Net premium vs Gross premium

[DevonMatthews]

Im trying to answer the following question from a textbook

"In many countires life insurance liabilities are calcuated using a net premium valuation method, what form of margins does this approach incorporate? What are the benefits and risks of this approach?"

The solution starts off by saying :

Net premium valuations are simplified formula-based valuations using conservative interest and mortality assumptions. In this context, this means that the interest (discount) rate is lower than best estimate while the mortality rates are higher.
For participating (also called with-profit) business, the interest rate is further reduced to allow for future bonuses (also called dividends).
Typically, net premium valuations incorporate an allowance for the amortization of some initial expenses, which reduces new business strain. However, this allowance is likely to be less than the actual level of initial expenses (again, being conservative).
Being simplified, net premium valuations do not allow for lapses or surrenders and the benefits payable in those circumstances. They also do not make explicit allowance for maintenance expenses.

I've always thought that net premiums are priced only based on the contingency alone and don't account for any profit/expense loadings. Therefore i can not understand what on earth the solution is refering too.

Any help, please? Thanks.

 

[mugono]

Devon,

I'll give it a go.

I think the key point about a net premium valuation is that it makes an explicit allowance for mortality and interest rates only. The key word here is 'explicit'.

In practice, the company will receive a gross premium (which would have allowed for the various loadings) but the liabilities are valued on a net premium basis.

In reality therefore, the difference between the gross and net premiums will be an additional source of surplus for the insurer, which could be used to cover expenses etc.

The point about amortisation of initial expenses refers to the ability for insurers to take advance credit for the initial expense loadings within the gross premium. (Remember that net premium valuations do not consider expenses at all). This is called Zilmerisation and has the effect of reducing new business strain.

One possible reason why the size of the initial expenses is constrained is so that part of the difference between the gross and net premiums is sufficient to cover maintenance expenses.

Hope that helps.