Valuation Reserve

What Is a Valuation Reserve?

The capital necessary to be set aside to cover a corporation against unforeseen debt is referred to as the valuation reserve.

Thes are based on the assumption that life insurance contracts like health insurance, life insurance, and other annuities can last long. 

These are the assets that the life insurance business holds by state law to offset the risks of declining investment values. They act as a hedge for an investment portfolio and safeguard the financial stability of an insurance firm.

This preserves the insurance company's safety from the risks imposed by investments that must meet the required criteria. Insurance companies should keep track of their investments and reserves to remain solvent.

Policyholders are rewarded for their claims, and annuity holders receive income without fail even if the worth of an insurance company declines, thereby ensuring the insurance company remains solvent.

These reserves ensure the insurance company has adequate assets to cover any risks arising from underwriting contracts over many years. 

It is also known as the Mandatory Securities Valuation Reserve (MSVR)

MSVR is the reserve required to offset declining valuations of securities held as assets and considers that life insurance contracts cover a longer period.

The value of an insurer's investment can affect the fluctuations in interest rates and impact the insurance claim.

Risk-Based Capital(RBC) ensures a minimum level of capital held by Insurance companies to fulfill their obligations to policyholders based on the Insurance company's size, inherent risks of assets, and identifying weak capitalized companies and facilitates actions to see policyholders receive the benefits. 

RBC requirements of Life insurance companies

The various types of risks faced by insurance companies are

• Asset risks are associated with investments held by the insurer and include the possibility of default of bonds or loss of market value for common stock.

• Underwriting risks reflect the amount of surplus to offset losses.

• Interest rate risks are concerned with potential losses due to changing interest rates.

• Business risks that reflect the general health of the insurer.

In 1992, the National Association of Insurance Commissioners (NAIC) enforced valuation reserves for investment assets to ensure insurance companies hold enough assets to protect against declines in the value of securities. 

As a result of these risks, insurance taxation issues prevent logical appraisal of the industry's performance. 

However, the parameter was revalued after 1992 to establish asset valuation and interest maintenance reserves. 

According to an American Council of Life Insurers report, life insurance accounted for 51% of company-owned reserves, compared to 8% held in individual annuity reserves. 

Paradoxically, Life Insurance company reserves fell to 29% of total reserves by 1990, while individual annuity reserves increased to 23%. The shift mirrored the expansion of insurance companies' efforts to popularize retirement programs.

Insurance and Insurance coverage

Insurance is a legal agreement between 2 parties, the insurer(insurance company) and the insured(policyholder). The insurer provides financial coverage or policy to policyholders or insurers for the insured's losses.

Insurance coverage is the assurance of protection and covers the monetary risks of a person during unprecedented contingencies. 

The policyholder pays a certain premium to the insurance company, and insurers assure the policyholder's losses to certain terms and conditions.

It provides monetary reimbursement during the financial crisis and can be provided for medical insurance, vehicle insurance, etc. 

The three main components of an insurance coverage policy are premium, policy limit, and deductible. 

Premium is the financial consideration that makes the insurance agreement a legal contract. Policy limit applies to health and general policies where compensation differs on the number of losses. 

The deductible is the maximum amount of losses. The insurer will only start paying off expenses when they exceed the deductible limit.

Insurance policies help people's saving and investing habits by keeping them paying a portion of their income as a premium. In addition, it mobilizes domestic savings for financial stability and promotes trade and commerce.

The insurance companies anticipate the potential risk and the cause for assessing the volume of risk. 

An insurance premium is an amount that every insurance policyholder must pay, and insurers provide coverage against losses as per policy.

The insurance premium is the source of income for insurance companies. They can invest in some of the amounts to get a higher return by maintaining a certain percentage of liquidity at all times.

Types of insurance policies, maximum coverage amount, age of policyholder and place he lives, and claims made by policyholders are the factors affecting the premium amount.

