A statutory reserve is a legal requirement for insurance companies to hold a certain amount of funds in reserves to protect policyholders’ future benefits and ensure that the insurers are financially healthy. Insurance companies are bound by law to hold a certain fraction of their assets as either cash or assets that can be converted to cash quickly.
The reserves allow the insurers to honor future obligations promptly. The insurance companies are required to report their statutory reserves in financial statements filed with insurance regulatory bodies.
A statutory reserve is a pool of funds that insurance companies are required by law to hold as a guarantor of liquidity in order to remain solvent and financially stable.
The regulatory authority granted to states by the McCarran-Ferguson Act has imposed measures for licensure and reserve requirements of insurance companies.
Statutory reserves are evaluated using two methods, namely, the rule-based approach and the principle-based approach.
Understanding Statutory Reserves
Implementation of the McCarran-Ferguson Act and Reserves
Under the McCarran-Ferguson Act of 1945, insurance companies are subject to consumer protection enforcement. Individual states are mandated to regulate virtually all aspects of insurance, ranging from financial solvency to market practices and taxation. The legislation provided a narrow antitrust exemption to promote fair competition by allowing insurers to exchange vital information regarding losses and other factors, facilitate oversight of state guarantor funds, and allow states control over liquidation.
A state insurance department must, therefore, provide licensure and regulations to any insurance company before conducting business. Among the regulations is how much an insurance company must keep in order to pay future policyholders’ claims. The regulations cover various insurance products, such as health insurance, life insurance, and annuity contracts, among others.
The state regulatory system makes different demands, depending on the state and insurance products. The requirement of statutory reserves is necessary to protect insurance companies from becoming insolvent.
Failure to Meet the Statutory Requirement for Reserves
An insurance company that does not meet the reserve requirements collects premiums as its revenue and bases its profit on the same. Typically, nothing can go wrong at the beginning since policy claims are infrequent. However, the number of policy claims is expected to increase as time goes by, consequently increasing claim costs. Still, policyholders expect an insurance company to keep its word in the event that the insured risk occurs.
At the same time, a company is bound by statutory laws to meet its customers’ financial obligations. Afterward, the claim costs may exceed the total premiums collected. The insurer would then be forced to hold a certain amount of its annually collected premiums to offset the soaring claim costs. Otherwise, it would jeopardize its financial strength. By keeping a statutory reserve, the insurance company can manage all its risks and operate more efficiently.
How to Calculate Statutory Reserves
Insurance companies that are ill-prepared in terms of statutory cash reserves subject individual policyholders to high risk if the insurer does not hold sufficient funds to settle policy claims. Insurers with inaccurate reserves tend to keep an underestimated or an overestimated statutory reserve. Flawed statutory reserve estimates result in adverse consequences on the insurers’ financial health. As such, insurance firms hire professional actuaries to calculate the net present value of expected future claims and premiums.
There are two approaches used to calculate statutory reserves, namely a rule-based method and a principle-based method. The majority of states prefer the latter approach, which uses standardized models and assumptions to prescribe how much funds insurers must reserve to reach the required capital requirement. The former approach is also popular as it gives insurers greater latitude to set their statutory reserves.
1. Rule-Based Approach
The rule-based method uses established assumptions that apply across all insurance companies, regardless of an insurance product.
It may leave an insurance company with excessive reserve for certain contracts.
It uses static mathematical formulas that may not capture all the risks of a policy.
2. Principle-Based Approach
Under the principle-based method, risks are quantified using risk analysis and management formulas.
It captures all the guarantees, identifiable material risks, and benefits of a policy.
It allows the use of a company-based experience and its level of credibility to determine the reserve amount.
Most states revised their standard valuation laws to implement the principle-based approach. The National Association of Insurance Commissioners (NAIC) announced that principle-based reserving (PBR) is the panacea to a current regulatory framework problem. However, the new approach allows a higher reserve to consider future economic conditions or prescribed factors.
The Principle-Based Reserving Implementation (EX) Task Force 2012 arranged for the utilization of the principle-based approach across all states and insurers. It also added NAIC actuaries to help the states’ review of assumptions and company-specific PBR. The task force also came up with the regulatory review and reporting process for PBR. Currently, the Financial Condition (E) Committee oversees the reporting of PBR in financial books.