An asset valuation reserve is capital required to be set aside to cover a company against unexpected debt. The asset valuation reserve serves as a backup for equity and credit losses. A reserve will have capital gains or losses credited or debited against the reserve account.
Breaking Down Asset Valuation Reserve (AVR)
Usually, the asset reserve consists of two components, a default component, and an equity component. The default component protects future credit-related losses and includes arrangements for corporate debt securities, preferred stock, mortgage-backed securities, farm, commercial and residential mortgages. For example, the National Association of Insurance Commissioners (NAIC) requires domestic insurers to maintain an asset valuation reserve to cover policyholder claims in the event of financial issues at the insurer. The NAIC also mandates a liability reserve be kept to cover claims in real estate and mortgages. The equity component has provisions for common stocks and real estate.
Why Asset Valuation Reserve Is Required
The intent for an asset valuation reserve is to function as failsafe or safety net of capital that can be accessed in the event of credit or equity losses that might adversely affect an organization’s ability to meet and fulfill its obligations. This can include covering invested assets such as bonds and stocks. Actuarial calculations are used to find the amount of asset valuation reserve is necessitated to cover different assets. This might also be done by making estimates of future losses the company believes it will be exposed to. Credit and equity capital gains and losses, whether realized or unrealized, are factored as debits or credits towards such a reserve.
Contributions are typically made at least annually toward an asset valuation reserve. There is a certain amount of risk when a company acquires an asset; the cash flow expected from the asset could miss its anticipated targets. There might be an overall change in the value of an asset, such as depreciation or the effects of bad debt. To build up the asset valuation reserve, a company’s earnings may see a recurring charge applied to be put toward such an allowance.
The asset reserve is meant to mitigate the fallout of such potential risks along the lines of other types of reserves. As an asset valuation reserve is amassed, especially among insurance companies, it typically reduces outstanding cash surpluses that might otherwise be put towards paying excess dividends or slip into other areas of potential risk.