An actuary is a person who manages the risks of ventures, insurance policies, and financial investments by assessing the risk associated and calculating a premium amount for insurance policies.

Types of Insurance Policies

There are broadly two types of insurance policies - Life insurance and general insurance policies.

Life insurance

Life insurance provides the family with a lump sum when the insured person meets with an unexpected death. And it protects the family against premature death during the policy's tenure.

General Insurance

These are the Non-life insurance policies provided for insurance coverage in Health insurance, Education insurance, property insurance, vehicle insurance, and travel insurance.

Let us now look at some common types of general insurance policies.

• Health Insurance: It is important to have medical insurance coverage to protect from financial crises during medical emergencies. 

• Vehicle insurance: It is a legal requirement for every vehicle owner under the Motor Vehicle Act, where your valuable assets are covered against various risks of damage or loss.

• Travel Insurance: It may vary depending on the individual's needs and the chosen provider. For example, travel insurance provides financial assistance when loss of baggage, trip cancellation, flight delay, reclaiming lost travel documents, etc.

• Property insurance pertains to any immovable property that can be insured through this plan, and if damages occur, we can claim financial assistance from an insurance provider. 

Examples include protection against fires, burglaries, floods, and natural calamities.

Asset Valuation Reserve (AVR)

In this section, we will look at two broad categories of reserves and study their accounting practices.

• Asset Valuation Reserve

• Interest Maintenance Reserve

This section deals with asset valuation reserves.             

AVR is the capital reserve or financial resource kept aside by an insurance company to cover any unforeseen crisis or financial debt. In addition, it serves as backup equity and credit losses for the company.

Banks are demanded to keep a certain reserve ratio of deposits to protect against losses on claims and realized and non-realized equity. Capital gains and losses are credited to or debited against this reserve.

It establishes the details in Regulation D, which sets down all the criteria for depository institutions. In addition, companies contribute to the asset value reserve on an annual basis to mitigate any risks and debts in the future.

The primary functions of the asset valuation reserve process are:

• First, ensure that all assets and liabilities are recorded on the most consistent financial basis possible.

• Provide a reserve following actuarial valuation criteria that effectively accounts for future volatile asset losses.

• Ensure proper recognition of long-term expected returns for the investments of the equity variety.

• Key assumptions are no change in current rules for valuing assets and liabilities.

• The said rule only applies to Life insurance companies and is valued as a going-concern principle.

The asset valuation reserve is a summation of the equity and default components.

Default component

The default component is calculated as follows.

AVR Default = 80% Default Accumulated Balance + 20% Default Reserve Objective

The basic contribution is based on expected yearly after-tax losses assuming no changes from the baseline assumptions in 1992. 

The default component serves as a backup for credit losses related to bonds, mortgages, and other fixed-income assets. The Reserve objective in the default component is 85% of the distribution of losses for each asset.

The maximum reserve is equal to after-tax Risk-based Capital factors for each asset class.

Accumulated balance = Beginning balance +/- Realized capital gains(losses)+ Basic contribution

Ending balance = Beginning balance +/- Unrealized gains or losses or basic contributions 20% of reserve objective-accumulated balances + Voluntary contributions                                           

Equity Component

The Reserve objective in the equity component is 20% of the common stock with adjustments in portfolio beta and real estate at 7.5%. The maximum reserve is 20% and 7.5% for real estate.

Accumulated balance = Beginning balance +/- Gains(losses)+ Basic contribution                          

Interest Maintenance Reserve (IMR)

The Interest Maintenance Reserve, or IMR, is a reserve fund usually required by regulators to maintain insurance companies' financial stability. It is held per standard accounting principles to deal with fluctuations in interest rates.

IMR maintains all types of realized, interest-related capital gains and losses on income assets and amortizes these gains and losses into income over the remaining life of the investments sold.

The liability reserve of which accumulated realized capital gains and losses resulting from fluctuation in interest rates are amortized, and adjustments to the net investment are shown.

