Loss Reserves What They Are and Examples

Loss Reserves: What They Are and Examples
What Is a Loss Reserve?

A loss reserve is an estimate of an insurer’s liability from future claims. It allows an insurer to cover claims made against insurance policies it underwrites. Insurers must consider the contract duration, type of insurance offered, and likelihood and timing of claims. Reserves must be adjusted as circumstances change.

Key Takeaways

• A loss reserve is an estimate of future insurance claims.
• Calculating loss reserves is difficult, involving guesswork on when and how many claims will be made.
• Regulations require nominal value reporting of loss reserves, while insurers prefer discounted present value.
• Estimating the correct loss reserve is crucial for an insurer’s profitability and solvency.
• Loss reserves for the banking industry are known as loan loss provisions.

Understanding a Loss Reserve

When an insurer underwrites a policy, it records a premium receivable (an asset) and a claim obligation (a liability). The liability is part of the unpaid losses account, representing the loss reserve.

Accounting for loss reserves is complex because losses can occur at any time. For example, a legal settlement may involve a lengthy court battle that drains funds over years. Adequate reserves put an insurer in a better position to pay claims and fund legal battles.

Calculating a Loss Reserve

Accurate loss reserve estimation is crucial for profitability and solvency. Conservative calculations allocate too much to the reserve, reducing income and investment ability. Liberal calculations result in booking losses and possible insolvency. Insurers prefer present value calculations, discounting future claim payments and considering interest earned. However, regulations require claims to be recorded at actual value, resulting in higher reported liabilities.

Other Impacts of Loss Reserves

Loss reserves affect an insurer’s tax liabilities. Regulators determine taxable income by summing annual premiums and subtracting increases in loss reserves. Incorporating loss reserves into financial statements can be used for income smoothing. Examining changes to loss reserve errors relative to past investment income indicates if an insurer is using them for this purpose.

Loss Reserves and Loans

Lending institutions use loss reserves, known as loan loss provisions in the banking industry, to manage their books similarly to insurance companies. For example, Bank ABC estimates that 2% of its loans, $200,000, will likely not be repaid and records this as a negative asset in its balance sheet. Writing off a loan removes it from the asset balance and deducts the amount from the loan loss reserve, which may be tax-deductible.