Reserve and Surrender Value

Reserve

Nature
• The reserve in life insurance is different from the reserve in other business.
• It is not an accumulation of profit.
• In insurance, it is a liability which is to be met by the insurer at and when it arises.
• It represents a liability which must be adequately met.
Reserve

Definition
• The reserve is that fund, which, together with future premiums and interest, will be sufficient
to pay the future claims. This is called prospective definition because here the future amounts
are considered.
• Another definition of the reserve is the retrospective definition under which the reserve is
considered as the accumulation at interest of the difference between the net premiums received
in the past and the claims paid out.
Reserve

Origin of the Reserve

• The reserve in any group of policies originates in the excess of premium receipts over payment of claim.
• The premium receipts more than the payments in the beginning and less after a point.
• The excess receipts are accumulated at the assumed rate of interest and build up the “Reserve” up to a
point of time, the “Reserve” grows, particularly, because of such receipts.

• Reserve is accumulated on the assumed mortality and interest .

Reserve
Sources of Reserve
1. Premium
• The first and foremost source of reserve is premium.
• It should be noted that reserve is accumulated in level premium plan because the premium is more the
actual cost of insurance in the beginning.
• In othe two methods of premium, reserve can not be accumulated. Discuss below:

a. Assesment Premium Plan:

• The member of a group would, under this plan, contribute to a fund which could be utilised in rendering
assistance at the time of death to the deceased’s dependents.
• The payment is made by contribution only at the time of death.
• Therefore, there is no need to accumuate amount for payment of the claim.
Reserve

b.Natural Premium Plan

• Under this plan, the rate of premium will increase as the insured grows older. It is based on the risk.

• Since risk increases as time passes, the premium charged from the policyholder also increases.

• The premium increases year after year with the increase in mortality rate and, so it is also called yearly
renewable premium plan.

c. Level Premium Plan

• Here, the premiums to be paid are levelled so that usually the same premiums are paid every year.

• The premiums in the early years are greater than the actual cost with the result that the excess payments of
premium in the earlier years are accumulated as reserve which makes up any deficiency out of lower
premium in later years.
Reserve

2. Interest
• The second source of reserve is interest because the accumulated fund is not remaining idle, it is invested.
• While calculating premium it was assumed that the insurer will earn a certain rate of interest, so to earn at
least that much of amount, the accumulated funds have to be invested.
• The assumed rate of interest is the source of reserve.

3. Nature of Policy
• The reserve can be calculated only in those policies where payment is not certain, reserve is generally not
requiring,
• Thus the amount of reserve depends upon the duration of the policy and nature of the policy.
Reserve

Need for Reserves

The reserves in life insurance is required for the following reasons:

I. To Meet the Amount of Claims

• The reserve is required to meet the amount of claim whenever the given event takes place.
• The insurer must have sufficient amount to meet the claims, therefore the reserve is essential to meet these
claims.

II. To Build up Funds

• Besides being essential for meeting future cost of claims, the reserve is also useful to build up funds that
can be invested for long period to earn at least assumed rate of return.
• The invested funds help not only to the insurer to obtain a required amount of return but are also helpful
for the economic development of the country.
Reserve

III. Policyholders are Benefited

• The accumulated fund or the reserve belongs to policyholders.
• This fund is safely and profitably invested by the insurer who are in a position to do that.
Reserve

Methods of Calculating Reserve

There are two methods for calculating reserve, these are
1. Retrospective Method

2. Prospective Method
Reserve can be calculated either on all the policies or on a single policy. This can be expressed by the following
illustration-

I. Present value of all premiums = Present value of all benefits

II. Accumulated value of past premium + discounted value of future premiums = Accumulated value of past
benefits + discounted value of future benefits
III. Accumulated value of past premiums – Accumulated value of past benefits = Discounted value of future
benefits + Discontinuity value of future premiu.

IV. Retrospective Reserve = Prospective Reserve

Reserve

Retrospective Method: Under this method, the reserve is derived entirely by reference to past experience.
There are two method:

i.Group approach:
• The calculation begins with the first year when the total net premium has been received for the first time.
• For example, there are 10 policyholders insured for 10000tk each for the period of 10 years. They are
required to pay net premium of 1000 each. The rate of interest is 10% annum.
Solution:
First Year
Net premiums of 10 policyholders 10,000
@1000tk each
Add interest @ 10% 1,000
Total amount 11,000
Less
Claims paid out (no Claims)
Terminal Reserve 11,000 tk
Reserve
Second year:
Net premium of 10 policyholders
@ 1000tk each 10,000
Add Terminal Reserve of last year 11,000
Initial Reserve 21,000
Add Interest @ Tk 10% 2100
23,100
Less claims paid out
(One Death) 10,000
Terminal Reserve 13,100tk

• The process of calculating reserve continues till the 10th year. In the third year, the net premium will be
paid by only 9 policyholders because one person is dead during second year.
Reserve

Reserve in a particular year

The reserve at a particular time can be calculated by the following formula-

Reserve = Reserve at the close of the previous year (if any) + Premium of the year + Interest thereon at the
assumed rate for one year – Claims for the year.

ii. Individual Approach

• The retrospective reserve may also be calculated on every policy. The reserve will be calculated on the
basis of cost of insurance instead of claims paid on.
• Cost of Insurance = Amount at risk × Probability of Death
= (policy Amount – Initial Reserve) × Probability of Death
Reserve

For example: a policyholder takes policy of 10000tk and pays 1000an annual premium, the rate of
interest being 10%. The probability of death in the first year is .002 and in the second
year .003. We have to calculate reserve for two years.

