Meaning of Surrender Value
It has been revealed in previous chapter that the premiums received by the insurer are accumulated with a certain rate of interest, which form the shape of reserve.
When the insured wishes to surrender his policy or fails to pay his premium, reserve is no longer accumulated and the insured, generally, is given a surrender value.
The surrender value will not be equal to the accumulated reserve because certain expenses or losses are involved in payment of surrender values.
Now, the definition of surrender value can be as that amount of premiums paid which is returned to the policy-holder at the time of surrendering the policy. Normally no surrender value is paid if the policy lapses within tow or three years of its issue because huge expenditures are involved during the inception of the policy.
It has been realized that the insurer may return the excess of receipts over expenditure only after two years of the policy.
In India, the policy can be surrendered for cash after the premiums have been paid for at least two years or to the extent of one-tenth of the total number, stipulated for in the policy, provided such one-tenth exceeds one full year’s premium.
Calculation of Surrender Value
There are two approaches for calculating surrender value:
I. Accumulation Approach
II. Saving Approach
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, theoretically he should pay all the accumulated reserve but if it is allowed, the insurer will be left a very small amount for meeting other obligations because huge expenses are involved at the time of surrender.
The accumulation approach is very scientific because it allows surrender values to all types of policies, whereas, in practice surrender values on the term policies and pure endowment policies are not allowed because there the question of payment may or may not arise.
Had the surrender values allowed on those policies, the insurer may be losing when claims would not arise on the policies.
The accumulation approach regards reserve for policy as the basis of distribution of surrender values.
The reserve is calculated in this case on gross premium. So the expenses are also deducted from the premium received. Thus, the reserve would be equal to all the premiums paid and interest earned thereon minus shares of death claims and of over all expenses of the insurer.
The surrender value can be the largest amount which the insurer can pay without going into loss.
The full amount of reserve to a particular policy cannot be given as a surrender value because there are certain expenses and loss because of surrendering the policies.
Surrender Value = Full Reserve – Surrender Charges
The surrender charges are those expenses and losses which occurred on account of a surrender or lapsation of policy. The surrender charges are discussed below:
(i) Initial Expenses
In the beginning of the contract, certain expenses are involved for processing the proposal, payment of commission to agents and medial officer, correspondence and issuing of policy.
The initial expenses are so high that the first year’s premium is unable to meet all the expenses. These expenses, actually, are recouped after several years’ continuation of the policy.
Moreover, the initial expenses involved are equally distributed throughout the premium paying period. If policy is lapsed or surrendered before maturity, a part of the initial expenses are left unpaid.
So, it is a justified matter to charge the unpaid initial expenses from the reserve of the policy which is surrendered. If it is not done, it would be a great injustice to remaining policy-holders who are willing to continue the policy.
The surrender values are lesser in the beginning and higher at later stage because initial expenses are to be recouped in the beginning are more than at later age.
(ii) Adverse Financial Selection
During the period of business depression, the surrendering of policies weaken the financial standing of the insurer because at that time most of the policy-holders will rush for surrender values and the insurer’s funds will be reduced to minimum.
In such cases the policyholders should not be allowed to receive surrender values more than the realized values of the invested funds.
The insurer has to liquidate some assets at depressed prices. The demand of surrender values necessitates some liquid assets with the insurer, which means the insurer is unable to earn sufficient amount on the liquid assets.
(iii) Adverse Mortality Selection
It is well-known fact that the person in extremely poor health are not likely to surrender their policies. They will beg, borrow or steal to maintain the protection.
Those who do surrender are expecting longer lives than those who do not surrender. Consequently at every surrender, the average or actual mortality tends to increase more than the assumed mortality. Thus, the increased mortality should be adjusted while surrendering value is permitted.
(iv) Contribution to Contingency Reserve
While calculating gross premium a small amount for contribution to contingency reserves is charged from the policyholders to meet the sudden and accidental rise in claims due to wars and epidemics. If the policy is surrendered in the beginning, the contribution is left unrealized.
(v) Contribution to Profits
The policy is expected to contribute a fund towards the profit. If the policy surrendered, the expectation is lost.
