What Is a Valuation Reserve?
Valuation reserves are assets that insurance companies set aside per state law to mitigate the risk of declines in the value of investments they hold. They function as a hedge to an investment portfolio and ensure that an insurance company remains solvent.
Because policies such as life insurance, health insurance, and various annuities may be in effect for extended periods of time, valuation reserves protect the insurance company from losses from investments that may not perform as expected. This helps ensure that the policyholders are paid for claims and that annuity holders receive income even if an insurance company’s assets lose value.
- A valuation reserve is money set aside by an insurance company to hedge against a decrease in the value of its assets.
- Valuation reserves are mandatory under state law to protect against the natural fluctuations in the value of investments.
- Valuation reserves are calculated using an asset valuation reserve and an interest maintenance reserve to separate valuations in equity versus interest gains and losses.
- Regulators are increasingly looking at risk-based capital requirements, such as valuation reserves, as a more prudent way to ensure solvency.
- To make sure that an insurance company remains solvent so that it can pay insurance claims and annuities, it must maintain a certain amount of valuation reserves.
Understanding a Valuation Reserve
Insurance companies receive premiums for the services they provide. When a client files an insurance claim that needs to be paid out, an insurance company must ensure that it has money on hand to do so. The same is with any annuities that an insurance company issues. It must ensure that it can meet the regular payments of an annuity. For these reasons it is critical for an insurance company to monitor its reserves and investments so that it remains solvent. Valuation reserves help insurance companies do this.
Valuation reserves make sure that an insurance company holds enough assets to cover any risks that arise from the contracts it has underwritten. Regulators are focused on using risk-based capital requirements to measure the solvency levels of insurance companies, which is a view of a company's assets versus its obligations separately rather than its assets versus its liabilities together.
History of Valuation Reserves
Valuation reserve requirements have changed over the years. Before 1992, a mandatory securities valuation reserve was required by the National Association of Insurance Commissioners to protect against a decline in the value of the securities an insurance company holds.
After 1992, however, the mandatory securities valuation reserve requirements were changed to include an asset valuation reserve and an interest maintenance reserve. This reflected the nature of the insurance business, with companies holding different categories of assets and customers purchasing more annuity-related products.
Changing Valuation Reserve Requirements in a Shifting Market
Life insurance companies have the obligation to pay beneficiaries that purchase insurance and annuities. These companies need to hold an appropriate level of assets in reserve to make sure they can meet these obligations over many years that the policies may be in effect.
Various state laws and standards require that this level be calculated on an actuarial basis. This approach accounts for expected claims among policyholders, plus forecasts on future premiums that the company will receive and how much interest a company can expect to earn.
Yet the market for insurance and annuity products had been shifting in the 1980s. The American Council of Life Insurers reported that in 1980, life insurance represented 51% of reserves held by companies while reserves held for individual annuities accounted for only 8%. But by 1990, reserves for life insurance fell to 29% of all reserves while the percentage held for individual annuities climbed up to 23%. This reflected the growth in the popularity of retirement plans that were administered by insurance companies.
A changing interest rate climate can create risk that impacts reserves needed for ongoing annuity payments more than for life insurance benefits that are paid in one lump sum. By recommending changing regulations to separate asset valuation reserves from interest maintenance reserves, the National Association of Insurance Commissioners recognized the need to protect against fluctuations in the value of equity and credit-related capital gains and losses differently than interest-related gains and losses.