Policy Reserve

• Policy reserve also known as legal reserve are major liability of insurance company

• Under the level-premium method , premiums are overpaid during the early years of policy (higher than necessary to pay the death claims).

• The excess premiums must be held for future payment to the policyownwer’s beneficiaries.

• Policy reserves are liability item in the balance sheet of insurance companies that have to offset by assets equal to the amount.

• Policy reserve are also called legal reserves because state law specifies the basis for calculating the policy reserve required by law.

Purpose of Policy Reserve • 1- It is a formal recognition of the insurer’s

obligation to pay future claims. The policy reserve plus future premiums add interest earnings must be sufficient to pay all future policy reserves.

• 2-The reserve is a legal test of insurer’s solvency. The insurance must hold assets at least equal to its legal reserves and other liabilities. Policy reserves should not be viewed as a fund. Rather, they are a liability item that must be offset by assets.

Definition of Reserve• The policy reserve can be defined as the

difference between the present value of future benefits and the present value of future net premiums.

• The net single premium is equal to the present value of future net benefits at the inception of the policy.

• The net single premium can be converted into a series of net level premiums without changing the relationship.

• After the first installment is paid ,the present value of future benefits and the present value of future net premiums are no longer equal to each other.

• Present value of future benefits will increase over time while the present value of future net premiums will decline because the premiums are lower the amount that is needed to pay for death benefit.

Type of Reserves• The reserve can be viewed either

retrospectively or prospectively. • If we refer to the past experience, the reserve is

known as a retrospective reserve. Retrospective reserve calculation method Reserve on Valuation date= Sum of the past net premiums with interest added minus Sum of the past mortality cost with interest added

• Prospective reserve is the difference between the preset value of future benefits and the present value of future net premiums.

• Prospective reserve calculation method Reserve on the valuation date= Present value of future benefits under the contract – Present value of future premiums

• The retrospective and prospective methods are the mathematical equivalent of each other.

• Both methods will produce the same level of reserves at the end of any given year if the same set of actuarial assumption is used.

Classification of Reserve• Reserve can be classified based on the time of valuation. 1- Terminal reserve: is the reserve at the end of any given policy year used by companies to determine the cash surrender value a well as amount of risk. 2- Initial reserve: is the reserve at the beginning of any policy year used by companies to determine dividends. 3- Mean reserve: is the average of the terminal and initial reserves used by insurers to determine dividends.