPk+I BI = dPiEPk+l Bo + EPk+I PI
EPk + ~ Bk = ~ E P k ~ Bk- 1 + EPk + ~ Pk.
Third moment s of {Bk} can also be found recursively, i f { EPi P1 Pk, O<_:i, j,
k<_n} are known, and so forth for hi gher moment s. Finally, the moment s of
Y,, are again the same as those of B,,.
(c) Ti me reversal arguments also apply when geomet ri c rates of interest
form a movi ng average process. I illustrate this for an n-year annuity-certain
when rates of interest are MA(1):
- l o g Vk = Ak = I~ + ek + "re~_l.
{ek, k>O} is assumed i .i .d. The discounted value of the annuity is
Y. = 1 + e - ( ~ + ' ' + ~ + ... + e - [( n- 1) t ~+:~j' , :}' j+T( j- f l .
Aft er replacing (% . . . . . e, -1) with (e . . . . . . el ), it is seen that Y, has the
same distribution as
B, = 1 + e -(~+~--'+'~) + ... + e-t("-l)"+zY d ~+-r~+q.
Furt hermore
Bk = e - ( ~ + ' ~ + ~ - ~ Bk - i + 1 , Bo = O.
Observe that B~-x is a f unct i on of (el , .... Ek-~) onl y. By defi ni ng
=
we get the pai r of equat i ons
B , = e-O,+~,~J Ck - i + 1
Ck = e-t~+(~+,)'~l C~_~ + e - ~.
The second equat i on al l ows the recursi ve cal cul at i on of the moment s of {Ck},
f r om whi ch t he moment s of {Bk} can be cal cul at ed by usi ng the first equat i on.
Thi s ends my descri pt i on of the t echni que of t i me reversal. For appl i ca-
t i ons to cont i nuous f unct i ons, the reader is referred to [5] and [6]. Ot her
applications and ext ensi ons are also possi bl e, f or exampl e, to MA processes
of hi gher order. Some of these wi l l be descri bed i n fut ure articles.
2. Specific Comments
Section 2. Use of onl y the first t wo moment s ma y not always gi ve an
adequate idea of the di st ri but i on of r andoml y di scount ed payment s. I illus-
trate this poi nt wi t h a r andom present val ue possessi ng a cl osed-form dis-
t ri but i on. Consi der the r andom count erpart of
-d~ = [ o e-~t dt.
Let the l og of t he di scount factors (log v, i n Dr. Fr ees' notation) f or m a
cont i nuous-t i me r andom wal k, t hat is to say, a Browni an mot i on process
- I V, wi t h mean - 8 t and vari ance o~t. Thi s is t he cont i nuous-t i me equi v-
alent of i .i .d, rates of interest. The di scount ed val ue of such a "c ont i nuous
per pet ui t y" is
Io
Y = e ~m dt.
DISCUSSION 137
I f 8 > 0, it can be proved that
1
~. - F( 28/ o a, oa/2)
(see Section 4 of [6]). Y has skewness coefficient
E ( Y - EY) 3
g = (Var IO 3a
4 V ' d - 2
- , a > 3 ,
a - 3
where a = 25/ o "2. A f ew val ues o f g are shown in Table 1.
TABLE 1
S~wr~.ss CoEmcmm (g) OF Comar~vous PE~mxn'rY (10
WHEN RETURNS ARE WHITE NOISE WITH MEAN 5 AND VARIANCE or 2
Standard Deviation
Mean (b) Or) a g
0.02 0.01 400 0.201
0.02 0. 10 4 5.657
0.05 0.01 1, 000 0.127
0.05 0.10 10 1.616
0.08 0.01 1, 600 0.100
0.08 0. 10 16 1.151
The skewness coeffi ci ent decreases to 0 at the same rate as 1/V' ~ = or/
X/'2"~. Most likely this indicates that the normal approximation wor sens as
the ratio 0-2/28 increases, that is, as the vari ance of returns increases relative
to the mean. This is rather unexpect ed: one woul d think that the absolute
size of the variance of returns woul d be the most important factor, but this
is not so, at least in the case at hand. We tentatively conclude that, when
average payment s are approximately level over an extended period, the nor-
mal approximation may not be appropriate, especi al l y i f the variance o f
discount rates is large relative to the mean. (When applying this criterion,
inflation and mortality should be taken into account.)
