Several readers requested more articles related to insurance company financial terminology. I appreciate these requests because I would have thought it would be one of the most boring subjects possible for anyone other than insurance geeks.
Words truly do matter. It’s funny, often ridiculous, and sometimes bordering unethical when I hear carrier employees, executives, and claims adjusters say things like, “Well, the contract does read that way, but that’s not what we mean so there’s nothing to worry about.” If it’s not what was meant, then change the contract! If that is too hard because it involves filings, then do a manuscript endorsement for the agent that is smart enough to request it. That's what manuscript endorsements are for. Otherwise, that perspective seems rather disingenuous to say the least.
The same thing happens on carrier financials but it is easier to disregard the issue because financial terminology knowledge is so lacking at the carrier level, even at the carrier CFO level, as well as the agent/broker/producer level. Below is additional guidance regarding what these terms mean.
Loss Ratio:
As I described in part one, but well worth repeating, most people do not know the true definition of the loss ratio they’re looking at and that is not their fault. The problem is that carriers, over the years, have created all sorts of definitions and usually have lost track of those definitions, which is why on one report the loss ratio is 65% and the next report, all else being equal, the loss ratio might be 67%.
Loss ratios are defined, 100% of the time, by some mathematical formula. The definition can be described in words which resemble the old-fashioned math word problems that most people hated in school. It’s easier to see the actual formula. At the very basic level, the formula is:
Incurred Losses/Earned Premium = Loss Ratio
However, different definitions of earned premium exist, and many different definitions of incurred losses seem to exist because carriers have different ways of recording incurred losses.
Also, not all loss ratios even use earned premiums. Some carriers, for reasons that I fail to understand, use written premiums. Sometimes they use direct written premiums and sometimes they use net written premiums.
Then you get into whether losses include reserves and if so, what kind of reserves. Do losses include loss adjustment expenses?
If an actuary or a high-quality underwriter is examining or modeling loss ratios, doing so with different inputs, say with and without reserves, provides clarity as to how the book is or should perform. But when those numbers are presented to field people, or are shown on production reports, whoever is reading the report needs to know the applicable definition. This is incredibly important when comparing lines of business, carrier vs carrier loss ratios, and contingency loss ratios because quite often, the definition of loss ratios in the contingency calculations is different from the definition used on the production documents.
One of my favorite questions to ask carriers when they are discussing loss ratios is, “What definition of loss ratio are you using?” To date, I’ve never received an immediate straight answer. The best carrier people will say they will research it and return with a definitive answer.
Loss Adjustment Expense (LAE):
This term is fairly self-explanatory. How much does it cost to adjust claims? This covers investigations, third-party reviews, data acquisition, and so forth. However, there are two kinds of LAE, allocated and unallocated. The former is specific to the claim(s) and the latter is associated with overhead such as salaries for claims staff, IT, and so forth.
Understanding LAE’s is important for understanding loss ratios and because some carriers use LAEs in their contingency calculations, it is important to understand how they are assigning these expenses. The answer sometimes is that the carrier does not understand how they’re assigning these expenses.
I'll use a story from long ago because age makes it a safer story to tell. That being said, by no means should anyone think this is an out-of-date scenario. The carrier for which I was an underwriter gave me, and all the underwriters and all the agencies, monthly production reports. As an underwriter, my goal was a loss ratio of X%. I’m a pretty careful analyst and after missing the mark, I decided to analyze my loss ratios every month the following year. I began the year strong but then my loss ratio began creeping up. I began analyzing my claims data and the claims data did not support the loss ratio being reported. I did a deep dive into why and learned that every month, my loss ratio was being increased due to unallocated loss adjustment expenses. The unallocated allocations were significant and barring a true loss ratio of maybe 35% or less, I was never going to achieve the required loss ratio.
When I inquired as to what was going on, the home office advised it was all a mistake, don’t worry about it, and they’d correct it. But they didn't it because I missed my target, and they did the same thing the next year.
Operating Ratio:
Operating Ratio is the KING of profitability measures. The combined ratio is what carriers most often report which is the combination of expense and loss ratios. On the income statement, this is basically the equivalent of the expense portion. The combined ratio lacks a full accounting of the revenues. Combined ratios only include premiums. As Warren Buffett said long ago, insurance companies are nothing more than poorly run mutual funds because they almost never make money in underwriting (the average combined ratio over the last ten years is approximately 100%, thereby proving his point) and their investment yields are nothing to get excited about.
The operating ratio includes investment income and because investment income provides 100% of the profits in many scenarios, the idea of leaving investment income out of the profitability measures is ridiculous.
The amount of investment income earned relative to premium varies tremendously from one carrier to another. Some carriers make as much as 20% of all their income from investments. While others make only 1% - 2%. That difference can make or break a carrier.
Whenever you are reviewing carrier financials, it is critical you know what definition is being used. Even at the A.M. Best and NAIC level, the definitions are not consistent from one report to another and figuring out the differences can be mentally painful. The differences between the carriers’ reports, even internal reports, can be far more painful. But knowledge is power and when I coach agents on these points, they gain tremendous power.
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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