SEER EEECEEELECEELELOLCLGOGEL SE € Oo omen Measuring the Financial Performance of Insurers Sound management of an insurer requires careful attention to its financial performance, One concern about any insurer’ financial performance is its profitability: Does the insurer generate enough profit to survive? A reiated concer is the insurer’ solveney: Does the insurer have adequate resources to meet all of its financial obligations? Insurers prepare and anal financial statements to monitor and report on their financial perlormance. Other interested parties also analyz the financial statements of insurers For example, state insurance regulators want to monitor insurers’ financial performance over time to Wentify any financial difficulties; insureds want to select insurers that have the financial resources to promptly pay covered losses estors want to determine the insurets’ potential for growth and profitability. INSURER PROFITABILITY To survive long term, an insurer must generate more money than it spends, that is, the insurer's revenue must exceed its expenses. In a given month or year, an insurer's expenses might exceed its revenues, requiring the insurer to pay some of those expenses with accumulated funds. Such a pattern, however, will eventually deplete accumulated funds, and the insurer will fail. Like any other business, an insurer must manage its revenue and expenses to produce an overall income (revenue minus expenses) gain from its operations and to ensure the profitability on which its survival depends. Insurers receive income from two major sources: (1) the sale of insurance and (2) the investment of funds. The first source generates underwriting income. Underwriting income (gain or loss) isthe amount remaining after underwriting losses and expenses ate subtracted from premiums. The second Soutee generates iavewtinent Income, Investment income (gain ot loss) is the amount remaining after inyestment expenses ace subtracted froma the ‘ross amount camed on investments during the period. While some insurers receive other income from the sale of specialized services or other incidental em ee sale of specialized: activities, most of the income an insurer receives i either underwriting income or investment income.articular calendar year, os inet ee em by totaling the premiuns charged uit ff policies written. we ates ; : premium are the sagiven _retial For example, when «policy s written to become effective on July or Premiums | Premiums famed | famed | (ese Investment Income Because an insurer collects premiums from its policyholders and pays claims for its policyholders, the insurer handles large amounts of money. Insurers invest available funds to generate additional income, Investment income can be substantial, particulaely during periods of high interest rates or high returns in the stock market es Sr An insuter has investment funds available for two reasons. First, the insurer is legally required to maintain a certain amount of funds, called policyholders” “Surplus, so it can meet its obligations even after catastrophic losses. (Policyholders COUT CLECLLLEC Lotta rh : _— ‘surplus is discussed later in this chapter. ) Provided that the insurer is operating > profitably. its policyholders’ surplus is penerally availabe or investment. Secon, the insurer usually receives premiums before it pays claims on the comresponding “Those und are ReSTT tO pay claims, However, when an insurer settles aims, =~ aTave fands readily available to meet it obligations. Similatly, fa policy is et canceled before the end of the policy period, the insurer must be able to refund Da abeaailaa Insurers have investment depastinents whose objective isto earn the highest — possible return from investments while ensuring that funds are always available tomeet the insurer's obligations. Thus, the investment department must select Converted to cash. One investment strategy may involve buying long-term “Roms that are scheduled for maturity to match expected claim payment needsSRM Eu TCU premiums and For an insurer to be profitable, its combined revenue from eamed investment income must exceed its total oss payments and other exh inggemene income mst ecenlits taal Ss Se FFMTEAE, as well as the various other typey of expenses thar an insurer CUT, ae discussed next | Examples of Written Premiums, Earned Premiums, and Unearned Premiums Case | Annal policy with $600 premium s effective July 1 | Atthe end of Calendar Year 600 $300 (6 of the 12 months of coverage have elapsed) $300 (6 ofthe 12 months of overage have not elapsed). ‘Written premiums Famed premiums Unearned premiums A the endof Calendar Year 2 (assuming the policy isnot enewe): Written premiums = 90. Earned premiums = $300 the remaining 6 months of coverage have elapsed), | Unearned premiums = $0 there sno mare coverageal the premium s eed} Cased | ‘Annual policy with $600 premium is effective December 1 Atthe end of Calendar ear 1 | ‘Written premiums = = $600. Eamed premiums = $50(1 oftie 12 months of coverage have elapsed). Uneared premiums = $550(11 ofthe 12 months of coverage have not elapsed). ‘tthe end of Calendar Yar 2 (assuming the policy isnot renewed): Wren premiums = $0. Earned premiums = $550 the remaining 11 months of overage have elapse). neared premiums = $0 (there isa more coverageall the premium s earned). Ineach case, the written premiums andthe eamed premiums total $600 by the time the coverage has expired. Howeves al ofthe written premiums ae