An insurance policy reserve represents (in present-value terms) the excess of the benefits promised over the net premiums yet to be collected. The reserve is zero at policy issuance because the present value of the benefits equals the present value of premiums at that instant. However, as time passes the value of the benefits promised (outgo) increases (nearer to time of payment and higher probability of payment) while the present value of premiums to be collected (income) decreases (fewer premiums left to collect). This relationship requires that the reserve increase with the passage of time.

More precisely, the reserve is the present value of future benefit payments (surrender and death) minus the present value of future incoming premiums. This broad definition can be applied to both the asset shares described in the previous chapter and to the net level premium reserves discussed in chapter 16. Asset shares include expenses and surrender benefits in the outgo; they use gross premiums as the income. They are useful management tools in product design and in measuring company performance. Net level premium reserves include only death and maturity benefits in the outgo and use a net level premium in the income. Regulators require life insurers to maintain this net level or benefits-only reserve to safeguard the policyowners in their jurisdiction. They require that the company show the reserve found in this manner as the liability for the policy on the annual statement it files with regulators.

Subtracting a level net premium from a level gross premium leaves a level loading with which to pay expenses. Since actual expenses are very heavy in the first year, early expenses in excess of the loading must be paid out of a company�s accumulated capital, known as surplus, and later recouped. A company that enjoys a strong surplus position can easily manage this "loan" from surplus. Over the years aggregate repayments from renewal loadings tend to offset the amounts needed to support newly issued policies. This lessens the net strain on surplus from new business. Eventually repayments might exceed withdrawals.

A small, recently organized or undercapitalized company, however, finds it much more difficult to meet the surplus demand from new business. Typically its new business is a significantly larger proportion of its total business in force. If such a company attempted to absorb its entire first-year deficit out of surplus, it might be forced to limit new business. In any case, it would probably have to reinsure more of its business than would a stronger company.

Theoretically a company could solve this problem by charging a higher premium in the first year than in subsequent years, but this approach is not practical. From a sales standpoint, the company would prefer to charge a lower premium for the first year, not a higher one.