Net Premium Reserve

Dr. Handayani, S.Si, MM, MHP, HIA, FLMI, AFSI, AAK, AAIJ, AMRP, FSAI
Introduction

Net Premium Reserve

Life insurers, in exchange for premiums, agree to pay death benefits

when the insureds die. Therefore, it is important for insurers to have
enough funds available to pay for benefits.
A fund that an insurer sets aside to satisfy these expected claims is
called a reserve. In this section, we will explore various types of reserves
and how they are calculated.
Reserve
What is a Reserve ?
Consider an insurance policy funded by level premiums.
Assuming the equivalence principle, at the initiation of the policy we
expect future premiums to be sufficient to pay for future benefits.

𝐸𝑃𝑉0 𝐹𝐵 = 𝐸𝑃𝑉0 𝐹𝑃

However, after a period of time, there will no longer be an equivalence

between future premiums and future benefits. Why?
As the duration of the policy increases, the insured gets older. Because
mortality rates increase with age, a policyholder is more likely to receive
a benefit sooner than when he or she was younger. As a result, for an
insured who is still alive t years after the policy's issue date, the EPV of
future benefits at that time is usually greater than that of future
premiums:

𝐸𝑃𝑉𝑡 𝐹𝐵 > 𝐸𝑃𝑉𝑡 𝐹𝑃

From an insurer's standpoint, this means that future premiums (from

time t) may not be sufficient to pay for future benefits. The amount
needed to cover this shortfall is called the reserve.
Both reserves and future premiums, together, serve as a source of funds
for an insurer to provide future benefits:

𝐸𝑃𝑉𝑡 𝐹𝐵 = 𝐸𝑃𝑉𝑡 𝐹𝑃 + 𝑅𝑡

Rearranging the expression above, the reserve at time t is the excess of

the EPV of future benefits over the EPV of future premiums at that time:

𝑅𝑡 = 𝐸𝑃𝑉𝑡 𝐹𝐵 − 𝐸𝑃𝑉𝑡 𝐹𝑃
Prospective Net Premium Reserve
Net Future Loss Random Variable

Recall 0𝐿 represents the present value of the net future loss at issue. The word

"net" implies expenses are excluded. 0𝐿 is the present value of future benefits
minus the present value of future premiums, each evaluated at time 0:

0𝐿 = 𝐸𝑃𝑉0 𝐹𝐵 − 𝐸𝑃𝑉0 𝐹𝑃

Since insurers are concerned with what happens to a policy after its issue, we must
consider the net future loss at intermediate times during the term of a policy.
Denote 0𝐿 as the present value of the net future loss t years after the
policy issue date, assuming the policy is still in force at that time (i.e.,
assuming the insured is alive at that time):

𝑡𝐿 = 𝑃𝑉𝑡 𝐹𝐵 − 𝑃𝑉𝑡 𝐹𝑃

From The expected value of the present value of the net future loss at
time t is:

𝐸 𝑡𝐿 = 𝐸𝑃𝑉𝑡 𝐹𝐵 − 𝐸𝑃𝑉𝑡 𝐹𝑃
The net premium reserve at time t is 𝐸 𝑡𝐿 calculated based on net premiums (i.e.,
premiums calculated based on the equivalence principle and excluding expenses). It
uses the same mortality and interest rates as net premiums do. It is denoted as 𝑡𝑉:

𝑡𝑉 =𝐸 𝑡𝐿 = 𝐸𝑃𝑉𝑡 𝐹𝐵 − 𝐸𝑃𝑉𝑡 𝐹𝑃

Since the reserve is based on the expected loss at a future time (i.e.,
a prospective loss), this method of determining reserves is called the prospective
method.
If 𝑡𝑉 occurs at the same time as a premium or benefit, then be careful
about which cash flows to include in calculating the future loss. Unless
stated otherwise, assume:

 all death benefits at time t occurred in the past,

 all premium payments occur in the future,

 endowment payments occur in the future.

