Asset Valuation Reserve - Definition
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Asset Valuation Reserve (AVR)
An asset valuation reserve (AVR) refers to the capital or financial resources kept aside by a company to cover unforeseen financial crises or unexpected debts. The asset valuation reserve is one of the required capital that companies must set aside to mitigate future risks and unexpected debt. AVR also serves as a capital backup for a company in terms of credit losses.
A Little More on What is Asset Valuation Reserve (AVR)
Asset valuation reserve is a lump sum of capital set aside for future use and to cater for contingencies in a company. It serves as a backup for equity for a company as well as credit losses. An asset reserve has two components, these are the default and the equity components. While the default component serves as a backup for credit losses such as losses relating to debt securities, preferred stock, real estate, and mortgages, among others, the equity component serves as a backup for the companys equity. Asset reserve is used in different companies, industries, and sectors. In the insurance industry, for instance, domestic insurers are mandated to have an asset valuation reserve that covers the future claims that policyholders will make and other financial obligations that might arise for the insurer. The National Association of Insurance Commissioners (NAIC) also expects insurance companies to keep a liability reserve in addition to an asset valuation reserve.
Why Asset Valuation Reserve Is Required
Essentially, an asset valuation reserve is required to act as a backup or safety net for companies when unexpected future financial obligations arise. This reserve also provides a safe-landing for a company in the event of a future credit or equity loss. Different companies have a varying amount of asset valuation reserve they must keep, the amount of AVR needed to cover different assets is determined through actuarial calculations. Estimating future losses a company is likely to be exposed to can also be used in determining the required asset reserve. There are other factors that companies consider when determining the asset valuation reserve such as the risk of the assets. Companies make contributions to the asset valuation reserve annually in order to be able to mitigate potential risks and debts in the future.
Reference for Asset Valuation Reserve (AVR)
Academic research on Asset Valuation Reserve (AVR)
- Analysis and valuation of insurance companies, Nissim, D. (2010). Analysis and valuation of insurance companies.CE| ASA (Center for Excellence in Accounting and Security Analysis) Industry Study, (2). During 2008 and 2009, the insurance industry experienced unprecedented volatility. The large swings in insurers market valuations, and the significant role that financial reporting played in the uncertainty surrounding insurance companies during that period, highlight the importance of understanding insurers financial information and its implications for the risk and value of insurance companies. To facilitate an informed use of insurers financial reports, this manuscript reviews the accounting practices of insurance companies, discusses the financial analysis and valuation of insurers, summarizes relevant insights from academic research, and provides related empirical evidence.
- The relations among asset risk, product risk, and capital in the life insurance industry, Baranoff, E. G., & Sager, T. W. (2002). The relations among asset risk, product risk, and capital in the life insurance industry.Journal of banking & finance,26(6), 1181-1197. This paper explores the relation between capital and risk in the life insurance industry in the period after the adoption of life risk-based capital (RBC) regulation. To examine this issue, we use a simultaneous-equation partial-adjustment model. Three equations express the interrelations among capital and two measures of risk: product risk and asset risk. The asset-risk measure used in this paper reflects credit or solvency risk as in RBC. Product risk assessment for life insurance products is rationalized by transaction-cost economics contractual uncertainty. A significant finding is that for life insurers the relation between capital and asset risk is positive. This agrees with prior studies for the property/casualty insurance industry and some banking studies. But the relation between capital and product risk is negative. This is consistent with the hypothesized impact of guarantee funds in other studies. The contrast between the positive relation of capital to asset risk and the negative relation of capital to product risk underscores the importance of distinguishing these two components of risk.
- The cost of financial frictions for life insurers, Koijen, R. S., & Yogo, M. (2015). The cost of financial frictions for life insurers.American Economic Review,105(1), 445-75. During the financial crisis, life insurers sold long-term policies at deep discounts relative to actuarial value. The average markup was as low as -19 percent for annuities and -57 percent for life insurance. This extraordinary pricing behavior was due to financial and product market frictions, interacting with statutory reserve regulation that allowed life insurers to record far less than a dollar of reserve per dollar of future insurance liability. We identify the shadow cost of capital through exogenous variation in required reserves across different types of policies. The shadow cost was $0.96 per dollar of statutory capital for the average company in November 2008. (JEL G01, G22, G28, G32)
- Life insurer risk-based capital measures, Pottier, S. W., & Sommer, D. W. (1997). Life insurer risk-based capital measures.Journal of Insurance Regulation,16(2), 179
- External financing in the life insurance industry: evidence from the financial crisis, BerryStlzle, T. R., Nini, G. P., & Wende, S. (2014). External financing in the life insurance industry: evidence from the financial crisis.Journal of Risk and Insurance,81(3), 529-562. The financial crisis and subsequent recession generated sizable operating losses for life insurance companies, yet the consequences were far less significant than for other financial intermediaries. The ability to quickly generate new capital through external issuance and dividend reductions let life insurers maintain healthy levels of equity capital. We use this experience to examine the causes and consequences of external capital issuance by U.S. life insurance companies. We show that, in general, new capital is issued both to support the growth of new business and to replace capital depleted by operating losses. This second channel is particularly important during macroeconomic recessions. Notably, we do not find any evidence that insurers had difficulty generating new capital, unlike other financial service providers that required large amounts of public support. For life insurers, what changed following the financial crisis was the demand to raise external capital, but the supply of external capital appears to have remained constant.
- A comparative analysis of US, Canadian and Solvency II capital adequacy requirements in life insurance, Sharara, I., Hardy, M., & Saunders, D. (2010). A comparative analysis of US, Canadian and Solvency II capital adequacy requirements in life insurance.Society of Actuaries.