Cl osed-form expressions for all moment s of Zx+ 1 and level payment an-
nuities a(K) are not too difficult to derive when returns are i.i.d; see Section
2 of [6]. As to reserves, here is how time reversal is applied to the calculation
of the second moment of
./r
d- . =b v j+l + c ~ , G .
$= 0
I am assuming a level death benefit b and level premiums P = - c . To
calculate E(~2~J = j ) , first assume J = j (fixed) and then reverse the order of
payments and discount rates.
Payments c c c c b
Original
Time Scale 0 1 j - 1 j
New Ti me
Scale J + 1 j 2 1
If B, is as in Equation (C), wi t h Po=b and P~=c for 1-<s-<_j+ 1, t hen
EB,+~ = d:IEB, + c, 13o = b,
=>Bs = 1- d:l + b 1 - ~1 0~
In the same wa y
= dlo + d n 6 ~ , O a s - < j + 1.
y +l
0
E B ~ + I = ~ : , E B , + 2 c d o ~ E B , + c 2 ( D )
= > E B ~ = d2o + d21 d:~ + d22 ~ .
T o ob tain the constants d2o and d21, sub stitute the ex pressions f or E B s, E B 2,
and E B b + ~ on either side of Eq uation ( D ) , and identif y the coef f icients of 1
and ~ . T his y ields
d2o --~ ( 2c( ~i dlo "I- c2) [ ( 1 - ( ~2)
( 1 - ( b ~ ) ( 1 - ~ b 2 )
D I S C U S S I O N 139
d2, = 2cd~, dnl(4>~ - +2)
* 2- - - - +, 1 "
To obt ai n d = , use the initial condi t i on EBo =b t o get
d22 = b 2 - d2o - d2,.
Thus
E(j: V = j) = eB} +x
= dzo + d2x ~ + ' + dz~ d~+'
= > EeL 2 = d2o + d2, Ax+k + d22 2A~,+k
whe r e A,,+k is va l ue d at rate ix =~p~' - 1 and 2A,,+ k at rate i 2=t p~ ' - 1. Thi s
f or mul a f or EeL 2 i s expr es s ed in t er ms o f i nsur ance f unct i ons, whi c h is t he
fashi on adopt ed i n Actuarial Mathematics and i s equi val ent t o Equat i on
( 3.13) whe n 0 = 0 . It is pos s i bl e t o det er mi ne t he const ant s d ~ in
EeL" = dmo + ~ a=sAx+k, m ~ 1, (E)
S = l
wher e sA~+~ is va l ue d at rat e i s = q ~ ; " - 1. The s ame ar gument s can be used
f or any pat t ern o f benef i t s and pr emi ums .
It is a si mpl e mat t er t o der i ve t he count er par t o f ( 2.5) whe n benef i t s are
pai d at t he mome nt o f deat h and ret urns are whi t e noi se; see [5, p. 196].
Section 3. In t hi s sect i on a smal l mi st ake has unf or t unat el y gone unnot -
i ced, and it af f ect s sever al o f t he equat i ons. The fi rst t er m o f
k
= X ", a s
s =O
is 1 ao. Si nce Evoa o = ao, Equat i on ( 3.4) s houl d b e
K
Ea(hO = ao + C, E ~ e -"'s as.
$=1
Thi s i mpl i es
K
Pu = E[ e -~(r+x) br +x] / (ao/Ct + E ~ e -~'~ as).
s =X
140 S T OC HAS T I C LI FE C ONT I NGE NC I E S
Hence it is ont y approxi mat el y true that " n e t pr emi ums are cal cul at ed as in
Sect i on 2, except we use ~1 in lieu of ~ . " The same comment appl i es to
Equat i ons (3.7) and (3.12):
J
kVx = C1E(e -~1 1) b~+j l) - P[ ak + C1E ~, e - ~ ak+,]
$- - 1
k v x = C Ax+k - e x ( 1 + G a x , k ) .
The second equat i on relates t o a whol e life pol i cy.
