What Are Conditional Reserves?

Conditional reserves are held by insurance companies to meet obligations in short order and are an important measure of a company’s ability to cover expenses.

Key Takeaways

  • Conditional reserves are held by insurance companies to meet obligations in short order and are an important measure of a company’s ability to cover expenses.
  • Conditional reserves can be thought of as a rainy-day fund for insurance companies to help cover unanticipated expenses during times of financial stress.
  • Examples of conditional reserves include surpluses from unauthorized reinsurance, undeclared dividends to policyholders, and other reserves established voluntarily and in compliance with statutory regulations.

How Conditional Reserves Work

Conditional reserves can be thought of as a rainy-day fund for insurance companies to help cover unanticipated expenses during times of financial stress. Insurers must be prepared to meet their obligations at all times and if an insurance company is unprepared by not having enough money set aside with acceptable liquidity, it may result in the company becoming insolvent.

To guard against this possibility, state insurance commissioners and insurance guarantee associations require insurance companies to maintain certain levels of reserves, which cannot be used as regular assets, and furthermore to list conditional reserves separately in their financial reports.

Conditional reserves are listed separately on financial reports to reinforce the need for liquidity, as insurance companies may need to use the reserves to meet unanticipated future obligations. They are set aside and not used in investments with long durations or greater risk because their existence is an indicator that the insurance company is less likely to become impaired or insolvent.

Examples of conditional reserves include surpluses from unauthorized reinsurance, undeclared dividends to policyholders, and other reserves established voluntarily and in compliance with statutory regulations.

Regulators rely on many financial ratios to determine how well an insurance company is protected against the possibility of a rapid increase in claims. Conditional reserves are subtracted from total liabilities and compared to any policy surpluses as one example of a common ratio. Any company that relies too much on its reserves as calculated by this ratio may be inspected more closely. A liquidity test compares a company’s cash and securities to its net liabilities. 

Analysts review changes to a company’s conditional reserves over time, especially in relation to the liabilities associated with the current roster of policies and their associated risks.

The Role of Rating Agencies

In the U.S. alone there were over 640 insurance company insolvencies during the 30-year period from 1969 through 1998. According to the National Organization of Life & Health Insurance Guaranty Associations, in the 20-year period starting in 2000, the number of insurance company bankruptcies has decreased in volume, totaling 38. A company becomes insolvent when its capital is eroded to the point that the company cannot cover its insurance liabilities.

Insurer Financial Strength Ratings (IFSR) is a benchmark representing the various rating agencies' current opinion of the financial security of a particular insurance company. The Big Three rating agencies provide over 95% of all ratings and consist of Moody’s Investor Services, Standard & Poor’s, and Fitch Ratings.