What Does Statutory Reserve Mean?
A statutory reserve is an amount of money set aside by a financial institution, such as a bank or insurance firm, in order to meet unmatured obligations - such as the promise of repayment insurance firms make in exchange for accepting premiums from clients. It is a component of the balance sheet for an insurance firm and can be in the form of anything easily convertible to cash, such as marketable securities.
This pool of funds is called a statutory reserve because the laws and regulations that govern these institutions require that they hold these funds in reserve on their balance sheet. These types of financial institutions play a big role in the global economy and serve as a stabilizing force against the unknown risk of losses (such as a fire destroying your home).
Without the ability to reliably offload these types of risks to large 3rd party entities, businesses and individuals would be less prone to take risks and we would all need to keep a large amount of capital in unproductive reserves in order to protect ourselves against losses.
The amount that must be held in a statutory reserve varies from jurisdiction to jurisdiction but they are usually set as a percentage of the firm’s total obligations. There are also rules around what types of assets can be held as statutory reserves, but the more liquid and stable they are, the better. The goal is to ensure the stability of the financial system by making sure the reserve can cover any claims or obligations that are due in the near future.
One of the most important priorities for an insurance firm or financial institution is to stay solvent and financially stable. Part of that means maintaining enough liquid assets (such as cash or marketable securities) in a statutory reserve to ensure they can meet their financial obligations. In the context of an insurance company, that means having enough liquidity to pay claims for all of the risks they retain on their books.
Insuranceopedia Explains Statutory Reserve
An insurance company accepts premiums from customers in exchange for coverage. This coverage is a promise of compensation when an insured peril damages an object of insurance or when the customer is found legally liable for causing financial loss or bodily injury to a third party. In layman's terms, this refers to your property coverages and 3rd party liability coverages.
Clients who pay premiums in good faith expect the insurer to keep their word in case the insured peril occurs. Because of the key role our financial institutions play in maintaining global stability, the government does not take chances on this issue and sets various standards through regulating bodies for this sector, and one requirement is maintaining a statutory reserve to ensure the insurer remains solvent and can meet their near-to-medium term financial obligations to customers.
By maintaining a statutory reserve of cash, near-cash, or other liquid marketable securities, an insurance firm can still fulfill its financial and legal obligations to pay out claims even if it operates under a loss. Additionally, in the event of a calamity that results in an unusually high volume of claims, the insurance firm can dip into these reserves to pay these claims in full and in a timely way to ensure consumers are not affected.
Depending on the jurisdiction, statutory reserves are calculated using 2 main approaches:
This is the strictest approach to calculating the amount of statutory reserves required. With this approach, the amount required is based on a standard formula based off of a set of assumptions that may not apply to all organizations nor will it capture all potential risk factors. There is no flexibility allowed here for the organization.
Like the name implies, this approach is based on the principle of promoting customer protection and ensuring the firm remains solvent. It is based on the risks the organization is capable of taking, factoring in intangibles like experience of the organization in accurately predicting future risks.
While maintaining a statutory reserve usually reduces profitability, it acts as a good indicator for investors and customers. This is one reason some insurance firms maintain another reserve known as a voluntary reserve.
If an insurance company suffers a catastrophic loss that exceeds its statutory and voluntary reserves, it will be considered insolvent. When this occurs, most jurisdictions will have an insurer of last resort, which is typically a government-run organization, that will step in and honor the insurer’s financial obligations including paying for outstanding claims owed and refunding policyholders the unearned portion of their premiums. However, coverage provided by these insurers of last resort is typically inadequate to fully cover a policyholder for their loss