DEFINITION of 'Conditional Reserves'

Surplus reserves held by insurance companies that are treated as liabilities, and which can be drawn upon in order to cover claims. Conditional reserves are an important measure of a company’s ability to cover expenses.

BREAKING DOWN 'Conditional Reserves'

Insurers must be prepared to meet their obligations at all times. If an insurance company is unprepared by not having enough money set aside with acceptable liquidity it may result in it becoming impaired or insolvent. In order to guard against this possibility, state insurance commissioners and insurance guarantee associations may require insurance companies to maintain a certain level of reserves that it cannot use as it would a regular asset. A company’s conditional reserve is often listed separately in financial statements.

Conditional reserves are treated as liabilities to emphasize the need for liquidity, as insurance companies may need to use the conditional reserves to meet obligations in short order. They are set aside and are 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, and because tying them in to long-term investments makes them less liquid.

Investors and regulators use a variety of financial ratios to determine how well an insurance company is protected against the possibility of a rapid increase in claims. An insurance company’s net liabilities to policyholder surplus, which measures errors a company might make when estimating its liabilities, is calculated by subtracting conditional reserves from total liabilities. The higher this ratio the more a company relies upon its reserves to remain solvent. One test – the 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 policies that it is exposed to. 

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