Is it some sort of system file?
Yes, it is, but just for system restore purpose. It can be disable or delete if you have other source of regular backup.
how critical or important is it?
Not critical if you have other backup in place. This feature can bring your system back to the point it was last running successfully. System restore can take up your resources and slower down the performance.
any solution to reduce the file size?
No. If your image is big, your system restore file should be big. If you don't need to use this feature, simply disable the service and delete the file.
Here is your reading info:
http://www.theeldergeek.com/system_volume_information_folder1.htmK