Early United States insurance policies made no provision for refunds upon termination before maturity. Forfeiture of all accumulated funds was still prevalent in the mid-1850s. Gradually companies recognized, with varying degrees of liberality, the withdrawing policyowner�s right to such funds. Interest in the issue grew, and Massachusetts enacted the first nonforfeiture law in 1861. It evolved into the Standard Nonforfeiture Law, the first modern nonforfeiture legislation, which became effective in 1948 in most jurisdictions. Policies issued since that date have provided at least the minimum surrender values prescribed by law.

Laws to assure policyowners who voluntarily terminate their contracts a fair share of the value built up inside some policies are called nonforfeiture laws. Refunds required by such laws are called nonforfeiture values. Unless it refers to legislation, the adjective "surrender" is synonymous with "nonforfeiture" and is generally used in this text. Chapter 25 describes the nonforfeiture options (or surrender options) offered to a policyowner.

The Standard Nonforfeiture Law does not require specific surrender values. The only requirement is that surrender values are at least as large as those that would be produced by the method the law prescribes. In addition, each policy must contain a statement of the method used to find the surrender values and benefits provided under the policy at durations not specifically shown. This permits companies to use alternate formulas by describing them in their policies.

Minimum surrender values under the Standard Nonforfeiture Law reflect these two important principles:

The technique used to accomplish these two objectives is called the "adjusted-premium" method. This method reflects the philosophy that each group of policies issued on the same plan and at the same age should pay its own way, including the costs of acquisition. It recognizes that expenses are concentrated heavily in the first year and that first-year loading is not sufficient to absorb these expenses. The basic assumptions and techniques underlying the preliminary term method of reserve valuation described in chapter 18 are adopted. The difference between adjusted premiums used to derive reserves and surrender values is simple but subtle.

The adjusted-premium method derives its name from the manner in which surrender values reflect unamortized acquisition expenses. First-year expenses beyond normal recurring expenses are treated as an additional obligation under the policy. This amount is amortized over the premium-paying period in precisely the same manner as the present value of policy benefits is amortized. The amount that must be added to the net level premium to amortize this additional obligation is determined by dividing the excess first-year expenses by the present value of an appropriate life annuity due. The result, when added to the net level premium, produces the "adjusted premium." In short, the net level annual premium is adjusted to reflect the annual cost of liquidating the initial acquisition expenses. The actuary finds the surrender value at any duration by taking the difference between the present value of the benefits under the policy and the present value of future adjusted premiums.

The similarity between the adjusted-premium method and the prospective reserve should be apparent. The only difference is the use of adjusted premiums in one case and net level premiums in the other. With the same mortality and interest assumptions, the present value of future benefits is identical under either calculation. Therefore the present value of future adjusted premiums is larger than the present value of future net level premiums because the adjusted premium is larger than the net level premium. This means that the surrender value is smaller than the reserve. With identical mortality and interest assumptions, the difference between the reserve and the surrender value at any particular point in time is the unamortized first-year expenses. This difference decreases with each premium payment and disappears with the last payment.

It is important to note, however, that the mortality and interest assumptions employed by a company to calculate surrender values need not be the same as those used by the company to calculate premiums and reserves. The actual values promised may be computed on any basis that produces values at or above the statutory minimum values.

There are three steps in deriving surrender values under the Standard Nonforfeiture Law. Step 1 is to find the special first-year expense allowance. The law safeguards terminating policyowners� interests by limiting the amount of first-year expenses that may be considered in computing the surrender values. The permitted values provide ample expense margins for a well-managed company.

Step 2 in the process is to calculate the adjusted premium. This may be either (1) the level annual premium required to amortize a principal sum equal to the present value of the benefits under the policy and the special first-year expense allowance or (2) the sum obtained by adding to the net level premium the annual increment needed to amortize the special acquisition expenses over the premium-paying period.

The former approach is illustrated here with an ordinary life policy issued at age 32. Assume that the maximum special first-year expense allowance for such a policy, calculated according to the prescribed formula, is $20.64 per $1,000. That amount is added to $140.28, the assumed net single premium for an ordinary life policy issued at age 32, to obtain the amount needed at the inception of the contract to meet the obligations under the contract�namely, $160.92. To obtain the equivalent annual sum, $160.92 is divided by $16.49, the present value of a whole life annuity due of $1 as of age 32, based on an interest rate of 5.5 percent. The result, $9.76, is the adjusted premium.

The second approach is equally simple. To find the amount that must be set aside out of each gross annual premium�including the first�to amortize the special costs of acquisition, divide $20.64 by $16.49. The answer, $1.25, is the amount that must be added to the net level premium for an ordinary life policy issued at 32�$8.51�-to arrive at the same adjusted premium obtained above, $9.76.

Step 3 entails substituting the adjusted premium for the net level premium in the formula for prospective reserves. Recall from chapter 18 that the 10th-year terminal reserve for an ordinary life policy issued at age 32 is determined as follows: $214.82 � ($8.51 x $15.06) = $86.66. The first element in the equation, $214.82, represents the net single premium for a whole life policy issued at age 42; the second element, $8.51, represents the net level premium for an ordinary life policy issued at age 32 (rounded to two digits after the decimal); the last element, $15.06, is the present value of a whole life annuity due of $1 calculated at age 42. All values are based on the 1980 CSO Table and 5.5 percent interest. To find the surrender value under this policy at the end of 10 years, substitute the adjusted premium, $9.76, for the net level premium, $8.51. The result, $214.82 � ($9.76 x $15.06) = $67.83, is the surrender value.

The difference between the reserve at the end of 10 years and the surrender value for the same period, $86.66 � $67.83, or $18.83, represents a form of surrender charge assessed to cover unamortized first-year expenses. The surrender value under the same policy at the end of 20 years is calculated as follows: $319.53 � ($9.76 x $13.05) = $192.16. Since the 20th-year terminal reserve for an ordinary life policy issued at 32 is $208.50, the unamortized acquisition expenses are reduced to $16.34. The disparity disappears completely when all premiums have been paid.

The detailed steps in the calculation of the 10th-year surrender value for an ordinary life policy issued at age 32, with all computed values based on the 1980 CSO Table and 5.5 percent interest, can be summarized as follows:

The surrender value under the adjusted-premium method also may be found retrospectively by accumulating the annual adjusted premiums (less the excess first-year expenses) at the assumed rate of interest and deducting death claims at the tabular rate. The process is identical to the calculation of retrospective reserves except that adjusted premium is used to reflect excess first-year expenses. The retrospective approach is particularly useful in considering modifications of the adjusted premium method.

The illustration above computes minimum surrender values under a 5.5 percent interest assumption. Many companies offer surrender values greater than those required by law if such adjustments are supported by the company�s expense rates, by competitive pressures, or by other considerations. Higher values are obtained by assuming lower first-year expenses than the maximum permitted by law or by assuming the maximum expenses and amortizing them over a shorter period than the number of years for which premiums are payable (or at an uneven rate over the entire period of premium payments).

For a well-managed company, the asset share of a particular policy will, after a few years, exceed its surrender value and eventually will exceed the reserve. If the policy goes off the books, equity suggests that the withdrawing policyowner should be permitted to take some share of the surplus created. Such a final settlement with a withdrawing policyowner can be accomplished through a surrender dividend. The surrender dividend, because it is not guaranteed, provides more flexibility to the insurer than surrender values of the same amount.