What is the loss reserve
The loss reserve is an estimate of an insurer’s liability for future claims. Generally made up of liquid assets, loss reserves allow an insurer to cover claims made against the policies it subscribes. Estimating liabilities can be a complex undertaking. Insurers must take into account the duration of the insurance contract, the type of insurance offered and the chances of settling a claim quickly. Insurers should adjust their claims reserve calculations as circumstances change.
When an insurer signs a new policy, it registers a premium receivable (which is an asset) and a settlement obligation (which is a liability). The liability is considered to be part of the account for unpaid losses, which represents the reserve for losses.
DISTRIBUTE the loss reserve
Accounting for loss reserves involves complex calculations because losses can occur at any time, including years later. For example, a final settlement of a litigation with a claimant may require a court battle of several years.
Insurers prefer to use the present value when calculating claims because this allows them to take interest into account. However, regulators require that claims be recorded at the true value of the loss – its nominal value. The undiscounted loss reserve will be greater than the discounted loss reserve. This regulatory requirement results in an increase in reported liabilities.
Regulators determine an insurer’s taxable income by taking the sum of annual premiums by subtracting any increase in claims reserves. This calculation is called a loss reserve deduction. Income, which is the insurer’s underwriting income, includes the loss allowance, plus investment income.
Insurance companies can use the loss reserve for income smoothing. The complaints process can be complex; To determine whether an insurer is using loss reserves to smooth income, it is necessary to examine the changes in the insurer’s loss reserve errors from previous investment income.
Reserves for losses and loans
Credit institutions also use loss reserves to manage their books.
Take, for example, ABC Bank, which has granted $ 10,000,000 in loans to various businesses and individuals. Although ABC Bank is working very hard to qualify the people to whom it makes loans, some will inevitably default or fall behind, and some loans will have to be renegotiated.
Bank ABC understands these realities and estimates that 2% of its loans, or $ 200,000, will probably never be repaid. This estimate of $ 200,000 constitutes the ABC loan loss reserve and records this reserve as a negative number on the assets side of its balance sheet.
If ABC Bank decides to write off all or part of a loan, it will withdraw the loan from its asset balance and also remove the amount of the write off from the loan loss reserve. The amount deducted from the loan loss reserve may be tax deductible for ABC Bank.