Reserves - Recursion

Dr. Handayani, S.Si, MM, MHP, HIA, FLMI, AFSI, AAK, AAIJ, AMRP, FSAI
Net Premium Reserve
Consider a fully discrete whole life insurance policy with face
amount 𝑏 issued to 𝑥 . Here is the diagram illustrating a single year of
age from 𝑥 + 𝑡 to 𝑥 + 𝑡 + 1.

At the beginning of the year (time t), we have the reserves from the
previous year, and we also collect premiums. At the end of the year
(time t+1), we set up another reserve. What is the relationship between
𝑡 𝑉 and 𝑡+1𝑉?
Suppose 𝑙𝑥 people purchase an identical policy at age x. After t years, the
number of people who are alive at that time is 𝑙𝑥+𝑡 . At that time, each policy
carries a reserve of 𝑡𝑉, and each person pays a premium P. Thus, the
reserves plus the premiums at time t is the total amount of money we have at
time t for that group of policies. Accumulate this money with interest for one
year:
𝑙𝑥+𝑡 ( 𝑡𝑉 + 𝑃)(1 + 𝑖)
At the end of the year (time t+1), this money will be used for two things:
1. For people who die, this money is used to pay death benefits. How many
people die between age x+t and x+t+1? 𝑑𝑥+𝑡 . We will pay a death benefit
of b to these people at time t+1.
2. For people who survive, this money is used to set up the next reserve. How
many people survive to age x+t+1? 𝑙𝑥+𝑡+1 . We will set up a reserve of
𝑡+1𝑉 for these people at time t+1.
The money we accumulate from time t to t+1 must be sufficient to pay for the two things
described above:
𝑙𝑥+𝑡 𝑡𝑉 + 𝑃 1 + 𝑖 = 𝑑𝑥+𝑡 (𝑏) + 𝑙𝑥+𝑡+1 𝑡+1𝑉

Dividing both sides of the equation by 𝑙𝑥+𝑡 , we have:

𝑡𝑉 + 𝑃 1 + 𝑖 = 𝑞𝑥+𝑡 (𝑏) + 𝑝𝑥+𝑡 𝑡+1𝑉

Expression above has the same interpretation as before, but it is on one policy rather than
on a group of policies.

In words, we are saying:

At the beginning of the year, we have two things: (i) the reserve from the previous year, and
(ii) the premium collected at the beginning of the year. We then accumulate both for one
year.
At the end of the year, for the insured who dies, with probability 𝑞𝑥+𝑡 , we pay a benefit of b.
For the insured who survives, with probability 𝑝𝑥+𝑡 , we have to set up the next reserve.
We can also rewrite the equation above by expressing 𝑝𝑥+𝑡 as 1 − 𝑞𝑥+𝑡 , and
then rearranging the equation:

𝑡𝑉 + 𝑃 1 + 𝑖 = 𝑞𝑥+𝑡 𝑏 − 𝑡+1𝑉 + 𝑡+1𝑉

Notice the left hand side remains unchanged, but the right hand side has
changed slightly. How should we interpret the right hand side?
• We set up a reserve at time t+1, regardless of whether or not the insured
dies or survives during the year. This is represented by 𝑡+1𝑉.

• For an insured who dies during the year, since we have the reserve of
𝑡+1𝑉 to cover a portion of the death benefit, the remaining amount
needed is 𝑏 − 𝑡+1𝑉, which is known as the net amount at risk (NAR).
REMARK

𝑡𝑉 + 𝑃 1 + 𝑖 = 𝑞𝑥+𝑡 𝑏 − 𝑡+1𝑉 + 𝑡+1𝑉 is helpful when you want to solve for 𝑞𝑥+𝑡 .

When will reserve recursion be useful?

It is often useful to start the recursion at time 0, because 𝑡𝑉 = 0.

