Top 5 Financial Ratios: Insurers

We're all familiar with insurance. We take out car insurance, health insurance, home and contents insurance. Some of us even change our insurer regularly in search of a bargain. But spotting a bargain among insurance stocks isn't so simple.

The nature of the industry means the financial statements are unique. In this instalment of our top 5 financial ratios series, we'll uncover and unravel some key ratios you're likely to encounter when scanning an insurer's financials.

To illustrate these calculations, we'll compare figures from the 2009 annual reports of two prominent Australian insurers; IAG and QBE Insurance.

Though this article delves into the top ratios for analysing the insurance industry, the first key figure we need is not actually a ratio. But it is important to help you understand the forthcoming ratios – Net earned premium (NEP).

When you pay your annual insurance premiums, the proceeds fall into a bucket called Gross Written Premium (GWP).  However, we're more interested in the Gross Earned Premium (GEP), which includes the portion of the premiums earned (or the revenue derived from the insurance written) during a financial year. For example, a $600 annual policy written on 1 May would only 'earn' $100 in the financial year to 30 June.

In turn, insurance companies take out insurance themselves. It's called reinsurance and protects against unusually large risks. Reinsurance costs are deducted from the insurer's GEP to arrive at NEP.

The amount of reinsurance taken out can vary, often depending on the existing level of reinsurance insured and the aggression of management (less reinsurance can help increase earnings, but makes them more lumpy). If an insurer prices its policies correctly, then avoiding excessive reinsurance should prove sensible (and profitable) over time.

Now that we have sorted out some crucial figures, let's get cracking on the ratios.

Ratio 1: Expense ratio and Loss ratio

The first part of this equation gives us an insight into how tight a ship management is running. The expense ratio shows the percentage of the NEP paid out in the course of acquiring, writing and servicing the insurance payments, often simplified as 'underwriting expense'.

Insurance is a commodity product, meaning that insurance purchased from one company is virtually the same as the next (unless your insurer goes broke before you need to claim). In light of the competitive industry economics, keeping costs in check is crucial.

The lower the costs, the more customers a company can attract with lower prices without hurting profitability. It's a simple but effective strategy. With that in mind, let's see how QBE and IAG compared in 2009.

IAG racked up NEP of $7,233m in 2009, against an underwriting expense of $2,128m. To arrive at our expense ratio, we divide our underwriting expense by the NEP, giving us an expense ratio of 29.4%.

Switching over to QBE, the company's expense ratio comes out at 29.3%, virtually in line with its rival. The respective expense ratios for IAG and QBE suggest that neither is working with an overall cost advantage, despite rather different business models.

The insurance game isn't just about costs though. It also entails the losses that stem from the risks taken on board. For that, we turn to the loss ratio.

When bad luck strikes, you may be in line to make a claim. Such claims are an expense to the insurer, and show up as part of 'net claims expense'.

This figure can get knocked around from year to year, and is an unavoidable aspect of these businesses. However, it's with the loss ratio that an insurer's underwriting discipline will be revealed.

Insurance is a game of probabilities and pricing. Prudent pricing in relation to the risks assumed should deliver profitability over the long term. So a consistently high loss ratio can indicate that an insurer is selling their insurance too cheaply. It may be obvious that if the price isn't right, you shouldn't take the risks, but the history of the industry is littered with ill-disciplined underwriting.

The loss ratio, calculated as net claims expense divided by NEP, for IAG in 2009 was 74.2%. QBE, on the other hand, posted a loss ratio of 60.3% in the same year. That's a fair margin below IAG, but a single year's loss ratio doesn't tell the whole story. It could be that one insurer was exposed to a highly unlikely (often referred to as 'fat-tail') event.

To gain a clearer picture of an insurer's underwriting discipline, it's best to take several years into account. For the five years to 2009, IAG had an average loss ratio of 68.3%, compared to QBE's 57.6%.

Ratio 2: Combined operating ratio

Taking the expense ratio and loss ratio, it's a simple step to calculate the combined operating ratio (or 'combined ratio'); simply add the two together.

A combined ratio below 100% means an insurance company is operating at an 'underwriting profit' – a profit before adding the returns from investing customers' premiums.

On the flipside, a combined ratio of more than 100% represents an 'underwriting loss', which means an insurer is reliant on investment income to square the ledger. Again, we need to take into account several years' of results to determine how the insurer is faring.

Generally, a combined ratio below 100% is a good result; a figure below 95% is considered exceptional but might involve forfeiting revenue opportunities (from both investment returns and underwriting profits).

Continuing with IAG and QBE, the former posted a combined ratio of 103.6% - an annual underwriting loss. QBE, however, notched up an incredible 89.6%. Taking a five year average, QBE's 87.7% comes out on top again, trumping IAG's 96.5%.

Ratio 3: Insurance margin

Next on our ratio list is the insurance margin; a combination of the combined ratio and earnings from the investment of 'float'

There's typically a gap between the time someone pays their premiums and when a claim is paid. During this period, an insurer has cash in its hands that it can plonk in the bank account to collect interest, or invest in other assets in search of higher returns.

By adding the return from investing the float to the underwriting result, we derive a figure called 'insurance profit'. To calculate the insurance margin, we simply divide our insurance profit by NEP.

In 2009, IAG scored an insurance margin of 7.1%, with an underwriting loss of $265m, and returns on its float of $780m. As we noted previously, an insurer that suffers an underwriting loss can still produce a profit if it's off-set by investment returns. QBE posted a much stronger 17%, benefiting from an underwriting profit of $827m in addition to investment gains of $1,237m.

An issue to keep in mind when assessing the insurance margin relates to the return on the float. This return can bob around from year to year, so it's important to view it in context of historical returns and those likely in the future.

Ratio 4: Minimum Capital Requirement

Similar to a bank, an insurer must retain a minimum amount of capital as a buffer against losses that exceed expectations. The idea is that the insurer will be able to continue operating and fulfilling policyholder obligations despite severe unexpected losses.

The calculation of the minimum capital is set by the regulator, APRA, and insurers are generally expected to hold well in excess of this amount. IAG's capital adequacy multiple of 1.79 is higher than QBE's multiple of 1.6.