Definition - 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. 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 laws and regulations require that they hold these funds in reserve.
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 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.
Clients who pay premiums in good faith expect the insurer to keep their word in case the insured peril occurs. 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 financial obligations to customers.
By maintaining a statutory reserve, 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.
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.