Introduction to Statutory Reserve
The statutory reserve is also known as an actuarial reserve can be defined as a portion of profits that any financial institution like insurer company or a bank is legally required to hold and maintain in compliance with the applicable laws and regulations so as 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 in lieu of insurance coverprovided 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 and therefore for smooth claim processing, it has mandated it. 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 of creating statutory reserves is to ensure enough availability of funds whenever required to meet out future obligations. Insurance companies provide various types of insurances such as life, motor vehicle, fire, theft, accidental, medical, etc and thus depending upon varied business forms, the probability of claim liability is certainly. 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 is required to transfer a certain portion of profits or Net Assets to a fund known as “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 person insured, the policy period, insurance plan, the mortality rate of region, actuarial present values. Depending upon the above factors different rates are prescribed for different levels and accordingly SR is calculated in the case of life insurance companies.
- Non-Financial Institution: Sometimes even non-financial institutions are also 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 availing such schemes benefits will create statutory reserves as per the applicable timelines.
Methods of Statutory Reserve
The SR can be calculated by two methods –
- Rule-Based Approach: This is a traditional approach used by states. It uses standardized formulas and assumptions to calculate the amount of reserve to be held by the insurance companies. Funds kept aside after calculation is compulsorily required to be maintained in assets form to meet our future obligations. It does not cover the complete risk of liability 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 are required to hold a higher amount of reserves based on future economic conditions. There is leeway for the maintenance of statutory reserve under this approach. Reserve amount is calculated by considering risks taken by the business thereby helps in sustaining the solvency of the business.
Statutory Reserve Requirement
The statutory reserve requirement is the tool for managing the liquidity of the organization. It is mandated for insurance and banking business to maintain funds in statutory reserve which is in proportion to the eligible liabilities and claims to be settled for the period. The requirement of this reserve is to build up adequate liquidity in the business. Non-compliance of 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 are also required to create and maintain SRs.
Statutory Reserve Rate
There is no fixed rate of statutory reserves to be maintained by each organization. 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 consignment value handled in the form of SRs. Some other business-related insurance companies are required to maintain 50% of the sum assured amount. Life insurance companies may be required to keep at some other rates. Also, financial institutions like banks may be required to keep SRs. Rates vary from industry to industry. Rates may be based on profits, assets value, claim values, etc.
Statutory Reserve vs General Reserve
Statutory reserves are required to be kept and maintained in accordance with prevailing rules and regulations whereas general reserves are reserve which is created and maintained voluntarily by the company itself. There are fixed statutory reserves rates prescribed by the regulatory authority which needs to be maintained whereas there is no such rate prescribed for GR. Non-compliance of SR may lead to financial penalties and goodwill loss which is not the same in the case of GRs. SRs are required to be kept and utilized for a specific purposes only but GRs may be maintained 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 to maintain a statutory reserve is it helps in processing claims of liabilities that are going to occur in the near future ensuring sufficient liquidity in the organization.
- The statutory reserve gives assurance to the investors that the amount they are going to invest in the products of the company 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.
- Statutory reserves are maintained in the form of cash or highly liquid investments ensuring liquidity to the organizations.
- Maintaining SR ensures the smooth running of business even in case of heavy claims lodgement periods.
Disadvantages of SR
Some of the disadvantages are:
- As the statutory reserve is a mandate to be followed, every organization needs to maintain it irrespective of their requirement.
- The amount of statutory reserve is decided by regulatory authorities leading to leading to loss of autonomy.
- Funds maintained in the statutory reserve can be utilized only against meeting obligations. It cannot be used for business operations in any sort of emergency.
- Reserve needs to be maintained irrespective of the profit of the company which lowers the position of the company.
With the motive of protecting the interest of insurance companies and financial institutions’ clients, regulatory authorities prescribe statutory reserves to be made and maintained. These reserves also aid companies in ensuring the smooth running of business operations. However, it may sometimes become cumbersome to follow in case the company is facing tough times. Non-compliance to statutory reserves may lead to financial loss in the form of penalties and may also hamper the goodwill of the organization.
This is a guide to Statutory Reserve. Here we also discuss the introduction to statutory reserve along with purpose, advantages, and disadvantages. You may also have a look at the following articles to learn more –