What is Statutory Reserve?
Statutory Reserve is the amount of money, securities or assets that need to be set aside as a legal requirement by insurance companies and financial institutions to cover its claims or obligations which are due in the near future. This is a mandatory reserve since the Government does not want to take chances in case an insurance company fails to make payments for the insured peril.
This is a legal reserve that is required to be maintained in accordance with the standards that are set by the regulating body for the sector which may vary from country to country. The primary aim for maintaining a statutory reserve is for the organization to meet its obligations promised to its customers even if it is running into losses.
Types of Statutory Reserve
The amount of statutory reserve that needs to be maintained is calculated either by a rule-based approach or a principle-based approach.
#1 – Rule-Based Approach
- The rule-based approach focuses on the amount required to be maintained as a reserve on the basis of standardized formulas and assumptions.
- Calculation of statutory reserve depends on various factors as set out in the static formula which may not necessarily capture the risk involved.
- The rule-based approach is stringent and does not allow any levy to the organization, the amount that is set out after the calculation needs to be mandatorily maintained by the organization.
#2 – Principle-Based Approach
- The principle-based approach allows leeway to the organization in terms of maintaining the statutory reserve.
- The principle-based approach focuses on the risk that an organization is capable of taking. It takes into account, the experience of the organization and its ability to foresee and control or influence the risks that may arise in the future.
- The primary objective of maintaining a statutory reserve is fulfilled by providing protection to the customer’s investment and promoting the solvency of the companies.
Statutory Reserve Examples
- In the US, where the rule-based approach is used to calculate statutory reserves, the National Association of Insurance Commissioners (NAIC) plan to implement the principle-based approach for calculating statutory reserves.
- The Commissioner’s Reserve Valuation Method (CRVM) is the most commonly used method to calculate the statutory reserves in the Life insurance industry. This is the method prescribed by law for computing the statutory reserve which every insurance company has to adhere to, failing which the insurance company might attract legal actions and penalties.
- The size of a CRVM reserve as with most life reserves is affected by the age and sex of the insured person, the number of years the insurance has been computed, plan of insurance offered by the policy, the rate of interest that has been used in the calculation and the mortality table with which the actuarial present values are computed.
- The Commissioner’s Reserve Valuation Method was established by the Standard Valuation Law (SVL) which was created by the NAIC and adopted by the different States shortly after World War 2. The first mortality table prescribed by the SVL in 1941, Commissioner standard ordinary table.
- The maximum interest rate was 3.50%. Subsequent amendments to the SVL have permitted the use of more modern mortality tables and higher rates of interest. The effects of these changes have in general resulted in the reduction of the amount maintained in reserves.
- The primary advantage of maintaining a statutory reserve is that it enables one to make payments for the obligations or claims which are due in the near future even if the business is not making any profits.
- This acts as a boosting indicator for the investors. An organization with a well maintained statutory reserve depicts that the organization is doing well in terms of business and the process and gives confidence that the organization will continue to do the same, which lures more and more investors.
- It gives the customers confidence to invest in the products offered by the organization since they can rest assured that the payment they make will be recovered from the statutory reserve if an unforeseen event occurs.
- Maintaining statutory reserves requires conscious efforts by the organization which results in a shift of focus from profit-making to maintaining reserves to avoid legal penalties and actions.
- Results into reduced profit since the reserve have to be maintained even if the business is not performing well.
- It requires organizations to bifurcate between the assets that it owns which requires a lot of documentation and related costs.
- Insurance companies are required to maintain the statutory reserve as recommended by the governing body.
- Financial institutions including banks may also require maintaining reserves as set out on a federal level.
- The governing body or the State decides the amount of money or assets that an organization is required to maintain a statutory reserve.
- The assets or securities in the statutory reserve should those which are readily marketable which means these should be easy to fetch money in times of urgency.
- Funds, assets, and securities maintained in the statutory reserve cannot be used for any other business operations other than paying an obligation. It can only be liquidated when the organization does not have the required amount of money to perform its general obligations and operations.
- This is a mandatory reserve as advised by the governing body for the sector which is required to meet the organization’s obligations or claims to the customers if the organization is in the loss.
- A governing or regulating body decides and communicates the amount of statutory reserve that an organization is required to maintain.
- This amount varies from sector to sector and is usually a percentage of the outstanding obligations.
- An organization needs to be licensed by the State and the rules that are set by the same which includes maintaining the statutory reserve.
- This is the need to be maintained for a variety of products including property insurance, life insurance, and health insurance to name a few.
- All the businesses in the insurance industry are required to maintain the statutory reserve.
This has been a guide to What is Statutory Reserve and its Meaning. Here we discuss the statutory reserve types along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –