For limited payment contracts, including fixed annuities, most or all of the premium is received at the start of the contract, whilst the benefits are paid out over the life of the contract.
Similar to traditional life policies, all future cash flows in the contract are discounted using high-quality corporate bond yields.
However, this time, a modified version of the net premium approach is used to spread the contract profit over the contract life.
This modified approach identifies the gross premium in excess of the net premium and defers this amount so that it is gradually recognized as the benefits are paid.
The net premium approach for limited payment contracts starts off in exactly the same way as for traditional contracts by determining 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%. The net premium ratio is then applied to the present value of gross premiums to give the present value of net premiums.
Although reserves are calculated in the same way as for traditional contracts, for limited payment contracts, a deferred premium liability is also recognized.
This is the gross premium received in excess of the present value of net premium.
In our example, if the entire $1,000 of gross premium is received at contract inception and the present value of future net premium is $900, the deferred premium liability is $100. This deferred premium is then gradually recognized in income as benefits are paid.
