Chapter 1: Introduction to Actuarial Statistics

T. Khalema

National University of Lesotho

ST3512: Actuarial Statistics
Year: 2025
Chapter 1: Introduction to Actuarial Statistics
Contents
1 Introduction to the Actuarial Profession 1
1.1 What is an Actuary? . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Actuarial Professional Bodies . . . . . . . . . . . . . . . . . . . . . . 1
1.3 Differences Between Actuarial Systems . . . . . . . . . . . . . . . . . 2

2 Fundamental Terms and Concepts 3

2.1 Cash Flow Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

3 Securities 4
3.1 Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.2 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.3 Derivative Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
3.3.1 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . 6
3.3.2 Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . 6
3.3.3 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.3.4 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

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1 Introduction to the Actuarial Profession
1.1 What is an Actuary?
An actuary is a professional who applies mathematical, statistical, and financial
theories to assess, model, and manage risks, particularly those associated with uncer-
tain future events. Actuaries are essential in industries such as insurance, pensions,
healthcare, investments, and risk management, where they help organisations make
informed decisions by evaluating potential outcomes and their financial implications.

1.2 Actuarial Professional Bodies

Actuarial bodies play a critical role in the professional development, regulation, and
support of actuaries worldwide. These organisations set educational and ethical stan-
dards, provide professional qualifications, and ensure that actuaries maintain compe-
tence through continuous professional development (CPD).
Some of the key actuarial organisation are:

• Institute and Faculty of Actuaries (IFoA) (UK): Recognised globally, par-

ticularly in the UK and Commonwealth countries.

• Society of Actuaries (SOA) (US): Focused on North America but with a

global presence in life insurance, pensions, and healthcare sectors.

• Casualty Actuarial Society (CAS) (US): Specialises in property and casu-

alty insurance.

• Actuarial Society of South Africa (ASSA) (SA): Key body for actuaries
in South Africa, aligned with global standards.

• International Actuarial Association (IAA): A global umbrella organisa-

tion that promotes collaboration and consistency among national actuarial bod-
ies.

Although other levels of membership with an actuarial body exist, the ones that
stand out are:

1. Student member: A student member of an actuarial body is an individual

who is registered with the organisation and is actively pursuing actuarial qualifi-
cations through the required series of examinations. Student membership serves
as the entry-level status in the actuarial profession, granting individuals access
to study resources, examination opportunities, and support networks within the
actuarial community. Student members are typically on a journey to achieve
fellowship status, which represents the highest professional designation in an
actuarial body. However, not all student members achieve fellowship status.
The path to fellowship is challenging and requires significant dedication, time,
and effort. Many student members may transition into roles that leverage their

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 actuarial skills without completing the full fellowship requirements. Others may
choose to specialise or pursue related fields where partial actuarial qualifications
are highly valued.

2. Associate: An associate member of an actuarial body is a professional designa-

tion granted to individuals who have successfully completed a specified portion
of the actuarial qualification process. Achieving associate membership signifies
that the individual possesses strong foundational knowledge and skills in actu-
arial science and has demonstrated proficiency in applying these to practical
problems. While associate members hold a respected professional designation,
they do not have the same rights or privileges as fellows of the actuarial body.
For example, associates may be limited in their ability to sign off on certain
actuarial reports or take on certain roles requiring fellowship status.

3. Fellow: Fellows are fully qualified actuaries and are often entitled to use the
title “Actuary” in a formal and legal capacity. A fellow of an actuarial body is
the highest professional designation within the actuarial profession, signifying
mastery of actuarial science and the ability to apply it to complex financial
and risk-related challenges. Achieving fellowship status demonstrates that an
individual has completed all required examinations, professional training, and,
in many cases, a period of practical work experience.