Si mi l arl y, Equat i on (3.6) does not hol d when s = 0. Thus, the t er ms voak
have t o be moved out of t he t wo sums on t he ri ght -hand side of Equat i on
(3.8) and dealt wi t h separately. Equat i ons (3.10), (3.11) and (3.13) are
t herefore i ncorrect . The effect on the number s i n Exampl e 4.1 is mos t prob-
ably negl i gi bl e, si nce C1, C2 and C3 are ver y close t o 1.
Concer ni ng Exampl e 3.1, readers mi ght be i nt erest ed in t he numeri cal
exampl e cont ai ned in [7]. It shows accumul at ed val ues under the assumpt i on
that ari t hmet i c rates of return are MA( 1) wi t h the same mean but var yi ng
covari ances. Bot h exampl es indicate that our i nt ui t i on needs to be reeducat ed
when deal i ng wi t h dependent rates of i nt erest .
Cl osed- f or m expressi ons can be f ound for the moment s of ~ i n t he case
of a whol e life pol i cy wi t h level pr emi ums . By usi ng t i me reversal as in
Sect i on l ( c) , a f or mul a similar to (E) can be obt ai ned. The f or mul a for the
second moment has onl y three terms ( compar e wi t h (3.13)).
Section 4. The devel opment l eadi ng to Proposi t i on 4 and Exampl e 4.1
shoul d be compar ed wi t h Sect i on 4 of [12]. Proposi t i on 5 is a di rect appli-
cat i on of the usual ergodi c t heor em f or st at i onary processes, see, for ex-
ampl e, [11, p. 87]. Conver gence hol ds wi t h probabi l i t y one (not onl y in
distribution) and EL 2 need not be fi ni t e. It shoul d be emphasi zed that t he
l i mi t Y has done away wi t h all mort al i t y fl uct uat i ons. Onl y r andom interest
and expect ed cash fl ows are left. Exampl e 4.2 is in effect an appl i cat i on of
t i me reversal. An y di scount ed val ue can be treated in the same wa y, whet her
rates of interest are i .i .d, or MA(1). Some exampl es of perpet ual bonds wi t h
cl osed-form distributions are gi ven in [6].
For a bl ock of busi ness, I woul d suggest the fol l owi ng alternative to
Proposi t i on 4:
(i) Project cash fl ows: det ermi ne mean and covari ance funct i ons.
(ii) Use t i me reversal to calculate mome nt s of di scount ed val ues.
DISCUSSION 141
The first step i nvol ves mort al i t y and wi t hdrawal s onl y, whereas the second
i nt roduces r andom interest. I see a number of possi bl e advant ages t o this
approach:
(i) Mul t i pl e scenarios for cash fl ows and interest rates probabl y require
l ess wor k;
(ii) Pr ogr ammi ng recursi ve equat i ons ma y be less t i me- consumi ng t han
usi ng explicit formul as;
(iii) Cl ai ms under di fferent pol i ci es do not have to be i ndependent ;
(iv) Moment s hi gher than the second can be cal cul at ed, ff desired.
Section 6. Proposi t i on 7 results f r om the central limit ~heorem for con-
di t i onal l y i ndependent r andom vari abl es. Suppose that, gi ven 0, X1, X2 . . . .
are i ndependent and have c ommon di st ri but i on Fo. Let 0 have di st ri but i on
G and
a 2 = f Var Fe dG(O).
Then ([9, p. 287, no. 21])
1
e - i d i st r .
wi t h
r x) = I
In t he case at hand 0 is t he vect or of r andom rates of interest. The l i mi t
distribution is a wei ght ed average of nor mal distributions. It may be obt ai ned
vi a si mul at i ons, or else by i nt egrat i ng wi t h respect t o the joi nt di st ri but i on
of interest rates. Of course the latter met hod is usual l y a serious exerci se in
numeri cal analysis, requi ri ng, f or exampl e, i nt egrat i ng in di mensi on 20, f or
a 20-year project i on.
REFERENCES
1. BOWERS, N.L., ET aL. Actuarial Mathematics. Itasca, Ill.: Society of Actuaries,
1986.
2. DUFRESNE, D. "The Dynamics of Pension Funding.'" Ph.D. thesis, The City Uni-
versity, London, England, 1986.
3. DUFRESNE, D. "Moments of Pension Contributions and Fund Levels When Rates
of Return Are Random," J ournal of the Institute of Actuaries 115 (1988): 535-.-44.
