What is an Insurance Reserve?
An insurance reserve, also known as a claims reserve or loss reserve, is a certain amount of funding set aside by an insurance company to meet any future claims it may have to payout.
The process begins with the insurance company formulating actuarial estimates of the levels of claim they can expect in the future for a particular type of insurance.
Part of the premiums earned from the policies in this type of insurance provision will then be used to pay the claims, while the rest will be set aside to add to the reserve. Part of the premiums may also be invested, and the investment returns may also be added to the reserve.
The insurance company builds up the reserve over many years and may also pool different policies together.
Having reserves set aside ensures the company can meet any claims made as set out in the insurance policy and in so doing fulfill their legal obligations. Furthermore, maintaining an appropriate reserve level is important for an insurance company as it can affect their solvency if an unusually large claim is made.
While recording this on the financial statements, premiums earned along with investments returns made are offset against any claims. The remaining amount is added to the reserve value.
Key Learning Points
- An insurance reserve is a certain amount of funding set aside by an insurance company to meet future claims
- Maintaining a certain level of reserves ensures the firm can meet its legal obligations of future claims and ensures its solvency in case future claims are higher than expected
- Future claims are estimated through an actuarial estimation
- The insurance company ensures the premiums earned are higher than the estimated future claims in order to sustain the insurance reserve
How does it work on the financial statements?
In order to record this calculation on the financial statements, the income statement records the current year’s actual claims (expense) against the premiums earned (income), net of which is added to the reserve.
The company may also have investment return earned from investing premiums from previous periods, which is then added as an income amount on the income statement.
On the balance sheet, future expected premiums from policies will be recorded as an asset, while the remainder of the potential claims, as calculated by an actuarial calculation, will be marked as a liability. To balance the balance sheet, an equal value will be recorded on the equity side which will be marked as ‘reserves’.
Below is a multiple-choice question to test your knowledge, download the accompanying excel exercise sheet for a full explanation of the correct answer.