Financial Analysis of Property-Casualty Insurance Companies
We will cover following topics
Loss Ratio
The loss ratio is a fundamental metric used to assess the financial performance of a property-casualty insurance company. It measures the proportion of incurred losses (claims paid and reserves set aside for future claims) to earned premiums. The formula for calculating the loss ratio is as follows:
- Loss Ratio= $\dfrac{\text{Earned Premiums}}{\text{Incurred Losses}} \times 100 \%$
Explanation: The loss ratio indicates the percentage of premium income that is used to cover losses. A lower loss ratio generally implies better financial health for the insurance company since it suggests that the company is effectively managing its claims and underwriting practices. Conversely, a high loss ratio could indicate that the company is paying out more in claims than it is collecting in premiums, which may lead to financial challenges.
Example: Suppose ABC Insurance Company earned 10 million in premiums during a specific period and incurred USD 5 million USD in losses (claims and reserves). The loss ratio for ABC Insurance Company would be:
- Loss Ratio = $\dfrac{5,000,000}{10,000,000} \times 100 \% = 50 \%$
In this example, ABC Insurance Company’s loss ratio is 50%, indicating that it uses 50% of its earned premiums to cover losses.
Expense Ratio
The expense ratio is another crucial metric used to assess an insurance company’s financial performance. It measures the percentage of underwriting expenses (operating costs) to earned premiums. The formula for calculating the expense ratio is as follows:
- Expense Ratio = $\dfrac{\text{Underwriting Expenses}}{\text{Earned Premium}} \times 100 \%$
Explanation: The expense ratio provides insights into an insurance company’s operational efficiency and cost structure. A lower expense ratio is generally more favorable since it suggests that the company is operating efficiently and keeping its administrative and underwriting expenses in check. Conversely, a higher expense ratio might indicate that the company’s operating costs are eating into its premium income, potentially impacting profitability.
Example: Suppose XYZ Insurance Company incurred 2 million USD in underwriting expenses during a specific period, and its earned premiums were 20 million USD. The expense ratio for XYZ Insurance Company would be:
- Expense Ratio= $\dfrac{2,000,000}{20,000,000} \times 100 \% = 10 \%$
In this example, XYZ Insurance Company’s expense ratio is 10%, suggesting that it spends 10% of its earned premiums on underwriting expenses.
Combined Ratio
The combined ratio is a comprehensive metric that takes into account both the loss ratio and the expense ratio. It assesses the overall profitability of the insurance company’s underwriting operations. The formula for calculating the combined ratio is as follows:
- Combined Ratio = Loss Ratio + Expense Ratio
Explanation: A combined ratio below 100% indicates that the insurance company is generating an underwriting profit, i.e., it is collecting more in premiums than it is paying out in losses and incurring expenses. On the other hand, a combined ratio above 100% suggests that the company is experiencing an underwriting loss.
Example: Using the data from the previous examples,
- Loss Ratio for ABC Insurance Company: 50%
- Expense Ratio for XYZ Insurance Company: 10%
- Combined Ratio for ABC Insurance = 50% + 10% = 60%
In this example, ABC Insurance Company’s combined ratio is 60%, indicating that it is making an underwriting profit.
Operating Ratio
The operating ratio is another important metric used in property-casualty insurance companies. It measures the sum of loss and expense ratios, which collectively represent the cost of operating the insurance business relative to earned premiums. The formula for calculating the operating ratio is as follows:
- Operating Ratio = Loss Ratio + Expense Ratio
Explanation: The operating ratio shows the proportion of the earned premiums that are utilized to cover both losses and expenses. Similar to the combined ratio, an operating ratio below 100% suggests that the company is generating an underwriting profit, while an operating ratio above 100% indicates an underwriting loss.
Example: Using the data from the previous examples,
- Loss Ratio for ABC Insurance Company: 50%
- Expense Ratio for XYZ Insurance Company: 10%
- Operating Ratio for ABC Insurance = 50% + 10% = 60%
In this example, ABC Insurance Company’s operating ratio is 60%, indicating that it is making an underwriting profit.
Conclusion
This chapter delves into the financial analysis of property-casualty insurance companies, providing insights into key metrics such as the loss ratio, expense ratio, combined ratio, and operating ratio. These metrics are essential for evaluating the profitability and operational efficiency of insurance companies, thus enabling better decision-making and risk management within the industry.