recorded immediate while the eamed premiums ae countedas they are eared ove time.In both cases, the unearned premiums disappear by the expiration dat ofthe policy becauseal of the writen premiums have been eared by the tme the policy period ends Expenses An insurer’ expenses fal into twvo broad categories: (1) expenses associated with underwriting activities and (2) expenses associated with investment activities. Expenses associated with underwriting activity inclide paymentPU eee Eee bole babu roca ve UU uuu ee Re fur loses, loss adjustment expenses, and other underwriting expenses. Some insurersaho pay dividend to their policyholders. Expenses assoctated with investment activities include salaries and other general expenses rAMGTT runing the investment department. Losses ‘The major expense category for most insurers is payment for losses arising from claims. Claims are demands for payment made by insureds based on the conditions specHeM i their tasurance policies, For property-casualy insu Toss payments often represent 70 to 80 percent of their total costs aims are not necessarily settled immediately after a loss occurs. Sometimes the loss is not reported right away. When the loss is reported, the insurers claim repre ntative investigates the loss and verifies whether the loss is covered before the insurer pays the claim. Liability claims may involve lengthy legal proceedings. Some losses ocr in one year but are settled in a later year. In any given year, an insurer knows only the amount of losses it has paid so far, but not a definite amount it will wlimately have to pay. To compare revenue and expenses, an insurer must calculate not only its paid Tosses but also its incurred losses for the period fie A paid loss isa claim payment that an insurer has made, Because it has heen _Paidloss paid, a paid loss isa definite amount. Paid losses, however, do not include those Achim paymenthataninsuer arto Ba Cehnite amount. losses ‘in the process of settlement oF losses thataremeured hutnot reported —_hasmade {IBNR). Therefore, another method to measure losses is to calculate incurre: ses foF a particular period. Incurred losses are the sum of paid losses and Incurred losses changes in loss reserves for a particular period and are calculated as follows: ‘The sum of paid lasses and changesin lass reserves for Incutd loses = Pid i : ed losses = Pad losses + Changes in ss eserves satay Loss reserves are amounts designated by insurers to pay claims for losses th: Fave already occurred but are not yet settled. Changes in loss reserves are Losseseves calculated as follows: ‘Amounts designated by insures Ghangesin os reserves = Loss reserves at end of period - Lossreseresat beginning of prind, (0 4msfor ses thathave a already occoedbutare not yet Because setting los reserves for individual claims is an important part ofthe sete, claim process, it is discussed in more detail later inthis text. Loss Adjustment Expenses Insurers also incur oss adjustment expenses related to investigating and settling insurance claims. For property insurance claims, the claim representative must identify the cause of the loss and whether the loss is covered by _the policy Ifthe Tos is covered, the claim representative must determine the covered amount For liability claims, the claim representative must determine whether the insured is legally responsible for the bodily injury or property damage that is the basis oF the claim and, so, for ich. Determining the legalMO orc cad responsibility of the insured fora lows might require a complex and costly Treconts to defend che insuradin the event of w hiwsuit, the insure 5 ETE Tames. Thus, kes adjustment eSpenses associated with a liability claim ean be substant gardlesy of whether Other Underwriting Expenses In addition to losses and loss adjustme insurance include other significant underwriting expenses, which can be categorized as follows: expenses, the costs of providing © Acquisition expenses * General expenses © Premium taxes, licenses, and fees The expenses associated with acquiring new business are significant. All property-casvalty insure’ have a marketing system to market and distribute their products. This system includes individuals involved ditectly with sales (usually called agents, brokers, producers, or sales representatives) and the — administrative staff that manages and supports the sales effort. Many people Who directly generate insurance sales for insurers receive a commission, which is usually a percentage of the premiums written by the salesperson: Others also a bonus based on sales, profit, or some other measure of productivity While some insurers operate without salespeople (usually through direct response systems such as mai, telephone, and the Internet), these insurers must still employ and pay staff to manage and administer their marketing operations. Advertising expenses can also be a significant component of acquisition expenses for most insurers Insurers incurtill other expenses in the process of underwriting and issuing insurance policies. They need staff and computer systems to review and analyze “Applications Tor insurance, assemble and issue insurance policies, generate billing statements, collect premiums, and record necessary information. Like other businesses, insurers incur various general expenses. While these expenses do not relate directly to activities such as claims, marketing, and underwriting, they are crucial to the insurers’ operations. These general ‘expenses are associated with staffing and maintaining departments such “Srice ifoaton Technology and bling maiterance. In addtion,— TASUTETS Tmust provide office space, Telephones, computers, and other utility services, as well as other office equipment and supplies for these necessary support functions. In the Ur red States, states levy premium taxes, which are usually between 2nd 4 percent ofall premiums generated by the inser ina TUTTE_~ — a a — PUGUECELELETCEULELEEECLELLOELIOLGCE Oe » inust hol and pay fur Ticenyey in each state in which they operate. In alton, insurers ‘MUSt Participate in various stare insurance pr uch ay guaranty fund and automobile imurunce plans. frourers are typically sseved to und oF subsidize these state insurance programs. Unless they function ay excess and sunpla lines insurers, insur Dividends Some insurers choose 10 return a portion of premiums to policyholders as dividends, which may be paigl ont on a_reyular hasis or may be aysociated with a special circumstance. Mutual insurers may pay a dividend tw palieyhohlers when operating results have been good. Dividends may also be paid by any insurer aya marketing technique. Insurers who want to provide the lowest cost tu their policyholders may prefer to accomplish that by paying dividends only after their operating results warrant such payments. In this way, the insurer’ solvency is better protected than i would be by changing low rates up front with little margin for ertor. Investment Expenses An insurer's investment department includes a staff of professional invest. ment managers who oversee the company's investment program. In addition to devising investment strategy and implementing it through the purchase and sale of stocks, bonds, and other investments, the investment department is responsible for a careful and thorough accounting of all invested funds. Investment expenses include staf salaries and all other expenses related to the es ofthe investment department. Insurers deduce these expenses from investinent come on their financial statements to calculate the net income from investments, as shown in the following: activi Net investment income westment income ~ Investment expenses Gains or losses realized from the sale of invested assets are added ‘ment income resulting in net investment gain or loss, which represents the _Netinvestment gain orlass total results from investment activities. An insurers gains or losses fram ‘the sale of invested assets plus net . + investment income Gain or Loss From Operations An insurer's net underwriting gain or loss is its earned Premiums minus its ‘Met underwriting gain or loss losses and underwriting expenses for a specific period. Adding net investment Aninsuerseamed gens gain of loss to net underwriting gain or loss shows an insurer’ overall gain or minsitsesesandundentng loss from operations and is reported by the follovring formula: eagenses fora spc pet, er gainr sam operations = Het imesten gan ors + NetunderwtinggainolOs. ye gainerlsstom This overall figure gives a more complete picture of an insurer's profitability operations than net underwriting gain or loss because net investment gains generally — _vetiesment ain ors pis help to offset underwriting Towes net underwiting gin ors,310° Property and Liability Insurance Principles Net Income Before Taxes An insurer fone tages is its total earned! premiums and invest- ment inco total Josses and other expenses in the comesponding Jjustments for other income items might be necessary. For the insurer might have to write off some uncollected premiums, or it period. Sc exampk might have to ad premiums that were written off during the previous period _ but were ultimately collected during the current periexl. Adjustments might also, Fe necessary fora gain or loss on the sale of equipment or other items. Mucual insurers would also deduct dividends to policyholders from their income: Income Taxes Like other businesses, insurers pay income taxes on their taxable income: Taxable income might viffer from net income before canes hecause ofthe Special requitements of the tax code. For example, a portion of interest earnings from qualified municipal bonds are not taked, and deductions for certain expenses are limited. Insurers often adjust theif investment strategy in response to changing tax laws. Net Income or Loss ‘After an insurer has paid losses and reserved money to pay additional losses, expenses, and income taxes, the remainder is net income, which belongs to the owners of the company. The owners may receive a portion of this remainder as dividends. Fora Fania held company, such dividends are payable to the shareholders. The amoune that i Tel after dividends are “paid becomes an addition to the insurer's surplus, which enables the insurer iSexpand its operations in the future. When evaluating insurers’ rates, regulators permit an allowance for profits and contingencies that should rovide the oworers with an adequate remmnron their investment. Unless the “jasaveT FeneraTes an adequate retum or prof, it will not attract and maintain the investment funds it needs to survive INSURER SOLVENCY To serve its policyholders in the long term, a property-casualty insurer must remain financially sound. Although comparing an insurer's revenue to its expenses ina single year reveals whether the company produced an i come gain OF 8 16%, this Taformarion alone does not the insurers financial condition. The financia