DEFINITION of 'Loss Reserve'

An estimate of an insurer’s liability from future claims. Loss reserves allow the insurer to cover claims made against policies that it underwrites, and are typically comprised of liquid assets. 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 that a claim will be 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 can involve complex calculations. This is because losses can come in at any time, including years down the road. For example, an insurer may enter into litigation with a claimant, and the final settlement may occur after a lengthy court battle.

Insurers would prefer to use present value when calculating claims, since this allows them to take the interest into account. However, regulators require that claims 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 reporting higher levels of liabilities.

Regulators determine an insurer’s taxable income by adding up the premiums that the insurer earns during the year, and then subtracting any increases in loss reserves. Subtracting out increases in loss reserves is called the loss reserve deduction. Income, which is the insurer’s underwriting income, includes the loss reserve deduction, plus its investment income.

Insurance companies may use the loss reserve as a tool for income smoothing. This tool exists because the claims process can be complex. Determining whether an insurer is using loss reserves to smooth income requires the examination of changes to the insurer’s loss reserve errors relative to past investment income.

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