Conditional Reserves

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. Insurance companies calculate the amount of funds they need on hand to meet insurance claims filed by customers as part of their business; however, in order to cover any unexpected costs, insurance companies also maintain conditional reserves.

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.
  • State insurance commissioners and insurance guaranty associations require insurance companies to maintain certain levels of reserves, which cannot be used as regular assets.
  • Examples of conditional reserves include surpluses from unauthorized reinsurance, undeclared dividends to policyholders, and other reserves established voluntarily and in compliance with statutory regulations.
  • Conditional reserves are listed separately on financial reports to reinforce the need for liquidity.

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 guaranty 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.

Financial Reports and Ratios

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.

Insurance companies paid out $90 billion in 2020 in the U.S. That is a 15% increase from 2019, which is the highest year-over-year increase since 1918.

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.

Special Considerations

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 39. 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.

How Do Insurance Companies Calculate Reserves?

Typically, an insurance company calculates its reserves based on past history. If there is no history, an insurance company can calculate its reserves by calculating the expected loss ratio.

Are Reserves an Asset or a Liability?

Claim reserves at insurance companies are listed as a liability on the balance sheet. The reason is that they represent possible claims that may need to be paid out to customers.

What Is a Claims Reserve?

Claims reserves are money set aside by an insurance company to be used to pay for future claims that have been filed or expected to be filed by policyholders.

What Are Negative Reserves in Insurance?

A negative reserve refers to a life assurance contract where the value of the future premiums is higher than the value of the benefits to be paid out plus the expenses for a policyholder. For an insurance company, this type of contract is an asset.

Article Sources
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  1. Fortune. "Life Insurance Payouts See Highest Increase in Over 100 Years." Accessed Jan. 26, 2022.

  2. National Organization of Life & Health Insurance Guaranty Associations. "Impairments & Insolvencies." Accessed Jan. 26, 2022.

  3. DTOS. "Understanding the Global Credit Rating Industry." Accessed Jan. 26, 2022.

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