Financial Analysis: Ratios for Life Insurers
Ratios turn a balance sheet into answers. Here are the ones the paper asks about.
An insurer makes money in two ways: underwriting (premiums less claims and costs) and investment income on the funds it holds. Its ratios split along the same line. CARE Ratings, in its August 2022 note on insurer ratios, groups them into three families: earnings, liquidity and solvency, and it judges the underwriting function and the investment function separately.
Life insurers add a fourth family that a general insurer does not need: measures of long-term value such as persistency, value of new business and embedded value. That is because a life policy earns its profit over many years, so one year's profit and loss account says little about the business written.
One warning before the formulas. Rating agencies and IRDAI do not always define the same ratio the same way. Learn which body uses which denominator, because that is exactly where a question can trip you.
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Earnings Ratios
Definitions as CARE Ratings (2022) states them unless another source is named.
Premium growth
How it is worked out
(This year's gross premium written − last year's) ÷ last year's, × 100
What it tells you
Growth in business undertaken
Risk retention
How it is worked out
Net premium written ÷ gross premium written
What it tells you
How much risk the insurer keeps versus cedes to reinsurers
Loss (claims) ratio
How it is worked out
Net claims incurred ÷ net premium earned, × 100
What it tells you
Nature of risk written and whether pricing is adequate
Expense ratio (CARE)
How it is worked out
(Management expense + net commission paid, or − net commission earned) ÷ net premium earned, × 100
What it tells you
Efficiency of insurance operations
Expense ratio (Crisil)
How it is worked out
(Operating expense + commission expense) ÷ net premium written
What it tells you
Higher ratio means lower efficiency and lower underwriting profit
Combined ratio
How it is worked out
Loss ratio + expense ratio
What it tells you
Underwriting profitability after claims and costs; higher is worse
Investment yield
How it is worked out
Total investment income ÷ average investments of this year and last
What it tells you
Seen both before and after capital gains (realised and unrealised)
Net earnings ratio
How it is worked out
Profit after tax ÷ net premium written
What it tells you
Underwriting, expenses, investment income and tax in one number
Return on revenue
How it is worked out
Profit before tax ÷ total revenue
What it tells you
Captures both underwriting and investment earnings
Return on net worth
How it is worked out
Profit after tax ÷ average net worth (CARE); ÷ net worth (IRDAI circular, Crisil's return on equity)
What it tells you
Use of shareholders' funds
Return on assets
How it is worked out
Profit after tax ÷ average total assets
What it tells you
Profit made on the whole balance sheet
| Ratio | How it is worked out | What it tells you |
|---|---|---|
| Premium growth | (This year's gross premium written − last year's) ÷ last year's, × 100 | Growth in business undertaken |
| Risk retention | Net premium written ÷ gross premium written | How much risk the insurer keeps versus cedes to reinsurers |
| Loss (claims) ratio | Net claims incurred ÷ net premium earned, × 100 | Nature of risk written and whether pricing is adequate |
| Expense ratio (CARE) | (Management expense + net commission paid, or − net commission earned) ÷ net premium earned, × 100 | Efficiency of insurance operations |
| Expense ratio (Crisil) | (Operating expense + commission expense) ÷ net premium written | Higher ratio means lower efficiency and lower underwriting profit |
| Combined ratio | Loss ratio + expense ratio | Underwriting profitability after claims and costs; higher is worse |
| Investment yield | Total investment income ÷ average investments of this year and last | Seen both before and after capital gains (realised and unrealised) |
| Net earnings ratio | Profit after tax ÷ net premium written | Underwriting, expenses, investment income and tax in one number |
| Return on revenue | Profit before tax ÷ total revenue | Captures both underwriting and investment earnings |
| Return on net worth | Profit after tax ÷ average net worth (CARE); ÷ net worth (IRDAI circular, Crisil's return on equity) | Use of shareholders' funds |
| Return on assets | Profit after tax ÷ average total assets | Profit made on the whole balance sheet |
Liquidity Ratios
Good liquidity lets an insurer meet an unexpected cash need without selling investments at a bad moment. CARE notes that forced sales can lock in large realised losses from temporary market conditions or tax effects.
- Liquid assets to technical reserves (CARE)
- Liquid assets ÷ technical reserves. Technical reserves are created to cover expected claims.
- Liquid assets to current liabilities (CARE)
- Shows whether current liabilities can be settled without selling long-term investments early or borrowing. Below one, liquidity becomes sensitive to premium collections.
- Liquid assets to policyholders' liabilities (IRDAI circular)
- Shown in times. Liquid assets are short-term investments, short-term loans and cash and bank balances. Policyholders' liabilities are claims due within 12 months plus unexpired risk and premium deficiency reserves.
- Sources of liquidity (Crisil)
- Underwriting cash flow, operating cash flow and the liquidity of the investment portfolio. A bank line of credit is an added plus. Surrenders, lapses and cancellations can weaken a life insurer's liquidity.
