an amount put aside by an insurer to cover future claims on a policy.
Policy Reserve Details
A life insurance company must, by law, establish a reserve fund to be able to settle future claims. When a client takes out an insurance policy, she is entering into a contract with the company, which guarantees her a payment if she meets the policy terms. In exchange, the client agrees to pay a monthly premium. Many insurance companies will publish the amount they hold in reserve to assure clients that they have sufficient funds to cover future claims.
This reserve amount is listed as a liability rather than an asset in a company's accounts because it owes its reserve to the policies' beneficiaries. The insurance company cannot draw upon the policy reserve to cover current expenses.
A person who takes out a life insurance policy, for example, will pay premiums every month. This premium will differ from person to person, depending on the risk that the policyholder represents to the company: a forty-year-old smoker will pay a higher premium than a healthy twenty-five-year-old. Some of the money paid in premiums will go to building up the insurer's reserves. Typically, insurance companies place around ten percent of their revenues in the reserve fund.
Policy Reserve Example
Margaret has decided to take out a term life insurance policy which will cover her for twenty years. The advantage of this type of policy is that the premiums are considerably cheaper than they would be for permanent insurance. Margaret is twenty-five and has two small children. She decides to take out a policy for ten years to pay her beneficiaries $250,000 should she die within that time. The monthly premium is a very reasonable $20.
Margaret knows little about the workings of insurance companies and doesn't know anything about the company that she is using, but a friend had advised her to check on the insurance company's financial stability. Governments and independent agencies regulate and assess insurance companies. One of the main things that an independent rating agency will look at is the insurance company's policy reserve strength. The better insurance companies will be careful about maintaining their policy reserve at a prudent level and able to cover reasonable demands on the reserve and payout when a policy falls due.
Margaret, young and healthy, is an ideal client as far as the insurance company is concerned. There is every chance that she will live a long life, and her children will not claim the $250,000. Her insurance company dedicates ten percent of her premium to its reserve fund, which increases the sum available to settle future payments of policies. However, insurance is always a gamble; no company can ever fully guarantee it holds sufficient funds in policy reserve to cover every future possibility, but state guaranty funds cover insurance company bankruptcy.
Cash Value vs. Policy Reserve
The cash value of a policy increases as clients pay more premiums. This amount will eventually belong to the policy owner, but the insurance company can use it whilst the insurance company holds it. This amount is considered an asset in the insurance company's accounts.
The insurance company cannot use a policy reserve. The company is legally obliged to maintain this reserve, and as such, the reserve is considered a liability.