Adjusted Premium Method

Adjusted Premium Method

The adjusted premium method is an approach used by insurance companies to calculate the amount owed to a customer who decides to cancel their insurance policy prematurely. When a policyholder pays regular insurance premiums on their life insurance policy, a portion of those premiums is applied toward savings while the remainder is applied toward a reserve fund. The adjusted premiums method is used by insurance companies to calculate the cash surrender value (CSV) of a life insurance contract. The adjusted premium method is the most commonly used formula that insurance companies use to calculate the cash surrender value of a life insurance policy. To calculate this value, the insurance carrier starts by looking at the net-value premium, which is essentially the death benefit of the policy divided by the number of years in which premiums are expected to be paid.

The adjusted premiums method is used by insurance companies to calculate the cash surrender value (CSV) of a life insurance contract.

What Is the Adjusted Premium Method?

The adjusted premium method is an approach used by insurance companies to calculate the amount owed to a customer who decides to cancel their insurance policy prematurely. Specifically, it is used to calculate the cash surrender value (CSV) of a life insurance policy.

The adjusted premiums method is used by insurance companies to calculate the cash surrender value (CSV) of a life insurance contract.
It is roughly equivalent to the total premiums paid on the contract, less the expenses incurred in acquiring and servicing that contract.
However, insurers often assess surrender fees that would reduce this amount, making it generally unprofitable to cancel a life insurance contract prematurely.

How the Adjusted Premium Method Works

When a policyholder pays regular insurance premiums on their life insurance policy, a portion of those premiums is applied toward savings while the remainder is applied toward a reserve fund. This reserve fund is then used to finance the death benefit of the policy, which is the amount paid to the policyholder's beneficiaries upon their death.

Initially, a larger portion of the premiums is directed toward the reserve fund as opposed to the savings portion, meaning that the amount of accumulated savings within the policy will be relatively low within the early years.

The CSV is drawn from the savings portion of that policy, as opposed to the portion that is set aside for payment of death benefits. In general, the surrender value will never approach the death benefit of the policy. For this reason, a policyholder should only consider canceling a policy under extreme financial hardship or when they are confident that they are moving assets to a superior investment. This is especially true considering that insurance companies often incorporate surrender fees, sometimes amounting to as much as 10% of a plan's CSV, which would further reduce the amount of money gained from surrendering the policy.

Broadly speaking, the method calculates the CSV by taking the total premiums paid up to the surrender date and deducting all expenses or fees accumulated up to that point. In doing so, the insurer will reduce the CSV in two different ways. First, it will allocate a portion of the costs incurred in order to acquire and service the contract. Then, it will assess surrender fees which will be larger if the contract was surrendered relatively early in its life.

Real-World Example of the Adjusted Premium Method

The adjusted premium method is the most commonly used formula that insurance companies use to calculate the cash surrender value of a life insurance policy. Insurance carriers use this formula to determine the payout due to a policyholder in the event they choose to cancel the policy prior to the end of its term, if applicable.

To calculate this value, the insurance carrier starts by looking at the net-value premium, which is essentially the death benefit of the policy divided by the number of years in which premiums are expected to be paid. Then, the insurer reduces this figure by the policy's expense allowance, which reflects the expenses incurred by the insurer in order to acquire the insurance contract. The carrier then deducts surrender fees, which will be higher if the policyholder cancels in the early years of their contract.

Related terms:

Accelerated Option

An accelerated option in an insurance contract allows the policyholder to withdraw benefits earlier than they would normally be payable. read more

Adjusted Premium

An adjusted premium is the premium of a life insurance policy that is adjusted by amortizing the costs associated with acquiring the insurance policy. read more

Cash Surrender Value

Cash surrender value is the sum of money an insurance company pays to the policyholder or account owner upon the surrender of a policy/account. read more

Free Look Period

A free look period is the time period when a new life insurance policyholder can terminate the policy without any penalties, such as surrender charges. read more

Guaranteed Death Benefit

A guaranteed death benefit guarantees that the beneficiary will receive a death benefit if the annuitant dies before the annuity begins paying benefits.  read more

Insurance

Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies and/or perils. read more

Life Insurance Guide to Policies and Companies

Life insurance is a contract in which an insurer, in exchange for a premium, guarantees payment to an insured’s beneficiaries when the insured dies. read more

Premium

Premium is the total cost of an option or the difference between the higher price paid for a fixed-income security and the security's face amount at issue. read more

Section 7702

Section 7702 of the U.S. Tax Code defines what the government deems to be a legitimate life insurance contract for tax purposes. read more

Surrender Fee

A surrender fee is a penalty charged an investor for the early cancellation or withdrawal of funds from an insurance or annuity contract. read more