1.3 Differences Between Actuarial Systems

While fellowship in one actuarial body is highly respected globally, it does not auto-
matically confer fellowship status in another actuarial body. For instance, fellowship
with the Institute and Faculty of Actuaries (IFoA) in the UK does not translate di-
rectly to fellowship with the Society of Actuaries (SOA) in the United States. This dis-
tinction underscores the importance of understanding jurisdictional differences when
pursuing fellowship or practicing internationally. For students taking ST3512 at NUL,
this distinction further underscores the need to carefully select supplementary mate-
rial. The content of courses that are considered equivalent by different actuarial bodies
can vary significantly, which may lead to discrepancies in topics, methods, and em-
phasis. Content for ST3512 is related to subject CM1 of the UK-based IFoA. For that
reason, students looking for information and resources including past papers (with so-
lutions) related to this course out of NUL are advised to visit https://actuaries.
org.uk/qualify/curriculum/actuarial-mathematics/. Otherwise, when select-
ing supplementary material the student is advised to consult with the instructor.

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2 Fundamental Terms and Concepts
In this section we define a few standard terms that you will encounter throughout the
course.
Cash Flow: In Financial Mathematics, the term cash flow can be used to refer to
either:
1. the movement of money into or out of an entity, such as an individual, company,
or investment or

2. a sum of money.
For purposes of this course, the second definition is the most important of the two.
In this definition, money coming in is referred to as an inflow or a positive cash
flow while money going out is referred to as an outflow or a negative cash flow.
So, for instance, the money you received from NMDS on September 15th last year
is a positive cash flow (from your perspective) while the money you paid for rent on
September 30th last year was a negative cash flow (from your perspective). A net
cash flow is the difference between inflows and outflows.
There are different ways of classifying cash flows. For instance, cash flows can be
classified as either certain (deterministic) or uncertain (stochastic). A cash flow
whose value depends on the outcome of an uncertain event (e.g., insurance payout) is
referred to as a contingent claim. Note however that, although the term contingent
claim has practical applications in financial markets, it is primarily a theoretical term
used in the theory of Financial Mathematics.
There are two parties to every financial transaction: the lender (also referred to as
a creditor) and the borrower (also referred to as a debtor). Alternatively, a lender
can be referred to as an investor; a corresponding alternative term for a borrower
is issuer. This terminology is common in contexts like bond markets, where the
borrower issues a bond, and the lender (investor) purchases it, effectively lending
money to the issuer. The sum of money lent to the borrower is commonly referred
to as principal or capital. The lender provides capital to the borrower expecting
repayment with interest. We define interest as a reward paid by the borrower to the
lender for the use of capital.

2.1 Cash Flow Models

A cash flow model is a mathematical framework used to represent and analyse
the timing, amount, and frequency of cash flows associated with a series of
payments. An alternative definition is: a cash flow model is a mathematical rep-
resentation of cash flows in a financial transaction. Cash flow models are crucial in
understanding the value, risk, and performance of financial instruments or projects.
The key elements of a cash flow model are:
1. Timing: Specifies when cash flows occur.

2. Amount: Quantifies the value of each cash flow.

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 3. Frequency: Indicates the regularity of the cash flows (e.g., annually, semi-
annually, monthly).

4. Certainty: Differentiates between certain (deterministic) and uncertain (stochas-

tic) cash flows.

Example 2.1. Discuss the cash flows occurring in a fixed loan repayment schedule
where a borrower repays a loan through equal monthly payments over 10 years. Each
payment consists of principal and interest.
solution: A series of fixed, predictable monthly outflows for the borrower and inflows
for the lender.
Example 2.2. An investor purchases shares and receives dividends based on the
company’s performance. Discuss the cash flows involved.
solution: An initial cash outflow (share purchase), uncertain periodic inflows (divi-
dends), and a potential inflow upon sale of the shares.
In later chapters we will apply cash flow models to the valuation of cash flows.

3 Securities
A financial security is a tradable financial instrument that represents a claim on an
asset or cash flow. In contrast, a private loan agreement between two individuals is
typically non-tradable because it lacks a standardised structure and an active market
for resale.
To illustrate, suppose Person A lends Person B $1,500 at the beginning of the
year, and Person B agrees to repay $2,000 at the end of the year. It is uncommon
for a third party, say Person C, to purchase this loan from Person A mid-year in
exchange for the right to receive the full $2,000 at year-end. Unlike private loans,
financial securities are structured to facilitate transferability and liquidity in financial
markets.
Financial securities exist in various forms, including stocks, bonds, and derivatives,
and they are traded in organised markets such as stock exchanges, bond markets,
derivative markets, and over-the-counter (OTC) markets.

