What is Equalization Reserve
Equalization reserve is a long-term reserve that an insurance company keeps to prevent cash-flow depletion in case of significant unforeseen catastrophe.
BREAKING DOWN Equalization Reserve
A disastrous event such as a flood, earthquake, or fire can result in the severe depletion of an insurance company's equalization reserve. These reserves could be seen as the company's personal "rainy day fund," compensating for unforeseen and often expensive events. For example, a massive storm hits an area where an insurer has insured a number of properties; the large number of losses requires the firm to access its equalization reserve. Flooding, fires, and tornadoes may cause similarly large losses.
Rules Governing Equalization Reserves in the UK
Full details on the rules governing equalization reserves for British insurance companies are included in the Insurance Companies (Reserves) Regulations 1996. This is a summary of the main points governing non-credit insurance reserves:
- A company should operate two separate equalization reserves, one for credit insurance business and one for all of the other types of business. In each case, at the end of each financial year, a company calculates the amount of any transfer to be made into the reserve, and separately determines the amount of any transfer out of the reserve. In addition, there is an overriding calculation to ensure that at the end of the financial year, the equalization reserve is not greater than its maximum permitted value. For other than credit insurance business, there are five categories of business for which equalization reserves are required:
- Business Group A: Property damage including corresponding proportional reinsurance treaty business
- Business Group Β: Direct, facultative and proportional treaty consequential loss risks
- Business Group C: Marine and aviation business, including corresponding reinsurance treaty business
- Business Group D: Nuclear risks
- Business Group Ε: Non-proportional reinsurance treaty business categories corresponding to business in accounting class 6 (property damage) and non-proportional reinsurance treaty consequential loss risks
- Transfers into the reserve should represent a percentage of net written premium as detailed in the following schedule:
- Business Group A: 3 percent
- Business Group Β: 3 percent
- Business Group C: 6 percent
- Business Group D: 75 percent
- Business Group Ε: 11 percent
- Transfers out of the reserve should be the amount to cover any "abnormal loss". This amount is determined according to separate rules depending on whether the business is accounted for on an accident year basis or on an underwriting year basis. In principle, the abnormal loss is the excess of incurred claims (net of reinsurance and other recoveries, excluding claims management costs but including direct claims handling costs) over the percentages of net (of reinsurance) premiums shown below. Strict definitions are different for the accident and underwriting year accounting bases. Those amounts are calculated separately for these two bases and then aggregated for each business group, and this aggregate amount is transferred, subject to the business group maximum. For the accident year accounting basis, net premiums earned are used, whereas for the underwriting year basis, net premiums written are used.