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Life Insurance Reserve and Capital Determination

Reserve and Capital Determination

Life insurance reserve and capital determination is one of the most important functions in the compilation of quarterly or annual financial statements. Athough actuaries play a central role in that process, they must work closely with several internal and external stakeholders to produce an optimal outcome. These include internal and external accountants, auditors, regulators, rating agencies and creditors. Each of these groups recognizes the importance of adequate reserve and capital establishment to ensuring the financial stability of life insurance companies.

Why Correct Reserve & Capital Determination Is Important

Policy reserves

Life insurers have to be careful to set aside adequate amounts at all stages of an insurance contract to meet their contractual obligations in later years. These amounts are known as actuarial or policy reserves and are explicitly disclosed in the balance sheet of the insurer. Life insurance reserve determination is one of the most important quarterly or annual functions involved in managing an insurer.

For term or permanent life insurance contracts, the policy reserves will usually include two basic components. The first (claim reserve) should be based on outstanding (unpaid) claims that have already incurred. In addition, the policy reserve should include an amount established to pay for the portion of future losses (claims) and expenses under the contract that is not covered by future premium receipts. This second component is analogous to the unearned premium reserve that needs to be established for casualty contracts such as those used for travel insurance.

For universal life contracts, the policy reserve will also include a component that corresponds to claims that have already incurred but have not been paid. In addition, the insurer will need to establish a reserve to cover the portion of expected future claims or losses and the costs of administration that is not covered by the future charges and premium deductions it expects to collect from the existing contracts.

Increasingly, life insurance companies are required to use reserve calculation methodologies that comply with International Financial Reporting Standards (IFRS). The IFRS standards comprise a collection of accounting standards that govern the manner of disclosure of certain types of transactions in financial statements. These standards have been adopted by an increasing number of jurisdictions in recent years.

Statutory Capital

As explained above, life insurance policy reserves are in principle intended to cover unpaid claims plus a best estimate of the additional resources required to meet future claims and expenses.

However, the long duration of most life insurance contracts introduces a considerable amount of uncertainty as the events that may take place before the contract has run its course. There is therefore considerable uncertainty around the amount of resources required to meet future claims and expenses. Additional amounts are therefore required to offset the impact of this uncertainty.

Accordingly, in order to provide a “cushion” to offset the potential consequences of adverse events that could not have been reasonably expected to occur, life insurers must set aside additional amounts known as statutory capital. If these adverse events ultimately do not occur, this capital can in principle be released to the company’s shareholders. Alternatively, it can be used to support a subsequent cohort of life insurance contracts.

In most jurisdictions, the amount of statutory capital is determined by rules established by the relevant regulator. For example, in the US, the amount of required statutory capital is determined the Insurance Department of the state in which the insurance company is domiciled. In Canada, this determination is made by federally by the Office of the Superintendent of Financial Institutions (also known as OSFI).

Economic Capital


In some cases, companies may wish to hold back additional amounts of capital to offset risks that are not addressed by their statutory capital balances. This additional capital is known as economic capital. Although it may not be required by statute, it may be necessary to set aside such capital in order to satisfy the company’s other key stakeholders such as policyholders, rating agencies and creditors.

The determination of the correct amount of economic capital should take account not only of the nature of the company’s insurance contracts but also its investment policy and internal risk controls. It should therefore be integrated tightly with the company’s risk management procedures as well as its risk appetite. The asset-liability management processes of the company also play a significant role in determining the amount of economic capital required.

As with reserves, a disciplined process life insurance capital determination is a critical part of ensuring long term financial strength. It underpins the ability to both properly administer the contracts and to pay the benefits required under these contracts as they fall due. Historically, many life insurance company failures can be traced back to inadequate capital resources that then rendered them unable to withstand the consequences of unexpected “shocks”, particularly in the financial markets.

One recent example of this was the 2007-8 financial crisis caused by the bursting of the US housing “bubble” as well as predatory lending practices in the US housing market. The resulting collapse in the values of mortgage backed securities tied to the US housing market created severe difficulties for many life insurance companies and other financial institutions, as well as a number of major failures. Had an event of this nature been anticipated in the establishment of reserves or capital for major life insurers, the impact would have been less severe.

How Actuarial Services, Inc. Can Help

Actuarial Services can provide assistance in the important function of life insurance reserve and capital determination. The specific areas in which you may need assistance that we can provide include:

  • Assessing the adequacy of the reserves and capital set aside by a life insurer and responding to questions from regulators;
  • Working with the insurer’s external accountants to confirm that the reserves and capital balances disclosed in the financial statements are consistent with IFRS requirements;
  • Providing technical support to in house actuarial staff in the introduction of new methodologies for reserve and capital balance calculation when needed to address changes in regulatory or other requirements.
  • We can provide peer reviews of the calculation of existing reserve and capital balances whenever this may be required by regulators, rating agencies or other stakeholders;
  • We can also serve as the Appointed Actuary in situations in which such an appointment may be required by applicable regulations.