mn of an insurer at any particular time is abe hnar easy Bs set liabilities, and policyholders’ surplus. Exhibit 3, later in this text, shows the balince sheet relationship of assets, Habilities, and policyholders’ surplus. These are discussed next.PUebeae [ee ee oo) 8b bo bebe ue mrPpoiooub od oe ee Assets Insurers accumulate funds when they receive premium and investment income, As stated previously, insurers do nor immediately need all of eheit premium income to pay claims and oper ing expenses. [n the meantime, insurers invest the in income-proalucing assets Assets are types of property, both tangible and intangible, owned by an of property both tangible and intangible, entity. Assets typically accumulated by an insurer include cash, stacks, and bonds; property, such as huildings, ofice furniture, and equipment; and accounts receivable trom policyholders, agents, brokers, and reinsurers. For the purposes of filing financial reports with state insurance regulators, an insurer’ assets are classified as either admitted aysets or nonadmitted assets Admitted Assets Admitted assets are types of property, such as cash and stoeks, thar regulators allow insurers to show as assets on their financial statements, Regulators allow admicted assets to be shown on insurers’ financial statements because these assets could easily be liquidated, of converted to cash, at or near the property’ market value. In addition to cash, admitted assets include stocks, bonds, ‘TROTEGAGRS, Fal estate, certain computer equipment, and premium balances due in less than ninety days Nonadmitted Assets Nonadmitted assets are types of property that cannot he readily converted to cash at or near their market value ifthe insurer were to liquidate its holdings For this reason, regulators do not allow insurers to show them as assets on their nancial statements. Nonadmitted assets include office equipment, furniture and supplies, and fremiunis that are more han ninety days overdue ‘The creation of the two categories of assets—admitted and nonadmitted reflects the conservative view that insurance regulators take when evaluating an insurer's financial strength, Regulators do not want insurers to overstate their true financial condition. Therefore, certain types of assets are deemed nonadimitted and cannot be counted toward the value of an insurers holdings ot its financial strength. Liabilities Liabilities are financial obligations, or debts, owed by a company to another entity. An insurer has a financial obligation to its policyholders: It must satisfy legitimate claims submitted by insureds and other partes. The major liabilities of an insurer arise ftom this financial obligation to pay claims. Three types of liabilities are found on an insurer's financial statements, ‘The two major” liabilities are the loss reserve and the loss expense teserve, and the unearned Spo eae et miscellaneous liabilities. Assts Typesof property bath tangible and inane, owned by an ety, Admitted assets ‘Types of property such as cash and sos tat egos alow {insurers to show as assets on their franca sateen. Nonadnited assets Types of prope suchasofice furiture and equipment that regulators do not alow insures toshow as sets on financial statements because these assets nt readily be converted tocash ‘at ornear their market value, Libis Finan obligations odes, ‘owed by a company to another entity, usually the policyholder in the case of an insurer,Porn ie and Loss reser ‘Theamount estimated and set aside insert pay cis for loses that have area occured boutare not yet sete, Unearned premium reserve Te total of an insurers unearned premiums onal poles ata pertclar time Pcyhoders’ surplus ‘An instr total admited assets riusits total ables. Loss Reserve and Loss Expense Reserve The loss reserve is the amount estimated and set aside by insurers to pay claims tur lowes that have already occurred but are not yet settled. The loss reserve is considered a liability because it represents a financial obligation cowed by the masurer Iris the insurer’ best estimate ofthe hnal settlement mount on all claims that have occurred bur have not yet been settled Although establishing loss reserves for claims whose value is nor yet detinite might scem impossible, insurets use their experience, the kaw of large num- hers, and their actuarial and statistical expertise make reliable estimates of furute claim setelement values, Insurers also set up the loss expense reserve to estimate the cost of settling the claims included in the Toss reserve. —oewvve—e—eoaes=«see’sses co —oveeer_ree Unearned Premium Reserve ‘The unearned premium reserve isthe toral of an insurer's unearned premiums onall policies ata particular time, The unearned premium reserve isa liability because it represents insurance premiums prepaid by insureds for services that the insurer has not yet rendered the insurer ceased operations and canceled all of its policies, the unearned premium reserve would represent the total of premium refunds that the insurer would owe its current policyholders. Other Liabilities ‘As mentioned, other liabilities on an insurer's financial statements are much mallet than the loss reserve and the loss expense reserve, and the unearned premium reserve. For some insurers, chere may be a significant obligation reflected in the liability for reinsurance transactions. Policyholders’ Surplus Once the total value of an insuter’s admitted assets (cash, stocks, bonds, real estate, and so