Insurance companies use the premiums paid by policyholders to provide the benefits guaranteed by the policy. The premiums collected from the policyholders are invested to generate profit and meet future claims. However, insurance providers rely on the company reserves to fulfil the protection guaranteed in the policy contract. Companies are pretty much susceptible to insolvency without reserves that is why reserve requirements are imposed by some states.
What are reserves?
Reserves are parts of the assets especially kept by a bank, financial institution or insurance company to keep up with future demands. It is an amount of money set aside by a company for a specific purpose. Reserves are made available to insure that the institution or insurance company has amount of funds or assets available at any given time to honor payment premiums and claims.
Some states require specific reserves to be separate from the amount of money that an insurance provider must keep on hand or must be in different accounts if practicable. For example in New York, the state makes it a requirement for the insurance company to separate the general accounts from sub-accounts. By not commingling the two accounts, there is an assurance that investments of one do not affect the guaranteed benefits of the other.
The requirements for insurance company reserves are typically determined by most states using some kind of formula and generally in terms of percentages. The type of insurance which a company provides may also be a determining factor for setting reserves. For example, even if the reserves of insurance companies are generally 10-12 percent of their revenue, the nature of claims from life insurance widely differs from health claims. Health insurance normally specializes in paying claims to restore the good health condition of a person prior to any accident or illness. This necessarily means that since the amount insurance providers ought to pay for medical bills are not known, health insurance providers need to have much higher reserves. In health policies, the insurers are pretty much susceptible to paying more than the anticipated costs for the benefits promised. The benefits to be offered by companies may be clearly stipulated in the policy contract but the payments may also change and be different from those originally estimated. Life insurance however, only pays a specific amount and which enables the insurer to know and estimate claim costs in advance.
Reserves are generally reckoned as a liability especially by life insurance companies. It is specifically designed to cover claims in the event that the insurance company is unsuccessful in its claims predictions or investments. Reserves are an essential part of the insurance company’s balance sheet and any change, error or adjustment can heavily affect the income report submitted by the company. The visible profitability and solvency of an insurance company is demonstrated in the value of reserves it has. The requirement for minimum reserves for a company to follow may vary from one state to another. However many insurance companies possess more reserves than the state’s minimum requirement. And the high amount of reserves means a greater chance of the company to stay solvent even in hard economic times.