It is a reserve applied to short-term and long-term fixed investments, calculated and periodically revised to protect additional investment transactions that are entered into changes in interest rate movements.

Companies with IMR can use it to cover losses caused by interest rate changes. Regulators require these to maintain the financial stability of the insurance industry.

IMR is the reserve of funds and other assets held per conventional accounting rules to deal with interest rate changes. The value of financial instruments like bonds and Mortgages can fluctuate in tandem with interest rates.

This prevents insurance companies from experiencing dramatic fluctuations in their balance sheet due to investment losses or gains. 

This maintains insurers financially secure and able to meet policyholder commitments in practically all economic scenarios.

Net investment income is the performance of securities like stocks and bonds after subtracting the amount paid for operational and administrative expenses.

This applies to anyone who owns securities in their investment portfolios, individual or company. 

Banks and other financial institutions are required by law to have an asset valuation reserve to safeguard their customers from being mistreated if they face financial difficulties.

Asset Valuation Review of Banks

During the Great Depression, many banks went bankrupt. One of the reasons for the establishment of the FDIC was to address this issue. 

When the agency was first established in 1993, up to 4000 banks in the US failed, and depositors had already lost up to 140$Bn by that point. 

With the FDIC, bank customers would be able to retrieve their savings. In addition, when a bank fails, the FDIC usually steps in to give financial assistance, such as capital loss coverage, to entice other banks to participate in the transaction. 

AVR sets a certain amount from other Financial institutions to acquire assets from insolvent banks.

The goal is to complete the liquidation procedure as rapidly as feasible while causing as little financial effects to the deposit insurance fund as possible.

Factors influencing the extensive use of the fair value of assets are the assets being held in the bank’s balance sheet in the short term and waiting for securitization are taken as the fair value of the asset.

Non-performing assets(NPA) are a debt obligation or an advance in default of loan interest and principal amount failure overdue for more than 90 days. 

Banks will increase interest rates when the accounts turn into NPA to maintain profit margins.  

Term Loans are mostly known as Non-performing assets as these are documented on the balance sheet when the borrower fails to pay the interest or principal amount and creates a burden on the lender.

Methods of Asset Valuation by Companies

Once the net asset value is determined, a company can know its net worth by subtracting all liabilities from the present value of all assets. Banking asset valuation methods are:

Fixed Asset Valuation Method 

These are the tangible assets reflected on the asset side of the balance sheet. Quality can diminish over the years with the type of wear and tear that comes with reducing the market value and developing transmission issues. 

Other fixed valuation methods are: 

• Cost method: Assets are valued with the purchase price, and this method is the simplest form of asset-based valuation.

• Market Value: Method: Assets are valued based on their market price or projected price.

• Value-based method: An asset is valued considering its liability to generate cash flow. 

Intangible asset valuation

These include patents, client relationships, trademarks, etc. The valuation of intangible assets can be determined by the market or cost approach.

• Market Value Method: Valuing your intangible assets based on what other companies have paid.

• Income Method: This approach values an asset based on the cash flow and assumes the asset's present value of future cash flows.

• Cost Method: This asset valuation is when companies use the cost of rebuilding or replacing the asset.

Now, let us look at various types of valuation.

1. Stock Valuation Method: Stocks are the type of assets that are not appraised, like fixed or intangible assets.

2. Discounted Dividend Model: This approach discounts the future dividends of a stock to its present value to determine the stock price.

3. Discounted cash flow: This determines the future cash flow and calculates the weighted average cost of capital.

4. Comparable Valuations: Using the price-to-earnings ratio, price-to-book ratio, and price-to-cash flow, we can determine the value of your stock.

Researched and Authored by Athira Anand M | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Cost Approach (Real Estate)
• Crossover Rate
• DCF Pros And Cons
• Unlevered Beta / Asset Beta
• Valuation Drivers