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Loss reserves are resources that are set aside to offset various types of financial loss or obligation. In some cases, the amount of these resources is based on projections of possible loss from investments, insurance claims, or other situations where a deficit of some type could occur. The term is used in many different fields, including insurance, business, and even in home budgeting.
When used in the insurance industry, a loss reserve is the resources that are held in check, so the provider can honor any claims that are presented by clients. Determining the amount of the reserve to keep on hand depends on the accurate calculation and projection of the number and size of claims that are likely to be filed within a given time period. Because many factors can impact the frequency and size of claims, insurance providers are constantly refining the calculation regarding the amount of insurance loss reserve they should maintain.
In like manner, many financial institutions also project and maintain loss reserves. In this scenario, the reserves tend to focus on the servicing of loans issued by the institution, including the potential for default of a percentage of the loans per annum. The creation of loan loss reserves allows the institution to continue operations in spite of any defaults or other negative factors that threaten to limit the cash flow of the institution.
Businesses and non-profit organizations also tend to maintain loss reserves to cover general operating expenses. This type of provision is sometimes referred to as a contingency or emergency fund. Essentially, the reserves are funds set aside to allow the company or the non-profit organization to continue operations even if there is not an adequate amount of income generated to maintain the current level. When and as required, funds are withdrawn from the reserve while the officers and other key players find ways to restore financial health to the organization.
Even home budgets may include a type of loss reserves. Many financial analysts recommend that households create and maintain reserves that are equal to at least six months of normal operating expenses. The idea is that a loss reserve ratio of this type provides adequate financial support for the household during periods of illness or unemployment, when cash flow is likely to be low or non-existent.