Method of calculating reserve

1. 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 how much
would have been paid by way of claims on the basis of assumed mortality
figures.

 Group Approach :
The calculation begins with the first year when the total net premium has
been received for the first time. We, then, determine the amount of interest
that this total of net premium receipts will earn for one full year at the
assumed rate of interest.

For the total of these two claims paid for the first year are deducted to get the
reserve. Again in the second year, we carry forward the reserve.

The net premium received from the surviving policyholders is added to the
reserve of past year which is taken together and is called initial reserve of the
second year. This process continues until all the policyholders are dead or
policy period expires.
Per policy reserve can be calculated by dividing the total reserve by the
number of policies. It can be illustrated with the following formula.

For example, there are 10 policyholders insured for Rs. 10,000 each for the
period of 10 years. They are required to pay net premium of Rs. 1,000 each.
The rate of interest is 10 per cent per annum.

Reserve in a Particular Year:

The reserve at a particular time can be calculated by the following formula-
Reserve = Reserve at the close of the previous year (if any) + Premium of the
Year.

Interest thereon at the assumed rate for one year – Claims for the year

With this help reserve can be calculated at any moment provided the initial
reserve is known.

 Individual Approach:
The retrospective reserve may also be calculated on every policy. The
method of calculation is the same as discussed above with only difference
that the reserve will be calculated on the basis of cost of insurance instead of
claims paid on.

The ‘cost of insurance’ reveals how much amounts will have to be shared by
the policyholders in payment of claims of other policy-holders.

Technically, the prorate share of death claims in any particular year is called
the ‘cost of insurance’. It is the amount which must be paid for the protection.
The cost of insurance is arrived by multiplying amount at the risk with the
probability of death to him. The amount at risk is the amount which is
obtained by deducting the initial reserve of the policy-holders from the policy
amount. In brief-

Cost of Insurance =Amount at risk x Probability of Death.

= (Policy Amount-Initial Reserve) x Probability of death.

The individual reserve can be explained by an illustration. For example, a

policyholder takes policy of Rs. 10,000 (for ten years) and pays Rs. 1,000 an
annual premium, the rate of interest being 10 per cent. The probability of
death in the first year is 0.002 and in the second year 0.003. We have to
calculate reserve for two years.

2. 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 benefit
exceeds the present value of future premiums. This is because fewer
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 the 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).

Terminal, Initial and Mean Reserves :

1. Terminal Reserve :
It is obtained by adding the net level annual premium for the year in question
to the terminal reserve of the preceding year increased by the one year’s
interest at the assumed rate and deducted the cost of insurance or claims paid.
It has been discussed in detail in previous section. It is obtained out at the end
of the year.

The reserve is used for calculating the amount of surrender value or paid up
values. It is also used for distribution of bonus.
2. Initial Reserve :

The initial reserve for any year is that amount which the insurer has with him
in the beginning after premium for the year have been collected and, the
terminal reserve of the last year has been added before earning any interest
thereon or payment of claims. It has also been discussed already.

This reserve is used for determining the interest earned by the insurer.

3. Mean Reserve :
The mean reserve is the arithmetic average of initial reserve and terminal
reserve during a year. This is used in connection with the Annual statements.
Mean reserve is used for valuation purposes.
Purpose And Formation of Reserve:
A reserve is money allocated for a specific intent. A claims reserve is money an insurance
company must set aside to pay claims. So, if a carrier approves a homeowners claim
following the kitchen fire, it will draw from its claims reserve to pay the policyholder.

A claims reserve is a forecast of the amount of money a carrier estimates it will need to
pay future claims. A professional called an insurance actuary, a person who manages and
measures risk using mathematics and statistics, produces such forecasts. Typically,
actuaries use several methods to forecast how much money a claims reserve needs to
cover future claims obligations.

There are two ways of formatting reserve

1. Actuarial projection method

2. Principle based reserving method

1. Actuarial Projection Methods

Actuarial projection methods are processes actuaries use to estimate future claims
liabilities. These methods include:1

Algorithm: Employs a dataset to estimate claim liabilities by applying a model based on

the incidences and frequency of claims and the settlement process.

Predictor dataset: Collection of information about claims that includes several data
elements. For example, a car insurance dataset might include the number of collision and
comprehensive claims, zip codes of where crashes occur, and the types of stolen vehicles.

Intervention points: Judgment calls that need to be made during the actuarial projection
process. For instance, an actuary may need to adjust the model’s parameters or override
certain data to manually tweak the algorithm.
 2. Principle-Based Reserving
For life insurance products, most states have adopted principle-based reserving (PBR)
methods. The amount of funds held in reserve can affect the cost of insurance policies.
High reserves can increase premiums, while low reserves can put an insurer at risk of not
having enough money to pay claims.2

The PBR method of reserving gives insurance companies the leeway to calculate reserves
based on their own experience via a set of fundamental principles. PBR employs
simulation models, which actuaries can use to forecast reserve needs based on many
economic scenarios. As economic conditions change and companies produce new data,
they must regularly recalculate reserve needs.

This new method of reserving produces a more accurate risk assessment. By pinpointing
risk, insurers can increase reserves for some life insurance products and decrease reserves
for others, as needed.

PBR reserving does not affect life insurance policies already purchased. It only applies to
new products issued after a state implements the new method.2