Adjusted Premium Method

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.

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.