ACT 551

Commutation Functions in Life Insurance

Commutation functions are used in actuarial science to simplify and calculate future cash flows for life
insurance policies. They provide a way to represent a series of future payments (such as benefits paid out
over time) in terms of a present value.

1. Definition:
o A commutation function is a mathematical function that represents the present value of a
stream of future payments, which may depend on time, the policyholder's age, or other
factors.
o It is useful in converting future liabilities into present values, making the analysis and
pricing of life insurance policies more manageable.

2. Common Types of Commutation Functions:

o Aₓ: The present value of a policyholder’s future life insurance benefit payments, given
that they are currently aged x.
o Aₓₙ: The present value of the benefit payments for a term insurance policy, where n is the
term of the policy.
o Aₓₙⱼ: The present value of the benefit payments given that the individual is alive at the j-
th year of the term insurance.

3. Applications:
o Pricing Life Insurance Products: Commutation functions allow actuaries to estimate
the present value of expected claims.
o Reserves: They are used to calculate the reserves that an insurer needs to maintain for
future policyholder claims.
o Valuation of Policies: Helps in calculating the total cost of a life insurance policy or its
premiums over the policy term.

Profit Testing of Conventional Life Insurance

Profit testing is a technique used by actuaries to assess the profitability of life insurance products. It is
particularly important for understanding how well a product will perform financially over time.

1. Purpose of Profit Testing:

o Evaluate the profitability of a life insurance policy by estimating the present value of
expected future profits.
o Compare the revenue from premiums with the expected costs (claims, expenses, etc.).
o Assist insurers in setting appropriate premiums that cover costs and provide profit.

Ms. Ubaida Riaz (M.Phil)

ACT 551

2. Components of Profit Testing:

o Premiums: The money paid by policyholders to the insurer.
o Benefits: The payouts made by the insurer to policyholders upon death, surrender, or
other policy events.
o Expenses: The costs incurred by the insurer, such as administration, acquisition costs,
and commissions.
o Investment Income: The returns the insurer generates from investing the premiums
collected.
o Reserves: Funds set aside by the insurer to cover future claims.

3. Key Considerations in Profit Testing:

o Assumptions: These include mortality rates, interest rates, and lapse rates (policyholders
stopping their policies before death).
o Profitability Metrics:
 Net Profit: The difference between income and expenses (including investment
income).
 Internal Rate of Return (IRR): A measure of profitability that represents the
discount rate at which the present value of future profits equals the initial
investment.
 New Business Strain: The initial financial burden when a policyholder’s
premiums are less than the immediate cost of providing the insurance.

4. Steps in Profit Testing:

o Step 1: Calculate expected future premiums, benefits, and expenses.
o Step 2: Discount the future cash flows to present value using an appropriate discount rate
(often based on expected investment returns).
o Step 3: Compare the present value of expected premiums with the present value of
expected benefits and expenses to determine the policy's profitability.
o Step 4: Adjust assumptions or product features (such as premiums or benefits) if
necessary to ensure the product is profitable.

5. Types of Profit Testing:

o Traditional Profit Testing: Uses deterministic assumptions to model the policy's future
cash flows and determine profitability.
o Stochastic Profit Testing: Incorporates random variations in key assumptions (such as
interest rates or mortality) to better understand the range of possible outcomes and risks.

Ms. Ubaida Riaz (M.Phil)

ACT 551

1. Investors

Definition:
An investor is an individual or institution that allocates capital with the expectation of generating income
or profit over time. Investors place their money in various financial assets or ventures with the hope that
the value of their investment will appreciate or produce regular income.

Types of Investors:

 Retail Investors: Individual investors who buy and sell securities for personal accounts.
 Institutional Investors: Entities such as pension funds, mutual funds, insurance companies, and
hedge funds that manage large amounts of money.
 Active Investors: Investors who buy and sell frequently in an effort to outperform the market.
 Passive Investors: Investors who buy and hold securities long-term, usually tracking an index
(like the S&P 500).

2. Investment

Definition:
An investment refers to the act of committing money or capital to an asset, venture, or project with the
expectation of generating income or profit over time. The main goal of investment is to increase wealth
by gaining returns in the form of interest, dividends, or capital appreciation.

Types of Investments:

 Stocks: Ownership in a company.

 Bonds: Debt securities issued by governments or corporations.
 Real Estate: Investment in properties for rental income or capital gain.
 Mutual Funds: Pooled investment funds managed by professionals.
 Commodities: Investing in physical goods like gold, oil, or agricultural products.

3. Gilt-Edge Securities

Definition:
Gilt-Edge Securities refer to government-issued debt securities that are considered extremely safe, with a
low risk of default. These are typically bonds issued by a government, particularly in stable economies,
and are often referred to as "gilts" in the UK or government bonds elsewhere. The term "gilt-edged"
signifies their high credit quality and security.

