Benchmarking
Key Financial Ratios
Presented by:
Mujtaba Datoo, ACAS, MAAA, FCA | Actuarial Practice Leader
Discussion Points
Background
Financial statement perspective
Historical perspective of financial ratios
Financial data
Background
Pooling and Self-Insurance...
are... Insurance Enterprises
In an insurance enterprise:
• Unlike other industries/products,
pay generally fixed premium up front for a promise to pay claims later
• Claims will not be known for a while and
Balance Sheet
Assets
Liabilities
Major Asset and Liability Components
Assets: • Cash • Bonds • Other investments • Real estate: Limited recognition • Etc. Liabilities: • Case reserves• Case reserve development
• Incurred But Not Reported (IBNR) reserves
• Allocated Loss Adjustment Expense (ALAE)
• Unallocated Loss Adjustment Expense (ULAE)
• Unearned premium reserves
Balancing Formula
inv income
premium
+
=
losses
+
expenses
minimal
fixed
variable
fixed
Variance…
Losses are inherently variable
Varies by coverage
• Excess Liability – very variable
• WC – indemnity less variable than medical
• Auto Liability – generally more stable
Sources of Variation
Process risk:
• Associated with projection of future contingencies
that are inherently variable
Parameter, model risk:
• Associated with selection of parameters of the
model (e.g., selecting inapplicable LDF)
• Misidentifying a process model (e.g., Poisson for
Surplus is Key Measure
Assets less Liabilities = Surplus
Surplus a.k.a.
• Net assets
• Pool equity
• Retained earnings
Capital Needs
Insurance company failures in the 1980s:
• U.S. Congress investigates
• NAIC strengthens state solvency standards
States set minimum capital requirements
Concept not new:
• Introduced long ago in Wisconsin
Reasons for Surplus
Absorb adverse loss development – KEY reason Reinsurers may become insolvent
• Contingent liabilities
Use for rate stabilization Rating agencies
Make pool more attractive to
• Prospective members
• Reinsurers
Use Regulatory Tests
Apply private sector tests:
• IRIS: Insurance Regulatory Information System
Easier to understand and apply Publicly available
Not quite apples-to-apples,
but apples-to-oranges:
• Ranges broad enough
Other Tests
RBC: Risk-Based Capital requirements:
• Complex; some parameters do not apply to
pools
• Establishes amount of required capital
• Compares required capital to insurer’s
surplus
More Tests
Other tests exist, but concept is same:
• A M Best’s Capital Adequacy Ratio (BCAR)
• S & P Capital Adequacy Ratio (CAR)
• PRISM by Fitch ratings
• Moody’s Risk Adjusted Capital (MRAC)
Financial Ratios
Basic concepts universal
Building blocks the same
Refinement adds complexity
RBC
IRIS Scenario-Based Probabilistic Models
Approach
Forward looking
Data is King!
No central depository for public sector
Compare to private sector companies
• Good benchmark of broad indicators
• Private Carriers data is from Best’s
Aggregates & Averages Private Carriers
This NLC data compiled to provide
meaningful results
• High level data extracted, details vary
Participants: 20 States
Key Financial Ratios
Focus on 6 key ratios:
1) Premiums (aka contributions)-to-Surplus
2) Reserves-to-Surplus
3) Surplus-to-SIR
4) Reserve Development-to-Surplus
5) Operating Ratio
Why do we look these ratios?
Readily available from financial statements
Easy to understand and apply
Studies show major impairment causes:
• Inadequate reserves
Ratio 1: Net Premium-to-Surplus
0.0 0.2 0.4 0.6 0.8 1.0 1.2 2004 2005 2006 2007 2008 2009 2010 201 1 Net premium-to-surplus ratio well within usual range of less than 3:1Able to:
• Increase retention
• Return dividends
Net Premium-to-Surplus
Highs and Lows
high high high high high high high high
low low low low low low
low low avg avg avg
avg avg avg avg avg
0.0 1.0 2.0 3.0 4.0 5.0 6.0 2004 2005 2006 2007 2008 2009 2010 201 1
Varies by pool and year (note: outliers not shown)
Net Premium-to-Surplus
Varies by Coverage
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 2004 2005 2006 2007 2008 2009 2010 201 1 Long tail coverages have higher ratios
• WC vs. Liability
Need to:
Ratio 2: Loss Reserves-to-Surplus
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2004 2005 2006 2007 2008 2009 2010 201 1 Reserve-to-Surplus ratio well within usual range of less than 3:1Able to withstand
Loss Reserves-to-Surplus
Highs and Lows
high high high high high high high high
low low low low low low low low avg avg avg
avg avg avg avg avg
0.0 2.0 4.0 6.0 8.0 10.0 12.0 2004 2005 2006 2007 2008 2009 2010 201 1
Varies by pool and year (note: outliers not shown)
Loss Reserves-to-Surplus
Varies by Coverage
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2004 2005 2006 2007 2008 2009 2010 201 1 Reserve-to-surplus ratio varies by coverage • higher for WC• lower for liabilities, auto
Ratio 3: Surplus-to-SIR
0 10 20 30 40 50 60 70 2004 2005 2006 2007 2008 2009 2010 201 1 Surplus-to-SIR ratio of greater than 10:1 From the standard that no one risk exposes
Ratio 4: Reserve Development-to-Surplus
-18.0% -16.0% -14.0% -12.0% -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 2004 2005 2006 2007 2008 2009 2010 201 1 Threshold is < 20% Key indicator of adverse development
Can also perform 2-year reserve
Ratio 5: Operating Ratio
As % of Premium
Net Premiums $598 Millions
Add Investment income 165 28%*
Less Losses and LAE 468 78%
Less Expenses 141 24%
Less Dividends 50 8%
Operating Ratio
0% 20% 40% 60% 80% 100% 120% 2004 2005 2006 2007 2008 2009 2010 201 1 Operating Ratio threshold is less than 100%
Operating Ratio > 100% is unprofitable; review loss ratio; review
Ratio 6: Liabilities-to-Liquid Assets
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% 2004 2005 2006 2007 2008 2009 2010 201 1 Measures the insurer’s
ability to meet the financial demands Provides rough
indication of the
possible implications for policyholders if
Review Ratios…
Over Longer Time Horizon…
Not in Isolation but Interdependently
Ratios are Relativity Concepts
Financial ratios are relative measures:
• Relative to other entities
or aggregated insurance companies
• Data needs adjustment to common levels:
Discounted vs. undiscounted
Absolute Ratios…Don’t Exist!
Absolute measures do not exist!
• No one right answer
• Use reasonable ranges
• Ranges broad enough to encompass
meaningful results
• Compare to similar or peer entities:
For Peak Performance
Monitor performance tests annually
Explain causes for outside “usual ranges”
Take gradual corrective actions
Don’t wait for the steep climb … quick fall!
Summary
Losses are inherently variable
Variability cushioned by surplus
Set financial targets:
• Reserves, Premium and SIR to Surplus
Understand and apply ratios judiciously
Review plan periodically:
• Details change: SIRs, membership, etc.
Questions?
Mujtaba Datoo, ACAS, MAAA, FCA
Actuarial Practice Leader Aon Global Risk Consulting (949) 608-6332