premium Valuation

Learning Objectives
chapter explains This the data for valuation of premium and then the 1 various
premium valuation methods, i.e., Net premium, Modified net premium, Gross
premium and Gross premium bonus reserve methods of anon. vala ts required in
calculation of premium and special reserves under special reserves and
adjustments, various types of " cleated for those adjustments are explained.
portion of surplus aims to explain the sources of surplus and various bonus systems.
For valuation of the premiums, certain data is required which has to be compiled
with we insurance policies comprise various classes as follows : 1, According to
class of policy, Le., Whole life, Term assurance and Endowment policies 2. According
to bonus, i.e., with profits or without profits 3. According to age Thus for collecting
the data for valuation, valuation and mortality cards are grouped according to these
four criteria: (0 Policy class (it) Bonus group (iii) Integral age of the life assured on
the valuation date, i.e., year of valuation less office year of death. (iv) Integral
outstanding term of assurance on the valuation date, i.e., office year of maturity
less year of valuation. After preparation of the relevant schedules for each group
with details such as sum assured, vested bonus, annual premium, outstanding
premium, etc. the

la period, ), the
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ereglit 7,'1 uatiorl 15 paid_up sum assured (this is to he stated only in respect of
paid-up policies where the paid-up sum assured and not the original sum assured is
available from original records. la particulars of Entry, i.e.. Policy is as new business,
reinstatement of surrendered policy, revival of policy, missing policy reincluded, etc.
17. particulars of exit, like date of exit and mode of exit.
685
pitailUM VALUATION METHOD Calculation on of Premium is a very tedious process
and some very important issues are involved in calculation of premium. These 1.
The premiums received, by an insurer during the early years of a policy are in
excess of those actually received. Excess premiums of early years are accumulated
and they are kept as reserves to meet the shortfall in future years. 2. The valuation

of liabilities of an insurer is the process of arriving at the policy values of various

contracts in existence on the date of valuation. There are two methods of valuation.
Prospective and Retrospective. 3. The excess premiums accumulated will be equal
to the prospective value of the policy at any point of time provided the premiums
are adequate and the business progresses are anticipated as per the basis on which
the premiums are computed.
Methods of Valuation 1. Net premium method of valuation 2. Modified net premium
method of valuation 3. Gross premium method of valuation 4. Gross premium bonus
reserve method of valuation
Net Single Premium It is that premium which is received by the insurer in a lump
sum and is exactly adequate along with the return earned thereon, to pay the
amount of claim whenever it arises whether at death or at maturity or even on
surrender. It does not provide for expenses of management and for contingencies.
Steps for Valuation I. Determine what constitutes a claim: (a) death, (b) survival, or
(c) both. 2. Determine when claims are paid: (a) at the beginning, or (h) at the end
or (c) during the year.

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3. Deterniine the number of people insured. 4. olicy. Determine the duration .of the
p Determine the probable number of Claims pr ear r:rinYteearre4st involved arid
find the 6, Determine the .value ofc:;!;eirarirss 7, Determine: the number value of a
rupee. 8. Determine the present value of the claim for each year. 9. Determine the
present value of all future claims. 10 Determine the net single premium pre .sent
value of future divided by number assumed for buying policy. Assumptions for Rate
Computations Premiums are collected in advance or in the beginning of the periv.
(II) All money collected through premiums is immediately invested ari zt will remain
invested until money is needed for the payment of rlai iu WO The insurer will
receive an assumed rate of interest. (iv) The interest or dividend or any return of the
invested fund is immedia, invested for re-earning. tely (v) As many policies of the
given type are being issued as are the number of persons. (vi) Mortality rate will be
the same as given in the mortality table uniformly distributed throughout the year.
(vii) Claims will be paid only at the end of the period.
Net Premium Method of Calculation. For calculating the policy values, the premiums
received by the insurer are office premiums which include expense loadings over
net premiums. Normally expenses incurred should not be in excess of those
provided for in the premiums, it would be sufficient if only net premiums are taken
into account in the valuation, and the entire expense loading is left for calculating
the future expenses. Similarly the bonus loading is also left for declaration of
bonuses in future. For calculation purpose, those net premiums are to be taken up
which are charged for new contracts on the basis of present and likely future trends
in mortality and interest. The office premium for each policy is fixed and known,
although at any valuation date, the office premiums of policies in force might be
based on different scales introduced at various dates. However there is only one
pure or net premium for each age at entry in case of endowment assurance. This is
mathematically based on the true rates of mortality and interest as estimated at the
date of valuation.