First year
Net Premium 1000
Add Interset @10% 100

1,100
Less: Cost of Insurance
= Amount of Risk × Probability of Death
= Policy amount – Reserve × Prob. Of Death
=(10000-0 × .002) 20
1080 tk
Reserve
Second Year
Net Premium 1,000
Add Reserve of Previous Years 1080
2080tk
Initial Reserve
Add Interset rate @ 10% 208
Total = 2288tk
Less: Cost of Insurance
=( 10,000 – 1080) × .003 = 8920 × .003 26 approx.
Terminal Reserve = 2,262 tk
Reserve

Prospective Method
• The second method of calculating reserve is prospective method. Under this method we determine how
much is required to be paid in future and how much premium will be received in future.
• Thus, PVFB = PVFP at the inceptions of the policy. But as soon as one premium is paid, the present value
of future benefit exceeds the present value of future premiums.
• Reserve = PVFB – PVFP this difference is reserve because so much of amount must be with the insurer to
pay the amount of claim.
• Prospective Reserve = NSP – PVFP
• The PVFP must necessarily be equal to the NLP for the contract under consideration multiplied by PVAD
for the remaining premium paying period.
• Reserve = NSP – (NLP×PVAD)
Surrender Value

• The surrender value is the actual sum of money a policyholder will receive
if they try to access the cash value of a policy.
• It is the amount the policyholder will get from the life insurance company
if he decides to exit the policy before maturity.
• There are two bases of calculating surrender value:

i.Accumulation Approach and

ii. Saving Approach

Surrender Value

I. Accumulation approach:

• Under this approach, surrender value is the accumulation of overcharges in the net
premium, which upon the surrender of the policy is no longer required to pay the amount
of claims, therefore, he should pay all the accumulated reserve.
• In short, Accumulation value is the full accumulated cash value in the policy.
• But if it is allowed, the insurer will be left a very small amount for meeting other
obligations because a huge expenses are involved all the time of surrender. Thus,
• Surrender Value = Full Reserve – Surrender Charges
Surrender Value
• i.Accumulation approach
• Surrender Chargres are those expenses and loses which occured on account of a surrender
or lapsation of a policy. The surrender charges are discussed below:
Initial Expenses
Adverse Financial Selection
Adverse Mortality Selection
Contribution to Contingency Reserve
Contribution to Profits
Cost of Surrender
Surrender Value

• ii. Saving Approach

• The saving approach is more scientific because it reveals the reason of payment of surrender
value.
• Under this approach, the surrender value is paid in lieu of the claim amount.
• So, at the time of surrender of the policy, it is expected that the policy would have continued
up to the maturity or till the end of mortality table.
• The surrender value on a policy can be calculated as below:
• Surrender Value = (Sum assured+ Accumulated value of future expenses+ Future reversionally
bonus, if participating policy) – (Accumulated value of all future premiums+ expenses
incurred in processing the surrender value).
Surrender Value

Forms of Payment of Surrender Values

The policyholder can get the surrender values in any of the following forms:
1. Cash surrender Value
• The policyholder can get the value of surrender in cash.
• When the policyholder gets the cash, the contract comes to an end and the insurer has no
further obligation to pay on that particular policy.
2. Reduced paid up Insurance
• In this case, the surrender value is not paid immediately, but the original amount of policy is
reduced in certain propertion and the reduced amount is paid according to the term of policy.
Surrender Value
3.Extended Term Insurance

• The sum assured will be paid only when death of the life assured occurs within the ter of the policy.

• The main disadvantage of this scheme is that if the life assured does not die within the specified
time, the premium paid is forfeited by the insurer.

• Thus, the surrender value would be lost with no use to the insured.

4. Automatic Premium Loan

• Under this scheme, the surrender value is used for payment of future premium.

• Thus, the policy will continue up to the period the surrender value is adequate enough to meet the
amount of further premiums.

• The advantage of this scheme is that if the policyholder dies after surrender but before expiry of the
surrender value, full policy amount minus the loan and interest thereon is paid.
Surrender value

5. Purchase of Annuity
• The policyholder, with the surrender value, can purchase an annuity.
• Thus instead of taking surrender value in cash, the annuity is purchased from the available
surrender value.
• The amount of annuity depends upon the amount of net cash value, the attained age of the
policyholders and the type of annuity required.
Thank You.....