3.1 Equity
Equity represents ownership in an entity, typically in the form of shares in a company.
It grants the holder a claim on the company’s residual assets and earnings after
all liabilities have been settled. It is common to use the terms equity and shares
interchangeably and the American term for shares is stocks.
There are two types of equity:

1. Common equity (or ordinary shares) typically carry voting rights and vari-
able dividends.

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 2. Preferred equity (or preference shares) usually offer fixed dividends and
have a higher claim on assets than common equity but typically lack voting
rights.

3.2 Bonds
A zero-coupon bond (also known as a discount bond) is a financial security that
promises to pay a single cash flow of fixed amount, say F , at maturity. The amount
F is referred to as the face value of the bond.
One distinguishes between two types of zero-coupon bond. Namely, a default-
free (or treasury) zero-coupon bond and a corporate (or defaultable) zero-
coupon bond. A default-free zero-coupon bond is issued by a government and is
therefore considered safe; a corporate bond is issued by a firm (or corporation) and
is considered risky as there is the possibility of default before maturity.
A coupon bond is a debt security that pays the holder periodic interest payments,
called coupons, and repays the principal amount (face value) at maturity. The
coupons are typically expressed as a percentage of the bond’s face value and are paid
at regular intervals, such as annually or semi-annually.
When the coupon payments remain constant throughout the life of the bond, the
bond is called a fixed-rate coupon bond. In some cases the coupon payments are
allowed to vary. When the coupon payments are linked to a benchmark interest rate,
such as LIBOR, and adjust periodically based on changes in that rate, then the bond
is called a Floating-Rate Note (or an FRN). For an Inflation-Linked Bond the
coupon payments and/or the principal are adjusted based on changes in an inflation
index, such as the Consumer Price Index (CPI).
Like zero-coupon bonds, coupon bonds can be classified as either default-free
or defaultable, depending on the creditworthiness of the issuer. The investor who
purchases the bond is known as the bondholder.

3.3 Derivative Securities

A derivative is a security whose value depends on (or is derived from) the value of
an underlying variable such as an index or another financial instrument. Common
underlying variables and financial instruments include shares, bonds, commodities,
currencies, interest rates, or market indices. Derivative securities are widely used in
financial markets for purposes such as:

• Hedging: Protecting against price fluctuations in the underlying asset.

• Speculation: Profiting from anticipated changes in the price of the underlying

asset.

Examples of derivatives include forwards, futures, options and swaps. These are
defined below:

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3.3.1 Forward Contracts
A forward contract is an agreement between two parties to buy or sell an underlying
asset at a specified price (called the delivery price) on a predetermined future date.
The underlying asset (i.e., the asset being traded) could be a stock, bond, commodity,
or currency. Forward contracts are traded over-the-counter (i.e., in OTC markets
and not in exchanges), meaning they are privately negotiated and customized to the
needs of the parties involved.
At the time the contract is initiated, the delivery price is chosen so that the value
of the contract to both sides is zero. Hence, the forward contract costs nothing to
enter. In other words, when the forward contract initiated, no money exchanges
hands. The cash flow occurs only at the maturity of the contract. The buyer pays
the delivery price, and the seller delivers the underlying asset (or the equivalent cash
settlement).
In addition to the delivery price, a forward contract will also have a forward
price. These two will in general not be equal. However, they are equal when the
contract is initiated. A forward price is defined as the delivery price that makes
the contract have zero value at the time the contract is initiated. As time passes,
the forward price changes following changes in the price of the underlying asset;
meanwhile, the delivery price remains constant.
Example 3.1. Consider a wheat farmer who enters into a forward contract with a
buyer. The contract specifies that the farmer will sell 1,000 bushels1 of wheat at a
price of $5 per bushel three months from now. Regardless of the market price of
wheat at the end of three months, the buyer will pay $5,000 ($5 per bushel × 1,000
bushels), and the farmer will deliver the agreed quantity of wheat.

