What Are Statutory Reserves? Definition and Explanation

Statutory Reserves

What Exactly Are Statutory Reserves?
Statutory reserves are money that state insurance regulators require insurance companies doing business in their state to keep on hand at all times. The purpose of statutory reserves is to enable insurance firms to ensure that they have enough liquidity to satisfy all genuine claims filed by their policyholders.
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What Are Statutory Reserves Definition and Explanation

Statutory Reserves Explained

Congress passed the McCarran-Ferguson Act in 1945, granting states the right to regulate insurance businesses. Each insurer must be licensed by the state's insurance department and follow its standards in order to do business in that state. 

Among these restrictions is the amount of money that an insurer must hold in reserve to ensure that it can pay future claims.

Insurance firms collect premiums from consumers and then invest those premiums in their general account to produce a return on investment (ROI). 

In theory, insurers may be motivated to invest a substantial portion of their premiums in order to maximize their return. However, doing so may leave them with inadequate cash on hand to meet their clients' demands.

To avoid this from happening, state insurance regulators require insurance companies to maintain certain levels of liquidity. 

These mandatory reserves can be retained in either cash or readily marketable securities that can be converted into cash reliably and quickly.

Statutory reserves are applicable to a variety of insurance products, including life insurance, health insurance, property and casualty insurance, long-term care insurance, and annuities. The criteria differ depending on the state and the type of insurance product.

Methods for Statutory Reserves

State insurance regulators utilize one of two procedures when determining the size of required reserves.

Approach Based on Rules

The first is a rules-based system, in which insurers are advised how much of their premiums must be held in reserve using defined calculations and assumptions.

Approach Based on Principles

The second technique, known as the principles-based approach, allows insurers more freedom in determining reserve levels. It specifically allows them to create reserves based on their own experience, such as actuarial statistics and prior claims behavior of their own customers, as long as they are equal to or greater than the rules-based approach's reserves.

Non-statutory or voluntary reserves are reserves that an insurance firm decides to hold in excess of the minimum amount necessary under the rules-based approach.

Statutory reserves, regardless of the method used to calculate them, will generally lead insurance businesses to lose some potential earnings. They do, however, improve the insurance markets as a whole by increasing insurance customers' confidence that their insurers will be able to endure severe economic conditions and stand behind their policies.

Statutory Reserves in Action

Take the example of ABC Insurance. According to its state insurance regulator's statutory reserve requirements, ABC would be required to hold $50 million in reserve under the rules-based approach.

ABC, on the other hand, elected to employ the principles-based approach and set its statutory reserves beyond the minimum required level after examining the competitive landscape in its state and reviewing the past performance of its insurance portfolio.

Although the higher reserves would most certainly result in lost investment revenue, ABC reasoned that this more conservative approach would reinforce its image as a responsible insurer and position it well to manage any prospective recession or other economic difficulties.

In the banking context, what is the distinction between Regulatory reserves and Statutory reserves?

Mandatory reserves are those required by applicable regulatory rules and are decided by the institution in charge of financial or banking system oversight. 

Statutory reserves, on the other hand, maybe reserve established solely for the purposes of a specific commercial bank. However, particular, required, statutory, and other reserves issues in each country may be clarified by national financial system supervision.

Individual commercial banks can increase their holding reserve levels over the required mandatory and purpose reserves. 

However, they do not significantly increase above these levels because a correspondingly larger portion of the financial capital that could be used for grants, for example, loans are excluded from the credit activity, the loan is smaller, the proceeds from the sale of loans are also lower, and as a result, the bank may lose in the market game against other banks, becoming less competitive.

However, in the event of an economic downturn and worsening of loan repayments and loan portfolio quality, a bank with a lesser amount of funds maintained in reserves may lose liquidity, increasing the risk of insolvency.
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