What is a Valuation Reserve?
A valuation reserve refers to the assets that life insurance companies set aside as a hedge against the decline in the asset’s value or unexpected market upheavals. The assets are allocated as per state law to protect the asset portfolio against devaluation risks.
- A valuation reserve is the amount of money that insurance companies allocate to provide economic protection against expected contingencies to maintain their capacity to serve as efficient financial intermediaries.
- Solvency monitoring in insurance firms has evolved over time from mandatory safety requirements to asset valuation reserve and interest maintenance reserve.
- The current valuation reserve requirements define the insurers’ obligations and the assets they hold.
The existence of valuation reserves is founded on the idea that life insurance policies and other annuities may span for an extended period.
Therefore, the role of the valuation reserve is to maintain the safety and soundness of an insurance company by protecting it against the risks presented by investments that may not perform as anticipated. The measure ensures that annual premiums are increasingly paid, and policyholders are compensated for their claims even if an insurance company depreciates in value.
It sets apart life insurance companies from other insurance companies, where the allocation of the valuation reserve is motivated by the desire to improve the security, and not from any theoretical requirement.
Understanding Valuation Reserves
Solvency monitoring in life insurance companies has changed over time. During the pre-1992 period, the National Association of Insurance Commissioners (NAIC) imposed valuation reserves for investment assets as a mandatory safety requirement.
The rule was associated with an unsatisfactory measure of efficiency and profitability that existed then. This is explained by different approaches in the valuation of assets and treatment of capital gains, differences in the use of discount rates and valuation tables, and the long-term nature of insurance contracts.
Consequently, these variations raised not only challenges for insurance taxation but also hampered the rational evaluation of the industry’s performance.
However, in the post-1992 period, the terms were re-evaluated to allow for the creation of asset valuation and interest maintenance reserve. This is considered the nature of policy contracts with different firms holding varying categories of assets and the high liquidity of their operations.
The committee argued that it was irrational to value the securities on the market based on liquidity since life insurance firms typically held their investments until maturity. The changes were aimed at cushioning firms against the risk of losses, and the appreciation and depreciation of securities in advance.
Furthermore, the maximum volume of accruals to the reserve was allocated according to the valuation risks of the cushioned capital losses.
Valuation Reserve Requirements
The current valuation requirements essentially define insurance risks by their obligations and the asset they hold, rather than by the blend of liabilities and assets.
For these companies to meet the obligations of compensating insurance beneficiaries and annuity buyers over many years, they need to hold enough assets in their reserves to consider the risks entailed by its policies and contracts.
The existing regulations and standards require that the risk-based capital requirement be calculated on an actuarial basis, and under the terms of a company’s policies dependent on life. The rules not only account for the anticipated claims by policyholders but also for the forecasted future premiums and interest a company will receive.
A report by the American Council of Life Insurers stated that life insurance represented 51% of company-owned reserves compared to the 8% held in individual annuity reserves.
Surprisingly, life insurance companies’ reserves plummeted to 29% of all reserves by 1990, while the ones for individual annuities jumped to 23%. The change mimicked the growth in efforts by insurance companies to popularize retirement plans.
Risk-Based Capital Requirements
Regulators are increasingly adopting risk-based capital requirements to ensure the safety and soundness of insurance companies, rather than regulations that limit their contracts and investments.
The regulations define a company’s risk based on the features of its assets and obligations treated in isolation, rather than the blend of assets and liabilities. The risk-based capital regulations accordingly deny much credit to companies that diversify their investments or match the terms of their assets and liabilities to mitigate risks.
The prevailing measures use market values, as well as book values, to mark insurers’ assets. Eventually, this approach misrepresents a firm’s capacity to overcome risk.
It means that a robust measure of a company’s ability to mitigate risk rests on a judgment about the odds of the anticipated and unexpected economic conditions, not to mention the implied relationship between return and investments.
The ever-changing premiums and interest rate portfolios can attract risks that adversely affect reserves needed for continuous payment of annuities. Although policyholders do not consider all insurance contracts as investments, the premium for all contracts depends on the returns that insurers anticipate earning on their reserves.
In this light, the NAIC advocated measures to cushion against market fluctuations.
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