What Is an Equalization Reserve?

An equalization reserve is a long-term reserve that an insurance company keeps to prevent cash-flow depletion in case of significant unforeseen catastrophes. 

How Equalization Reserves Work

A disastrous eventsuch as a flood, earthquake or firecan result in the severe depletion of an insurance company's equalization reserves. These reserves can be seen as the insurer's "rainy day fund," covering unforeseen and often expensive events. For example, a massive storm hits an area where an insurer has insured several properties. The equalization reserve would allow the insurer to cover the resulting large losses. Flooding, fires, and tornadoes may cause similarly large losses.

Key Takeaways

  • An equalization reserve is a reserve maintained by an insurance company to prevent cash depletion due to catastrophic events, such as floods, tornadoes, and fires.
  • In the United Kingdom, insurers must adhere to specific rules, such as how much reserves should be maintained and how much can be transferred in and out of reserves.
  • The Insurance Companies (Reserves) Regulations of 1996 details the rules governing equalization reserves for British insurance companies.

Equalization Reserves in the UK

The Insurance Companies (Reserves) Regulations 1996 contains full details on the rules governing equalization reserves for British insurance companies. Below 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. Also, 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 premiums 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 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.

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.