forth) and liabilities (loss reserve and loss expense reserve, tuncamed premium reserve, and other liabilities) is known, the insurer can determine its policyholders? surplus. Policyholders’ surplus equals the insurer's total admitted assets minus its total liabilities. Policyholders’ surplus measures the difference between what the company owns (its admitted assets) and What it owes (itsliabilities). = =~ SSSSSStStCS ‘Policyholders’ surplus provides a cushion that isa wer Thave an adverse financial experience. While premiums may include a margin “Tor error, that margin might not be suficient to offset unexpected loses, particularly catastrophic losses, flosses exceed expectations, che insurer must draw on its surplus to make required claim payments, Policyholders’ surplus also provides the necessary resources if the insurer decides to expand into anew {GTO or develop new insurance products This, the moun ofPolcyhol des surplus held by an insurer is an important Measure of is financial condition. Exhibit 3-3 summarizes the admitted assets, liabilities, and policyholders’ sunplus held by the propercy-casualty insurance industry in 2003 _- air Walaa Vala Wane’ ‘eile WAIT aM acl ety vay ely ae? OY Die yun] ey 7 ee; og ee eee eee iy er, pe, ez”‘Measuring the Financial Performance of Insurers _ 3.13 | Consolidated Balance Sheet for the Property-Casualty Industry Based on data fom Bes Agoregctes nd Averages Property Casualty © A.M Best Cmpany-used with permission MONITORING INSURER FINANCIAL PERFORMANCE Because the objectives of most insurers include being profitable and remaining in business in the long term, insurers must carefully monitor their financial performance. Regulators, investors, and others also monitor the performance of insurers. ~~ = — — = (2,380 Companies) > | =< | Consolidated Property-Casvalt Industry Totals | ~ | Balance Sheet December 31, 2003 = Cinrilions of dots) | - Admitted Assets | —> sh and short-term investments 5 esl | = Bonds 642838 a Prefered stock 9.05 | - «Cl Common stock 126560 - Realestate 9,466 — Other assets 2asr.007 | S| raltinitedases 17438 | ables — | Lass reserve and loss expense reserve $445.22 eee Uneatned premium reserve 176311 = Conditional reserve funds 19882 ae Other abies 178854 | = Total libltes $ e079 —> Palicyoldrs Surplus 35389 ~} Total ibis and Polcyholders'Supls $1,174328 nancial losurers must record and report financial information in a consistent = manner, using various financial statements, Interested parties can analyze . these financial statements to evaluate the insurers’ financial performance. Ensurance buyers, agents, and brokers often use the reports and evaluations Of financial rating organizations, such as A.M. Best Company and Standard ‘& Poor's Corporation, to select insurers that are considered to be in strong = and stable financial condition.Pie Balancesheet Ananda statement that shows acomparysfnancl poston t arta point in time. Foran insurer tincades tenses admitted assets ait, and policyholders sup, Financial Statements Insurers must prepare accurate financial statements that describe the company’ financial postion in an objective, standardized format. The two tnancial statements that provide the most information concerning the financial condition of an insurer are the balance sheet and the income statement Balance Sheet The balance sheet shows an insurer’ financial position ata particular point in time and includes the insurers aakmiteed assets, liabilities, and policyholders surplus. Exhibit 3-4 shows a condensed balance sheet for Atwell Insurer, a fictitious insurer, on the last day of the year, Although a halance sheet shows in insurer's assets and liabilities only as of a articular date, they change constantly Insurers establish unearned prema réserves for premiums they receive, The unearned premium reserve tor each policy declines with the passage of time, Also, losses occur and insurers establish loss reserves. New policies are written, and old policies expire or are renewed, Meanwhile, the insurer buys and sells stocks, bonds, and other investments as needed to meet its obligations while earning investment income. Therefore, an analysis of an insurer’ assets andl liabilities is only as current asthe date of the Palanee sheet, Which PRESEN a snapshor of the Financial position of the company at that point in time Eee ae 4 3 Atwell Insurer Balance Sheet as of December 31 Admitted Assets: ‘Cash and short-term investments Bonds Other liabilities, 200,000 Total Liabilities $1,000,000 Poliyholders Surplus 500,000 Total Liabilities and Poticyholders Surplus $1,500,000 Common stack Total Admitted Assets $1,500,000 a Liabilities: ’ Loss reserve and loss expense reserve $ 550,000 | ‘Unearned premium reserve 250,000 | ‘Pee eee et LECCE CL thet bea ts aby Income Statement An insurer income statement show its reventies, expenses, and net income _ Income statement fora particular period, usually one year, Exhibit 5-3 shows condenved ——_Afinanialstatement that shows nent for Atwell Insurer. ‘company's revenues, expenses, and netinceme fra particular prin, usualy one yea vg the year, Atwell [nvurers revenues from eusned premiums totaled $1,000,000. In the same yeas, the company’s expenses totaled $1,080,000 These expenses included incurred losses, loss adjustinent expenses, eqs: tion expenses, general expenses, premium taxes, licenses, and fees. Because losses and underwriting expenses exceeded earned premium, Atwell Insurer experienced a