There are two bases of calculating surrender values:-
I. Accumulation Approach and II. Saving Approach.
I. The Accumulation Approach :
Under this approach, surrender value is the accumulation of overcharges in the net premium, which upon the surrender of the policy is no longer required to pay the amount of claims, therefore, theoretically he should pay all the accumulated reserve but if it is allowed, the insurer will be left a very small amount for meeting other obligations because a huge expenses are involved at the time of surrender.
The accumulation approach is very scientific because it allows surrender values to all types of policies, whereas, in practice surrender values on the term policies and pure endowment policies are not allowed because there the question of payment may or may not arise. Had the surrender values allowed on these policies, the insurer may be losing when claims would not arise on the policies.
The accumulation approach regards reserve for policy as the basis of distribution of surrender values. The reserve is calculated in this case on gross premium. So the expenses are also deducted from the premium received.
Thus, the reserve would be equal to all the premiums paid and interest earned thereon minus shares of death claims and of over all expenses of the insurer.
The surrender value can be the largest amount which the insurer can pay without going into loss. The full amount of reserve to a particular policy cannot be given as a surrender value because there are certain expenses and loss because of surrendering the policies. Thus,
Surrender Value = Full Reserve-Surrender Charges
The surrender charges are those expenses and losses which occurred on account of a surrender or causation of policy. The surrender charges are discussed below:
(i) Initial Expenses :
In the beginning of the contract, certain expenses are involved for processing the proposals, payment of commission to agents and medical officer, correspondence and issuing of policy. The initial expenses are so high that the first year’s premium is unable to meet all the expenses. These expenses, actually, are recouped after several years’ continuation of the policy.
Moreover, the initial expenses involved are equally distributed throughout the premium paying period. If policy is lapsed or surrendered before maturity, a part of the initial expenses are left unpaid. So, it is a justified matter to charge the unpaid initial expenses from the reserve of the policy which is surrendered.
If it is not done, it would be a great injustice to remaining policy-holders who are willing to continue the policy. The surrender values are lesser in the beginning and higher at later stage because initial expenses to be recouped in the beginning are more than at later age.
(ii) Adverse Financial Selection :
During the period of business depression, the surrendering of policies weaken the financial standing of the insurer because at that time most of the policy-holders will rush for surrender values and the insurer’s funds will be reduced to minimum. In such cases the policyholders should not be allowed to receive surrender values more than the realized values of the invested funds.
The insurer has to liquidate some assets at depressed prices. The demand of surrender values necessitates some liquid assets with the insurer, which means the insurer is unable to earn sufficient amount on the liquid assets.
(iii) Adverse Mortality Selection :
It is well-known fact that the persons in extremely poor health are not likely to surrender their policies. They will beg, borrow or steal to maintain the protection. Those who do surrender are expecting longer lives than those who do not surrender.
Consequently at every surrender, the average or actual mortality tends to increase more than the assumed mortality. Thus, the increased mortality should be adjusted while surrender value is permitted.
(iv) Contribution to Contingency Reserve :
While calculating gross premium a small amount for contribution to contingency reserve is charged from the policyholders to meet the sudden and accidental rise in claims due to wars and epidemics. If the policy is surrendered in the beginning, the contribution is left unrealised.
(v) Contribution to Profits :
The policy is expected to contribute a fund towards the profit. If the policy surrendered, the expectation is lost. So this contribution should also be treated as surrender charges while permitting surrender of policy.
(vi) Cost of Surrender :
The insurer will incur a certain amount of expenses in processing the surrender of policies. Sometimes, the cost of surrender is like other expenses, spread over the premium paying period. In early surrender, the cost is left unrealised and a deduction from the reserve is permitted.
These expenses and losses are estimated by the actuary. He tries to allow maximum surrender values keeping all the above factors.
II. Saving Approach :
An insurer is responsible for payment of claims whenever it may arise; but if a policy is surrendered, the insurer is relieved of its obligation for payment of the assured sum. He is in a position to save something due to non-payment of claims.
Thus, where the insurer is relieved of the responsibility of payment of claims, he is in a position to return some amounts to the insured. But where he may not be required to pay the claims, he is not relieved of the responsibility and no surrender value can be given to the policyholders.
For example, in Term Insurance and Pure Endowment policies, the insurer may or may not be required to pay the claims. So the insurer is not bound to pay the amount of surrender. The insurer may certainly agree to pay a cash surrender value to the policy-holder in lieu of paying the sum assured at maturity or death.
The saving approach is more scientific because it reveals the reason of payment of surrender value. Thus, it forbids payment of surrender values on term and pure endowment policies and agrees to pay the surrender amount on whole life and endowment policies.
Under this method, the surrender value is paid in lieu of the claim amount. Here it is to be understood that the amount of saving in non-payment of claim can be calculated only after considering various transactions from the inception of the policy up to its surrender and from the date of surrender up to the maturity or deaths.
Had, instead of surrendering the policy, the insurance continued, the insurer would have received the level premiums on the policy and have earned interest on invested amounts and would have occupied certain expenses.
Thus, at the surrender of the policy, the insurer does not get certain income and has not to occur future expenses in relation to the policy. The incomes or expenses will continue up to the policy life.
Therefore, the life expectancy is to be known while determining the saving in expenses or loss of income. So, at the time of surrender of the policy, it is expected that the policy would have continued up to the maturity or till the end of mortality table. The surrender value on a policy can be calculated as below:
Surrender Value = (Sum assured + Accumulated value of future expenses + Future reversion ally bonus, if participating policy) – (Accumulated value of all future premiums + expenses incurred in processing the surrender value).
On the basis of above formula, at the time of maturity or death, the surrender, value is calculated; but it does not mean that the surrender value is paid only at that time.
A provisional sum, called minimum surrender allowance, is paid at the time of surrender and then, at the time of maturity or death the surrender value is adjusted. The adjusted amount will be the full surrender value minus the accumulated value of the minimum surrender allowance.