An alternative to adjusting the first-year gross premium is to allocate a larger share of the first-year gross premium to expenses and a smaller share to creating the reserve. With a level loading the single largest portion of the premium goes to the policy�s reserve to assure the payment of future benefits. But remember that the objective of the reserve is to measure the company�s liability against a solvency standard. Regulators agree that a smaller portion (down to the net cost of the first year�s insurance) of the first-year gross premium can be recognized as the first-year net premium. This leaves a larger share of the gross premium for expenses. Of course, net premiums in future years must increase to keep the present value of net premiums equal to the present value of benefits. A reserve that results from modifying the net premium pattern from the level one is called a modified reserve.

The full preliminary term method of reserve valuation assumes that the first-year net premium needs to cover only the first-year benefits. The remainder of the first-year gross premium is available to help pay first-year expenses. This method produces a zero reserve at the end of the first year. The reallocation does not change the fact that the reserve needed at the end of the premium-paying period is the full net level premium reserve for that policy�s duration. The only way to accomplish this is to allocate a larger share of each renewal gross premium to the reserve. Also since the net amount at risk under the full preliminary term method is slightly higher throughout the premium-paying period, the cost of insurance is a little higher. Both factors mean that full preliminary term net premiums after the first year must be larger than net level premiums.

One way to view the full preliminary term method is to consider the first year of coverage as term insurance and the original contract of permanent insurance as taking effect at the beginning of the second policy year. For modified reserve calculations, policies are considered to be a combination of term insurance for the first year and permanent insurance issued at an age one year older and for a period one year shorter than the actual contract. For example, a 20-year endowment issued at age 30 becomes, for purposes of reserve computation, a combination of a one-year term policy issued at age 30 and a 19-year endowment issued at age 31. A 30-payment life policy issued at age 25 is considered to be a one-year term policy written at age 25 and a 29-payment life policy issued at age 26. The origin of the term preliminary term arises from this view.

The first year, in which the policy is regarded as term insurance, requires no reserve at the end of the year. Therefore a larger portion of the premium can be used for expenses. Similarly, if the permanent contract is viewed as one written at an age one year older and for a period one year shorter than the original contract, the full preliminary term renewal net premium must be larger than the net level one. The difference will be equivalent to the annual sum necessary to amortize the first-year net level premium reserve over the remaining premium-paying period.

As an example, consider again the ordinary life policy issued to a 32-year-old male. Earlier, using the 1980 CSO Male Table and an interest rate of 5.5 percent, we calculated the net level premium to be $8.51 and the first-year reserve to be $7.16. On a modified-reserve-valuation basis the full preliminary term first-year premium (death benefit only) would be $1.73 ($1000 x .00183/1.055), the first year reserve would be zero, and the renewal premiums would equal $8.94 ($8.51 + $0.43), where $0.43 is the annual amount required to amortize the $7.16 difference in the first-year reserves. (This is determined by dividing the reserve reduction by the present value of a stream of $1.00 payments for the premium-paying period.) Table 18-1 compares the two valuation methods.

Table 18-2 compares the amount available to pay expenses in the first year for the $100,000 policy (on the same basis illustrated in previous chapters).

All the amounts in table 18-2 are considered paid at the beginning of the year. The $678 difference in the deficiency ($1449 � $771) is exactly the $716 reserve difference ([$7.16/1,000] multiplied by 100,000) when one year�s interest is added to the $678.

Figure 18-1 illustrates these relationships for the $100,000 policy graphically. In net level premium reserve valuation, the loading is $450 each year, including the first. In contrast, the loading under the full preliminary term method of reserve valuation is $1,128 in the first year and $407 after that.

While full preliminary term valuation is defined by a first-year net premium equal to the one-year term premium, modified preliminary term valuation refers to a broader family of reserve methods. Specifically modified preliminary term includes any valuation method in which the first-year net premium is at least as large as the one-year term premium but less than the net level premium. Renewal net premiums are then set sufficiently high to accumulate the net level premium reserve by the end of the premium-paying period.

Over the years, states developed and/or adopted a variety of modified preliminary term valuation methods. The lack of standard valuation methods, however, imposed a substantial administrative burden on many companies. Ultimately the Standard Valuation Law of the NAIC was developed as a reserve valuation method to deal with the first-year expense problem, and that method was acceptable to all states.

Reserves under the CRVM are computed in the same manner as net level premium reserves except that a modified annual level premium is substituted in the prospective reserve formula for the net level premium. The so-called modified premium spreads the present value of benefits and the additional expense allowance in the first year over the premium-paying period of the policy.

For an ordinary life policy issued at age 32 (based on the 1980 CSO Male Table and 5.5 percent interest) the modified premium is $8.94. The CRVM reserve at the end of the first policy year is zero (when enough decimal places are used): 1st CRVM reserve = $146.43 � ($8.94 x 16.37) = $0.

This shows that the entire first-year reserve is available for expenses, as is characteristic of full preliminary term valuation. This is confirmed by the modified premium, $8.94, which is the same as the net level premium at age 33. At the end of 10 years, the CRVM reserve is $80.18 (when carried to enough decimal places): $214.82 � ($8.94 x 15.06) = $80.18.

The Commissioners Reserve Valuation Method differs from the full preliminary term when the net renewal premium on the full preliminary term basis for a policy (such as a short-term endowment) exceeds the net level premium for a 19-payment life policy issued at an age one year older than the actual issue age. The modified premium for a 20-year endowment issued at age 32 is $29.70.

When this modified premium is inserted into the prospective reserve formula, it results in a positive value for the first-year reserve: 1st CRVM reserve = $374.722 � ($29.701 x $11.994) = $18.49. This means that some first-year premium, $18.49, applies to offset the reserve rather than to pay acquisition expenses allowance. The 10-year reserve is $360.81: $592.807 � ($29.701 x $7.811) = $360.81. For all policies issued at age 32 (based on the 1980 CSO Male Table and 5.5 percent interest) $10.47 is the maximum amount that can be added to the net single premium in calculating the modified premium ($12.209 � $1.735).

Other values, of course, apply to other ages of issue. The maximum possible amount that can be added to the net single premium to derive the modified premium for any age of issue is the net level premium for a 19-payment life policy issued at an age one year older than the policy being valued, minus the net premium for one-year term insurance at the actual age of issue. By limiting the size of the modified premium that can be used in the reserve computation, the Standard Valuation Law in effect prescribes the minimum level of reserves-�the primary objective of any valuation law.

Table 18-4 shows the reserve required for a 10-payment life policy issued to a woman aged 32 under each of the valuation methods we have described. The largest reserves occur with the net level premium method; the smallest occur using the full preliminary term method. Table 18-4 can assist students in understanding the relationship of reserves under the Commissioners Method to those required under other methods. Overall, an established company with normal distribution of insurance by age, duration, and plan is estimated to carry total reserves under the CRVM of about 95 percent of those computed on the net level premium basis. In any rapidly growing company, the aggregate difference between reserves on the two bases may be much larger.

Although not an inherent feature of the CRVM, the Standard Valuation Law prescribes, as the minimum basis, the use of the 1980 CSO Tables and an interest rate no greater than a market-linked value that changes annually. Currently that interest rate is 5 percent for valuation of ordinary reserves.