Meaning of Insurance Reserve| Origin & Various Methods of Calculating Reserve

                 Introduction: Meaning of Insurance Reserve

The seed of every insurance company’s demise is enshrined in managerial business reserve. This is because the reserve system always stands as a guiding principle for the insurance company to make a provision for liabilities in order to pay policyholders who have filed a legitimate claim on their policies.

An amount of money saved out of the main capital for a specific purpose best describes what reserve is all about. The reserve in life insurance is not the same as the reserve in other businesses.

It is not an accumulated profit or gain. In insurance, it is a liability that is to be met by the insurer at and when it arises represents a liability that must be adequately met. The need for any business concern to hold reserve is obvious, but specific reserve ought to be made for particular known liability, or contingencies.

Examples of specific reserve funds other than for internal purposes, such as staff benevolent funds, staff pension funds, etc. However, the meaning of insurance reserve, the need for reserve, and various methods of the calculating reserve are contained in this article.

          Definition of Reserve

Reserve can be defined as that specified amount of money, which in addition to future premiums and interest, will be enough to pay the future claims.

Reserve also is the accumulation of funds or provisions for losses, claims, premiums, and interest of the difference between the net premiums received in the past and the claims remitted or paid out.

Ordinarily, a reserve can be seen as that specific amount of funds, set aside to meet a particular purpose or liability if any arises at the cause of an insurance transaction.

It is very important to note that the different definitions given about reserve above are quite different from the term ‘ Loss Reserve’ which is an accounting entry that estimates the amount an insurance company would have to pay out on future insurance claims on policies that it has underwritten.

        Origin and Sources of Reserve

As everything on the surface of the universe has a trace of its existence or origin, so is a reserve. Reserve in any group of policies emanated from the accumulated or excess premium receipts or overpayments of insurance claims. The premium receipt is more than the payments in the beginning and less after a point.

The excess receipts are accumulated at the assumed rate of interest and build up a “Reserve” up to a point in time, the ‘reserve’ grows, particularly because of such receipts. It is very important to understand that the reserve is accumulated on the assumed mortality and interest. The reserve based on these assumptions is compared to the funds based on the actual experience. The difference may create a ‘surplus’ or deficit.

Sources of reserve funds: The first and the major source of the reserve is premium. It should be noted that reserve is accumulated in a level premium plan because the premium is more than the actual cost of insurance in the beginning. In the other two methods of premium, a reserve cannot be accumulated. This is discussed below.

             Need for Reserve

The reserve in the life insurance business is classified into the following.

1. To build up transparent relations between the insured and the insurance company, through the use of the accumulated funds to offset premiums.

2. To meet the number of claims: Reserve is needed to meet the number of claims whenever the given event takes place. The incurring of this liability does not bother the insurer at all if any in any given period it receives by way of consideration from the policyholders concerned an amount that is equal to the amount it has to pay during this period. However, the insurer must have enough capital to remit the claims. Therefore, the reserve is needed to meet these claims.

3. To accumulate funds: Reserve is highly needed to build up funds that can be reinvested for long period to earn at least the assumed rate of return. The invested fund usually facilitates the growth and development of a nation’s economy.

4. Policyholders are entitled to a huge benefit: The huge accumulated reserve generally belongs to the policyholders. In most cases, this accumulated fund is safely and profitably invested by those who are in a position to do that.

5. To minimize the increment of heavy loss: Reserve helps to estimate the amount an insurance company would have to pay out on future insurance claims on policies that it has underwritten. Therefore, using the accumulated funds to meet up with such events when the need arises.

          Methods of calculating Reserve

The generally applied method of calculating reserve is as follows

a. Retrospective method and

b. Prospective method

Reserve is basically calculated using either of the following methods. However, the application of any of the two methods will still give the same answer provided that the mortality and interest rate remain the same in either of the two methods. The following illustration best explains the two methods.

Illustration:

a. PVP =PVB

Where PVP is the present value of all premiums while PVB implies the present value of all benefits.

b. AVPP+DVFP=AVPB+DVFB

Where AVPP=accumulated value of the past premium, DVFP= the discounted value of future premiums, AVPB= the accumulated value of the past benefit, DVFB= the discounted value of future benefits.

c. AVPP-AVPB=DVFB+DVFP

Where AVPP=The accumulated value of the past premium, AVPB= The accumulate the value of past benefits, DVFB=The discounted value of future benefits, DVFP= The discontinuity value of the future premium.

d. RR=PR

Where RR= implies retrospective reserve while PR = prospective reserve.

Basically, the Retrospective reserve method comprises single policies and group policies While the prospective methods of the reserve comprise the group and single policies as well.

                  Summary

To what oxygen is to “to man”, that’s what reserve “is to the insurer or insurance companies”. This is because the reserve is highly needed to build up funds that can be reinvested for long period to earn at least the assumed rate of return.

The invested fund usually facilitates the growth and development of a nation’s economy. It is that amount of money that when added to the future premium and interest, will be enough to settle future claims.

The retrospective method of calculating reserve is the use of past experience to determine what reserve is all about
While the Prospective method is achieved by determining how much is required to be paid in the future and how much premium will be received in the future. All these are the two methods of calculating a premium.

We have also pointed out that; to meet the number of claims, accumulating funds and policyholders’ benefits is among the various need for reserve in the insurance business.

 

 

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