If the gross premium charged by an insurance company for a particular class of policies should be less than the valuation net premium, the company must establish and maintain a supplemental reserve, which often used to be called a deficiency reserve, for those policies. Such a requirement has long been a feature of state insurance laws. Recently the laws were changed to retain the required supplemental reserve but to eliminate use of the title "deficiency reserve." Emphasis on price competition had pushed many insurers� gross premiums to levels below valuation net premiums in recent decades. The indeterminant premium policy was introduced specifically as a way of reducing the burden of such deficiency-based supplemental reserves. The insurer can base reserves on the maximum possible premium and thus avoid the burden of additional reserves even if the actual gross premium being charged is lower than the net valuation premium.

Reserve laws are founded on the premise that the use, in the prospective reserve formula, of a net level premium larger than the gross premium that will actually be received overstates the present value of future premiums and consequently understates the amount of reserves required. The extent of the deficiency is assumed to be represented by the present value of the excess of the valuation net premium over the gross annual premium. This presumes that the entire gross premium is available for the payment of policy claims�which, of course, is contrary to the facts. Thus the formula for calculating supplemental reserves understates, by the present value of future expenses, the sum of money needed to supplement the conventional policy reserves.

The required supplemental reserve at any particular age is computed by multiplying the excess of the valuation net premium over the gross annual premium by the present value of a life annuity due of $1 for the remainder of the premium-paying period. If a company calculates its reserves on the basis of the 1980 CSO Male Table and 4.5 percent interest, the valuation net premium for an ordinary life policy issued at age 35 is $11.60 per $1,000, and the present value of a whole life annuity due of $1 at that age is $18.29. For each dollar by which the gross premium falls short of the valuation net premium at that age, a supplemental reserve of $11.60 must be created. If the gross premium is $10.00, for example, the required deficiency reserve will be $18.29 x $1.60 (the valuation net premium of $11.60 minus the gross premium of $10.00), or $29.26 per $1,000 of coverage.

In contrast to ordinary policy reserves that increase with duration, the required supplemental reserves based on a gross premium deficiency for a given class of policies decrease as the years go by. This is a natural consequence of the fact that the present value of a life annuity due of $1 declines with each premium payment or with each increase in attained age. From a retrospective point of view, it is assumed that the supplemental reserve is drawn upon with each premium payment to offset the deficiency in the gross premium. Hence it must decline with duration. Under either the prospective or the retrospective point of view, it is apparent that the supplemental reserve will disappear altogether at the end of the premium-paying period.

Inasmuch as deficiency-based supplemental reserves are computed on the basis of actual valuation net premiums rather than the smaller net premium that would be used to compute minimum reserves, an insurer may be penalized for adopting conservative assumptions.