3.3.2 Futures Contracts

A futures contract is a standardised financial agreement between two parties to buy
or sell an underlying asset at a predetermined price, on a specified future date. Unlike
a forward contract, which is customized, a futures contract is traded on organised
exchanges. Similarly to a forward contract, a futures price is defined as the delivery
price that makes the contract have zero value at the time the contract is initiated.
While the futures price will fluctuate during the life of the contract based on market
conditions, the delivery price is fixed at the time of entering the contract and does
not change.
Somewhat similarly to the case of forward contracts, money does not directly
exchange hands at initiation, at least not in the form of a purchase price or delivery
price. However, unlike in the case of forward contracts, both parties to a futures
contract are required to post an initial margin with a clearinghouse. Margin is a
deposit or collateral required to enter into a futures contract. It is not a payment or
down payment for the contract but rather a form of security to ensure performance.
The margin system reduces the credit risk for both the buyer and seller by ensuring
1
A bushel is equivalent to 36.4 litres.

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that they can cover potential losses resulting from price movements in the underlying
asset. One other feature that makes futures different from forwards is that futures
contracts are marked-to-market daily. This means that the gains and losses based
on the daily price changes of the futures contract are settled at the end of each trading
day:

1. If the futures price increases, the buyer’s account is credited with the gain, and
the seller’s account is debited with the loss.

2. If the futures price decreases, the seller’s account is credited with the gain, and
the buyer’s account is debited with the loss.

The amount credited or debited is typically the same for both the buyer and the seller
as one party’s gain is the other party’s loss. At maturity the final cash flow occurs,
which could either involve the physical delivery of the underlying asset or a cash
settlement, depending on the contract specifications. It should be noted that, physical
delivery rarely happens in practice, especially for financial institutions. Instead, these
investors typically close out their positions before the contract’s maturity by taking
an opposite position (selling if they originally bought, or vice versa). This offsets
their obligations and avoids physical delivery.
A futures contract can specify that settlement be made either by physical delivery
or in cash. The next two examples illustrate this and introduce the concepts of main-
tenance margin and variation margin. Maintenance margin is the minimum
margin balance required to keep a futures position open while variation margin is
the amount of money that must be deposited into a margin account to cover losses
incurred due to adverse price movements. In other words, variation margin is the
additional margin required to bring the account balance back to the initial margin
level.
Example 3.2. Suppose that a trader buys a futures contract on 100 barrels of crude
oil at an initial futures price of $75 per barrel, and the contract specifies physical
delivery. The initial margin is $1,000, and the maintenance margin is $800. Assume
the futures price rises from the initial $75 to $80 at maturity with no intermediate
steps. Discuss what happens from initiation to maturity.
Solution: The buyer deposits an initial margin of $1,000 into their margin account
to enter the contract. The price change from $75 to $80 earns the buyer a profit of
$5 per barrel, or $500, and for this reason, a variation margin of $500 is credited to
the buyer’s margin account.
At maturity, the buyer’s margin account balance reflects:

$1, 000 + $500 = $1, 500.

The buyer pays the delivery price of $7,500 as follows: the margin balance reduces
the total amount the buyer needs to pay by $1,500, leaving $6,000 to be paid. The
buyer deposits the additional funds (i.e., $6,000) to complete the delivery payment.
The seller then delivers 100 barrels of crude oil to the buyer.

