Statutory Reserve

What Does Statutory Reserve Mean?

A statutory reserve is an amount of money set aside by financial institutions, such as banks or insurance companies, to meet unmatured obligations—like the promise of repayment that insurance firms make in exchange for premiums from clients. It appears on the balance sheet of an insurance firm and can take the form of easily convertible assets, such as marketable securities.

This reserve is termed “statutory” because laws and regulations governing these institutions mandate that they maintain these funds on their balance sheets. These financial entities play a significant role in the global economy, serving as a stabilizing force against unpredictable risks of loss, such as a fire destroying a home.

Without the ability to transfer these risks to large third-party entities, both businesses and individuals would be less inclined to take risks, necessitating the retention of substantial capital in unproductive reserves to protect against potential losses.

The required amount for a statutory reserve varies by jurisdiction and is typically set as a percentage of the firm’s total obligations. Additionally, regulations dictate the types of assets that can be held as statutory reserves; generally, more liquid and stable assets are preferred. The primary goal is to ensure the stability of the financial system by ensuring the reserve can cover any claims or obligations that are due in the near future.

One of the most critical priorities for an insurance company or financial institution is to maintain solvency and financial stability. This involves having sufficient liquid assets—such as cash or marketable securities—within the statutory reserve to meet financial obligations. In the context of an insurance company, this means having adequate liquidity to pay claims for all the risks they retain on their books.

Insuranceopedia Explains Statutory Reserve

An insurance company accepts premiums from customers in exchange for coverage, which represents a promise to provide compensation if an insured peril damages an insured object or if the customer is found legally liable for causing financial loss or bodily injury to a third party. In simpler terms, this coverage includes property insurance and third-party liability insurance.

Clients who pay premiums in good faith expect the insurer to uphold their promise if an insured peril occurs. Given the crucial role that financial institutions play in maintaining global stability, the government does not take chances on this issue. Regulatory bodies set various standards for this sector, including the requirement for insurers to maintain a statutory reserve to ensure solvency and the ability to meet 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 fulfill its financial and legal obligations to pay claims, even if it is operating at a loss. Additionally, in the event of a catastrophe that results in a high volume of claims, the insurance firm can access these reserves to pay claims in full and on time, ensuring that consumers are not adversely affected.

Statutory reserves are calculated using two main approaches, depending on the jurisdiction:

1. Rules-Based Approach:
   This approach is the strictest method for calculating the required statutory reserves. The amount is based on a standard formula derived from a set of assumptions that may not apply universally to all organizations, and it does not account for all potential risk factors. There is no flexibility allowed for the organization under this method.
2. Principle-Based Approach:
   As the name suggests, this approach focuses on promoting customer protection and ensuring the firm’s solvency. It considers the risks the organization can effectively manage, factoring in intangibles like the organization’s experience in accurately predicting future risks.

While maintaining a statutory reserve may reduce profitability, it serves as a positive indicator for investors and customers. This is one reason some insurance firms also maintain an additional reserve known as a voluntary reserve.

If an insurance company experiences catastrophic losses that exceed its statutory and voluntary reserves, it will be deemed insolvent. In such cases, most jurisdictions have an insurer of last resort—typically a government-run organization—that steps in to honor the insurer’s financial obligations, including paying outstanding claims and refunding policyholders for the unearned portion of their premiums. However, coverage provided by these insurers of last resort is usually inadequate to fully compensate policyholders for their losses.