4. Dutn~.srcE, D. "Stability of Pension Systems When Rates of Return Are Random,'"
Insurance: Mathematics and Economics 8 (1989): 71-76; ARCH 1989.1: 81-96.
5. DUFRESNE, D. "'Weak Convergence of Random Growth Processes with Applications
to Insurance," Insurance: Mathematics and Economics 8 (1989): 187-201.
6. Do~y~st,~, D. "The Distribution of a Perpetuity, with Applications to Risk Theory
and Pension Funding," Scandinavian Actuarial Journal, 1991, in press.
7. DUFRESNE, D. "Fluctuations of Pension Contributions and Fund Levels," ARCH
1990.1: 111-20.
8. DUFRESNE, D. "Fluctuations of Pension Contributions and Fund Levels." Report
of project sponsored by the Actuarial Education and Research Fund, 1990.
9. FELLER, W. An Introduction to Probability Theory and its Applications, Vol. 2,
2rid Ed. New York: Wiley, 1971.
10. GOLDBERG, S. Introduction to Difference Equations. New York: Dover, 1986.
11. Loi rE, M. Probabili(y Theory H. New York: Springer Verlag, 1978.
12. PAPATRIANDA~O_.OO, A., AND WATERS, H.R. "Martingales in Life Insurance,"
Scandinavian Actuarial J ournal (1984): 210-30.
ELIAS S. W. SHIU"
Dr. Frees is to be thanked for another contribution to the t heory of sto-
chastic life contingencies. The fol l owi ng are some thoughts on the paper.
In the context of life cont i ngenci es, it seems to me that Ak should mean
the rate of total return in the k-th period of the i nvest ment portfolio that
funds the insurance pol i cy. The total return of an investment portfolio in a
period is determined b y the interest and dividend i ncome recei ved during
the period and the market val ues of the portfolio at the beginning and end
of the period. In other wor ds , Sexp(Ak) should be the amount that one get s
at time k i f one invests $1 at time k - 1. In practice, it may be difficult for
an insurance company to come up with such numbers. Although it is rela-
t i vel y easy to determine interest and dividend i ncome, capital maturities and
initial investment val ues, there are many assets whos e market val ues are
difficult to assess because t hey are not traded publ i cl y. It may be useful to
poi nt out that, in Exampl e 3.2 of the paper, some of the annual returns of
bonds wer e negative because the bond portfolio incurred capital losses and
not because interest rates became negative.
It is stated in Section 5 of the paper that the one-peri od spot rates,
hs(s, s + 1) = As+l, s = 0, 1, 2, ... ,
DISCUSSION 143
are used for di scount i ng asset and liability fl ows. I have three remarks. First,
not e that the one-peri od spot rate hs(s, s + 1) is known at t i me s. In part i cul ar,
ho(0, 1) = A1 is fixed at t i me 0; it is not a r andom vari abl e. Second, because
spot rates shoul d not be negat i ve, one ma y object to model i ng t hem as normal
r andom vari abl es. Thi rd, the expressi on
gi ves the ' "act uar i al " present val ue at t i me 0 of 1 t o be pai d at t i me k. Is it
the same as t he s p ot p r i c e , at t i me 0, of a k-peri od (noncallable and default-
free) zero coupon bond
ex p [- o(0, k)]?
In general , for t > s > O, is
Under the no-arbitrage hypot hesi s, t he paper [6] shows how one ma y con-
struct a t erm st ruct ure evol ut i on model , in whi ch (D.1) is satisfied for all t
and s , t >s>- O. However , a probabi l i t y measur e under whi ch (D.1) hol ds is
not l i kel y t o be t he "a c t u a l " probabi l i t y measur e (because we do not l i ve
in a risk-neutral worl d). Al so, in such model s , even t hough the expect ed
val ues are mar ket val ues, t he meani ng of vari ances, et c. is not clear; see
also [4].
It is stated in Sect i on 5 t hat Fi sher and Wei l posi t ed that the move me nt
of t he t erm st ruct ure of interest rates is gover ned by
hi( j, t) = hj_~( j, t) + 8 j, t >_ j, j = O, 1, 2 , . . . .
wher e 8j does not depend on t . I woul d l i ke t o add that such t erm structure
movement s necessari l y admi t arbitrages; see [6, p. 236].
