FINA2342CDE Insurance: Theory and Practice

Assignment 2 Answers

April 1, 2022

Instructions

1. There are two questions in total. Each question has multiple subquestions. Show your effort
clearly so that you get points for intermediate steps.
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sion.
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Assignment” starting from April 15, 2022 (Friday). Click on it and follow the instructions on
the webpage to upload the PDF file onto Moodle. Remember to accept students’ submission
statement to ensure you have successfully handed it in.
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if you submit hand-written answers.
8. If your answers are handwritten, you can scan it as a PDF file in order to submit the
softcopy of your assignment. If you use Excel to calculate your answers, submit your
spreadsheet together with your writeup.
9. Before your submission, you are suggested to make a copy of your finalized work and keep it
for your own reference.
10. If you feel you need to make additional assumptions, clearly state them and
explain why these assumptions are necessary.

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1 Life Insurance (50’)
The following table present the cash flow arrangement of a life insurance (including critical illness)
policy. Use the information in the table to answer the following questions. Assume all premiums
are paid at the beginning of each year, and all payments (death benefit and surrender value) are
paid at the end of each year.

1. Basics. (15’)
(a) What is the annual premium payment required by this policy? (3’)
Answer: 4879 USD per year
(b) If the policy holder wants to surrender the policy and guarantee the total premium he
pays in the last column (assuming survival and not getting major disease), how many
years must he wait? If the non-guaranteed terminal bonus is included in the surrender
benefit, how many years must he wait to recover the total premium payment? (6’)
Answer: After 35 years when he is 80, the guaranteed cash value is identical to the
total premium paid. If including non-guaranteed terminal bonus, he needs to wait for
20 years when the total cash value is 113,654 USD.
Note: If the student uses linear interpolation to calculate total cash value in each year
between year 15-20 and conclude with 19 years, the student should get full mark.

2
 (c) Assume the premium paid by the policyholder can earn an 1% interest rate from an
outside asset, and assume the insured survives without getting major diseases. Add a
column that calculate the future value of total premium payment at the end of each
policy year. [Hint: You may use the NPV function and FV function in Excel. See here
for the use of NPV. ](6’)
Answer: After period T , the future value is calculated as follows.
• If T < 20, the future value is

4879 × (1 + 1%)T + 4879 × (1 + 1%)T −1 + ... + 4879

• If T ≥ 20, the future value is

4879 × (1 + 1%)T + 4879 × (1 + 1%)T −1 + ... + 4879 × (1 + 1%)T −20

For numbers, see the spreadsheet.

2. Cash value and major disease/death protection. (20’)

(a) Note that Column (D) lists free 10-year crisis cover amount, which indicates that if the
insured dies or gets majaor diseases within 10 years after purchasing the policy, there
will be an additional 44,800 USD major disease/death benefit. Calculate the major
disease/death protection that this policy provides (based on guaranteed values) 5 years
and 20 years after purchasing the policy. (6’)
Answer: death protection after 5 years 128, 000 + 44, 800 − 1, 830 = 170.970. After 20
years is 128, 000 − 63, 432 = 64, 568.
Note: If the student includes non-guaranteed terminal bonus for both surrender value
and major disease/death benefit, the student should get full mark. If the student only
includes terminal bonus in one of the two values, some penalty is imposed.
(b) What is the “cost” of the free 10-year crisis cover, or, what’s the premium level if there
is no free 10-year crisis cover? To answer this question, let’s make a few simplifying
assumptions. (10’)
• Ignore any non-guaranteed terminal bonuses (column E).
• Assume all premium loadings take place in period 1.
• Assume a constant discount rate of 2%.
• For simplicity, we assume the probability of receiving benefit (death + getting major
diseases) is the probability of death listed in the Life Table attached (ignore the
probability of getting major diseases).
Under the assumptions above, please calculate the annual premium payment (over the
20 years) if there is no free 10-year crisis cover. This is a hard question, so I provide
you with some hint.
[Hint: You may proceed in the following three steps. First, calculate the probability of
receiving the benefit in each year. Second, calculate the premium loading based on the
current major disease/death benefit and premium payment as the difference between PV
of premium payment and PV of claim cost. Third, using the new major disease/death
benefit without the 10-year free crisis cover, calculate the annual premium payment. ]
Answer:

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 • Step 1: Calculate the death ptobability in each age (see Column D of the spread-
sheet) and calculate the expected claim cost at every age (see column F of the
spreadsheet)
• Step 2: Calculate PV of expected death claim cost (see G2) and premium payment
(see J2). Remember that only the survivers pay the premium. Take the difference
of the two, calculate premium loading.
• Step 3: Calculate the expected claim cost every year without the free 10-year crisis
coverage. (See column M).
• Step 4: Calculate the PV of new expected claim cost (see N2).
• Step 5: Calculate the new premium level, denote by X, by
 
p45 p46
X 1+ + + ... =
1 + r (1 + r)2

PV of expected claim cost (N2) + premium loading (K2)

Solve for X = 4812, 87, see spreadsheet Q2.
For numbers, see the spreadsheet.
(c) If you want to calculate the premium loading of this policy, what additional information
is needed? (4’)
Answer: Interest rate credited to the policy, mortality cost
3. Policy surrender and policy loans. (15’)
Suppose Mr Chan has paid premium on time for 15 years. He retired at 60 and his income
experienced a large drop. He cannot fulfill the next 5 years of premium payment requirement.
He has two options. Option 1: surrender the policy at 60. Option 2: pay 5 more years of
premium using policy loans.
(a) What is the surrender value of Option 1 (assuming the projected non-guaranteed ter-
minal bonus is realized)? (5’)
Answer: 45,221 USD
(b) Suppose the policy loan requires an interest rate of 5%. What is the cash value that
he can receive after he uses policy loan to pay for 5 additional years of premium and
surrender at age 65 (assuming survival and no major diseases)? (5’)
Answer:
113, 664 − 4879 × (1 + 5%)5 + (1 + 5%)4 + ... + (1 + 5%)

For calculation, see the spreadsheet, the answer is 85,356.47.

(c) Suppose Mr Chan dies at 65. What is the benefit that the beneficiary can get if Mr
Chan chooses option 1 and option 2, respectively at 60? (5’)
Answer: 0 if option 1, 128,000 if option 2.

2 Annuity (50’)
In this exercise, we analyze the HKMC Annuity Plan (simplified). The following table lists infor-
mation of this plan. For more details, check this website. In this exercise, we assume the buyer is

4
male. The first column lists the age of the insured at the purchase. The second column lists the
guaranteed monthly annuity payment. The third and fourth columns list the number of guaran-
teed period of annuity payments, which we will analyze further in subquestions. For simplicity, we
assume that payments are made annually. For example, if a 60-year-old buyer buys the annuity,
he gets an annual payment of 5100 × 12 at the end of every year if he survives. For simplicity, you
don’t need to calculate the payment and death probability in each month of the year. The pay-
ment ends when the insured is 100 years old. Use the Life Table attached to answer the following
questions.

1. Suppose the policy does not have any death benefit, which means if the insured dies the policy
stops making payments. Assume the policyholder does not surrender the policy before death.
(15’)
(a) Calculate the internal rate of return (IRR) of this policy for buyers of 60 (the buyer is
right before his 60th birthday). Assume the first payment starts one year later. (10’)

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 Answer: We proceed with the following steps. The expected payment in each year
is 5100 × 12 × pT , where pT is the probability of surviving into year T (T ≥ 60), see
Column D in the spreadsheet. Then use the IRR function to calculate the internal rate
of return as 2.985%.
(b) Suppose there is another financial instrument (e.g., a bond) that can achieve the same
level of IRR as you calculate in part (a). What is the benefit of the annuity plan,
compared with the alternative instrument? (5’)
Answer: If one uses the alternative instrument, if he lives longer than he expected, he
will run out of wealth.

