Introduction to Profitability ratios
Profitability 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. In simple words, with these profitability ratios, insurance companies generally compare numbers from their financial performance to determine how profitable, effective or liquid their businesses are, in certain areas, from year to year. These ratios also allow the insurance companies to compare with their competitors across the street. Higher ratio results are more favorable, but these ratios provide much additional information when results are compared to other similar companies or the company’s own past performance. Now, let us sort some crucial figures for different types of profitability ratios.
It evaluates the total incurred losses with respect to the total collected insurance premiums. It includes paid insurance claims and adjustment expenses. The formula for the loss ratio is insurance claims paid plus adjustment expenses divided by total earned premiums. We can take an example of a company that pays $80M in claims for every $160M in collected premiums. The loss ratio for the company is 50%. If loss ratios associated with any policy becomes unreasonable, the insurer may raise premiums or choose not to renew a policy for next year.
The expense ratio (ER), is sometimes also be called the Management Expense Ratio (MER). It calculates how much of a fund’s assets are used for managing and operating the other expenses. The expenses of recordkeeping, custodial services, taxes, accounting and auditing fees, and legal expenses affect the expense ratio. The expense ratio is generally treated as total expenses, but we need to understand the difference between gross expenses and the expense ratio. The Costs of operating expenses such as loads, contingent deferred sales charges (CDSC), and redemption fees (it is a fee charged to an investor when shares are sold from a fund) are not included while calculating the expense ratio.
Operating Expense Ratio:-
The costs associated with running the business that is not directly tied to the production of the product or service are the operating expenses. The operating ratio indicates the efficiency of an insurance company by comparing the total operating expense of the company with the net sales of the company. Almost all expenses except taxes and interests are included in operating expenses. As some companies are committed to paying large interest payments, which are not included in the operating expenses, two companies can have an equal operating ratio with different debt levels. The operating expense ratio is calculated by considering the costs of accounting and legal fees, bank charges, salary and wage expenses, rent and utility expenses, office supply costs, sales and marketing costs.
Operating Expense Ratio = (Operating Expenses + Cost of goods sold) ÷ Net Sales
Combined ratio after policyholder dividends ratio:-
The combined ratio is simply a unit of measurement used to measure the profitability of an insurance company on the basis of daily performances. The combined ratio shows the amount of money flowing out of an insurance company in the form of expenses, losses, and dividends. Among combined ratio, expense ratio and loss ratio; the combined ratio is most important as it provides a comprehensive standard of an insurer’s profitability. It is typically expressed in percentage form; A ratio below 100% means the company is gaining underwriting profit, while the ratio above 100% shows that the company pays more amount in claims than the earned premiums. Even if the combined ratio of an insurance company is more than 100, the company can still earn profits as a combined ratio does not consider the investment income.
Combined Ratio= (Incurred Losses + Expenses) ÷ Earned Premium
NOI to NPE Before Taxes:-
Net Operating Income (NOI) of an insurance company analyzes the profitability of income generated by the company in real estate investments. NOI is an amount before taxes that excludes principal and interest payments on loans and capital expenditures. NOI is also known as EBIT that stands for “Earnings before interests and taxes”. The normal range of NOI to NPE (Net premium earned) ratio is from 3 percent to 6 percent. The ratio below 3% is understood as a poor profitability ratio. The formula for NOI is:
NOI= Total revenue – operating expenses
The Yield on Invested Assets (IRIS):-
It is defined as Net investment income of the company as a percent of the cash, invested assets plus investment income minus borrowed money. This ratio does not reflect realized and unrealized gains or income taxes. This is another IRIS (Insurance Regulatory Information System) test adopted to calculate the profitability ratio of insurance companies.
Investment Yield = Average investment Assets ÷ Net Investment Income
Return on PHS (Policyholder Surplus):-
Return on PHS is the ratio of operating income, after taxes, realized gains and unrealized investment gains, to the prior year Policyholders Surplus. Policyholder surplus means the difference of assets of a policyholder-owned insurer and its liabilities.
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