I now t ry to rephrase Proposi t i on 6 in the l anguage o f f unct i onal anal y si s.
Let ( ~ , ~;, P) be a probability space. Let L2(fl , ~;, P) be the Hilbert space
wi t h the i nner pr oduct
<X, Y> = E(XI 0.
Let ~J be a sub-o-al gebra of $;. The funct i ons in L2(O, ~:, P) , whi ch are ~3
measurabl e, f or m a closed subspace N, t hat i s, N =L2(I~, ~J, P) . Let
r l : L~(n, ~ , P) ~ L ~ ( n , ~ , P)
144 STOCHASTI C LI FE CONT I NG ENCI ES
be the or t hogonal project i on ont o N. Then, f or X e L2(~~, ~;, P) ,
E(XI~ ) = 1-IX
al most sur el y. Cons equent l y, we have the Pyt hagor ean Theor em:
J[X - E(X]~J)II 5 + IIE(X~J) - ~12 = IIX - I' ll 2 ( D.2)
for all Y ~ N. Wi t h X= SL and ~J = 4 , (D.2) becomes
)ISL - E ( &I ~ ) I I 2 + I ~E( SLI ~) - g ( A , , A 5, A 3 . . . . )115
= I lS z - g ( A , , As, A a . . . . )112
for all Borel measur abl e f unct i ons g .
To deri ve (5.3) o f the paper, wri t e
7 = s - E ( S ) ,
T a = S A -- E ( S . 4 )
and
T hen
I" ~ = s~ - E ( S L ) .
Va t ( S ) = I s r l l z
= l i r a - r LI I 5
= I I TAI ? + I I TLI I = - 2 < T ~ , T L > .
N o w , i f w e assume t hat SA is o f the f or m
SA = g( A1, A2, , % . . . . ),
t hen TA = IITr. Hence
< T .4, T L > = < I I T ,4, T L > = < T A , H * T L > .
S ince II is a self -adj oint operator, that is
H * = H ,
w e have
< T A , T L > = < T A , I I T L > = < r.4, E ( T L I ~ ) > = Cov ( S A, E(S L[.~)).
DISCUSSION 145
Dr. Frees points out that, under mild assumptions,
Var(S,~ - E(SLI~))
is zero i f and onl y i f c, =fk for all k. Some suggestions on how one may
match cj, with f~ can be found in Section VI of [5].
Finally, I wi sh to mention that two recent papers, by Beekrnan and Fuell-
ing [1] and by Dufresne [3], contain results related to those in t he present
one. Bl ack' s paper [2] is also of interest.
REFERENCES
1. BEEKMAN, J.A., AND FUELLING, C.P. "Interest and Mortality Randomness in Some
Annuities," Insurance: Mathematics and Economics 9 (1990): 185-96.
2. BLACK, F. "A Simple Discounting Rule," Financial Management (Summer 1988):
7-11.
3. DUI~,ESN~, D. "'Weak Convergence of Random Growth Processes with Applications
to Insurance," Insurance: Mathematics and Economics 8 (1989): 187-201.
4. HEATH, D., JARROW, R., AND MORTON, A. "Bond Pricing and the Term Structure
of Interest Rates: A Discrete Time Approximation," Journal o/F inancial and Quan-
titative Analysis 25 (1990): 419--40.
5. KOCHERLAKOTA, R., ROSENBLOOM, E.S., AND Srnu, E.S.W. "Algorithms for Cash-
Flow Matching," TSA 40 (1988): 477-84.
6. PEDERSEN, H.W., SHIU, E.S.W., AND THORLAClUS, A.E. "Arbitrage-Free Pricing
of Interest-Rate Contingent Claims," TSA 41 (1989): 231---65; Discussion, 267-79.