2. Death benefit. (20’)

The death benefit we consider is simpler than the death benefit from the actual plan (if
you read the document through the link). Assume that if the insured dies within the
guaranteed period, the beneficiary can get a death benefit equal to the 105% of the total
premium payment (1,050,000) minus the total monthly payments that have been collected
(simple sum, ignore the discount rate). For example, if a 60-year-old male purchases the
policy but dies after 12 months, his beneficiary could get 1, 050, 000 − 5, 100 × 12 as death
benefit. The guaranteed period is calculated as the ratio of 1, 050, 000 HKD to the monthly
payment in Column 2. Therefore, after the guaranteed period the death benefit is 0.

(a) Suppose a buyer purchases the annuity policy right after his 60th birthday amd dies
right after his 66th birthday. What is the death benefit his beneficiary can obtain? (5’)
Answer: 1, 050, 000 − 5, 100 × 12 × 6 = 682, 800
(b) Using the information in the table, calculate the IRR of the policy for buyers of age 60.
For simplicity, you can use 204 months (17 years) as the guaranteed period and ignore
the additional two months. (15’)
Answer: We need to take into consideration the death benefit in each year. The death
benefit is 1, 050, 000 − 5, 100 × 12 × (T − 59) for year T (T ≥ 60), and the probability of
death for the buyer in year T is calculated as pT −1 × qT , where pT −1 is the probability
of surviving into year T − 1 and qT is the probability of death in year T taken from the
life table (see columns D and F in the spreadsheet). Calculate the IRR as 3.586%.

3. Policy surrender. (15’)

In this subquestion, we examine the surrender of the policy. Suppose a buyer purchases the
policy right after his 60th birthday and receives the specified payments until right before
his 65th birthday. Then he unfortunately is diagnosed with cancer and needs to pay a large
amount of medical expenses (0.5 million HKD).

(a) Suppose the annual interest credited to the account is 3%, and assume the premium
loading is 0. Calculate the acturially fair surrender value of the policy when the buyer
surrenders the policy. (5’)
Answer:
• Before 61st birthday: 1, 000, 000 × (1 + 3%) − 5100 × 12 × p60 = 969, 191.45, where
p60 is the probability of surviving age 60.
• Before 62nd birthday: 969, 191, 45 × (1 + 3%) − 5100 × 12 × p61 = 937, 887.41.
• ...

6
 • The actuarially fair surrender value before the 65th birthday is 841,251.54. For
calculation, see the spreadsheet.
(b) Explain why such policy surrender brings adverse selection problem to the annuity
policy. (5’)
Answer: Those that have health shocks may surrender the policy. The remaining
buyers in the pool tend to have lower probability, so that the insurance company will
need to pay more.
(c) If you are a financial consultant to an elderly who is going to enter into the annuity
policy, can you provide a reason to convince the buyer to simultaneously buy a health
insurance? (5’)
Answer: Buying a health insurance can prevent early liquidation of the annuity, which
is subject to front-end premium loading.

7
人口生命表 Life Tables

表 12 2019 年香港男性人口生命表
Table 12 Hong Kong life table for males, 2019
確切年齡 確切年齡 確切年齡
x 歲和 x+1 歲之間的 確切年齡 x 歲的 x 歲和 x+1 歲之間的 x 歲和 x+1 歲之間的 確切年齡 x 歲以上 確切年齡 x 歲的
年齡 死亡概率 尚存人數 死亡人數 生存人年 總生存人年 平均預期壽命
Age Probability Number of Number of deaths Number of Total person-years Expectation
of dying survivors between exact person-years lived lived after of life
between exact at exact age x age x and age x+1 between exact exact age x at exact age x
age x and age x+1 age x and age x+1
x q(x) l(x) d(x) L(x) T(x) e(x)

