Corporate Finance & Accounting

Valuation Reserve

What is a valuation reserve?

Valuation reserves are assets that insurance companies set aside under state law to mitigate the risk of a decline in the value of investments they hold. They act as portfolio hedges and ensure that insurance companies remain solvent.

Since policies such as life insurance, health insurance, and various annuities may be in effect for an extended period of time, a valuation provision protects insurers from losses on investments that may not perform as expected. This helps ensure that policyholders get claims and that annuity holders receive income even if the insurer’s assets depreciate.

key takeaways

  • Valuation reserves are funds set aside by insurance companies to hedge against a decline in the value of their assets.
  • Valuation reserves are mandatory under state law to protect against natural fluctuations in the value of an investment.
  • Valuation reserves are calculated using asset valuation reserves and interest maintenance reserves to differentiate equity valuations from interest gains and losses.
  • Regulators are increasingly looking at risk-based capital requirements, such as valuation reserves, as a more prudent way to ensure solvency.
  • To ensure that an insurance company remains solvent to pay insurance claims and annuities, it must maintain a certain amount of valuation reserves.

Understanding Valuation Reserves

Insurance companies charge premiums for the services they provide. In return, when a customer makes an insurance claim that needs to be paid, the insurer must ensure that it has the funds on hand to meet this requirement.

The same applies to any annuity issued by an insurance company. It must ensure that it can meet the regular payments of the annuity. For these reasons, it is critical for insurers to monitor their reserves and investments to remain solvent. Valuation reserves help insurers do just that.

Valuation reserves ensure that insurance companies have sufficient assets to cover any risks arising from their underwriting contracts. Regulators have focused on using risk-based capital requirements to measure an insurer’s level of solvency, a view that separates a company’s assets from its obligations rather than lumps them together.

History of Valuation Reserves

Valuation reserve requirements have changed over the years. Prior to 1992, the American Association of Insurance Commissioners required the establishment of a mandatory securities valuation reserve to prevent a decline in the value of securities held by insurance companies.

However, after 1992, the mandatory securities valuation reserve requirement was changed to include an asset valuation reserve and an interest maintenance reserve. This reflects the nature of the insurance business, with companies and customers holding different asset classes buying more annuity-related products.

Changes to valuation reserve requirements

Life insurance companies are obligated to pay beneficiaries who purchase insurance and annuities. These companies need to hold an appropriate level of asset reserves to ensure they can meet these obligations over the years the policy is likely to be in effect.

Various state laws and standards require this level to be calculated on an actuarial basis. This approach takes into account expected claims from policyholders, as well as projections of future premiums the company will receive and how much interest the company can expect to earn.

However, the market for insurance and annuity products was changing throughout the 1980s. American Life Insurance reported that in 1980, life insurance accounted for 51% of the reserves held by the company, compared with just 8% for individual annuities. Then, by 1990, life insurance reserves fell to 29% of all reserves, while the percentage of individual annuity holdings climbed to 23%.This reflects the growing popularity of retirement plans managed by insurance companies.

A changing interest rate environment can create risks that have a greater impact on the reserves required for ongoing annuity payments than for a one-time payment of life insurance benefits. By proposing a change in regulations to separate asset valuation reserves from interest maintenance reserves, the National Association of Insurance Commissioners recognizes the need to protect against fluctuations in the value of equity and credit-related capital gains and losses in a different way than interest-related gains and losses.

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