Insurance companies underwrite insurance policies that provide protection against disease, death, theft and other forms of risk. Policyholders pay monthly or annual premiums for insurance policies. Payouts for insurance claims represent losses for insurance companies, which incur additional expenses for operating and growing their businesses. Investors should analyze an insurance company’s financial ratios to evaluate its underwriting discipline, operational efficiency and investment success.
Evaluate an insurance company's loss ratio, which is the loss plus adjustment expenses divided by the premium earned. The loss adjustment expense is the cost of investigating policy claims and making payouts. The premium earned is the premium for the expired portion of an insurance policy. A low loss ratio could indicate a well-managed operation. High loss ratios compared to the rest of the industry could indicate poor risk management policies and inadequate due diligence on insurance claims.
Assess the expense ratio, which is the underwriting expense divided by the premium earned. Expenses include commissions paid to insurance agents and brokers, training costs, advertising costs and other operational expenses. High expense ratios mean low profit margins, which means less flexibility to deal with unforeseen or catastrophic events (for example, floods and hurricanes).
Add the loss ratio and the expense ratio to get the combined ratio. Investors prefer insurance companies with combined ratios below 100 percent because they are efficient operations. An insurance company can invest the surplus funds in high-performing assets or reinvest the funds to expand the business. A high combined ratio could be the result of several factors, including high claim volumes, rising operating expenses, pricing pressure on new insurance policies and lack of consumer demand for new policies.
Calculate the ratio of new written premiums to policyholder surplus. This ratio should be greater than 1, which would mean that the insurance company is able to generate more than a dollar of new premiums for each dollar in surplus. Policyholder surplus is the difference between total assets and total liabilities. An insurance company is usually required to maintain a minimum level of surplus to make payments for insurance claims.
Determine the profitability, which is net operating income divided by total revenues. Net operating income consists of revenues, which are mainly derived from premiums, minus operating expenses. Investors tend to prefer companies that are consistently profitable because that generally means assured dividend payments and share price stability. A related measure of profitability is the investment yield, which is the average investment assets divided by the net investment income before taxes. The investment yield is one measure of the effectiveness of the company's investment policies for its surplus funds.