Examples of Gilt-Edge Securities:

 Government Bonds: Long-term securities issued by a government.

 Treasury Bills: Short-term debt issued by the government.
 Municipal Bonds: Debt securities issued by local governments.

Ms. Ubaida Riaz (M.Phil)

ACT 551

Key Features:

 Low default risk.

 Issued by central governments.
 Relatively lower returns compared to riskier investments.

4. Yield Curves

Definition:
A yield curve is a graphical representation that shows the relationship between the interest rates (or
yields) of bonds of equal credit quality but different maturity dates. It is used as a tool to understand the
cost of borrowing and the economic outlook.

Key Features:

 The yield curve plots the interest rate (y-axis) against time to maturity (x-axis).
 The curve typically slopes upward, meaning longer-term bonds usually have higher yields than
short-term ones (reflecting higher risk over time).

Types of Yield Curves:

 Normal Yield Curve: The typical upward-sloping curve, indicating that long-term bonds yield
more than short-term ones. This suggests a stable and growing economy.
 Inverted Yield Curve: When short-term interest rates are higher than long-term rates. This is
often seen as a signal of economic recession.
 Flat Yield Curve: When short-term and long-term yields are similar, which can indicate
uncertainty or transition in the economy.
 Humped Yield Curve: A rare curve where short-term rates are lower, medium-term rates are the
highest, and long-term rates fall. It suggests an economic transition or uncertainty.

Applications of Yield Curves:

 Predicting future interest rates and economic conditions.

 Pricing bonds and other fixed-income securities.
 Helping investors assess the level of risk associated with bonds of different maturities.

Index-Linked Gilts

Definition: Index-linked gilts are a type of government bond whose interest payments and the
final principal repayment are adjusted for inflation, specifically tied to an inflation index (usually
the Consumer Price Index or CPI). This makes them particularly attractive to investors looking
for a hedge against inflation, as their returns keep pace with changes in the cost of living.

Unlike traditional gilts, which offer fixed interest payments, index-linked gilts provide returns
that are tied to inflation, ensuring that the purchasing power of the returns is maintained over
time.

Ms. Ubaida Riaz (M.Phil)

ACT 551

Types of Index-Linked Gilts

1. Fixed-Interest Index-Linked Gilts:

o These gilts offer a fixed rate of interest, but the principal (face value) and interest
payments are linked to inflation.
o The interest paid is typically lower than on conventional gilts, but this is offset by
the inflation adjustment, which can lead to higher payments over time if inflation
rises.
o Example: The UK government issues bonds linked to the Retail Price Index
(RPI), where both the principal and interest are adjusted for inflation.
2. Principal-Only Index-Linked Gilts:
o These gilts provide interest payments based on a fixed rate, but the principal
repayment at maturity is adjusted according to inflation.
o The value of the principal increases with inflation, ensuring that the investor
receives the real value of their original investment.

Key Features of Index-Linked Gilts:

1. Inflation Protection:
o The primary benefit of index-linked gilts is that they protect investors from
inflation risk. The interest payments and the face value of the bonds increase with
inflation, so the investor’s purchasing power is maintained.
2. Lower Initial Yield:
o Because index-linked gilts offer protection against inflation, they tend to have a
lower yield than conventional gilts. This lower yield is compensated by the
inflation-adjusted returns.
3. Government Backing:
o Like other gilts, index-linked gilts are issued by the government, meaning they are
considered very low-risk investments, especially in stable economies like the UK.
4. Long-Term Investment:
o These bonds typically have long maturities, making them suitable for investors
looking for long-term, stable returns.

Other Types of Gilts (Non-Index-Linked)

1. Conventional Gilts (Fixed-Interest Gilts):

o These are the most common type of government bond.
o They pay a fixed interest rate (coupon) over the life of the bond and repay the face
value at maturity.

Ms. Ubaida Riaz (M.Phil)

ACT 551

o The risk here is that if inflation rises significantly, the real value of the bond's
interest and principal payments could be eroded.
2. Treasury Bills (T-Bills):
o Short-term debt securities issued by the government, typically with maturities of
less than one year.
o They are sold at a discount to their face value and do not pay interest. The
investor receives the face value at maturity, with the difference between the
purchase price and face value representing the return.
o These are used by governments to meet short-term funding needs.
3. Treasury Bonds:
o These are long-term debt securities issued by a government, often with maturities
of 10 years or more.
o Treasury bonds pay regular interest and return the principal at maturity.
4. Inflation-Indexed Bonds:
o Similar to index-linked gilts, these bonds are linked to inflation indices (like the
CPI or RPI) but can be issued by various governments around the world.
o These bonds may adjust both the principal and interest payments to keep up with
inflation.

Ms. Ubaida Riaz (M.Phil)