I received a request to write an article relative to critical insurance carrier financial ratios. The suggestion was to give explanations and definitions of various terms. My first reaction to this request was, I should have done that long ago!
My second reaction was the impossibility of fulfilling the request. I have spent probably a solid 1,000 hours studying insurance company financial definitions. It really should have taken less than 40 hours. Maybe I’m slow but this industry’s measures are so screwed up that it’s literally impossible to list the definitions because the definitions change with almost every report. There is so little consistency from one report to another that definitions are a joke.
We need a National Standards Board for this industry. For example, the U.S. National Standards Board defines various units such as a mile, a kilogram, and so forth with extreme precision. This is in comparison to the reality that, and I’m slightly paraphrasing, “In this report, claims mean this, but in that report, claims means something else and also, carriers are allowed to count claims as they choose.”
An excellent example I’ve often used is the definition of loss ratio. Because of poor internal controls, most carriers’ reporting systems have different definitions of loss ratios based on what some programmer modeled 20 years ago. Few companies ever go back to create a consistent definition of loss ratio.
The NAIC has a common definition of loss ratio, the only one I know. It is the “Pure” loss ratio. Every carrier must submit its pure loss ratio to the NAIC quarterly and annually. As an interesting side story, I was advising a client that a specific carrier’s pure loss ratio was X%. I was literally reading the number from the NAIC report. I was not making any of my own calculations. The top brass of the carrier became rather upset and absolutely, categorically denied that was their loss ratio and furthermore, they never measured their “pure” loss ratio and did not know what it was! This was a publicly traded national carrier. So I gave them their NAIC report.
What follows then should be read and considered with the understanding these are generic definitions and explanations. The details matter a lot and no one should ever read a financial report or a carrier’s production report or even a contingency statement, without knowing the exact definition of each term as that term is used in that document. Premium, for example, is not premium from one report to another.
Direct Written Premium is the premium charged to the consumer. This is the premium upon which agents’ commissions are generally based (with some major exceptions). While not exactly correct, written premium is like cash accounting. It’s recorded as received.
Net Written Premium is the direct written premium plus or minus reinsurance. For example, if the direct written premium is $100 but the carrier buys $1 of reinsurance, net written premium is $99.
Earned Premium is after reinsurance and is accrual in nature. For example, if the annual premium is $1,200, then the earned premium per month is $100 (obviously major exceptions exist such as those policies where the premium is fully earned, i.e., not refundable after 60 days).
A major national carrier got caught by the SEC several years ago for treating all their premiums for a certain product as earned immediately. In other words, their written premium matched their earned premium. They paid some fines and got off with a slap on the wrist.
Loss Ratios are a function of losses divided by earned premiums, but the definition of losses is complex. What constitutes a loss and when should the loss be recorded? Those are tricky questions because losses often take years to fully develop. When someone steals a ring, the loss is simple to calculate. Let’s say it’s $1,000, paid tomorrow, and there is almost no uncertainty left. But let’s say someone is horribly injured. No one knows how much it will cost to settle that claim at the moment the claim is delivered.
This is why we have calendar year and accident year loss ratios. It is also why carriers set reserves. Does the loss ratio include reserves? A good question to ask. Then one gets into the various types of reserves. That discussion requires more pages than I have room.
Combined Ratios are supposedly the key profit ratio for insurance companies. Executives frequently talk about how bad their combined ratios are and how they can never make money because their combined ratio is above 100%. Combined ratios are the losses plus expenses (including commissions and reinsurance) divided by earned premiums. If this industry had to have combined ratios below 100%, the industry would have gone broke sometime around 1940 because the industry average combined ratio is about 100% over the last twenty years (it was worse prior to that).
The combined ratio is a red herring in many ways. The most important profitability measure is the Operating Ratio. The key difference between the Combined Ratio and the Operating Ratio is that the Operating Ratio includes investment income. As Warren Buffett said years ago, insurance companies are nothing more than glorified mutual funds. He said this because insurance companies rarely make an underwriting profit and this is by design or incompetence (take your pick).
Every investor makes investment money the same way with the same two variables. The first variable is yield. When I ask carrier CFOs what two variables determine how much money they make, they typically correctly identify “yield”. But they almost never get the second part correct. The second part is the amount of money invested. This is the first hour of Finance 201 in college so all CFOs should know the answer. For insurance companies, what matters most is how much money they’ve invested relative to their net written premiums because that is how the operating ratio is calculated. The more investment income relative to premiums, the more profitable and also, the more flexibility carriers have in setting prices.
Surplus is defined as assets less liabilities. Surplus is highly correlated to the amount of money invested relative to premiums. But surplus can include or exclude certain investments from a regulatory perspective, so the numbers are not the same. The more surplus a company has, all else being equal, the more stable the carrier will be in the event of large losses such as catastrophes. Therefore, if you live along the coast and the carrier has $3 million in surplus, I would not count on having my claim paid if a hurricane or even a tornado hits. You’re probably just throwing premiums down the tubes other than satisfying your mortgage company.
Surplus is affected by many factors including the amount of reinsurance purchased and also the quality of surplus, including the liquidity of such surplus. These calculations get rather complex and to say subjectivity of the analyst is not a factor is to fool oneself. For simplicity purposes, I highly recommend reviewing A.M. Best’s BCAR (Best Capital Adequacy Ratio) score. Other capital adequacy ratios exist but Best’s is likely the most accessible for most readers. The scores themselves are plotted on a statistical confidence model which unfortunately is similar to reading Chinese for most people but I don’t have an alternative solution. For my clients, I’ve created additional context that helps them understand these scores in English, but I don’t know of any other options besides getting a statistical degree.
I appreciate the request for more information on the terminology, and I sincerely hope that it helps readers better understand insurance company financial metrics. Always though keep in mind how the actual measure of these numbers varies materially from one report to another and from one carrier to another. And last, always check the carriers’ numbers they present to you against their actual results. Sometimes the variances are significant.
NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.
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