For traditional life insurance contracts, the approach used under US GAAP follows three key principles for calculating insurance reserves and how those reserves are released to profit.

All future cash flows are discounted using high-quality corporate bond yields. These discount rates are updated each reporting period and reflect current estimates of future cash flows.

So they reflect current estimates of mortality, lapses, and surrenders.

Gross premiums are recognized as revenue as they are due.

So if a term life policy requires a level premium of $100 per year, this is recognized as revenue as premiums earned each year.

The net premium approach is used to match the benefits expense to gross premiums so that profits are gradually released over the coverage period.

The net premium approach determines the net premium ratio.

That's the ratio of the present value of future benefits to the present value of gross premiums, which in the example shown here, would be a net premium ratio of 90%.

We can think of this as similar to the loss ratio in P&C insurance. The net premium ratio is then applied to the present value of gross premiums to give the present value of net premiums, which would be $900 in our example shown here.

The claims expense in the income statement is in the net premium ratio multiplied by the premiums recorded in earnings each year. So if there are no changes to initial expectations, the claims expense will always be 90% of the premium revenue recognized.

So the net premium approach is a way of ensuring that profits are recognized as a constant percentage of premiums over the life of the insurance contract, provided the benefits are as expected.

Life insurance reserves are calculated to reflect the present value of future benefits, less the present value of future net premium.

Remember that the present value of future net premium is the present value of gross premium multiplied by the net premium ratio.

Let's continue with our previous example where the present value of gross premium was $1,000 and the present value of future benefits was $900, so the net premium ratio was 90%.

Now, let's assume that premium of $100 is received shortly after contract inception.

The present value of gross premiums is now $900.

That's the original $1,000 gross premium, less the $100 now received, and the present value of future benefits is still $900.

The net premium ratio of 90% is then applied to the present value of gross premiums to give the present value of net premiums of $810.

The insurance reserves each period then reflect the present value of future benefits in excess of the present value of future net premiums, which in this example is $900 less $810, giving a reserve balance of $90.

A $90 benefits expense is therefore included in the income statement.