(AUTHOR'S REVIEW OF DISCUSSION)
EDWARD W. FREES:
The discussions by Dr. Dufresne and Dr. Shiu serve to expand and to
focus certain aspects of t he paper. They expand the paper by providing
details of related areas that I had nei t her the inclination nor expertise to delve
into here. Both Dr. Duf~esne and Dr. Shiu demonstrated how we can sharpen
our understanding of the model s that we use by using deeper results in
mathematics, probability, and statistical theory. On the other hand, one of
my goals in wri t i ng this paper was to use onl y t he tools that students learn
t oday in their actuarial curriculum. For students of the Soci et y of Actuaries,
the onl y tool not encountered in Courses 100, 110, 120, 121, 140 and 150
is the Bounded Convergence Theor em used in the pr oof of Proposition 7. I
found both discussions to be intellectually stimulating in that t hey forced me
to focus on certain aspects of the paper that I had not given enough thought
to. Although not planned, the two discussions complemented the paper nicely
in that Dr. Dufresne' s discussion essentially focuses on Part L Stochastic
Life Contingencies, while Dr. Shiu mai nl y addresses Part II. Solvency Val-
uation. I thank both discussants for their comment s.
Dr. Dufresne offers a discussion on a technique for simplifying certain
probability calculations. I am fortunate that he chose to exercise this tech-
nique on the ideas presented in this paper, because it led him to discover
errors in some of the formulas for net premi um and reserve calculations in
the MA(1) model. The point that I missed when originally trying to sort out
these ideas was how to jump-start a movi ng average series. I assumed t he
existence of a noise t erm at time 0, %, so that t he random t erm at time one,
A1, had an identical distribution to subsequent discount factors. The mat h-
emat i cal l y inconsistent thing that I did was to assume that the discount fact or
at time 0, Ao, was identically equal to zero. Thi s, of course, produces t he
logical result of %= 1. To be somewhat more consistent mat hemat i cal l y,
one could assume that Ao = % - 0c_1. With this definition, the expect ed
value of Ao is 0, but there is a distribution around it. Further, one coul d
defi ne
v~ = exp ( - ~ o As) for k = 0, 1, 2, . . . .
By doing so, similar to Proposition 1, one can check that E(Vk)=C*~ exp
( - k ~1) where C~=M( 0) M( - 1 ) for k = 0, 1 , 2 . . . . . Further, Proposition
2 holds by similarly redefining C2 and Ca. This then provides a model so
that the intuitively appealing formulas that appear in Section 3 are val i d
using new definitions of the C factors. I think the solution offered by Dr.
Dufresne is the more practical one. With his solution, one only needs to
remember in our spreadsheet formul a that time 0 is a little different f r om
the others because we assume that vo = 1. The interpretation, that we can
accommodat e an MA(1) structure by merel y reinterpreting the force o f in-
terest, that I offered in the paper is still essentially valid. An alternative
solution, again from a spreadsheet standpoint, is to note that in calculating
variances we can take cash flows at time zero to be equal to zero. Thi s is
because variances si mpl y are measured of dispersion of unknown quantities.
Following the suggestion of Dr. Dufresne, I comput ed some of the per-
centage differences for annuities due in Exampl e 4.2 and found the di ffer-
ences bet ween the exact results and approximations to be of the order 10 -5 .
Still, an equality should represent sameness, and I thank Dr. Dufresne for
pointing out this inconsistency in the paper.
One contribution of the discussion of Dr. Shiu is to rephrase the statement
of Proposition 6 using the language of functional analysis. By doing so, he
DISCUSSXON 147
has i mpl i ci t l y pr ovi ded the f oundat i on for swi t chi ng f r om the discrete t i me
model of the paper to a cont i nuous t i me model . Thi s is a natural ext ensi on
in that ma ny of the model s used in financial economi cs are cont i nuous. It
will be i nt erest i ng to see i f t he new measure of durat i on leads t o anyt hi ng
of use in t he fut ure. Anot her i mport ant cont ri but i on of his di scussi on is to
chal l enge my vague st at ement s in Sect i on 5 concer ni ng the l i nk bet ween a
so-called actuarial approach and a financial economi cs approach to val ui ng
surplus. Before respondi ng t o t hese remarks, let me first summari ze some
of t he difficulties that I encount er ed in arriving at a consi st ent model of
reality.
