What Is a Deficiency Reserve in Insurance?
A deficiency reserve is a required liability that reconciles an insurer's low premiums with the long-term cost of its policyholder obligations.
To ensure an insurance company can fulfill its long-term obligations, it must maintain adequate funds. A deficiency reserve is a special liability an insurer must establish when it determines future premiums for a group of policies will not cover expected claims and expenses. This proactive measure protects policyholders by ensuring the insurer’s solvency. It forces the company to recognize a future loss today, setting aside funds from its current capital to cover the projected gap and preventing it from appearing healthier than it is.
The Trigger for a Deficiency Reserve
The need for a deficiency reserve arises from a mismatch between the gross premium and the valuation net premium. The gross premium is the actual amount a policyholder pays, determined by the insurer based on market conditions and competition. In contrast, the valuation net premium is a theoretical figure calculated by actuaries for financial reporting that represents what regulators, through prescribed formulas, deem necessary to cover future policy benefits using standardized, conservative assumptions.
A deficiency reserve is triggered when the gross premium is less than the calculated valuation net premium. This situation can occur if an insurer sets low premiums to capture market share. It can also happen if the rules for calculating the valuation net premium change after a policy is issued, such as if regulators mandate a more conservative mortality table or a lower interest rate, which would increase the valuation net premium for an existing policy.
Calculating the Reserve Amount
Calculating a deficiency reserve quantifies the total expected shortfall over the life of a block of policies. The objective is to determine the present-day value of all future shortfalls, ensuring sufficient funds are set aside to cover the projected loss. The first step is to find the annual deficiency per policy by subtracting the gross premium from the valuation net premium. For example, if a policy’s valuation net premium is $1,200 but the gross premium is only $1,000, the annual deficiency is $200.
Next, this annual deficiency is projected over the remaining life of the policy. If the policy is expected to continue for 20 years, the insurer anticipates a series of 20 future shortfalls of $200 each.
The final step is to calculate the present value of this stream of future deficiencies. Present value is a financial concept stating that an amount of money today is worth more than the same amount in the future due to its earning capacity. The calculation discounts the future shortfalls using an interest rate to determine how much money is needed today to cover those future deficiencies, and the sum of these discounted amounts is the total reserve that must be established.
Regulatory Framework and Accounting Principles
Deficiency reserves are mandated by rules designed to protect policyholders and ensure insurer solvency. The primary guidance comes from the National Association of Insurance Commissioners (NAIC), which sets nationwide standards that are typically adopted by state insurance departments. The requirement is rooted in Statutory Accounting Principles (SAP), the framework insurers use when reporting their financial condition to state regulators, with specific rules outlined in the NAIC’s Accounting Practices and Procedures Manual, including SSAP 54 for health insurance.
This regulatory framework contrasts with Generally Accepted Accounting Principles (GAAP), the standard used for reporting to investors. GAAP focuses on a company’s profitability over time, rather than the immediate solvency focus of SAP. While GAAP has a concept of a premium deficiency reserve, its calculation and trigger are different and not as stringent as the SAP requirement. For instance, under GAAP, a deficiency can often be offset by writing down a related asset, whereas under SAP, the full reserve must be established as a liability.
Impact on Insurer Financial Health
Establishing a deficiency reserve has a direct negative impact on an insurer’s financial statements. The reserve is recorded as a liability on the company’s statutory balance sheet, which simultaneously reduces the insurer’s surplus, the statutory equivalent of net worth. This reduction in surplus affects the company’s health because surplus is a primary measure of an insurer’s financial strength and its capacity to take on new risks. A lower surplus affects the company’s risk-based capital (RBC) ratio, a metric used by regulators to assess solvency.
A substantial drop in the RBC ratio could trigger increased regulatory scrutiny, potentially requiring the insurer to raise additional capital or limit its business activities. The initial act of establishing the reserve also affects the insurer’s income statement, as the amount is recognized as an expense that directly reduces statutory net income and can turn a profit into a net loss.