Also, note that:

At the time-0 net premium reserve is 0 because the equivalence principle is

assumed:

0𝑉 =𝐸 0𝐿 =0

The time-n net premium reserve for an n-year term insurance is 0 because there are
no future benefits or premiums due at time n:

𝑛𝑉 =0
Also, note that:

The time-n net premium reserve for an n-year endowment insurance right before
the endowment benefit is paid is equal to the endowment benefit, because there
are no future premiums due at time n, and the only future benefit due at time n is
the endowment benefit.

𝑛𝑉= endowment benefit

Premium Basis vs Reserve Basis
Premiums and reserves may be determined using different sets of mortality and interest

assumptions. The set of assumptions used in calculating the premium is called the premium

basis. The set of assumptions used in calculating the reserve is called the reserve basis.

Why would the reserve basis differ from the premium basis?

In practice, reserve assumptions are often set by regulations. They are usually conservative.

When setting premiums, insurers try to use more realistic assumptions and ones that fit

their block of business. Thus, the reserve basis is often different from the premium basis
Example 1

For a fully discrete 3-year endowment insurance of 1,000 on (𝑥), you are given:

• 𝑘𝐿 is the prospective loss random variable at time k.

• 𝑖 = 0.10.

• 𝑎𝑥:3 = 2.70182.

• Premiums are determined using the equivalence principle.

Calculate 1𝐿, given that (𝑥) dies in the second year from issue
Example 2

For a fully continuous 25-year, 15-pay endowment insurance on (35) with face
amount 1,000, you are given:

• 𝜇35+𝑡 = 0.03, t ≥ 0.

• 𝛿 = 0.05.

• 1,000𝐴135:25 = 324.25.

• 𝑎135:25 = 8.7351.

Calculate the net premium reserve at time 5.

Retrospective Net Premium Reserve
Recall from interest theory that an outstanding loan balance can be calculated using the
retrospective method. Similarly, a reserve can also be calculated using the retrospective
method, if the following 2 requirements are satisfied:

1. The premium is determined using the equivalence principle.

2. The same basis is used for premium and reserve.

Using the retrospective method, the net premium reserve at time t is determined by
considering only the past activity between time 0 and t. Specifically the net premium
reserve is the actuarial accumulated value of past premiums minus the actuarial
accumulated value of past benefits.
Retrospective Net Premium Reserve

𝑡𝑉 = 𝐴𝐴𝑉𝑡 𝑃𝑃 − 𝐴𝐴𝑉𝑡 𝑃𝐵

Why does this method work?

Consider a fully discrete whole life insurance policy of 1 on (𝑥).

At issue, assuming the equivalence principle, we have:

0𝑉 =𝐸 0𝐿 = 𝐴𝑥 − 𝑃 𝑎 𝑥 = 0
Split the whole life insurance and the annuity into t-year term and t-year
deferred whole life products:

𝐴1𝑥:𝑡 + 𝑡𝐸𝑥 𝐴𝑥+𝑡 − 𝑃 𝑎𝑥:𝑡 + 𝑡𝐸𝑥 𝑎𝑥+𝑡 = 0

Rearranging the equation, we have:

𝑃𝑎𝑥+𝑡 − 𝐴1𝑥:𝑡
= 𝐴𝑥+𝑡 − 𝑃𝑎𝑥+𝑡
𝑡 𝐸𝑥
The left-hand side of the equation is the net premium reserve at time
t calculated using the retrospective method, where:

 𝑃𝑎𝑥+𝑡 is the EPV at time 0 of the premiums through time t.

 𝐴1𝑥:𝑡 is the EPV at time 0 of the benefits through time t.

1
 The difference is accumulated with interest and mortality to time t by .
𝑡𝐸𝑥

Recall from the life contingency accumulation factor accounting for both

1
interest and mortality for n years starting from age x is .
𝑡𝐸𝑥
The right-hand side of the equation is the net premium reserve at time t for a fully
discrete whole life insurance policy of 1 on 𝑥 calculated using the prospective method.

