“A reserve is an appropriation of profits for a specific purpose. The most common reserve is a capital reserve, where funds are set aside to purchase fixed assets. By setting aside a reserve, the board of directors is segregating funds from the general operating usage of a company.”

For example, suppose a company installs a product and, as part of their service contract, guarantee their work for a specific amount of time. In order to pay for this work, the company’s accountant sets aside a specific amount of money in a “reserve” account to indicate the potential cost of this service. Over a number of years, the size of the reserve increases as the company sells more of its service.

In effect, a reserve is nothing more than a company saying, “we potentially have to spend $X amount of dollars on this item.” But the reserve is an accounting liability; the larger it grows, the more it can negatively impact the company’s net worth and, by extension, the company’s ability to get and maintain credit.

A far better option is for the company to reclassify the reserve as an expense, usually by converting it into a warranty program. This allows the company to remove the liability from its balance sheet and place it into a captive insurer. This also turns a segregated liability into an expense, which is far more efficient.
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In reality, if your company is using a reserve for a liability, it’s already more than halfway to forming a captive insurer.