So what happens if cash flow expectations change during the contract life? The net premium ratio is updated each year to reflect changes in cash flow expectations.

Remember that each year that passes, some cash flows will have been paid or received, so the revised net premium ratio is the ratio of actual plus future benefits to actual plus future gross premiums.

This revised ratio is then used in the calculation of reserves going forward. It's important to note that it is only cash flows which are updated in the revised net premium ratio.

The calculation uses a discount rate from contract inception, and it is what we refer to as a locked-in discount rate.

Let's revisit our previous example where the present value of gross premiums was $1,000, and the present value of future benefits was $900. So the net premium ratio was 90%, and $100 of premium was received shortly after contract inception, giving a benefits expense of $90.

Now, let's assume that we have new information on mortality, which suggests that future benefits will be higher than previously anticipated. The present value of future benefits are now $950 instead of $900.

Since insurance premiums don't change, the present value of actual and gross premium is still $1,000, and we have a revised net premium ratio of 95%. So the contract will generate less profit than originally expected.

Remember that reserves reflect the present value of future benefits, less the present value of future net premium.

If $100 of premium was received after contract inception, the present value of future gross premium is $900.

The revised net premium ratio is 95%, which therefore gives a present value of future net premium of $855.

Deducting this from the present value of future benefits of $950 gives reserves of $95 and a benefits expense of $95 as well.

This is $5 higher than before. So the increased present value of benefits of $50 is gradually added to reserves and released to earnings each year as premiums are received. We refer to this as a catch-up approach. The profits recognized going forward are still a constant percentage of premiums over the life of the insurance contract, but this percentage reflects current expectations for how profitable the insurance contract will be.

Now let's see what happens if discount rates change.

Insurance reserves are updated each year to reflect current discount rates.

However, the effect of discount rate changes don't affect earnings.

They're recognized in full in other comprehensive income.

We can therefore view the original discount rate as being locked in when calculating the net premium ratio and also for interest rate accretion. Let's revisit our previous example of an insurance contract where the net premium ratio is 95%, $100 of premium has been received, and insurance reserves brought forward are $95.

Let's assume that the discount rate now decreases.

So the present value of future benefits increases to $1,000, and the present value of future net premium increases to $900. The new insurance reserves will be $1,000 less $900, which is $100.

The increase in reserves of $5 will be recorded as a loss in other comprehensive income.

Note, however, that the net premium ratio will still be 95%, as this is unaffected by the discount rate change, and the interest accretion on reserves will continue to use the original discount rate.