GIM7070 - Equalisation reserves: classes other than credit business: creation of the reserve

In the first financial year after the commencement of the scheme (or the first financial year in which the insurer writes business above the de minimis limits), companies must create an equalisation reserve, to be carried forward at the end of that financial year.

• First, transfers into the equalisation reserve are calculated by reference to that year’s net written premiums.
• Secondly, transfers out of the equalisation reserve are calculated by reference to claims incurred (or paid) and premiums earned (or written) in that year.
• Thirdly, a maximum equalisation reserve limit is calculated by reference to net written premiums. If necessary a further transfer out is made to bring the reserve down to the permitted maximum.
• Finally, transfers out are set against transfers in so as to arrive at a single net figure for the transfer into or out of the reserve for the year.

Each year the same computations are made - transfers in and transfers out are calculated, then a reserve maximum is applied. Note that the order of these calculations is important. The amount transferred into the reserve in each financial year is a set percentage of the net written premiums of that financial year. The relevant percentages for each business group are shown in the table at GIM7040.

For business that is accounted for on an accident year basis transfers out of the reserves are made when net claims incurred in a financial year for a particular business group exceed a set percentage of net earned premium for that same business group of that financial year. This is called an ‘abnormal loss’.

For business that is accounted for using an underwriting year basis the ‘abnormal loss’ is the amount by which net claims paid for a particular business group, plus the increase (or less the decrease) in the net technical provisions, exceeds a set percentage of net premiums written for that business group in that year.

The amount of transfer out of the reserve is the amount of the abnormal loss but this is capped, if necessary, so that it does not exceed the maximum reserve level for that business group at the end of that year. The business group maximum reserve is calculated as shown in GIM7040. If both accident and underwriting year accounting is used for the same business group, the maximum reserve cap is applied to the aggregate of the abnormal loss calculations on an accident year and underwriting year basis.

Transfers out may also be limited because the amount of any transfer out cannot exceed the amount available in the reserve, after taking account of any transfers into the reserve for that year. This means that a negative equalisation reserve cannot be created.

The percentage of claims to premiums for each business group, above which a transfer out of the reserve is triggered are shown in GIM7040.

Although the calculation of the quantum of transfer out is made business group by business group, the whole of the reserve is available for transfer out in respect of any qualifying business group regardless of the origins of transfers into the reserve. The only limiting factor is that the overall reserve cannot be negative, so that the aggregate of all of the transfers out cannot exceed the amount actually in the equalisation reserve taking account of the balance brought forward and any transfers in that year.

It should be noted that high claims in a year are not the only trigger for transfers out of the reserve. Because the total equalisation reserve maximum is calculated afresh each year, based partly on previous years' results, it will possible for the recalculated reserve to exceed the new maximum where the pattern of business has changed. So, even if there are no transfers out on account of adverse claims experience, after calculating transfers into the reserve, there will be a transfer out of the reserve of the excess over the new total maximum reserve. GIM7090 explains how the maximum reserve level calculation is made.