0 0.00162250 1 000 000 1 623 998 702 82 212 463 82.21

1 0.00019344 998 377 193 998 281 81 213 761 81.35
2 0.00015686 998 184 157 998 106 80 215 480 80.36
3 0.00012524 998 027 125 997 965 79 217 374 79.37
4 0.00009857 997 902 98 997 853 78 219 409 78.38
5 0.00007701 997 804 77 997 766 77 221 556 77.39
6 0.00006084 997 727 61 997 697 76 223 790 76.40
7 0.00005002 997 666 50 997 641 75 226 093 75.40
8 0.00004524 997 616 45 997 594 74 228 452 74.41
9 0.00004718 997 571 47 997 548 73 230 858 73.41
10 0.00005633 997 524 56 997 496 72 233 310 72.41
11 0.00007291 997 468 73 997 432 71 235 814 71.42
12 0.00009653 997 395 96 997 347 70 238 382 70.42
13 0.00012564 997 299 125 997 237 69 241 035 69.43
14 0.00015800 997 174 158 997 095 68 243 798 68.44
15 0.00018870 997 016 188 996 922 67 246 703 67.45
16 0.00021443 996 828 214 996 721 66 249 781 66.46
17 0.00023349 996 614 233 996 498 65 253 060 65.47
18 0.00024539 996 381 245 996 259 64 256 562 64.49
19 0.00025127 996 136 250 996 011 63 260 303 63.51
20 0.00025481 995 886 254 995 759 62 264 292 62.52
21 0.00026013 995 632 259 995 503 61 268 533 61.54
22 0.00027172 995 373 270 995 238 60 273 030 60.55
23 0.00029114 995 103 290 994 958 59 277 792 59.57
24 0.00031860 994 813 317 994 655 58 282 834 58.59
25 0.00035281 994 496 351 994 321 57 288 179 57.61
26 0.00039116 994 145 389 993 951 56 293 858 56.63
27 0.00042968 993 756 427 993 543 55 299 907 55.65
28 0.00046707 993 329 464 993 097 54 306 364 54.67
29 0.00050262 992 865 499 992 616 53 313 267 53.70
30 0.00053344 992 366 529 992 102 52 320 651 52.72
31 0.00055947 991 837 555 991 560 51 328 549 51.75
32 0.00058352 991 282 578 990 993 50 336 989 50.78
33 0.00060809 990 704 602 990 403 49 345 996 49.81
34 0.00063664 990 102 630 989 787 48 355 593 48.84
35 0.00067580 989 472 669 989 138 47 365 806 47.87
36 0.00073018 988 803 722 988 442 46 376 668 46.90
37 0.00080236 988 081 793 987 685 45 388 226 45.94
38 0.00089355 987 288 882 986 847 44 400 541 44.97
39 0.00100287 986 406 989 985 912 43 413 694 44.01
40 0.00112482 985 417 1 108 984 863 42 427 782 43.06
41 0.00125401 984 309 1 234 983 692 41 442 919 42.10
42 0.00138511 983 075 1 362 982 394 40 459 227 41.16
43 0.00151730 981 713 1 490 980 968 39 476 833 40.21
44 0.00165192 980 223 1 619 979 414 38 495 865 39.27
45 0.00179352 978 604 1 755 977 727 37 516 451 38.34
46 0.00194738 976 849 1 902 975 898 36 538 724 37.40
47 0.00211958 974 947 2 066 973 914 35 562 826 36.48
48 0.00231228 972 881 2 250 971 756 34 588 912 35.55
49 0.00252595 970 631 2 452 969 405 33 617 156 34.63

香港人口生命表 2014–2069 30 Hong Kong Life Tables 2014–2069

人口生命表 Life Tables

表 12 （續） 2019 年香港男性人口生命表

Table 12 (Cont’d) Hong Kong life table for males, 2019
確切年齡 確切年齡 確切年齡
x 歲和 x+1 歲之間的 確切年齡 x 歲的 x 歲和 x+1 歲之間的 x 歲和 x+1 歲之間的 確切年齡 x 歲以上 確切年齡 x 歲的
年齡 死亡概率 尚存人數 死亡人數 生存人年 總生存人年 平均預期壽命
Age Probability Number of Number of deaths Number of Total person-years Expectation
of dying survivors between exact person-years lived lived after of life
between exact at exact age x age x and age x+1 between exact exact age x at exact age x
age x and age x+1 age x and age x+1
x q(x) l(x) d(x) L(x) T(x) e(x)

