Valuation Reserve What It is How It Works

Valuation Reserve: What It is, How It Works

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 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, valuation reserves protect insurance companies from losses from investments that may not perform as expected. This helps ensure that policyholders are paid for claims and annuity holders receive income even if an insurance company’s assets lose value.

Key Takeaways

• 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 fluctuations in investment value.
• 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, to ensure solvency.
• To maintain solvency, an insurance company 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 or needs an annuity payment, the company must ensure it has sufficient funds to honor these requests.

The same applies to annuities. An insurance company must ensure it can make regular annuity payments. For these reasons, it is critical for insurance companies to monitor their reserves and investments to remain solvent. Valuation reserves help insurance companies do this.

Valuation reserves ensure that an insurance company holds enough assets to cover any risks that arise from the contracts it has underwritten. Regulators focus on using risk-based capital requirements to measure insurance company solvency, comparing assets to obligations separately instead of assets versus liabilities combined.

History of Valuation Reserves

Valuation reserve requirements have changed over the years. Before 1992, the National Association of Insurance Commissioners required a mandatory securities valuation reserve to protect against declines in the value of securities held by insurance companies.

After 1992, 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

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 meet these obligations over many years.

State laws and standards require this level to be calculated on an actuarial basis, taking into account expected claims, future premiums, and interest earnings.

The market for insurance and annuity products has shifted over time. In the 1980s, life insurance represented a larger portion of reserves held by companies compared to individual annuities. However, by 1990, reserves for life insurance decreased while reserves for individual annuities increased. This reflected the growing popularity of retirement plans administered by insurance companies.

Changing interest rates can impact reserves needed for ongoing annuity payments more than for life insurance benefits. To address this, the National Association of Insurance Commissioners recommended separating asset valuation reserves from interest maintenance reserves. This recognizes the need to protect against fluctuations in equity and credit-related gains and losses separately from interest-related gains and losses.