It is also useful to start the recursion at the end (when applicable). Note that:
✓ For n-year term insurance, 𝑛𝑉 = 0.
✓ For n-year endowment insurance, 𝑛𝑉 = endowment benefit.
REMARK

To start recursion off, you can start at time 0, since 𝑡𝑉 = 0. You can also start at
the end, at which point the benefit reserve is 0. The following rules help:
1. For paid up insurance, the benefit reserve is the single benefit premium.
2. For term insurance, the benefit reserve at expiry is 0.
3. For endowment insurance, the benefit reserve right before maturity is the
endowment benefit.
Example 1
A fully discrete 3-year endowment insurance with a face amount of 1,000 is issued on
(𝑥).
✓ 𝑖 = 0.06
✓ The following has been taken from a mortality table
𝒚 𝒍𝒚
𝑥 1,000
𝑥+1 900
𝑥+2 810

✓ The net premium is 332.51

Calculate the net premium reserves at time 1 and 2.

Solution 1

To find 1𝑉, since we know 0𝑉 = 0, we can use the recursion involving

0𝑉 and 1𝑉 :

0𝑉 + 𝑃 1 + 𝑖 = 𝑞𝑥 1,000 + 𝑝𝑥 1𝑉

1,000 − 900 900

0 + 332.51 1.06 = 1,000 + 1𝑉
1,000 1,000
∴ 1𝑉 = 280.51
Solution 1

To find 2𝑉, we use the fact that 𝑛𝑉 for an n-year endowment insurance is
equal to the endowment benefit, i.e., 3𝑉 = 1,000. Thus, we can use the
recursion involving 2𝑉 and 3𝑉:

2𝑉 + 𝑃 1 + 𝑖 = 𝑞𝑥+2 1,000 + 𝑝𝑥+2 3𝑉

2𝑉 + 332.51 1.06 = 1,000

∴ 2𝑉 = 610.89
Gross Premium Reserve
We now incorporate expenses and develop a recursion for gross
premium reserves.
Let e denote the expense (per policy or per premium), and let E denote
the settlement expense. Below is a diagram illustrating a single year of
age from age x+t and x+t+1.
Note that at the time of death, we must take into account both the death benefit
and the settlement expenses. Thus, the recursion becomes:

𝑔+𝐺−𝑒 𝑔
𝑡𝑉 1 + 𝑖 = 𝑞𝑥+𝑡 𝑏 + 𝐸 + 𝑝𝑥+𝑡 𝑡+1𝑉

In words, we are saying:

At the beginning of the year, we have three things: (i) reserves from previous year,
(ii) premiums collected, and (iii) expenses paid. Then, we accumulate the money for
one year.

At the end of the year, for an insured who dies, with probability 𝑞𝑥+𝑡 , we pay a
benefit of b and a settlement expense of E. For an insured who survives, with
probability 𝑝𝑥+𝑡 , we have to set up the next reserve.
Example 2

For a fully discrete whole life insurance of 100,000 on (45) you are given
✓ The gross premium reserve at time 5 is 5,500 and at time 6 is 7,100.
✓ 𝑞50 = 0.009
✓ 𝑖 = 0.05
✓ Renewal expenses at the start of each year are 50 plus 4% of the gross premium.
✓ Claim expenses are 200.

Calculate the gross premium

Solution 2
Since we are given 𝑉 𝑔 and 𝑉 𝑔 , we can use the recursion to connect
5 6
them.

𝑉 𝑔+𝐺−𝑒 1+𝑖 =𝑞 𝑉 𝑔
5 50 𝑏 + 𝐸 + 𝑝50 6

5,500 + 𝐺 − 50 + 0.04𝐺 1.05 = 0.009 100,000 + 200 + 1 − 0.009 7,100

𝐺 = 2,197.82
Recursion - Continuous
In the previous subsection, we discussed reserve recursion for policies with
discrete cash flows.
In this subsection, we will derive a reserve recursion for policies
with continuous cash flows (i.e., premiums/annuities are payable
continuously and death benefits are payable at the moment of death).
The continuous time version of the reserve recursion is given by Thiele's
differential equation
Recursion - Continuous
𝑑
𝑡𝑉 = 𝛿𝑡 𝑡𝑉 + 𝐺𝑡 − 𝑒𝑡 − 𝑏𝑡 + 𝐸𝑡 − 𝑡𝑉 𝜇𝑥+𝑡
𝑑𝑡

where
• 𝛿𝑡 is the force of interest per year assumed earned at time t
• 𝐺𝑡 is the annual rate of premium payable at time t
• 𝑒𝑡 is the annual rate of premium-related expense payable at time t
• 𝑏𝑡 is the face amount payable at time t if the insured dies at exact time t
• 𝐸𝑡 is the expense of paying the face amount at time t (e.g., settlement/claim expense)
• 𝜇𝑥+𝑡 is the force of mortality at age x+t.
What is the intuition behind Thiele's differential equation
The left hand side asks, "What is the rate of change in the reserve at time t?"
The right-hand side explains that the reserve is changing at a rate resulting from the
following components:
• The reserve is earning interest a rate of 𝛿𝑡
• Premiums are received at a rate of 𝐺𝑡
• Expenses are paid at rate of 𝑒𝑡
• For insureds who die during the next instant (with "probability” 𝜇𝑥+𝑡 ), we have to
pay the death benefit of 𝑏𝑡 and a settlement expense of 𝐸𝑡 . However, we have
reserves to help cover these costs. Thus, the amount needed is 𝑏𝑡 + 𝐸𝑡 − 𝑡𝑉.

For a net premium reserve, drop all the expense-related terms, and substitute the
net premium for 𝐺𝑡
Thiele's differential equation usually does not have a closed form solution, but it
can be solved numerically using Euler's method. Using Euler's method, the rate of
change in reserve can be approximated as the change in reserves adjusted by the
period length:

𝑑 𝑡+ℎ𝑉− 𝑡𝑉
𝑡𝑉 ≈ (a)
𝑑𝑡 ℎ

𝑑 𝑡𝑉 − 𝑡−ℎ𝑉
𝑡𝑉 ≈ (b)
𝑑𝑡 ℎ

(a) uses the derivative at time t to relate 𝑡𝑉 and 𝑡+ℎ𝑉 (i.e., we look forward). This
approximation is called the Forward Euler Approximation.

(b) uses the derivative at time t to relate 𝑡𝑉 and 𝑡−ℎ𝑉 (i.e., we look backward). This
approximation is called the Backward Euler Approximation.
Exercise 1

For a fully discrete 3-year endowment insurance is issued on (𝑥) with face
amount 1,000. You are given:

✓ 𝑖 = 0.06

✓ The following extract from the mortality table:

𝒚 𝒍𝒚
𝑥 1,000
𝑥+1 900
✓ 1,000𝑃𝑥:3 = 332.51
𝑥+2 810

Calculate the increase in the benefit reserve in the second year, 2𝑉 − 1𝑉

Exercise 2

For a fully discrete 3-year endowment insurance of 1,000 on (𝑥):

✓ 𝑞𝑥 = 𝑞𝑥+1 = 0.20

✓ 𝑖 = 0.06

✓ 𝑃𝑥:3 = 373.63

Calculate the increase in the benefit reserve in the second year, 2𝑉 − 1𝑉

Exercise 3

For a fully discrete whole life insurance of 1,000 on (𝑥):

✓ The benefit reserve at time 18 is 482

✓ The benefit premium is 18

✓ 𝑖 = 0.06

✓ The benefit reserve at time 19 is 520

Determine 𝑞𝑥+18
Exercise 4

For a fully discrete 10-pay whole life insurance of 1 on (40):

✓ 𝐴50 = 0.19

✓ 𝐴51 = 0.20

✓ 𝑞49 = 𝑞50

✓ 𝑖 = 0.08

✓ The benefit premium is 0.02.

Calculate 9𝑉