Keeping the insurance industry afloat, and protecting the policyholders' interests, hinges on a crucial financial requirement - statutory reserves. These are funds that insurance companies must maintain at all times, enforced by the state insurance regulators. The statutory reserves ensure that insurance companies have enough liquidity not just to survive an economic downturn, but also to meet all the valid claims by their policyholders.
The McCarran-Ferguson Act of 1945 laid the foundation for this oversight, empowering states to regulate insurance companies. Therefore to operate, every insurer must abide by the state's insurance department regulations, which include maintaining a specified level of reserves to cover future claims.
Insurance companies collect premiums from customers and invest these funds for returns. While merging a large fraction of these premiums can elevate their ROI, it could also result in a cash shortage for paying customer claims. The statutory reserve system prevents this from happening by enforcing minimum liquidity levels that insurers must keep, either in cash or convertible securities.
The scope of statutory reserves spans across multiple insurance products, like health, life, property, casualty, long-term care insurance, and annuity contracts. The reserve requirements vary from one state to the other and also according to the type of insurance.
To establish the statutory reserves, insurance regulators use either the rules-based or the principles-based approach. The former mandates a certain amount of premiums be kept as reserves based on standardized assumptions and formulas. The latter, however, gives insurers the liberty to calculate reserves based on their own experiences, like past claims behavior, as long as they are as large as or larger than amounts under the rules-based approach.
Some insurance companies may retain reserves exceeding the minimum under the rules-based approach, known as non-statutory or voluntary reserves.
Although maintaining statutory reserves might mean missed profiting opportunities for insurance companies, it infuses confidence among insurance customers about the insurer’s financial strength even under challenging economic environments.
Consider the case of XYZ Insurance, which, according to its state regulation, is required to maintain a reserve of $50 million. However, after analyzing its competitive space and previous performance, XYZ decided to use the principles-based and set reserves higher than required. While these extra reserves might reduce its investment income, XYZ intends to portray an image of a prudent insurer, aptly equipped to navigate recession and economic turbulence.