Introduction to financial strength of an insurance company

In another blog, we have already discussed “How do an Insurance company makes money?” Usually, the business element of the insurance agencies revolves around charging premiums in exchange for insurance coverage, then reinvesting those premiums into other interest-generating assets.

Insurance companies deal with large and complex claims made against policies that are sold by them. Including this, an insurance company faces various kinds of risks. Therefore, before investing in an insurance company, investors should know the financial status of that company. In this blog, we will discuss, how we can measure the financial strength of an insurance company.

Financial strength and its measurements for insurance companies

At the most basic level, financial strength is the ability of insurance companies to generate profits and sufficient cash flow to pay bills and repay debt or investors. It is a key component necessary for an insurance company to sustain, expand and ultimately return capital to owners.
There are some agencies with their expertise in rating insurance companies according to the financial conditions of companies. Some famous agencies out of them are the following:

1. A.M. Best Company
2. Demotech
3. Fitch Ratings
4. Moody’s Investor Service
5. Standard and Poor’s Corporation

Most of these kinds of agencies follow a standard set of ratios for evaluating Insurance companies. These ratios can be divided into the following categories:

• Earnings Ratios
• Liquidity Ratios
• Solvency Parameters

Now, let’s discuss these in detail.

• Earning Ratios:
  Earning ratios are defined as a set of financial metrics that are used to evaluate a business’s ability to make profits relative to its revenue, operating values, balance sheet assets, and shareholders’ equity over time by using the data from a specific point in time. These ratios are analyzed separately to measure the financial strength of an insurance company. These ratios can be understood by the following table:

  Ratios	Formula	Significance in analysis
  Risk-retention	Net premium Written/Gross Premium Written	Indicates the level of risks retained by the insurer. It plays a vital role in the risk spreading process.
  Loss Ratio	Net claims Incurred x 100/Net Premium Earned	It evaluates the total incurred losses with respect to the total collected insurance premiums. It reflects the nature of risk underwritten and the adequacy of the pricing of risks.
  Expense Ratio	Management Costs +/(-) Net commission paid/ (received) x100 _______________________ Net Premium Earned	The expense ratio calculates how much of a fund’s assets are used for managing and operating the other expenses. It is analyzed by a class of business, along with the trend of the same.
  Combined ratio	Loss Ratio + Expense Ratio	The combined ratio reflects the amount of money flowing out of an insurance company in the form of expenses, losses, and dividends.
  Investment Yield	Average investment Assets/Net Investment Income	This ratio is a measure of the average return on the company’s invested assets before and after capital gains and losses. Both realized as well as unrealized capital gains are considered during the calculation of the investment yield.

• Liquidity Ratios
  The liquidity ratio of a company shows the ability of a company to turn its assets into cash. Liquidity ratio is used to compare the financial performance of insurance companies and also used to determine how profitable a company is from year to year. Investors and creditors use this ratio to observe the potentiality of an insurance company before investing in it. Good liquidity helps an insurance company to attract investors promptly. These ratios show the financial strength of an insurance company in the following way:

  Ratios	Formula	Significance in analysis
  Liquid assets vis-à-vis technical reserves	Liquid assets/Technical Reserves	Technical reserves are assets of a company to take care of ‘expected’ claims that may occur. A higher proportion of liquid assets would help the insurance companies in taking care of these ‘expected’ claims.
  Current Ratio	Current Assets/Current Liability	It indicates the efficiency of a company to use its current assets. Generally, 2:1 is taken as an ideal liquidity ratio for an insurance company.
  Acid Test Ratio or Quick Ratio	(Current assets – Inventory – Prepaid expenses)/Current Liabilities	It indicates the short-term liquidity position of the company. The normal Quick Ratio for a company is 1. For example, a quick ratio of 1.5 for an insurance company shows that the company has $1.5 of liquid assets available to cover each $1 of its current liabilities.
  Absolute Liquidity Ratio	Absolute Liquid assets/Total Current Liabilities	This ratio shows a relationship between the absolute liquid assets and current liabilities of the company. The optimum value of the Absolute Liquidity Ratio for a company is 1:2 indicates the sufficiency of the 50% worth absolute liquid assets of a company to pay the 100% of its worth current liabilities in time.
  Current Liquidity	Liquid assets/Current Liabilities	This ratio is an indication of the ability of an insurance company to settle the current liabilities without prematurely selling long term investments or to the extent of borrowing money. If this ratio is less than one, then the liquidity of the company becomes sensitive to the cash flow from premium collections.

• Solvency Parameters
  The solvency parameters are key metrics used to measure an enterprise’s ability to meet its debt commitments. These parameters are used often by prospective business lenders. These solvency parameters indicate whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. All insurance firms are required to comply with the solvency margins ratio requirements of the regulator as prescribed from time to time.

  Ratios	Formula	Significance in analysis
  Solvency Margin	Available Solvency Margin (ASM)/Amount of Required Solvency Margin (RSM)	Adequacy of solvency margin forms the basic framework for meeting policyholder obligations.
  Operating Leverage	Net premiums Written/Net worth	This ratio shows current as well as potential underwriting capacity through an analysis of a company’s Operating Leverage.

  [sc_fs_multi_faq headline-0=”h3″ question-0=”Why is it important to know financial status of a company?” answer-0=”Insurance companies deal with large and complex claims made against policies that are sold by them. Including this, an insurance company faces various kinds of risks. Therefore, before investing in an insurance company, investors should know the financial status of that company. In this blog, we will discuss, how we can measure the financial strength of an insurance company.” image-0=”” headline-1=”h3″ question-1=”Which are some agencies with expertise in rating insurance companies?” answer-1=”There are some agencies with their expertise in rating insurance companies according to the financial conditions of companies. Some famous agencies out of them are A.M. Best Company, Demotech, Fitch Ratings, Moody’s Investor, Service Standard and Poor’s Corporation” image-1=”” headline-2=”h3″ question-2=”What are categories of ratios for evaluating Insurance Companies?” answer-2=”The categories of ratios are: 1. Earnings Ratios 2. Liquidity Ratios 3. Solvency Parameters” image-2=”” headline-3=”h3″ question-3=”What are earning ratios?” answer-3=”Earning ratios are defined as a set of financial metrics that are used to evaluate a business’s ability to make profits relative to its revenue, operating values, balance sheet assets, and shareholders’ equity over time by using the data from a specific point in time.” image-3=”” count=”4″ html=”true” css_class=””]