net underwriting loss of $80,000. However, Atwell also eared net investment income of $100,000 during the year. Therefore, Atwell Lnsurer realized a net income gain of $20,000, before income taxes. Atwell Insurer Income Statement for the Year Ending December 31 Revenues | Earned Premiums $1,000,000 | Expenses: , Incured losses $650,000 | Loss adjustment expenses 100,000 Other underwriting expenses: Acquistion expenses 220,000 General expenses 90,000 Premium taxes licenses, and fees 200 | Total Expenses $1980,000 Net Underwriting Gain (Loss) $ (80,000) Net investment income 109,000 Net income Before Income Taxes $2.00 | Financial Statement Analysis Analyzing the relationship of different items that appear on insuters’financial statements helps determine how well insurers are performing, Comparing {wo items produces a ratio thac highlights a particular aspect of financial performance. Several Such ratios are widely used in the insurance industry by ‘Many People and organizations. Insurers use them to identify strengths and \weaknesses in their companies’ operations. Investors analyze the ratios to identify the insurers that are most attractive a investments. Regulators also examine the ratios to determine whether insurers have the financial strength ‘To remain Viable i the Tong term and to meet their financial obligations to policyholders and other parties.3.16 Property and Liability Insurance Principles Lossratio Aninsuresncuredlases (indudingiss adjustment expenses for given period vided byt earned pears for the same peri Expense ratio Aninsurersincured underwriting expenses fora given period vided by ts writen premiums forthe same peti. these ratios are important to insurance sents and brokers as well. The financial condition of an insurer should he one of the factors considered when producers select the companies with which they place business. Producers should be reasonably sure that an insurer is financially sound and that it will be able to meet its financial obligations. Profitability Ratios ‘There are several ratios for measuring the profitability of an insurer, inclu the following * Loss ratio # Expense ratio * Dividend ratio + Combined ratio # ovestment income ratio * Overall operating ratio Profitability ratios are usually converted into percentages for easier analysis of financial performance. The loss ratio compares an insurer's incurred losses to its earned premiums for 1 specific time period, The figure for incurred losses includes loss adjustment expenses. The loss ratio is calculated as follows: Incurred losses (ining loss adjustment expenses) {oss fat = A$$ $$ famed premiums ‘When converted into a percentage, the loss ratio indicates what proportion of ceamed premiums is being used to fund losses and their settlement. By looking AC This percentage, SUTES, TERUTOTS, THvestors, and others can determine hhow closely actual loss experience compares to expected loss experience. For cexample, atthe beginning of the year, management might have decided that an 85 percent loss ratio is the target for the coming year. As each month progresses, the loss ratio is recalculated based on che company’s experience to date to determine whether the iisurer is meeting the targeted 85 percent ratio The expense ratio compares the insurer's incurred underwriting expenses to its writcen premiums in a specific time period. The expense ratio is calculated as follows: Incuted underwriting eenses Expense ratio Witten premiums When converted into a percentage, the expense ratio indicates what proportion of an insurer's written premiums is being used to pay acquisition costs, general expenses, and premium taxes. In other words, this ratig ~ indicates the insurer's general cost of doing business as a proportion of the— — — os, Pervert te bl ek fot part oF either the fos ratio or the expense ratio.) The cen premiums it has rit (Investment income and investment expens » are tio expense gives a general picture of how eficientl-the inser is pening. Insurers watch the Rjense ratio careflly overtime andattempe to reduee iby managing eis flow and contiolling expen The dividend ratio applies to tone insurers that pay dividends to policyholders. —bivdend rato It indicates what proportion of an insurer's earned premiums (if'any) is being Aninsuer polyol ddends retumed to policyholders in the form of 1fuividends. The dividend ratio is calculated forgiven period divided by ts as follows: ‘tamed premiums for the same Polcyholder dividends pet Oividend ratio = — Earned premiums The dividend ratio by ivelf is not a measure of profitability but its sometimes a component of the combined ratio, described next. Combined ati The combined ratio isthe sum ofthe loss ratio and the expense ratio and is Thesumofthe sat andthe used co compare ¢ : operations. The ees ati, combined ratio is caléulated as follows: Combined rata = Los ratio + Expense ati. Looking at the individual components of the loss ratio and the expense ratio would give the following formula for calculating the combined ratio: Incured ses tncutrgssajustmentepenses)_cedurderutng expenses Combined ratio= EE TE PE Cn eS Famed premiums Witten premiums Notice thet both the numerators (top numbers) and the denominators (bottom numbers) in the loss ratio and the expense ratio are different The loss ratio attempts to relate the level of losses as they are incurred the corresponding earned premiums. Both the incurred losses und eared premiums reflect the insurance coverage