A voluntary reserve is a financial reserve held by insurance companies. The reserves are frequently regulated by government agencies to ensure the solvency of an insurance company. Voluntary reserves are additionally held as liquid assets.
Understanding Voluntary Reserves
To appear financially stable and improve liquidity ratios, insurance companies will hold voluntary reserves. The requirements of a voluntary reserve are decided by the insurance company and not government regulators. The solvency ratio of an insurance company is determined by state regulators using tools from the Insurance Regulatory Information System (IRIS), which is managed by the National Association of Insurance Commissioners (NAIC).
The two regulatory bodies use financial information filed by insurance companies to calculate which insurance companies will face solvency issues. The IRIS comprises a range of values that are considered a company as a solvent, with values outside the range requiring close consideration.
For every insurance company, a voluntary reserve is a balancing act. It is because insurers need to meet the minimum required by state law, but increasing reserves beyond the minimum will reduce the amount of capital allocated by the insurance company towards the creation of shareholder wealth. Various accounting and tax laws prevent property and casualty insurers from setting aside extra money for future events like disasters.
The ideal level of a voluntary reserve is 8% to 12% of the insurance company’s total revenue. However, there is no fixed amount, as a voluntary reserve depends on the type of risk the company is experiencing.
A: High capital reserve and low voluntary reserve. It is not an ideal level.
B: Is the perfect balance between the capital reserve and voluntary reserve.
C: High capital and voluntary reserve. It is practically not possible, as there is a trade-off between the two variables.
The Shift in Voluntary Reserves
For U.S. life insurance companies, Principle-Based Reserving (PBR) is a new method to determine the voluntary reserve. In a report, the National Association of Insurance Commissioners introduced the PBR method.
PBR also introduced the Standard Valuation Model Law (SVL), which focuses on the risk profile of each company, and introduces metrics such as the health of customers, their age, the company’s financial strength, and investment performance. Providing a detailed framework of the PBR methodology, SVL took effect on January 1, 2017.
The Structure of PBR
Under PBR, an insurer must consider three different reserves to determine the minimum reserve, including:
1. Deterministic Reserve
The deterministic reserve methodology values gross premium using a single best economic assumption of income and expense by a margin. The margin considers the level of risk that an insurer experiences in a single economic scenario.
An exemption test is undertaken for deterministic reserve, where a group of policies is considered and discarded if their net premium is less than the sum of anticipated gross premiums all year.
2. Net Premium Reserve (NPR)
The net premium reserve (NPR) is the minimum level of reserve an insurer estimates using set formulas and assumptions for each of their product. Nevertheless, the formula for Universal Life Secondary Guarantees (ULSG) and term life products are different. The formula for NPR is the actuarial present value of future benefit payments minus the actuarial present value of future net premium payments.
3. Stochastic Reserve
The stochastic reserve method is used where estimates are determined by changing a set of random values of variables like morbidity rate, mortality rate, etc., and noting the outcome. Through the stochastic method, the risk of rare events is measured as the methodology is repeated more than a thousand times.
To calculate the stochastic reserve, the average of the top 30% of the estimates are considered, and a stochastic exclusion test is used by a life insurer to exempt certain policies while calculating the stochastic reserve.
In conclusion, under PBR, the level of reserves may be different for each product, as it portrays the level of risk accurately. Hence, PBR, as a methodology, is suitable and adaptable to new insurance products.
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