What is Loss Reserve
Loss reserve is an estimate of an insurer’s liability from future claims. Typically comprised of liquid assets, loss reserves allow an insurer to cover claims made against policies that it underwrites. Estimating liabilities can be a complex undertaking. Insurers must take into account the duration of the insurance contract, the type of insurance offered and the odds of a claim being resolved quickly. Insurers have to adjust their loss reserve calculations as circumstances change.
When an insurer underwrites a new policy, it records a premium receivable (which is an asset) and a claim obligation (which is a liability). The liability is considered part of the unpaid losses account, which represents the loss reserve.
BREAKING DOWN Loss Reserve
Accounting for loss reserves involves complex calculations because losses can come at any time, including years down the road. For example, a final settlement of litigation with a claimant may require a multi-year court battle.
Insurers prefer to use present value when calculating claims since it allows them to consider interest. However, regulators require claims to be recorded at the actual value of the loss – its nominal value. The undiscounted loss reserve will be greater than the discounted loss reserve. This regulatory requirement results in higher reported liabilities.
Regulators determine an insurer’s taxable income by taking the sum of annual premiums subtracting any increases in loss reserves. This calculation is called a loss reserve deduction. Income, which is the insurer’s underwriting income, includes the loss reserve deduction, plus investment income.
Insurance companies may use loss reserve for income smoothing. The claims process can be complex; determining whether an insurer is using loss reserves to smooth income requires examining changes to the insurer’s loss reserve errors, relative to past investment income.
Loss Reserves and Loans
Lending institutions also use loss reserves to manage their books.
For example, consider Bank ABC that made $10,000,000 of loans to various companies and individuals. Though Bank ABC works very hard to qualify the people to whom it grants loans, some will inevitably default or fall behind, and some loans will have to be renegotiated.
Bank ABC understand these realities and, thus, estimates that 2 percent of its loans, or $200,000, will probably never be paid back. This $200,000 estimate is Bank ABC's loan loss reserve, and it records this reserve as a negative number on the asset portion of its balance sheet.
If Bank ABC decides to write all or a portion of a loan off, it will remove the loan from its asset balance and also remove the amount of the write-off from the loan loss reserve. The amount deducted from the loan loss reserve may be tax-deductible for Bank ABC.