So this contribution should also be treated as surrender charges while permitting surrender of policy.
(vi) Cost of Surrender
The insurer will incur a certain amount of expenses in processing the surrender of policies.
Sometimes, the cost of surrender is like other expenses, spread over the premium paying period.
In early surrender, the cost is left unrealized and a deduction from the reserve is permitted.
These expenses and losses are estimated by the actuary. He tries to allow maximum surrender values keeping all the above factors.
II. Saving Approach
An insurer is responsible for payment of claims whenever it may arise; but if a policy is surrendered, the insurer is relieved of its obligation for payment of the assured sum.
He is in a position to save something due to non-payment of claims.
Thus, where the insurer is relieved of the responsibility of claims, he is in a position to return some amounts to the insured. But where he may not be required to pay the claims, he is no relieved of the responsibility and no surrender value can be given to the policyholder.
For example, in Term Insurance and Pure Endowment policies, the insurer may or may not be required to pay the claims. So the insurer is not bound to pay the amount of surrender.
The insurer may certainly agree to pay a cash surrender value to policy-holder in lieu of paying the sum assured at maturity or death.
The saving approach is more scientific because it reveals the reason of payment of surrender value. Thus, it forbids payment of surrendered values on term and pure endowment policies and agrees to pay the surrender amount on whole life and endowment policies.
Under this method, the surrender value is paid in lieu of the claim amount. Here it is to be understood that the amount of saving in non-payment of claim can be calculated only after considering various transactions from the inception of the policy up to its surrender and from the date of surrender up to the maturity or deaths.
Had, instead of surrendering the policy, the insurance continued, the insurer would have received the level premiums on the policy and have earned interest on invested amounts and would have occupied certain expenses.
Thus, at the surrender of the policy, the insurer does not get certain income and has not to occur future expenses in relation to the policy.
The incomes or expenses will continue up to the policy life. Therefore, the life expectancy is to be known while determining the saving in expenses or loss of income.
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).
On the basis of the above formula, at the time of maturity or death, the surrender, value is calculated, but it does not mean that the surrender value is paid only at that time.
A provisional sum, called minimum surrender allowance, is paid at the time of surrender and then, at the time of maturity or death the surrender value is adjusted.
The adjusted amount will be the full surrender value minus the accumulated value of the minimum surrender allowance.
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.
Since all the amounts surrendered is given at the time of surrender, the cash benefit is generally less than the other benefits.
However, the cash surrender value gives immediate relief to the policyholders, so it is generally preferred by them.
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 proportion and the reduced amount is paid according to the term of Policy.
Thus, if after at least two full years’ premiums have been paid in respect to the policy, any subsequent premium be not duly paid, the policy shall not be wholly void, but the sum assured by it shall be reduced to such a sum as shall bear the same ratio to the full sum assured as the number of premiums actually paid shall bear to the total number premiums payable as originally stipulated for in the policy provided such reduced sum together any attached bonus in the case of a policy for a sum assured of Rs.1,000 or over be not less than Rs.100 and in the case of a policy for or a sum assured of less than Rs.1,000 be not less than Rs.50.
3. Extended Term Insurance
The net cash value arisen at the time of surrender of a policy can be used for payment of as single premium for purchase of term insurance, where the sum assured will be paid only when death of the life assured occurs within the term 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. However, in case of death during the term, the policy-holder would be benefited for a higher amount with only a small sum of surrender value. Moreover, the term insurance under this scheme is given without medical examination.
4. Automatic Premium Loan
Under the 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 to meet the amount of further premiums.
Each premium is paid automatically as it comes due by creation of a loan which with interest becomes a lien upon the face of the policy amount until paid.
The premiums continue to be paid until the surrender value is completely exhausted.
After this period the policy stands cancelled and no amount is paid to the policy-holder because all the surrender value has been used for payment of 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.
The policy does not lapse but remains in full force subject to the lien. The insured is permitted to regain his original status without furnishing an evidence of insurability by simply repaying the amount which he owes to the insurer.
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 form 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. The option of an annuity is better alternative to those who require to use all their savings during their life-times.