Updated July 20, 2023
Introduction to Statutory Reserve
The statutory reserve, also known as an actuarial reserve, can be defined as a portion of profits that any financial institution like an insurance company or a bank is legally required to hold and maintain in compliance with the applicable laws and regulations to meet future unmatured obligations and contingencies and are generally held in the form of either cash or high liquid marketable securities.
Statutory reserves are the amount set aside from companies’ net profits, funds, and other assets in order to meet future liabilities. Insurance companies charge a premium from their customers instead of insurance coverage provided to them. They will receive a certain sum of money in any kind of uncertainty. The regulatory authorities do not want to take any default risk, so it has mandated it for smooth claim processing. Companies to maintain a statutory reserve out of their asset portion. These reserves said such companies to meet the claims even if the company is bearing a loss. Maintenance of stat. reserves are acknowledged as an efficiency tracker. Rates of SR may vary from country to country as fixed by its local regulatory authorities.
Purpose of Statutory Reserve
The prime motive for creating statutory reserves is to ensure enough availability of funds whenever required to meet future obligations. Insurance companies provide various types of insurance such as life, motor vehicle, fire, theft, accidental, medical, etc.; thus, depending upon varied business forms, the probability of claim liability is certain. In the case of natural calamities also, statutory reserves play a vital role in meeting companies’ obligations. Also, it helps to ensure the smooth running of insurance companies.
Examples of Statutory Reserve
Examples of the SR are given below:
- Banking Company: As per the guideline set under the banking regulation act of any country, each banking company must transfer a certain portion of profits or Net Assets to a fund known as a “Reserve Fund” or statutory reserve. Rates may vary from country to country from 1 to 30% or even more.
- Life Insurance Company: Commissioner’s Reserve Valuation Method: In the USA, life insurance companies are required to create and maintain SRs depending upon various factors like age, sex of the person insured, the policy period, insurance plan, the mortality rate of region, and actuarial present values. Life insurance companies calculate the Solvency Ratio (SR) based on prescribed rates for different levels, depending on the above factors.
- Non-Financial Institution: Non-financial institutions are sometimes required to maintain SR. Example: income tax waived on goods manufactured and exported from Special economic zones(SEZs) with the condition of creating a certain percentage of such profits as reserves for the stated number of years, which can be utilized only in a specific manner, say for the development of unit in SEZ, etc. Companies benefitting from such schemes will create statutory reserves per the applicable timelines.
Methods of Statutory Reserve
Two methods can calculate the SR –
- Rule-Based Approach: States commonly employ this traditional approach. Insurance companies use standardized formulas and assumptions to calculate the amount of reserve that should be held. We must maintain funds in assets form to meet our future obligations after calculation. It does not cover the complete liability risk as it is formula-based and does not cover all factors determining the risk. There is no leeway under this approach.
- Principle-Based Approach: Under this method, insurers must hold more reserves based on future economic conditions. There is leeway for the maintenance of statutory reserve under this approach. Businesses calculate the reserve amount by considering the risks they take, which helps sustain their solvency.
Statutory Reserve Requirement
The statutory reserve requirement is the tool for managing the organization’s liquidity. It is mandated for insurance and banking businesses to maintain funds in statutory reserve which is in proportion to the eligible liabilities and claims to be settled for the period. This reserve requires building up adequate liquidity in the business. Non-compliance with SRs, in turn, may create financial imbalance and lead to a risk of financial instability. Also, as part of compliance against benefits granted, some non-financial institutions must create and maintain SRs.
Statutory Reserve Rate
Regulatory authorities do not impose a fixed rate of statutory reserves that each organization must maintain. Depending upon the nature of business and the ruling state rules and regulations, rates may vary. Like marine insurance companies, they may need to keep 100% of the consignment value handled as SRs. Some other business-related insurance companies must maintain 50% of the sum assured amount. Regulatory authorities may impose different reserve requirements on life insurance companies. Also, financial institutions like banks may be necessary to keep SRs. Rates vary from industry to industry. Rates may be based on profits, asset value, claim values, etc.
Statutory Reserve vs General Reserve
Companies must keep and maintain statutory reserves according to prevailing rules and regulations, whereas general reserves are reserves that the company creates and maintains voluntarily. The regulatory authority prescribes fixed statutory reserve rates that companies must maintain, whereas there is no prescribed rate for general reserves. Non-compliance with SR may lead to financial penalties and goodwill loss, which is not the same as GRs. Companies must keep and utilize statutory reserves for specific purposes only, but they may maintain general reserves for undefined purposes.
Advantages and Disadvantages of SR
Below are the advantages and disadvantages:
Advantages of SR
Some of the advantages are:
- The basic advantage of maintaining a statutory reserve is it helps in processing claims of liabilities that will occur shortly, ensuring sufficient liquidity in the organization.
- The statutory reserve assures the investors that the amount they are going to invest in the company’s products is secured by means of reserves, i.e., it helps to build trust among the customers and clients.
- Maintenance of statutory reserve represents goods business health as it has a well-maintained statutory reserve which gives confidence to its various stakeholders.
- Organizations maintain statutory reserves as cash or highly liquid investments to ensure liquidity.
- Maintaining SR ensures the smooth running of the business, even in heavy claims lodgement periods.
Disadvantages of SR
Some of the disadvantages are:
- Since maintaining a statutory reserve is a mandatory requirement, every organization must keep one, regardless of their needs.
- Regulatory authorities determine the amount of the statutory reserve, resulting in a loss of autonomy.
- Companies can only use funds maintained in the statutory reserve to meet obligations. They cannot use these funds for emergency business operations.
- The company must maintain reserves regardless of its profit, which weakens its position.
Conclusion
To protect the interests of insurance companies and financial institutions’ clients, regulatory authorities require the creation and maintenance of statutory reserves. These reserves also aid companies in ensuring the smooth running of business operations. However, it may sometimes become cumbersome to follow if the company faces tough times. Non-compliance to statutory reserves may lead to financial loss in the form of penalties and may hamper the organization’s goodwill.
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