Actuarial Finance

2 Financial markets and their securities

As described in Chapter 1, insurance companies and pension plans collect premiums and contributions in exchange for protection. These premiums are then invested in the financial market, in securities such as stocks, bonds and derivatives. Moreover, life insurers offer complex policies, in which living and death benefits are sometimes indexed to the returns of an investment portfolio. Consequently, the financial market and financial securities have an impact on actuarial liabilities, so a basic understanding is necessary.

The main objective of this chapter is to provide an introduction to the financial market and financial securities, especially stocks, bonds and derivatives, from the point of view of an actuary. The specific objectives are to:

• understand the term structure of interest rates and the ties with bond prices;
• calculate the present and future value of cash flows using spot rates and forward rates;
• understand the impact of dividends on stock prices and how dividends can be reinvested;
• determine how actuaries can use derivatives;
• explain why pricing in the financial market is different from pricing in the insurance market;
• understand basic financial terminology related to trading;
• identify price inconsistencies and create arbitrage opportunities.

It is important to note that this chapter is not meant to be an exhaustive analysis of stocks, bonds or derivatives and their market-specific characteristics. This chapter covers ...