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Valuation
rriocip--- C' premium are : 6fi7 i .eilli"" ' ,,/,,,,-; )f Vaittation of net Jre 1 True
mortality table combined with a true rate of interest should be used for the factors
required to determine the value of the sum. assured and any additions by way of
bonuses previously declared: and similarly for the factor required to value the future
premiums. 2. The future premiums to be valued should be the net premiums
calculated according to the mortality and interest basis used for. Tbus the policy
value starts with zero on the date of commencement of progresses with duration
and finally reaches the sum assured and policy,1 ed bonuses. The difference
between the office premium and net premium d: :er valuation loading. i g:trects of
Net Premium Valuation. Expenses on policy can be divided into two : (1) aeavy
initial expenses, and (2) Relatively smaller renewal expenses; whole of the first
premium may be spent or expenses may be even more than the collection of first
premium. Thus this deficiency in premium will be compensated. from the future
premiums when the expenses will be less. Compensation from the Business. In this
method of net premium valuation, 1 necessary reserves have to be set up at the
end of first year of insurance also; whether the actual balances of net premiums are
on hand or not for the Purpose. The means to do so have to be found from sources
other than the premiums for first year. The only source to fall back upon is the fund
built up from the working of the business written in previous years. But this results
in / an increase in the liability without corresponding increase in the assets by way
of balance premium income and a decrease in the profits of the insurer which would
have been higher if new business were not underwritten. Surplus or profit is given
by : S1 = F + F, - (V+ V1) = F - V + (F1 - V1) = S - (V1 - F1) as V1 is greater than F1
Where F --) fund on the current valuation date relating to policies in force on that
date excluding new policies issued since the date of preceding valuation.
Where V -> Corresponding policy reserves --> Addition to the fund because of new
policies V1 ---> Policy reserves corresponding to F1 Modified Net Premium Method of
Valuation .4thiowing the heavy initial expenses of business, a slightly higher net
premiul $1. for next higher age can be taken in arriving at policy values.

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Principles fJ#'insurant* "1111-; rronflii( ;if istil reduces the net premium policy value
by the amount Terence bctwccn the modified net premium and the net premium, Of
dif 111 the ease of tUI endowment assurance, the modified net premium win t),
reduction in the term, keeping rilatu, tar next higher age with Correspondthg JILY
age saran. Gross Premium Method of Valuation This method takes into account
actual office premiums receivables. A cep percentage of office premium is thrown
off to provide for expenses. The balance of the office premium is then taken as the
premium to be used in arriving 'at policy values, The percentage thrown off will
correspond to that which the total expenses bear to total premiums. Total expenses
include first year heavy erases which will not recur again. Thus such an allowance
will be too great for business which has been on books for some time. On the other
hand, if bare renewal expenses of OW existing business were reserved, no direct
provision would be made for the cost of future replacement of business, which is
essential in a continuing concern. Use of such an overall expense ratio, therefore,
assume that in future also the proportion of new business to the old business will be
maintained at the same level as at the date of valuation. If the insurer, at the time
of valuation is writing a higher proportion of new business as a result of a drive for
rapid expansion, it is likely that after some lapse of time, the proportion on new
business to old business may be considerably less than at the time of valuation. In
such a case, it is justified to use a lower percentage of premium (expense ratio) in
arriving at premiums for valuation, As per Insurance Rules, 1939 following definite
proportions of first year premiums are allowed as first year expenses:
Table 28.1
Term of Policy Percentage of first year premiums allowed for initial expenses 12
years or over 11 years 10 years 9 years 8 years 7 years 6 years 5 years 4 years 3
years 2 years I year 90.0 82.5 75.0 67.5 60.0 52.5 45.0 37.5 30.0 22.5 15.0 7.5

'1 e4, 4111 10 h.1eN ve ki to .1 cook thit wil Itst ccb,J, l be tar other h 00 ( 14 .
'rect. tf ?-ss, , Ptoy 14.k. is 7, , e
assume tbr, N!! 3 NI be th '14111lks, 1 at the tinieoz..::: at -41 kIl4b.. 4 result of
a :le, the pr oporiz at the time It of prentz Insurance Rui. 3 are allowed

rst year premirs initial eApenses

20 2,5 3, 0 7,5 ,0 5
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After allowing percentages .of first year premiums as above; the balance lenses
are to be related to renewal premium income which gives the renewal ()%rilense
ratio. This percentage Only refers to renewal expenses. When new :1;15.iness
writte2 at heavy cost, the percentage allowance in a valuation out of 0-1fice
premiums tor expenses should be more than the renewal ratio as arrived above
actual practice an analysis of expenses is carried out by which the expenses
incurred are allocated between initial and renewal cost of business aild related to
the corresponding premium income so as to determine the cost ratio for new
business underwritten and renewal servicing and claims (renewal cost ratio). Gross
Premium Method for With-Profit Policies. T the ratio of total expenses to total
premium income and higher than the bare renewal expense ratio, which is
considered in gross premium method of valuation Is not sufficient for with-profit
office premiums as they contain bonus loading in addition to expenses. Thus a
further provision for future bonuses has to be allowed by throwing off a higher
percentage of the office premiums in arriving at valuation premiums.
. - 1 C .110

Gross Premium Bonus Reserve Method of Valuation. The above method of valuation
for with-profit makes provisions for bonuses in an indirect way. The office premiums
under with-profit policies contain a specific bonus loading, if credits were taken for
full office premiums. In calculating premium rates, some safety margins are retained
in the rates of interest and mortality. Therefore, a small profit may be expected to
emerge from these sources. Full rate of anticipated bonus need not be treated as a
specific liability in bonus reserve valuation. A slightly lower rate of bonus than
expected to be declared in future can be assumed in the valuation.
Criticism
1. This method treats future bonuses as a liability. But under with-profit policies,
policyholders have the right to share the profit if they arise. But they have no right
to any definite amount of bonus. But making provision for a definite rate of bonus
becomes a liability for bonus and the policyholders think that they have a right to
the bonuses shown in the valuation. 2. It is indicated from this method that if bases
for mortality, interest and expenses adopted for bonus reserve valuation are to geth
m er ore favourable than the corresponding elements in premium basis, the
valuation will capitalise the future surplus arising from the difference in
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