Introduction to the Reserves
Insurance companies deal with large and complex claims made against policies that are sold by them. It may often take months, or even years, to settle some claims. To ensure the company reports and avoid unpleasant surprises, insurers assign a claim reserve to each incident that reflects their best estimate of the liability.
The term ‘Reserve’ is defined by the amount of money earmarked for a specific purpose. Theoretically, the reserve is an amount simultaneously with interest to be earned and premiums to be paid that will exactly be equal to all of the company’s contractual commitments.
Insurance reserves – The money which is reserved by insurers for the purpose of ensuring future payments of the insured sums and insurance compensation depending on the types of insurance.
There are several different types of Reserves. Life insurance companies maintain policy reserves while Property and casualty companies maintain unearned premium reserves, loss reserves, and voluntary reserves.
Following are the different types of insurance reserves maintained by property and casualty companies:
- Claims Reserves
- Statutory Reserves
- Unearned premium reserves
- Loss reserve
- Voluntary reserve
Now we will discuss all these types of reserves:
A claim reserve is an amount of money that is set aside by an insurance company or by an insurer to pay policyholders who have filed or expected to file legal claims on their policies. This reserve is also known as the ‘balance sheet reserve’. The reserve amount of money under the claim reserve is for both the type of claims i.e. for RBNS(reported but not settled) and IBNR(incurred but not reported) claims.
For instance; Company X provides home insurance to people living across the U.S. Unfortunately, a big earthquake ends up destroying a lot of property insured by the company. Company X knows that it will receive a lot of claims soon, even when these claims are not reported yet. To avoid this trouble, Company X creates a claims reserve putting money aside based on its estimates of how much they will likely have to payout.
These reserves are state-mandated reserve constraints for insurance companies. By law, insurers must hold a part of their assets as either cash or temporary securities so that they will be able to make good on their claims in a timely manner. Statutory reserves for insurance corporations are measured in two different ways; a rule-based approach and a principle-based approach. The Rule-based approach basically tells insurers how much money must be kept on reserve based on standardized formulas and sets of assumptions. More recently, many states have been moving toward a principle-based approach, which gives insurers greater freedom in setting their reserves.
Under a principle-based approach, insurers will be required to hold the reserves which consider a wide range of future economic conditions. These reserves are computed using justified insurer experience factors specific to an insurer, such as mortality, policyholder behavior, and expenses.
Unearned premium reserves
Unearned premium reserves (UPR) is something that appears in the liability portion of the balance sheet of an insurance company. It is a kind of technical reserve that reflects the measure of written premiums but not yet earned. The unearned premium reserve of a company may be considered as its deferred income. It is the premium corresponding to the time duration remaining of an insurance policy. This reserve is proportionate to the unexpired portion of the insurance.
For example, an insurance company receives $800 on February 27 for coverage from March 1 to August 31, but as of February 28, the company has earned $800. The insurance company reports the $800 in its cash account and reports $800 as a current liability in its unearned premium revenue account. When the company will earn the premium, the provider will move the amount earned from the liability account to a revenue account on its income statement.
Loss reserve is the estimation of liability of an insurance company from future claims. Typically, composed of liquid assets, loss reserve allows an insurer or insurance company to cover claims made against policies that it underwrites. These estimating liabilities may be a complicated undertaking. Insurers must take into account the span of the insurance contract, the type of insurance offered and the edges of a claim being resolved quickly. Insurers have to adjust their loss reserve calculations according to the circumstances.
When a new policy is underwritten by an insurer, it records a receivable premium and a claim obligation (which is a liability). The liability is a considered portion of the unpaid losses account, which depicts the loss reserve.
Voluntary reserve refers to fiscal reserve or other liquid assets set aside by insurance companies. Voluntary reserves are surplus or additional liquid assets above the requirement that ensure the solvency (the ability of a company to meet its long-term debts and financial obligations) of the insurance agencies. The most common reason for establishing a voluntary reserve for a company is that it helps to make the company appear liquid and stable. Moreover, voluntary reserve acts as a contingency fund, that is, to meet unexpected obligations and pay future liabilities.
Insurance companies need to be proactive, customer-sensitive, financially strong and solvent. Insurers are also long-term players who build substantial and sufficient reserves over the years from which the liabilities of policyholders are discharged. However, holding reserves make investors more confident that an insurer is in a solid position to withstand a bear market or other financial calamity.