The Reserve in Life Insurance

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.

Definition of The Reserve

The reserve is that fund, 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 of interest of the difference between the net premiums received in the past and the claims paid out.

The reserve has nothing to do with an insurer’s actual past experience. It is always calculated on the assumption that experience has been in accordance with the mortality table selected and interest rate assumed.

However, the assumptions as to future interest and mortality are made on a safe basis. It is, thus, clear that on each policy a certain sum must be accumulated every year to be increased at an interest to form fund to meet the future liability of the policy. This accumulated is called the Reserve on the Policy.

Origin of Reserve

The reserve in any group of policies originates in the excess of premium receipts over payment of claims. The premium receipts are 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.

It is to be noted again here that the reserve is accumulated on the assumed mortality and interest. The reserve based on this assumptions is compared to the funds based on the actual experience. The difference may create ‘surplus’ or deficit. As has been noted that the reserve accumulates at a point and starts declining thereafter because of heavy mortality and receipts of premium at the advanced age.

Sources of Reserve

First Source

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 than actual cost of insurance in the beginning.

In other two methods of premium, reserve cannot be accumulated. This is discussed as below.

(a) Assessment Premium Plan

The members of a group would, under this plan, contribute to a fund which could be utilized 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 accumulate amount of payment of the claim.

(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.

The reserve is not accumulated in this case, because premium increases as cost of insurance increases.

(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 (determined by the mortality rate) 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.

Second Source

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.

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 incurring of this liability odes not bother the insurer at all if in any given period it receives by way of consideration from the policy holders concerned an amount which is equal to the amount it has to pay during this period.

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.

The insurers are in a position to accumulate a huge fund and, therefore, can contribute a significant amount for country’s advancement.

III. Policyholders are Benefitted

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.

The main purpose of creating reserve is to meet the obligation of payment of claims whenever it arises.

How should the reserve be created is the main problem of the insurer. The assumed rates of mortality and interest are mainly taken into consideration while calculating reserve for a particular policy, assumed mortality rate, assumed rate of interest, nature of policy, period of premium payments and duration of policy.

Methods of Calculating Reserve

The reserve can be calculated by applying retrospective method of by prospective method.

The reserve calculated by either of these methods will give the same result provided the mortality rates and interest rates remain the same in both the methods.

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 premium

IV. Retrospective Reserve = Prospective Reserve

Retrospective Method

Under this method, the reserve is derived entirely by reference to past experience. The reserve represents the net premiums collected by the insurer for a particular class of policies plus interest at an assumed rate, less the death claims paid out.

We calculate for each year how much would have been received by way of premiums on the basis of assumed mortality figures, how much interest would have been earned on the basis of assumed interest rate and who much would have been paid by way of claims on the basis of assumed mortality figures.

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.

So, how much the insurer should arrange for payment. The present values of future claims and of future premiums are calculated.

In other words, the reserve is the difference between the present value of future benefits and the present value of premiums.

At the beginning of the contract the present value of future claims or benefits (PVFB) is exactly equal to the present value of the future premiums.

Thus, PVFB = PVFP at the inception of the policy.

But as soon as one premium is paid, the present value of future benefits exceeds the present value of future premiums. This is because less premiums remain to be paid and the present value of future benefits increases as the policy is nearer to the claim.

The difference will go on increasing up to the point when the present value of future benefit equals to policy amount and the present value of future claims goes on decreasing until it becomes zero.

The difference between these two must be held by the insurer. This difference is reserve because so much of amount must be with the insurer to pay the amount of claim.

Reserve = PVFB – PVFP

Since, the net single premium of a policy is equal to the present value of future benefits, the PVFB can be replaced by NSP (Net Single Premium).