What Are Statutory Reserves?
Let me explain statutory reserves directly: these are the funds that state insurance regulators require insurance companies operating in their state to maintain at any given time. You need to know that the purpose here is straightforward—to ensure insurance companies have enough liquidity to honor all legitimate claims from their policyholders.
Understanding Statutory Reserves
The McCarran-Ferguson Act, passed by Congress in 1945, gave states the authority to regulate insurance companies. If you're an insurer wanting to do business in a state, you must be licensed by that state's insurance department and follow its rules, including how much money you keep in reserve to pay future claims.
Insurance companies collect premiums from customers and invest them in their general account for returns. In theory, they might invest most of those premiums to maximize profits, but that could leave them short on cash for claims. To stop this, state regulators enforce minimum liquidity levels—these are your statutory reserves, held in cash or securities that convert to cash quickly and reliably.
These reserves apply to products like life insurance, health insurance, property and casualty, long-term care, and annuities. Requirements differ by state and product type, so keep that in mind.
Statutory Reserves Methods
When setting statutory reserve levels, regulators use two basic approaches. First, there's the rules-based approach, where insurers follow standardized formulas and assumptions to determine how much of their premiums to reserve.
Then there's the principles-based approach, which gives insurers more flexibility. You can set reserves based on your own experience, like actuarial data and past claims from your customers, as long as they're at least as large as the rules-based minimum.
Important Notes on Reserves
If a company keeps reserves above the rules-based minimum, those extras are called non-statutory or voluntary reserves. No matter the method, these reserves mean insurers forgo some potential profits, but they strengthen the overall market by building customer confidence in the company's ability to handle tough economic times and back their policies.
Example of Statutory Reserves
Take XYZ Insurance as an example. Under its state's rules-based requirements, XYZ must keep $50 million in reserves. But after reviewing the competition and its portfolio's past performance, XYZ chose the principles-based approach and set reserves higher than the minimum.
This costs them in lost investment income, but XYZ sees it as a way to project responsibility and prepare for recessions or other economic issues.
