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.
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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 :
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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 :
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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.