CHAPTER XVI

THE RESERVE IN FIRE INSURANCE

The Reserve Defined. The reserve in fire insurance has its origin in the fact that the insurer collects the whole premium in advance, whereas the protection can only be given as time elapses during the one, two or five-year policy period. It may be defined as that portion of the premium which the company has not yet had time to earn.

The nature and purpose of the reserve in fire insurance become apparent if we take into account the manner in which a company earns its premium. Thus let us suppose that a company issues an annual policy for a premium of $120. This premium is payable in advance, and since the policy has a year to run it is clear that the company has not yet earned this sum, but will become entitled to it only in the proportion that the policy reaches its maturity. At the end of the first month one-twelfth of the term has elapsed, and the company can rightfully consider that part of the premium, or $10, as earned. Eleven-twelfths of the premium, however, or $110, must be considered unearned, since the company has not yet furnished protection for the eleven months remaining in the term. At the end of six months one-half of the premium, or $60, is earned, and the other half unearned. It is not until the end of the twelfth month that the company has furnished the full year's insurance, and is, therefore, entitled to the full to the premium.

This unearned portion of the premium constitutes the reserve. It must be regarded as a sum held in trust by

the company for its policyholders. Although paid to it in advance the company cannot claim this sum as its own property. It belongs to the policyholders, and must be earned by the company before it can be used at will for its own purposes. The reserve may thus be defined as "the unearned premium"; or as the liability of the company to its policyholders for that portion of the premium already collected, but not yet earned.

Real Purpose of the Reserve.-The term "reinsurance reserve," so generally used in insurance terminology, is a misnomer, and does not convey a true idea of the purpose for which the reserve exists. Certainly an insurance company does not start in business with the idea of winding up its affairs and reinsuring its business in another company. And even where a company reinsures its business, it does not at all follow, as some have argued, that the reserve should contain only that sum which would be required to reinsure its old business. Innumerable instances of reinsurance contracts exist where one company assumed the business of another company, and was willing to take considerably less than the unearned premium as the price for carrying the policies to maturity. Vice versa, where the company, desiring to cease business, is known to have been careless in the underwriting of its risks at inadequate rates, the reinsuring company might demand much more than the unearned premium as the price for carrying the reinsured policies to the end of their term.

Whatever the reasons may be that are advanced for the existence of a reserve, and there have been many, it will be found upon examination that all are untenable except that which regards the reserve as consisting of a sum equal to the unearned portion of the company's premium income, to be held by it in trust for the exclusive benefit of the policyholders. In case a company becomes insolvent, the receiver or assignee will take this view of

the case, and will consider each policyholder a creditor for the unearned premium on his policy. Even in case the company reinsured its business in another company, it by no means follows that the policyholders must consent. They can decide to withdraw, and are entitled to the unearned premium on their policies. If the company chooses, it may decide to retire from business, and no objection can be raised provided the company makes a settlement with all its policyholders by returning to them the unearned portion of the premiums. In fact, with or without giving a reason, either party to the insurance contract may decide to cancel it, and in such a case the company must have on hand the unearned premium, because every fire insurance contract provides that "if this policy shall be canceled as herein before provided, or become void or cease, the premium having been actually paid, the unearned portion shall be returned on surrender of this policy, or last renewal, this company retaining the customary short rate, except that when this policy is canceled by this company by giving notice, it shall retain only the pro rata premium.'

Legislative and State Departmental Requirements for a Reserve. From the foregoing it is evident that the maintenance by every company of a fund equal to the unearned premiums on all its policies in force should be a necessary requirement for its financial solvency. It is only natural, therefore, that the several states have enacted laws requiring the companies to maintain such a reserve, and making it the duty of the insurance commissioner to determine annually their financial condition. These laws are of the greatest importance, and upon their strict observance depends, very largely, the security of policyholders. The law of Pennsylvania with reference to the determination of the reserve and financial solvency of the companies resembles, in its general outline, the law of most other leading states, and is as follows:

In determining the liabilities upon its contracts of insurance of any insurance company other than life insurance, and the amount such company should hold as a reserve for reinsurance, he shall, for fire insurance companies, charge fifty per centum of the premiums written in their policies upon all unexpired risks that have one year, or less than one year, to run, and a pro rata of all premiums on risks having more than one year to run; on perpetual policies he shall charge the deposit received, less a surrender charge of not exceeding ten per centum thereof. For marine and inland risks he shall charge fifty per centum of the premium written in the policy upon yearly risks, and the full amount of the premium written in the policy upon all other marine and inland risks not terminated.

Using the Insurance Department of the State of New York as a basis, the forms on pages 221 and 222 indicate the general nature, exclusive of numerous details, of the financial report required of fire insurance companies. The financial importance of the reserve becomes apparent from a study of such reports for any considerable number of companies. Thus, with respect to four of the largest representative fire insurance companies reporting to the State of New York, the unearned premium reserve for 1918 exceeded $61,000,000, as contrasted with $21,700,000 of capital stock, $47,500,000 of surplus, and $151,000,000 of total admitted assets.

Ascertainment of the Reserve.-In its strictest sense, we have seen that the reserve of a fire insurance company should consist of the unearned portion of all premiums collected. But when it is remembered that policies vary in their term all the way from a short period to a period of five years, and even longer, and that more policies are written at one time of the year than at another, it is apparent that it would be a difficult task to examine indi

vidually the thousands of policies of a large company with a view to determining the unearned portion of the premium for each. For all practical purposes a short cut rule may be adopted for the approximate ascertainment of this unearned fund. The law of Pennsylvania, already quoted, and generally applied throughout the United States, furnishes such a rule. It provides that the insurance commissioner shall calculate the reserve