What Are Balance Sheet Reserves?
Balance sheet reserves, also known as claims reserves, are accounting entries that show money set aside to pay future obligations. Balance sheet reserves appear as liabilities on a company's balance sheet, one of the three main financial statements. Balance sheet reserves are particularly relevant in the insurance industry because companies must have sufficient funds to pay any claims filed by clients. There are set standards for setting up balance sheet reserves depending on the state where the company is based.
- Balance sheet reserves are liabilities that appear on the balance sheet.
- The reserves are funds set aside to pay future obligations.
- The balance sheet reserves of insurance companies are regulated so that these companies have sufficient reserves to pay client claims.
- Insurance companies will often set up balance sheet reserves that equal the value of claims filed but not yet paid.
Understanding Balance Sheet Reserves
Balance sheet reserves are entered as liabilities on the balance sheet and represent funds that are set aside to pay future obligations. For insurance companies, balance sheet reserves represent the amount of money insurance companies set aside for future insurance claims or claims that have been filed but not yet reported to the insurance company or settled. The levels of balance sheet reserves to be maintained are regulated by law. Balance sheet reserves are also known as claim reserves.
Balance sheet reserves are required of insurance companies by law to guarantee that an insurance company can pay any claims, losses, or benefits promised to claimants.
Types of Insurance Reserves
Property and casualty (P&C) insurers carry three types of reserves:
- Unearned premium reserves, the balance of the premium that has not yet been "earned" during the policy period.
- Loss and loss adjustment reserves or obligations that have been incurred from claims filed or soon to be filed;
- Incurred but not reported (IBNR) reserves, which are set aside for hard-to-estimate claims such as workers' compensation and product liabilities.
Example of Balance Sheet Reserves
As an example of balance sheet reserves for a company not in the insurance company, Company XYZ must recall one of its products and issue refunds to customers. Customer refund claims are expected to come in at a steady rate for the next six months. To cover the refunds, the company sets aside a balance sheet reserve of $15,000. As the customers requests arrive and the amounts are refunded, Company XYZ reduces the $15,000 reserve on the balance sheet accordingly.
Insurance companies will often set up balance sheet reserves that equal the value of the claims that have been filed but have not yet been distributed.
Balance Sheet Reserves and Profitability
The reserving policy of an insurer can significantly impact its profits. Over-reserving can result in an opportunity cost to the insurer as it there are less funds available for investments. Conversely, under-reserving can boost profitability as more funds are freed up to invest. Regulators, however, closely watch the reserving policies of insurance companies to make sure adequate reserves are set aside on the balance sheet.