What Are Statutory Reserves?
Statutory reserves are funds that state insurance regulators require insurance companies to maintain at any given time. Their primary purpose is to ensure adequate liquidity for honoring all legitimate claims made by policyholders.
Key Takeaways
- Statutory reserves comprise minimum amounts of cash and readily marketable securities that insurance companies must hold.
- They are mandated under state insurance regulations.
- Insurance companies can set their statutory reserves above the minimum level using a principles-based approach.
Understanding Statutory Reserves
The McCarran-Ferguson Act, passed by Congress in 1945, gave states the authority to regulate insurance companies. For an insurer to do business in a state, it must be licensed by the state’s insurance department and adhere to its rules, including maintaining adequate reserves to ensure the payment of future claims.
Insurance companies typically collect premiums from customers and invest those funds to generate a return on investment (ROI). While maximizing investments, they could be tempted to invest a substantial fraction of these premiums. However, doing so might leave insufficient cash to satisfy claims. State insurance regulators, therefore, enforce minimum levels of liquidity that companies must maintain.
These statutory reserves can either be in cash or in liquid, readily marketable securities convertible into cash reliably and on short notice. Statutory reserves apply to various insurance products, including life insurance, health insurance, property and casualty insurance, long-term care insurance, and annuity contracts—though state-specific requirements may vary.
Statutory Reserves Methods
State insurance regulators use two primary approaches to set the level of statutory reserves:
Rules-Based Approach
This approach dictates that insurers must keep a specific portion of their premiums in reserve based on standardized formulas and assumptions.
Principles-Based Approach
This approach allows insurers greater flexibility by letting them set reserves based on their own experience, such as actuarial statistics and past claims behavior, provided that the reserves are at least equal to or greater than those dictated by the rules-based approach.
Importance of Reserves
When an insurance company opts to keep reserves in excess of the minimum required under the rules-based approach, these are known as non-statutory or voluntary reserves.
Although maintaining statutory reserves could lead to lost investment opportunities, they enhance overall insurance market stability by boosting customer confidence that insurers can endure economic challenges and honor their policies.
Example of Statutory Reserves
Consider XYZ Insurance. According to the statutory reserve requirements of its state insurance regulator, XYZ needs to keep $50 million in reserve based on the rules-based approach. After analyzing its competitive landscape and reviewing past performance, XYZ opted for the principles-based approach and set reserves above the required minimum.
While the extra reserves might decrease potential investment income, XYZ believes this conservative stance bolsters its reputation as a reliable insurer and better equips it to handle potential economic downturns.
Related Terms: liquidity, marketable securities, insurance premiums, return on investment, actuarial statistics, investment income