What is the intuition behind the retrospective method?

For a contract funded by level premiums, since the cost of mortality increases as the
insured ages, the insured overpays in the early years of the contract and underpays in
the later years.

For a portfolio of policies, the insurer will hold on to excess cash flows from earlier years
to meet any shortfalls in later years. The excess cash flows form the reserve, which
consists of the accumulation of past premiums, less the past benefits for the group of
policies.
Prospective vs Retrospective
Which method should you use? Consider the following:

• While both methods work for all insurance or annuity products, the prospective method
works for all premium types, whereas the retrospective method only works for premiums
calculated using the equivalence principle (i.e., net premiums). To calculate a reserve that
assumes a premium other than the net premium, the prospective method is the only
method that can be used.

• The retrospective method is easier to use when dealing with deferred insurance, or a
deferred annuity, during the deferral period. This is because no benefits are paid during
the deferral period, and so the actuarial accumulated value of past benefits is 0.
Example 3

For a special fully discrete whole life insurance policy on (40), you are given:

• The death benefit is 50,000 in the first 20 years and 100,000 thereafter.

• Level net premiums of 1,116 are payable for 20 years

• 𝑖 = 0.06.

• 𝑎40 = 14.8166; 𝑎50 = 13.2668; 10𝐸40 = 0.53667

• 𝐴40 = 0.16132; 𝐴50 = 0.24905

Calculate 10𝑉, the net premium reserve at the end of year 10 for this insurance.
Special Formula
There are two special formulas that are useful in calculating the net level premium
reserves for fully discrete/continuous whole life and endowment insurance. One
formula uses a life annuity; the other uses life insurance.
To develop these formulas, let's consider a fully discrete whole life insurance policy
of 1 on (𝑥).

Using Life Annuity

The net premium reserve at time t is:

𝑡𝑉 = 𝐴𝑥+𝑡 − 𝑃 𝑎𝑥+𝑡
Recall:

𝐴𝑥+𝑡 = 1 − 𝑑 𝑎𝑥+𝑡

The net premium at time t can be expressed as:

1
𝑃= −𝑑
𝑎𝑥

Thus, the net premium reserve at time t can be expressed in terms of just life
annuities:

1 𝑎𝑥+𝑡
𝑡𝑉 = 1 − 𝑑 𝑎𝑥+𝑡 − − 𝑑 𝑎𝑥+𝑡 = 1 −
𝑎𝑥 𝑎𝑥
Special Formula
Using Life Insurance

The net premium reserve at time tt can also be expressed in terms of life insurance:

1 − 𝐴𝑥+𝑡
𝑎𝑥+𝑡 𝑑 𝐴𝑥+𝑡 − 𝐴𝑥
𝑡𝑉 = 1 − = 1−
1 − 𝐴𝑥
=
𝑎𝑥 1 − 𝐴𝑥
𝑑
Special Formula
The formulas above only work for fully continuous/discrete whole life insurance and
endowment insurance.

• For fully discrete endowment insurance, use the appropriate A's and a's with n.

• For fully continuous whole life and endowment insurance policies, replace
the A's, a's, and d with their continuous counterparts.
Variance of Loss
General
We have discussed the variance of the net future loss at issue. Recall that for a fully
continuous whole life or endowment insurance with premiums P, the variance of the
net future loss at issue is:
2
𝑃
Var 0𝐿 = 𝑏 + . Var 𝑍
𝛿
where:

Var 𝑍 = 2𝐴𝑥 − 𝐴𝑥 2 for whole life insurance

Var 𝑍 = 2𝐴𝑥:𝑛 − 𝐴𝑥:𝑛 2 for endowment insurance

We can generalize these results to the net future loss at time t. For a fully
continuous whole life or endowment insurance with premiums P, the variance of the
net future loss at time t is:
2
𝑃
Var 𝑡𝐿 = 𝑏 + . Var 𝑍
𝛿

where:

