Statutory reserves are state regulated reserve requirements. Insurance companies must hold a portion of their assets as either cash or marketable investments. Statutory reserves are the amount of liquid assets that firms must hold to remain solvent and attain partial protection against a substantial investment loss, and holding reserves reduces the risk of insurance.
Statutory reserves lead insurance companies to lose some potential profits as they are unable to invest these funds into mutual funds or other forms of high-yield investment. However, holding reserves increases investor confidence that the company will be able to fulfill its commitment in a bear market. Some insurance companies hold additional capital, called voluntary reserves.
A statutory reserve is a minimum amount certain institutions, such as financial institutions and insurers, must maintain as liquid funds. The purpose of the reserve is to prevent an insurer from becoming insolvent. It is considered statutory because the amount required is dictated by certain laws and regulations governing the actions of the associated industry.
The statutory reserve is in place to avoid an organization becoming insolvent in the event of extreme circumstances, specifically those pertaining to deposit accounts. For example, a financial institution must have a minimum percentage of all deposit accounts available as cash. This provides a reasonable amount of certainty that, should a large number of account holders attempt to withdraw funds simultaneously, the financial institution will be capable of providing those funds as requested.
With regard to insurers, the statutory reserve requires that a certain amount of their funds be liquid to provide payments to those they insure, especially during a larger scale event. An example of a high-demand insurance event may include a natural disaster impacting a large number of homeowners. The reserve funds are available to payout to those affected by the event without any additional transactions being required. Should an insurer be able to invest those funds instead of being required to maintain them as a reserve, there could be significant difficulty in paying out a large number of claims happening at the same time.
Brokerage firms are not required to hold reserves as other deposit-based financial institutions. This is mainly because the brokerage is paid through transaction fees and not through interest on financial holdings. While a brokerage may facilitate a transaction, it is not technically in possession of investor’s funds directly.