Texas Adjuster Practice Test

What is the primary purpose of reserves in insurance?

1. To fund claims that have already been settled

2. To cover potential future claims liabilities

3. To increase premium income

4. To manage operational costs

The correct answer is: To cover potential future claims liabilities

Reserves in insurance primarily serve the crucial function of covering potential future claims liabilities. Insurers set aside a specific amount of money, known as reserves, to ensure they have sufficient funds to pay for claims that may arise in the future, whether these are incurred but not reported (IBNR) or reported but not yet settled. This practice is vital for maintaining financial stability and regulatory compliance, as it ensures that the insurer can meet its obligations to policyholders. Setting reserves allows insurance companies to manage their financial risk effectively. By estimating the expected value of future claims, insurers can ensure they have adequate financial backing to cover policyholder claims as they arise. This practice helps uphold the principle of insurance, which is to provide security and peace of mind to policyholders that their claims will be handled in a timely and sufficient manner. In contrast, funding claims that have already been settled does not relate to the establishment of reserves but reflects already incurred expenses. Increasing premium income pertains to the revenue aspect of the insurance business, while managing operational costs focuses on the internal expenses associated with running the insurance company. These aspects are essential for overall business health but do not capture the fundamental purpose of reserves in the insurance context.