provided over time. Because these “two measurements represent corresponding cash inflows and outflows on an accrual basis, they provide the most informative basis for the loss ratio. Expenses are a different matter. Many of the underwriting expenses incurred _ by insurers involve acquisition expenses, such as producers! commissions. Because these expenses occur at the begins riod, the use cof written premiums, which recognizes the entire premium as soon a it is ‘written, is appropriate for cor renuex, Therefore, written “premiums are used in lieu of earned premiums as the denominator in the expense ratio. While the combined ratio is considered the accepted measure of an insurers underwriting performance, this ratio does not take into account the insurer's investment income, and thus does not measure the insurer’ overall financial performance. Overall financial performance includes the result from both the insurer’ underwriting activities and its investment activities.Investment income ratio Netinvestmentincame divided by eamed premiums fora given period. Overall operating ratio The combined ratio minus the investmeatincame rt, “expenses. Ofall the commonly used ratios, the overall operating For insurers that pay pol holder divadends (mot suck aasulendh), the thin component of the combined ratio isthe dividend ratio, The ratio would then be calculated as follows Combined rata = Loss ato + Expense ratio + Dividend ratio. For clarity, when the combined ratio is calculated using policyholder dividends itis often called "combined ratio after policyholder dividends.” When loss ratios are calculated, the results are decimal expressions such as 0.90 (an insurer whose outflow equals 90 cents of each premium dollar) or 1.15 (an insurer whose outflow is $1.15 for each premium dollar). In the industry vernacular, these ratios ave typically expressed without the decimal, such as “90” or “115,” much as one might express that a baschall player is “batting 333” when the mathematical calculation of getting one hit in each, thiee at-bats results ina hatting average of 0.333 The lower the combined ratio, the better. Most insurers considera combined ratio under 100 to be acceptable, because itindicares a profit from underuriting, even Before investment income is considered, In fact, many insurers regularly experience a combined ratio over 100 and artempe to offser underwriting losses with investment income. The investment income ratio compares the amount of net investment income (investment income minus investment expenses) with earned premiums over i s Nt investment income Eammed premiums The investment income ratio indicates the degree of success achieved in the insurer's investment activites. The higher the ratio, the more successful are The overall operating ratio is the combined ratio (loss ratio plus expense ratio) minus the investment income fafio (net investment income divided by earned premiums) and can be used to provide an overall measure of the financial performance of the insurer fora specific period. It is calculated as follows: (verl operating rato = Combined rato — Investment income rt ‘The investment income ratio must be subtracted from the combined ratio because investment income is used to offit the insurer’ losses and underwriti whe ‘most complete measure of insurer financial performance. To obtain a true pictute ofan insure’ profitability, overall operating ratios fora numb of yeas ‘hould beanalee, Deca an company might havea single kad ear hat “offset by apat od. Exhibit 3-6 shows how to of profitability overa longer p culate the various profitability ratios forthe fictitious Atwell InsurerMeasuring the Financial Performance of insurers 3.19 Profitability Ratios for Atwell Insurer | LUV Win | Bamed premiums $1,000,000 ‘Written premiums 1,100,000 | Incured underwriting expenses 330,000 | Incrted losses (incuding las austment expenses) 750,000 | Netinvestment income 100,00 Incured losses {inducing lossadjusiment expenses) $750,000 | oe Sree oe — = 0.75(0r 75%) lossratio ae Eamed premiums $1,000,000 Incuredunderwting expenses $330,000 es Oey oleae Whiten premiums $1,100,000 | Expense rat Combined ratio= Los rato + Expense ratio= 0.30 + 0.75 = 1.05 or 105%), Netinvestmentincome $100,000 Investment income ratio Eamed premiums $1,000,000 i = 0.10 (or 1096), | ral operating rato = Combined ratio Investment ince ratio= 1.05 ~ 010 =0.95 (or S585) | | Expressed as percentages, the expense ratio for Atwell Insurer is 30 percent, while its loss ratio is 75 percent. This creates a combined ratio of 105 percent. When the investment income ratio of 10 percent is subtracted, the overall operating ratio equals 95 percent. Using ingurer jargon, the overall operating ratio would be expressed simply as “95," An insurer with an overall operating ratio of 100 percent breaks even because revenue from all operations equals total expenses plus incurred loses. ratio of less than 100 percent indicates an overall operating gain because revenues are sreater than total expenses. Conversely, ifthe ratio is greater than 100 percent, an operating loss has occurred because total expenses ate greater than revenue. Although these ratios are the clearest indicators of insurer profitability, they should be used carefully and reexamined frequently. The loss ratio includes incurred losses as a key component. Because measu urred involves an estimate of the amount that will ultimately be paid on claims that were incurred