50 0.00274999 968 179 2 662 966 848 32 647 751 33.72

51 0.00297844 965 517 2 876 964 079 31 680 903 32.81
52 0.00320998 962 641 3 090 961 096 30 716 824 31.91
53 0.00345019 959 551 3 311 957 896 29 755 728 31.01
54 0.00370895 956 240 3 547 954 467 28 797 832 30.12
55 0.00400300 952 693 3 814 950 786 27 843 365 29.23
56 0.00434727 948 879 4 125 946 817 26 892 579 28.34
57 0.00475490 944 754 4 492 942 508 25 945 762 27.46
58 0.00523369 940 262 4 921 937 802 25 003 254 26.59
59 0.00578616 935 341 5 412 932 635 24 065 452 25.73
60 0.00639625 929 929 5 948 926 955 23 132 817 24.88
61 0.00705099 923 981 6 515 920 724 22 205 862 24.03
62 0.00774045 917 466 7 102 913 915 21 285 138 23.20
63 0.00847057 910 364 7 711 906 509 20 371 223 22.38
64 0.00925418 902 653 8 353 898 477 19 464 714 21.56
65 0.01009394 894 300 9 027 889 787 18 566 237 20.76
66 0.01100561 885 273 9 743 880 402 17 676 450 19.97
67 0.01201798 875 530 10 522 870 269 16 796 048 19.18
68 0.01315812 865 008 11 382 859 317 15 925 779 18.41
69 0.01445331 853 626 12 338 847 457 15 066 462 17.65
70 0.01590698 841 288 13 382 834 597 14 219 005 16.90
71 0.01752795 827 906 14 511 820 651 13 384 408 16.17
72 0.01933036 813 395 15 723 805 534 12 563 757 15.45
73 0.02134681 797 672 17 028 789 158 11 758 223 14.74
74 0.02361215 780 644 18 433 771 428 10 969 065 14.05
75 0.02615837 762 211 19 938 752 242 10 197 637 13.38
76 0.02901072 742 273 21 534 731 506 9 445 395 12.72
77 0.03218674 720 739 23 198 709 140 8 713 889 12.09
78 0.03570063 697 541 24 903 685 090 8 004 749 11.48
79 0.03955787 672 638 26 608 659 334 7 319 659 10.88
80 0.04376247 646 030 28 272 631 894 6 660 325 10.31
81 0.04831253 617 758 29 845 602 836 6 028 431 9.76
82 0.05320361 587 913 31 279 572 274 5 425 595 9.23
83 0.05843045 556 634 32 524 540 372 4 853 321 8.72
84 0.06398744 524 110 33 536 507 342 4 312 949 8.23
85 0.07005385 490 574 34 367 473 391 3 805 607 7.76
86 0.07667262 456 207 34 979 438 718 3 332 216 7.30
87 0.08388956 421 228 35 337 403 560 2 893 498 6.87
88 0.09175339 385 891 35 407 368 188 2 489 938 6.45
89 0.10031580 350 484 35 159 332 905 2 121 750 6.05
90 0.10963133 315 325 34 570 298 040 1 788 845 5.67
91 0.11975740 280 755 33 622 263 944 1 490 805 5.31
92 0.13075406 247 133 32 314 230 976 1 226 861 4.96
93 0.14268386 214 819 30 651 199 494 995 885 4.64
94 0.15561151 184 168 28 659 169 839 796 391 4.32
95 0.16960348 155 509 26 375 142 322 626 552 4.03
96 0.18472755 129 134 23 855 117 207 484 230 3.75
97 0.20105214 105 279 21 167 94 696 367 023 3.49
98 0.21864560 84 112 18 391 74 917 272 327 3.24
99 0.23757528 65 721 15 614 57 914 197 410 3.00
（註釋 Note）
100+ 1.00000000 50 107 50 107 139 496 139 496 2.78

註釋： 這數字是指 100 歲的平均預期壽命。 Note : This figure refers to the expectation of life at age 100.

香港人口生命表 2014–2069 31 Hong Kong Life Tables 2014–2069