Understanding the accounting for insurance loss reserves is essential for insurance professionals to understand the company’s financial statements and financial health. In this blog post, you have a basic overview of how insurance companies estimate their loss reserves based on past and future losses, how they are presented on the balance sheet, and why they are essential.
What is a loss reserve?
A loss reserve is a government-regulated estimate of an insurer’s expected liabilities on current and future claims. It is key to helping insurers operate at healthy profit margins. Loss reserves are typically composed of liquid assets and held in cash or another easily accessible financial instrument. They allow an insurer to cover claims made against its underwrites insurance policies. Insurers have to adjust their loss reserve calculations as circumstances change; for example, a share that takes longer than anticipated to resolve will increase the amount held in reserves.
The amount of the loss reserve is determined by an insurance company actuary.
The amount of a loss reserve is determined by an actuary, who is a person that studies risk and uncertainty. Actuaries use statistical methods to estimate future losses. In addition to the experience of an insurance company, current conditions are considered as well as future expectations (e.g., weather patterns). An actuary may make probability statements using such terms as “likely,” “unlikely,” or “probable.”
Loss reserves are best estimates based on experience and probable future events.
Loss reserves are best estimates based on experience and probable future events. They’re determined by an actuary, who will analyze historical data to help make their projections.
Loss reserves represent a future liability for the insurance company. These liabilities are used to determine earned premiums (the amount of money the insurer has made from policyholders).
Insurance loss reserves are a future liability for a company.
The accounting for insurance loss reserves is very similar to the accounting for any other future liability. A non-contingent liability is a debt that is certain to be paid, whereas a contingent liability may or may not exist in the future. For example, if you borrow money from your bank and promise to pay it back whether you use it or not, this would be considered a non-contingent liability because you are 100% certain that you will have to pay the bank back with interest in the future. If instead of borrowing money from your bank, they set up an automatic payment system where they take money directly out of your account every month without asking first and then send it on its way. That’s called a contingent liability because there is no guarantee that these payments will continue into perpetuity (or even beyond this month).
The same concept applies when dealing with insurance companies: An insurance loss reserve represents an estimated amount needed by an insurance company before having enough evidence to determine whether or not they will have payouts related to their policies (for example car accidents).
Most insurance companies will hold unearned premium reserves, too.
The same concept applies to unearned premium reserves. Unearned premium is the amount expected to be collected from insureds in the future but has not yet been received. For example, if you purchased a policy for $10,000 and paid your first premium of $1,000 today—the remaining $9,000 will be due in six months (remember: another payment date may be specified).
Unearned Premium Reserve: A liability for the insurance company
Because it’s money they don’t have yet—which they won’t get until after their policyholders make their following payments—an unearned premium adds up to future liability for an insurance company. When calculating their liabilities on balance sheets and profit & loss statements, most companies include this estimated value under “unearned premiums.” This number gets subtracted from total premiums earned in an accounting period, making it appear that the company received all monies. However, this does not affect actual cash flow because any funds collected later go directly into a separate account called “unapplied premiums” until true claims are made against them.
Loss reserves are used to determine earned premiums, too.
Loss reserves are used to determine earned premiums, too.
Earned premiums are the premiums that have been earned but not yet collected. They’re an estimate of future earnings from policies in force. The premium is the amount paid by policyholders for insurance coverage, and it’s often referred to as “admitted assets” because it represents assets that an insurer owns. The reserve is a provision set aside against future losses. If a claim is paid out, the insurer will subtract its reserve from its gross written premium before calculating the net written premium.
An insurance carrier must estimate future losses to set up its loss reserves.
An insurance carrier must estimate future losses to set up its loss reserves. The actuary uses historical data and analysis of probable future events to determine how much should be set aside for future claims. The carrier uses these estimates to set policy premiums that cover losses and expenses.
The sum of all a company’s loss reserves is referred to as its liabilities or capital surplus. An insurer usually invests this money until it needs it for claims payments, at which point it becomes income available for distribution as dividends or retained earnings.
In sum, a loss reserve estimates how much the insurance company will pay in future claims. The reserve amount is an estimate based on experience and probable future events. Of course, if actual losses are more significant than estimated, the insurance company will have to dip into its surplus. If substantial losses are less than estimated, the insurance company might be able to deduct that amount from its taxes or add it back as income.