during the current year, che [oss ratio is subject a losses develop. Likewise, because the loss ratio is part of POPUL EE bier bb ibaa tlPE ees The insurer cannot know exactly how it performed in a specific perio until al claims for incurred losses in that period are fully paid, which may not occur for several years, Monitoring financial results trom past years helps to deter mine she accuracy of the insurer's los reserve estinnates Capacity Ratio In addition to profitability, an important concer for an insurer is its capacity to write new business and thus to grow: The measute uf an insurer's capacity is Cyacty ato orpremiumto- its eapacity ratio, also known as its premium-to-surplus ratio. [tis calculated surplus ratio as follows: sania 7 ten premiums fritten pret in ms divided by Witten premiums policyholder’ surplus Capacity ratio = —— Policyholders’ surplus The capacity ratio compares an insurer's written premiums (which represent its exposure to potential claims) to its policyholders’ surplus (which represents its cushion for absorbing adverse results). If losses and expenses exceed written premiums must use its surplus to meet its obligations. Therefore, an insurer's new written premiums should not become too lange relative to is polieyholders surplus ind investment income, an insur Exhibit 3-7 shows the capacity ratio for Atwell Insurer, using data from Exhibits 3-4 and 3-6. The ratio of 2.2-to-l is not unusual, because insurers often have ghen have 2 premium-to-surplus ratio close to 2-to-L, While it is nox a magie figure, isUaNCe regulators use the capacity ratio as a benchmark to determine whether an insurer may be headed tows cial difficulty. For example, a premium- to-surplus ratio above 3-to-1 could be a sign of weakness insurer may nor have a suflicient cushion of policyholdei ingreased exposure to claims. However, regulators cannot financial condition by this measure alone. In addition to the capacity ratio, regulators use many other measures of financial performance. Because the Capacity Ratio for Atwell insurer Written premiums $1,100,000 | Policyholdes’ surplus a0, 000 Wiriten premiums $1,100,000 _ 2.2 Policyholders’ surplus $500,000 1 pacity ratio =‘Measuring the Financial Performance of Insurers 3.21 SUMMARY Sound operation of an insurer requires that great care be ven to as financial condition and performance, To survive long term, an insurer’ revenue must exceed its expenses. Insurery must operate profitably, remain solvent, and provide financial statements so that their financial performance ea monitored by state insurance departments and others he The profitability ot an insurer is more difficult to measure thaa the profitability of many other businesses because of timing differences between the receipt of money (premiums) and the performance of the corresponding service (claim payments). Eamed premiums are a better measure of premium revenue than written premiums during a specific period. Similarly incurred losses area better measure of losses during that period than 3 € paid lenses An insurer's income includes both underwriting income and investment income. Its expenses include losses, oss adjustment expenses, other underwriting expenses, and investment expenses, The company’s ovenll gain vor loss from operations is the sum of its net underwriting yan or loss and its net investment gain or los fora specific period. Unless there isan overall sgain—that is, 2 profit—the insurers financial condition will deteriorate ial condition. Solvency Solvency is the primary measure of an insurer's finan indicates the insurer’ ability to meet its obligations, Is assets, or what it owns, must exceed its liabilities, or what it owes. The difference between admitted assets and liabilities is policyholders’ surplus. To be certain that insurers do not overstate their policyholders’ surplus, regulators require insurers to follow conservative accounting procedures. These procedures allows insurers to show on their financial statements only admitted assets. which include defined categories of assets that can be readily converted to cash. These accounting procedures for insurers also require that insurers show as liabilities their loss reserve and loss expense reserve, and unearned premium reserve. To monitor financial performance, regulators and others examine insurers’ financial statements, The balance sheet, which measures an insurer's financial position, shows the insurer's assets, liabilities, and policyholders’ surplus con a given date, such as the last day of the year. The income statement, which measures profitability, shows the company’s revenues, expenses, and net income before taxes during a given period, such as a year. Analysis of these financial statements makes it possible to measure an insurer's financial performance over time, to compare one company to another, and to identify financially weak insurers. Analyzing financial statements often involves using ratios to make these comparisons. Several different ratios measute various aspects of profitability The most useful ratio for measuring profitability isthe overall operating ratio, which is calculated as the combined ratio (loss ratio plus expense ratio plus dividend ratio) minus the investment income ratio (net investment income vided by earned premiums). The capacity ratio (written premiums divided by policyholders’ surplus) is also important because it measures an insurers capacity to write new business and thus to grov.