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Article Excerpt
Insurance companies price the policies they sell based on the statistical prediction of the amount of benefits they eventually will have to pay out. If the insurer collects more premium than it makes payments, then it makes what is called an underwriting profit. Insurance companies also invest the premiums people pay, called the float, and they can make money on these investments. If the insurance company is good at investing, this can be an area where they make the majority of their profit.
However, an insurer that is able to take in premiums may not be on solid ground. Premiums typically are collected before benefits are paid out. If an insurer has not calculated properly, and/or an event such as a catastrophe occurs, any gains an insurer has made can be wiped out when it has to satisfy claims.
A primary source of information A.M. Best uses in its ratings process comes from each company's official annual, and if available, quarterly financial statements. Supplements include publicly available documents such as U.S. Security and Exchange Commission filings, Generally Accepted Accounting Principles or International Accounting Standards financial statements. Other sources of information may include certain audit and/or loss reserve reports, confidential documents provided by company managements, A.M. Best's proprietary Background and Supplemental Rating Questionnaires, and annual business plans. A.M. Best does not audit company financial records or statements, so the accuracy of this information, although believed to be reliable, cannot be guaranteed.
Property/Casualty
Profitability Tests
Profit is the goal that every business seeks. Often called the "bottom line," it is the end product of business activity and the measurement of success. For an insurer to remain viable in the marketplace, it must show a financially strong balance sheet. These tests are a few examples of how to analyze the stability and sustainability of the insurer's sources of earnings in relation to that company's liabilities. Due to rounding and simplification of some formulas, results may differ slightly than what appears in A.M. Best publications.
Insurers' World
Insurance companies offer more than insurance policies. They also provide annuities. which are contracts under which a lump-sum payment or series of payments are made to the insurer. In return. the insurer agrees to make periodic payments to the annuity holder, beginning immediately or at some future date. The taxes on these financial accounts are deferred until withdrawals are made.
Annuities can take many forms. Some are similar to a Certificate of Deposit (CD), while others may act like a pension. Many company retirement plans are annuities that will pay a regular income to the retiree. Annuities also can resemble an investment portfolio. With a fixed annuity, the cash value earns a current rate of interest that will never go below a minimum guaranteed interest rate. A variable annuity provides a rate of return which can fluctuate depending on investment performance.
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How Agents Earn a Living
Insurance agents earn commissions for each policy they sell--and historically, it's how they've earned a living. Typically, the more policies they sell, the better they do financially. Also, an agent that deals in selling auto, home and business policies can receive additional commissions for selling policies to "quality customers." or policyholders who don't make claims and pay their premium bills on time.
Today, many agents have seen their commissions cut considerably as companies adapt to the Internet and try to compete with direct selling companies. The heavy movement of consumers moving their insurance shopping online has sparked agents to realign their marketing programs to keep pace with their clients.
Combined Ratio (after Policyholder Dividends)
This is a percentage of premium income an insurer has to pay out in claims and expenses. The components are the sum of ratios that look at how certain expenses relate to income:
* Loss and LAE ratio is a measure of an insurer's underlying profitability.
* Underwriting expense ratio measures a company's operational efficiency.
* Policyholder dividend ratio shows the percentage of premium returned to policyholders.
Calculation:
Loss and LAE Ratio Underwriting Expense Ratio + Policyholder Dividend Ratio/ Combined Ratio
Loss and LAE Ratio:
Losses and loss adjustment expenses/ Net Premiums Earned
Underwriting Expense Ratio:
Commissions and Underwriting Expenses/ Net Premiums Written
Policyholder Dividend Ratio:
Policyholder Dividend/ Net Premiums Earned
Combined ratio after dividends 1970-2007
THE SEVENTIES
1975:107.9 Recession ripples (Stock market downturn, 1973-1974; Inflation causes insurance claims, expenses to soar above premium income; Real estate market plummets; unemployment hovers near 9%)
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THE EIGHTIES
1984: 118.0 Worst year of a very poor underwriting cycle
1989: 109.2 Hurricane Hugo
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THE NINETIES
1992: 115.7 Hurricane Andrew
1994: 108.4 Northridge earthquake
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2000 AND BEYOND
2001: 115.7 Sept. 11 terrorist attacks
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In other words:
An insurance company realizes an underwriting profit when the premium it charges on the policies it issues exceeds its total losses and expenses. An underwriting loss occurs if total losses and expenses exceed premium income. A combined ratio greater than 100% means that an insurance company is not producing enough revenue to cover the cost of incurred claims and operating expenses. The acceptable range for property insurers is from 95% to 105% and 100% to 110% for casualty insurers. An increasing ratio could indicate catastrophic losses, inadequate rates, increasing expenses, a decline in premium income or a strengthening of loss reserves.
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Example:
MetLife Auto & Home (03933) HQ: Warwick, R.I. FSC: XIV ($1.5 billion to $2 billion) Specialty: Personal auto, homeowners insurance Rating (as of 6/16/2009): A (Excellent)
Report, financial update: 05/27/2009
In 2008 ($ billion)
Losses and loss adjustment expenses $1.9 Net Premiums Earned $3.0 Loss and LAE Ratio: 63.3% Commissions and Underwriting Expenses $0.8 Net Premiums Written $3.0 Underwriting Expense Ratio: 26.7% Policyholder Dividend $0.01 Net Premiums Earned $3.0 Policyholder Dividend Ratio: 0.33% Combined Ratio 90.3%
HQ = Headquarters
FSC = Financial Size Category
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Operating Ratio
This ratio measures the profit from operations, not including realized or unrealized capital gains. A capital gain is the amount that an asset's selling price exceeds its initial purchase price. A realized capital gain is an investment that has been sold at a profit, and an unrealized capital gain is an investment that hasn't been sold, but if it was, it would result in a profit.
Calculation:
Net Investment Income Ratio:
Net Investment Income/ Net Premiums Earned
Combined Ratio after Policyholder Dividends - Net Investment Income Ratio/ Operating Ratio
In other words:
Results are an indicator of the management's efficiency. The smaller the ratio, the greater the insurer's ability to generate profit from underwriting and investment income. A value over 100 means the insurer was not able to generate an operating profit.
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Example:
ACE American Insurance Company (02257)
HQ: Philadelphia FSC: XV ($2 billion or greater) Specialty: General liability, workers' compensation, commercial automobile and property Rating (as of 6/16/2009): A+ (Superior)
Report, financial update: 5/06/2009
In 2008 ($ billion): Net Investment Income $0.22 Net Premiums Earned $1.15 Net Investment Income Ratio 19.1% Combined Ratio 84.8% Net Investment Income Ratio 19.1% Operating Ratio 65.7%
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Pretax Return on Revenue (ROR)
This takes a year-to-year measurement of a corporation's profitability on its core business operations.
Calculation:
Net Underwriting Income Other Income + Net Investment Income/ Pretax Operating Income
Pretax Operating Income/ Net Premiums Earned
= Pretax ROR
In other words:
A measure of profit made from operations, it is a good tool for comparing the operating performance of companies, because it eliminates the impact of nonoperating factors such as capital structure or income tax. The normal range for this test is from 3% to 10%. Return on revenue typically excludes realized capitals gains, as some believe that a result containing capital gains would be skewed by economic and interest rate conditions.
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Example:
Erie Insurance Group (04283) HQ:...
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