What is the Adjusted Premium Method
The adjusted premium method is a formula that insurance carriers use to calculate the cash surrender value of a life insurance policy. In a broad sense, this method is based on the total value of premiums paid up to the surrender date, net of any expenses or fees that have accumulated to that point.
BREAKING DOWN Adjusted Premium Method
The adjusted premium method is the most commonly used formula for calculating the cash surrender value (CSV) of a life insurance policy. Insurance carriers use this formula to determine the payout due to a policyholder in the event that they choose to cancel the policy prior to the end of its term, if applicable. The CSV of a policy is drawn from the savings portion of that policy, as opposed to the portion that is set aside for payment of death benefits. The CSV should not be confused with the policy’s face value, which is another term for the death benefit.
When a policyholder makes annual premium payments, a fraction of each payment goes to savings while the remainder funds the reserve which supplies the death benefit. Earlier in a policy’s term, a larger portion of the premium goes to this reserve. This means that the surrender value will be very low in those early years. In general, the surrender value will never approach the face value or death benefit of the policy. 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.
Calculating Cash Surrender Value under the Adjusted Premium Method
To calculate the CSV of a life insurance policy using the adjusted premium method, the carrier first adjusts the net-value premium to reflect expenses incurred to acquire the business. These costs are known as the expense allowance. The net-value premium is equal to the death benefit of the policy divided by the number of years that the carrier expects premiums to be paid. The expense allowance is amortized and subtracted from the net-level premium, and the remaining sum is the adjusted premium. The adjusted annual premium is then multiplied by the number of years that the policy has been in effect. The carrier then assesses surrender fees, which will be higher in the early years of a policy to compensate the carrier for lost premium revenues. These fees are deducted from the product of adjusted premium and payments made to arrive a