Var 𝑍 = 2𝐴𝑥+𝑡 − 𝐴𝑥+𝑡 2 for whole life insurance

Var 𝑍 = 2𝐴𝑥+𝑡:𝑛−𝑡 − 𝐴𝑥+𝑡:𝑛−𝑡 2

for endowment insurance

For fully discrete insurance, remove the bars and replace 𝛿 with d.
Equivalence Principle
Recall that if the equivalence principle is assumed, then the variance of the net
future loss at issue can be expressed as:

2
𝐴𝑥 − 𝐴𝑥 2
Var 0𝐿 = 𝑏2 . 2 for whole life insurance
1−𝐴𝑥

2
𝐴𝑥:𝑛 − 𝐴𝑥:𝑛 2
Var 0𝐿 = 𝑏2 . 1−𝐴𝑥:𝑛 2
for endowment insurance
We can also generalize the results above to the net future loss at time t. If the
equivalence principle is assumed, then the variance of the net future loss at
time t can be expressed as:

2
2 𝐴𝑥+𝑡 − 𝐴𝑥+𝑡 2
Var 𝑡 𝐿 = 𝑏 . 1−𝐴𝑥 2 for whole life insurance

2
2 𝐴𝑥+𝑡:𝑛−𝑡 − 𝐴𝑥+𝑡:𝑛−𝑡 2
Var 𝑡 𝐿 = 𝑏 . 2 for endowment insurance
1−𝐴𝑥:𝑛

Notice these formulas are the same as before, except the numerators are based on
age x + t instead of age x, and the denominators are based on age x.

For fully discrete insurance, remove the bars.

Example 4
You are given:
• 𝑣 2 = 0.75
• 𝑞𝑥+𝑡 = 0.2
• 𝐴𝑥+𝑡+1 = 0.5
• 2𝐴𝑥+𝑡+1 = 0.3
• 𝑘𝐿 is the random variable representing the net future loss at the end
of k years for a fully discrete whole life insurance of 1 issued to (𝑥) if the
premium is the net premium.

Var 𝑡𝐿|𝐾𝑥 ≥𝑡
Calculate
Var 𝑡+1𝐿|𝐾𝑥 ≥𝑡+1
Summary
Net Premium Reserve

• 𝑡𝑉 denotes the expected net future loss t years after the policy issue date,
assuming the policy is still in force at that time.

Under the prospective method:

• 𝑡𝑉 =𝐸 𝑡𝐿 = 𝐸𝑃𝑉𝑡 𝐹𝐵 − 𝐸𝑃𝑉𝑡 𝐹𝑃

Under the retrospective method:

• 𝑡𝑉 = 𝐴𝐴𝑉𝑡 𝑃𝑃 − 𝐴𝐴𝑉𝑡 𝑃𝐵
Summary
The retrospective method can only be used when:

1. The premium is determined using the equivalence principle.

2. The same basis is used for premium and reserve.

To calculate the variance of future loss at time t, use the formula for variance of
future loss at issue, except substitute age x + t for age x.

• Var 𝑍 = 2𝐴𝑥+𝑡 − 𝐴𝑥+𝑡 2

NOTES
continuous whole life insurance with constant force of mortality
𝜇
𝐴𝑥 =
𝜇+𝛿

continuous term life insurance with constant force of mortality

𝜇
𝐴1𝑥:𝑛 = 1 − 𝑒 −𝑛(𝜇+𝛿)
𝜇+𝛿

continuous endowment life insurance with constant force of mortality

𝜇
𝐴𝑥:𝑛 = 1 − 𝑒 −𝑛(𝜇+𝛿) + 𝑒 −𝑛(𝜇+𝛿)
𝜇+𝛿