In fi nanci al economi cs, no-arbitrage-type argument s have been available
for al most 20 years to val ue wi del y traded securities usi ng risk-neutral prob-
ability measures. For derivative securities that depend on exogenous processes
that are not wi del y t raded, such as interest rates, no-arbitrage-type argument s
have appeared much mor e recent l y; see, f or exampl e, the Cox, Ingersol l
and Ross [9] paper. Ther e are at least four mai n sources of di ffi cul t y in
val ui ng surpl us usi ng t hese t ypes of argument s. First, t he surpl us process
clearly depends on an interest rate pr ocess, whi ch is exogenous i n t he sense
that it is not subject to the usual preferences of i nvest ors. Second, the fact
that the t erm structure changes at each val uat i on date furt her compl i cat es
the model . Thi rd, t he liability port i on of t he surpl us process is not wi del y
traded and hence it is not clear t hat no-arbitrage model s offer a reasonabl e
representation of reality. Fourt h, actuaries per f or m val uat i ons for ma ny rea-
sons. A sol vency val uat i on seems t he closest t o a fi nanci al economi cs val -
uat i on because bot h rel y on mar ket forces to det er mi ne the price f unct i on.
Now, papers such as that by Peder sen, Shi u and Thorl aci us ([6] in Shi u' s
list of references) address the first and second concer ns, at least i f one is
wi l l i ng to l i ve in a lattice f r amewor k. The third concer n is a deeper one and
perhaps not wel l enough f or mul at ed t o be able t o model wi t h mat hemat i cs.
Insurance t heoret i ci ans have t radi t i onal l y addressed t he economi c concer ns
of di fferent pl ayers t hrough their respect i ve ut i l i t y f unct i ons. One of t he
desirable feat ures of the no-arbitrage argument s is that t hey seem to be robust
t o the shape of t hese vari ous ut i l i t y funct i ons as l ong as players desire t o
make mor e riskless money. One of the goal s of this paper was to i ncorporat e
as much of the no-arbitrage pri ci ng as seems reasonabl e, whi l e r ecogni zi ng
that this val uat i on t echni que is not di rect l y appl i cabl e to ot her classes of
assets/liabilities. Thi s goal is t emper ed by the fourt h concern that, as actu-
aries, we have the not i on that a reserve shoul d represent our best forecast
of t he fut ure at a gi ven t i me. Thi s posi t i on woul d l end i t sel f to usi ng our
knowl edge of the entire term structure of interest rates when calculating
reserves for sol vency valuation. Conversely, this attitude could be vi ewed
as myopi c in that we know that the entire t erm structure will undoubtably
change at subsequent valuations. For the purposes o f this paper, I advocate
the cl umsy yet practical solution of using our knowl edge of the term structure
for one class of assets and disregarding this information, as unreliable, f or
another. Because of this, no attempt was made to move into the risk-neutral
worl d that is so conveni ent for probability calculations.
With this background, my response to Dr. Shi u' s third remark is that spot
rates in this paper are meant to be realizations of an actual company in-
vest ment policy. The probability measure governi ng that measure corre-
sponds to that i nvest ment pol i cy, not one that lives in a risk-neutral wor l d.
The harder problem that I have not addressed here is how to link the spot
prices to actuarial present values. With respect to the first remark, I model ed
A~ =ho(0, 1) as a random variable for at least t wo reasons. First, I want ed
to be consistent wi t h the division of assets into t wo types: one that uses
knowledge of the term structure and one that does not. Second, even t hough
we use discrete model s in practice, most of us bel i eve the world is bet t er
approximated through the use of continuous model s. I f we think of our
discrete time interval as a quarter of a year , we mi ght interpret ho(0,1) as a
90-day Treasury bill spot rate. Of course, this is known at time 0, but by
day 1 we must replace it by an 89-day Treasury bill, an unknown quant i t y
at time 0. Now, i f I did wish to assume that ho(0,1) is known, I also have
to assume that ho(0,2), ho(0,3), and so on, are known. For consistency, I
assumed the entire structure was known for one set of assets and unknown
for the other. With my notation, hs(s, t) is assumed known at time s. Whi l e
assumed known at time s , it is also considered unreliable for forecasting the
asset/liability mat ch of one class of assets.
Overall, I found the discussions thoughtful, well-written and enlightening.
While I have not comment ed on all aspects of each discussion, this is gen-
erally because t hey are self-contained and I coul d add little by wa y o f a
response. I hope that this response serves to sharpen some of the issues
underl yi ng sol vency valuation and suggest some important new areas in
actuarial research.

Transactions of Society of Actuaries: Edward W. Frees

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