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Example 3.3. Consider the same futures contract as in Example 3.2 but now suppose
the contract specifies cash settlement (instead of physical delivery) and discuss what
happens from initiation to maturity.
Solution: The buyer deposits an initial margin of $1,000 into their margin account
to enter the contract. The price change from $75 to $80 earns the buyer a profit
of $5 per barrel, or $500 and for this reason, a variation margin of amount $500 is
credited to the buyer’s margin account. At maturity, the buyer’s margin account
balance reflects:
$1, 000 + $500 = $1, 500.
The profit is left in the margin account, the buyer receives the entire balance and no
physical delivery takes place.
The notional value of a futures contract is calculated as the product of the con-
tract size and the delivery price (or the initial forwards price). For instance, the fu-
tures contract considered in Examples 3.3 and 3.3 is calculated as 100×$75 = $7, 500.
The initial margin is often calculated as a percentage of the contract’s notional value.
The examples above only consider the case when the forwards price increases, in
which case the trader’s margin account is credited with a profit. What happens when
the futures price decreases? When the margin balance falls below the maintenance
margin the trader/buyer gets a margin call. The trader must deposit enough funds
to restore the margin balance to the initial margin (and not just to the maintenance
margin). A margin call is a notification (in the form of a message on your trading
platform, an email, a pop-up alert on your mobile app or a notification on your on-
line account dashboard) to deposit additional funds to meet the minimum margin
requirements. Consider the example below.
Example 3.4. Suppose that a trader buys a futures contract on 100 barrels of crude
oil at an initial futures price of $75 per barrel, and the contract specifies physical
delivery. The initial margin is $1,000, and the maintenance margin is $800. Assume
that on day 2, the futures price decreases to $73, triggering a margin call. By maturity,
the price rises to $80. Discuss what happens from initiation to maturity.
Solution:
Step 1: Initial Margin Deposit The buyer deposits an initial margin of $1,000
into their margin account.
Step 2: Price Decline and Margin Call On day 2, the futures price falls to $73
per barrel, causing a loss of:

(75 − 73) × 100 = 2 × 100 = $200.

The new margin balance becomes:

1, 000 − 200 = $800.

Since this balance equals the maintenance margin ($800), no margin call occurs yet.
However, if the futures price drops slightly further, even by $0.01 per barrel, the
margin balance would fall below $800, triggering a margin call. Suppose the price

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drops to $72.90 on day 3, causing an additional loss of:

(73 − 72.90) × 100 = 0.10 × 100 = $10.

The margin balance now falls to:

800 − 10 = $790.

Since $790 < $800, a margin call is issued. The buyer must deposit enough funds to
restore the balance to the initial margin level of $1,000. Thus, the buyer deposits:

1, 000 − 790 = $210.

Step 3: Price Increase to $80 at Maturity By maturity, the price rises to $80,
leading to a gain of:

(80 − 72.90) × 100 = 7.10 × 100 = $710.

This amount is credited to the margin account, bringing the final balance to:

1, 000 + 710 = $1, 710.

Step 4: Settlement and Delivery The buyer pays the delivery price of:

100 × 75 = $7, 500.

The margin balance reduces the amount the buyer needs to pay by $1,710, so the buyer
deposits an additional $5,790 to complete the payment. The seller then delivers 100
barrels of crude oil to the buyer.

3.3.3 Options
An option is a type of derivative contract that grants the holder the right, but not
the obligation, to buy or sell an underlying asset at a predetermined price (called
the strike price) on or before a specified date (called the maturity). American
options can be exercised at any time up to maturity while European options can
only be exercised at maturity. The two types of options are:

• Call Option: This grants the holder the right to buy the underlying asset at
the strike price within the specified time period.

• Put Option: This grants the holder the right to sell the underlying asset at
the strike price within the specified time period.

The party that sells the option contract is often called the option writer. The
option writer is obligated to fulfill the terms of the option if the holder exercises
it. The price paid by the holder to the writer for the option contract is called the
premium.

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Example 3.5. Suppose an investor purchases a call option on a stock with a strike
price of $50 and an expiration date in one month. If the stock’s price rises to $60,
the holder can exercise the option, buying the stock at $50, and potentially selling it
at $60 to make a profit.
Example 3.6. An investor buys a put option on a stock with a strike price of $40.
If the stock’s price falls to $30, the holder can exercise the option, selling the stock
at $40 to make a profit.

3.3.4 Swaps
A swap is a financial derivative in which two parties agree to exchange a series of
cash flows over a specified period, typically based on differing financial instruments
or market variables. Swaps are commonly used for hedging or speculating on changes
in interest rates, currency exchange rates, or other market factors.

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