Policy Reserve

A client asks why the premium on his newly issued whole life policy stays the same every year when the probability that he will die keeps rising with age. What is the actuarial explanation for the LEVEL premium design?

1. A.Early premiums exceed the current cost of mortality, and the excess accumulates at interest as a reserve that funds the shortfall in later yearsCorrect. Level premium design prefunds later mortality cost through a reserve built from early overpayments.
2. B.Mortality cost is actually level for a given individual once a policy is issued and the class is setMortality cost rises with attained age. Issue-age classification does not freeze the underlying cost.
3. C.The insurer charges the average annual mortality cost over the policy life, so no reserve is neededAveraging alone would not work, because the money must be held and earn interest between the overpayment years and the shortfall years. That holding is the reserve.
4. D.The insurer subsidizes older insureds from the profits earned on its newer policies each yearCross-subsidy between generations of policies is not how level premium whole life is funded. Each policy prefunds its own later cost.

Why: The true cost of mortality protection rises every year, and a policy priced at that annually increasing cost would eventually become unaffordable at exactly the age it is most needed. The level premium solves this by charging MORE than the current cost of mortality in the early years and LESS than it in the later years. The early overcharge does not disappear: it is held and accumulated at interest as the policy RESERVE, and that reserve is drawn down in the later years to make up the shortfall between the level premium and the true rising cost. The reserve is also what gives a permanent policy its cash value and its nonforfeiture values.

A department examiner reviewing Thornbury Life statutory annual statement focuses on two figures: the POLICY RESERVES and the SURPLUS. A newly licensed producer assumes reserves are the company savings account and surplus is money owed to policyholders. How should each figure actually be understood?

1. A.Reserves are a liability representing future policy obligations; surplus is admitted assets less all liabilities and serves as the solvency cushionCorrect. Reserves sit on the liability side; surplus is the residual cushion supporting growth and absorbing adverse experience.
2. B.Both are assets, with reserves invested conservatively and surplus invested for growthReserves measure an obligation. The assets backing them are reported separately on the asset side.
3. C.Reserves are an asset the insurer has set aside, and surplus is the total amount owed to policyholdersThis reverses both. Reserves are the obligation, and surplus is what remains after obligations are met.
4. D.Both are liabilities, with reserves covering current claims and surplus covering future claimsSurplus is not a liability. It is the excess of admitted assets over all liabilities.

Why: The producer has it backwards. Policy RESERVES are a LIABILITY. They represent the insurer computed obligation to pay future benefits on policies already in force, and they are the largest item on the liability side of a life insurer balance sheet. SURPLUS is what remains after subtracting all liabilities, including reserves, from admitted assets. It is the cushion that absorbs adverse experience and supports new business growth, and it belongs to the company rather than to any policyholder. Statutory accounting is deliberately conservative about both: reserves are computed on prescribed mortality and interest bases and certain assets are non-admitted, so that solvency is measured with a margin rather than optimistically.