The Solvency Ratio
Solvency ratio = available solvency margin (ASM) ÷ required solvency margin (RSM). ASM is the excess of assets over liabilities across policyholders' and shareholders' funds (Crisil). RSM is worked out by a method the regulator prescribes, and it rises with the risk in the underwriting book and the investment portfolio: Crisil's example is that crop insurance needs a higher RSM than fire insurance.
CARE (2022) states that IRDAI has prescribed a statutory minimum of 1.5x, and IIFL and Max Life give the same 1.5 (150%). CARE looks both at compliance with 1.5x and at the cushion above it. Max Life's worked example: assets ₹10,000 crore, liabilities ₹7,000 crore and RSM ₹1,000 crore give ASM of ₹3,000 crore and a solvency ratio of 3.
Max Life says life insurers report solvency quarterly in their public disclosures, and year-end ratios appear in the IRDAI Annual Report. The IRDAI circular's ratio list also takes the ASM to RSM ratio from quarter-end solvency reporting, shown in times.
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What the Solvency Ratio Does Not Tell You
Max Life lists these limitations:
- check_circleIt is insensitive to short-term liquidity. Solvency is about long-term obligations; liquidity is about the short term.
- check_circleIt overlooks operational risks such as claims speed and management competence.
- check_circleValuation methods for assets and liabilities can change the ratio artificially.
- check_circleA high ratio does not by itself show profitability, and an exceptionally high one may mean idle capital.
Life Insurer Measures
- Persistency
- How many policies stay in force. Sources define it differently: policies in force ÷ policies issued in a fixed period, by count or premium (IIFL); policyholders paying premium ÷ total active policyholders (Crisil key ratios); policies renewed this year ÷ policies outstanding in prior years (Crisil 3.1). Value Research says it is often quoted for the 13th, 37th and 61st months. A higher figure signals policyholder trust.
- Conservation ratio (Crisil)
- Renewal premium collected this year as a percentage of total premium collected last year.
- Annualised premium equivalent (APE)
- Regular annualised premium on new policies plus 10% of single (lump-sum) premiums received. Not 100% of single premium.
- Value of new business (VNB) and VNB margin
- VNB is the present value of expected future earnings from policies written in the period; IIFL calls it the key profitability measure. VNB margin = VNB ÷ APE. Crisil's illustration: a 30% margin means about ₹30 of lifetime expected profit per ₹100 of new policy written.
- Embedded value (EV)
- A measure of shareholder value in a life insurer: present value of expected future profits on existing policies plus capital and surplus net of liabilities. Return on EV (Crisil) = profit after tax ÷ (present value of future profits + net asset value of capital and surplus). Value Research says life insurers are valued on price to embedded value.
- Death claims settlement ratio (IIFL)
- Death claims settled ÷ (death claims reported + those outstanding at the start of the year). A customer-service measure, different from the unfair business practice ratio (grievances on unfair practices ÷ policies issued).
From Cost of Capital to an EV Discount Rate
Embedded value is very sensitive to the discount rate chosen. The donor paper on valuing life insurers sets it out in this order.
- 1
Start with the cost of equity (CAPM)
Cost of equity = risk-free rate + β × (market return − risk-free rate). Common practice takes the ten-year government bond yield as the risk-free rate. Only systematic risk (beta) is rewarded; company-specific risk can be diversified away.
- 2
Read beta
A beta of 0 means no market risk; a beta of 1 means the same risk as the whole market.
- 3
Blend in debt (WACC)
WACC = (debt ÷ total capital) × cost of debt + (equity ÷ total capital) × cost of equity. In theory it is the right rate for business as risky as the whole company.
- 4
Adjust for the business
Product range (guarantees, who bears investment risk), distribution strength and expense overruns can push the rate above WACC. Unit-linked business, where policyholders bear most investment risk, carries a higher rate than participating business.
- 5
Show a range
An insurer may show EV under optimistic, central and pessimistic scenarios. The European Embedded Value principles were set in 2004 by the CFO Forum.
Exam Traps
Solvency ratio is ASM ÷ RSM, never the other way round. APE counts 10% of single premium, not 50% or 100%. Gross written premium is before reinsurance; premium earned is after it. Operating leverage (net premium written ÷ net worth) is a non-life measure. CARE divides its expense ratio by net premium earned, Crisil by net premium written. Insurer hybrid capital (subordinated debt or preference shares) is likened to Basel II upper Tier II bonds, not equity.
FAQs
What is the solvency ratio of an insurance company?expand_more
Available solvency margin divided by required solvency margin. CARE (2022), IIFL and Max Life all give IRDAI's minimum as 1.5 (150%).
What is the combined ratio?expand_more
The loss (claims) ratio plus the expense ratio. It measures underwriting profit after claims and operating costs; the higher it is, the lower the underwriting profit.
How is VNB margin calculated?expand_more
Value of new business divided by annualised premium equivalent, where APE is regular annualised new premium plus 10% of single premium.
Why do life insurers use embedded value instead of just profit?expand_more
Life insurers take time to break even, so Crisil looks at VNB margin and return on embedded value alongside return on equity. EV captures the future profit locked in the policies already written.
What is persistency in life insurance?expand_more
The share of policies that stay in force. Definitions vary by source, and figures are often quoted at the 13th, 37th and 61st months.
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