Definition and Purpose of the Reserve

In The Net Single Premium I, The Net Single Premium II, and The Net Level Premium, premium rates were computed on the assumptions that a specified rate of interest would be earned on funds in the possession of the company and that the mortality experienced among policy holders would be at the rate shown in the American Experience table. If these assumptions are realized in practice the premiums will be adequate. From the standpoint of premiums there are two ways of viewing the reserve. It may be considered as the difference between the premiums collected in the past and the policy claims paid that is, the surplus premiums on hand at any given time; or it may be looked upon as that fund which together with future premiums to be collected, if any, will enable the company to pay future estimated claims. The former is called the unearned premium reserve, or the reserve is said to be valued retrospectively, that is, looking backward to past accumulations; the latter is the reinsurance reserve, or the reserve is valued prospectively looking forward to future requirements. The word " reserve," however, has come to have a technical meaning in life insurance, due to the fact that most of the states have passed laws requiring some definite method of valuing this fund, and when the term is now used this technical or legal reserve is ordinarily meant.

The legal reserve required by state laws to be held is invariably the prospective reserve, or the fund which with future premiums, if any, based on assumed rates of interest and mortality will pay estimated future claims. If the actual experience of a company as regards interest and mortality exactly coincides with the expected or assumed experience the reserve fund will always be the same whether valued as unearned premium or as a reinsurance fund, but such coincidences do not occur in practice. If premiums are redundant the unearned premiums will be greater than the legal reserve; if they are inadequate the surplus left from them after payment of claims accrued will be less than the legal requirement.

That the legal reserve shall be determined on the basis of future requirements is necessary because of the fact that the life-insurance contract is written for a long term and cannot be cancelled by the company and the premium rates can never be changed. Therefore, the assumptions as to future interest earnings and mortality must be made on a safe basis, and the reserve must be valued with one object in mind, viz, the continued solvency of the company. The state, in establishing a method of valuing life-insurance contracts, sets certain standards of interest and mortality that can safely be realized and then says, in effect, that any company is solvent if on the basis of estimates made with these standards its future premiums plus its reserve fund will enable it to pay all claims. The standards set by state law in most instances are a 3½ percent, interest rate and mortality according to the American Experience table. This fixes the minimum reserve required, but a company may usually value its liabilities by a higher standard if it so chooses. Many companies to-day value their reserves on new policies on a 3 percent, interest basis and thus hold a larger reserve than required by law. The solvency of a company is thus guaranteed if the assumptions made are adequate, and years of experience with insurance under American conditions have shown that they are.