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Negative reserves

+2 votes
asked Sep 29, 2017 in BUS 3024S - Contingencies by anonymous

Why are negative reserves/policy values a problem for insurance companies? Aren't negative reserves actually a good thing since it suggests that a profit will be made?

1 Answer

+3 votes
answered Oct 3, 2017 by Dean_Bunce (1,160 points)
selected Oct 4, 2017 by Njabulo.Dube
Best answer

A policy value is a liability that is set up by the insurance company, based on the expected future cover that it is offering to a policyholder. Over time, as the amount held exceeds the amount expected to be needed, the liability is reduced and profits are released.

Now lets consider a negative value. A negative liability is an asset. This is why it seems like a negative policy value is good, because assets are good. However, this asset is one where the policyholder essentially owes you money for the cover that they have already received. But they do not have the obligation to pay that money if they don't want to i.e. they can lapse. in fact, they have the incentive to lapse because they have received more cover than they have paid for in the past and will receive less cover than they will pay for in the future (as the negative policy value is their "owing you" for future cover). This means that the contract has a design flaw in that it is susceptible to lapse and re-entry, where it would repeatedly offer more cover than was paid for in the early years.

Intuitively, the policy value is the difference between the premiums the company expects to receive and the amounts that it expects to pay out in the future. If this is negative this means that the premiums that it expects to receive are greater than the amount it expects to pay out in the future. from the policyholders perspective this is equivalent to having to pay more in the future than the cover one would expect to receive. Again we find ourselves in the position of incentive to lapse

Releasing the negative policy value as profit ignores the incentive to lapse, which is why it is no good.