Key Financial Measures

Study guides: Exam 6C, Exam 6U, Exam CFE-201, Exam GH-201C, Exam GI-201

Key Financial Measures are the standard ratios regulators, rating agencies, analysts and management use to summarise an insurer's profitability, leverage, reserve adequacy, liquidity and capital strength. They are the numbers through which a growth plan, a reserve change or a reinsurance strategy is actually judged.

\text{Premium-to-surplus} = \frac{\text{Net written premium}}{\text{Policyholders' surplus}}

\text{Operating ratio} = \text{Combined ratio} - \text{Investment income ratio}

• Profitability — loss and LAE ratio, expense ratio, combined ratio, the operating ratio (combined ratio net of investment income as a percentage of premium), and return on equity. See Basic Insurance Ratios.
• Leverage — premium to surplus (how much business each dollar of capital supports) and reserves to surplus (how far a reserve error reaches into capital); see Insurance Leverage. The NAIC's IRIS Ratios flag net premiums written to surplus of 300\% or more and gross premiums written to surplus of 900\% or more.
• Reserve adequacy — one-year and two-year development on prior reserves as a percentage of surplus (IRIS flags 20\% or more), and an estimated current reserve deficiency to surplus. Development is the measure most often ahead of a failure.
• Reinsurance and liquidity — recoverables to surplus, overdue and uncollateralised recoverables (Schedule F in the U.S.), surplus aid to surplus, and liabilities to liquid assets.
• Capital — the MCT ratio in Canada, the RBC ratio in the U.S., and each rating agency's own capital model. Agencies adjust reported capital for items they do not trust in a stress — goodwill, deferred tax assets, surplus relief from quota share reinsurance, holding-company debt — and weigh operating performance, business profile and risk management alongside it.
• Canada under IFRS 17. The MSA Ratios and the industry's key performance indicators were rebuilt around Insurance Revenue and the Insurance Service Result from 2023; ratios spanning the transition are a break, not a trend.

Quota Share Effect on Leverage and Profit An insurer writes \$600 million of net premium on \$200 million of surplus, with \$300 million of unearned premium at year end. Its expected loss and LAE ratio is 66\% and expense ratio 30\%. It buys a 25\% quota share on its in-force and future business with a 30\% ceding commission (not exceeding the acquisition costs on ceded business). Under U.S. statutory accounting, find premium-to-surplus before and after, and the underwriting profit given up.

Answer Before: 600 / 200 = 3.00 — at the IRIS threshold, so flagged.

Surplus relief on the ceded unearned premium:

\begin{align*}
\text{Relief} &= 0.30 \times (0.25 \times 300) \\
&= 22.5 \\[4pt]
\text{P/S after} &= \frac{0.75 \times 600}{200 + 22.5} \\
&= \frac{450}{222.5} \\
&= 2.02
\end{align*}

Profit ceded each year, on ceded premium of \$150 million:

\begin{align*}
\text{Reinsurer's margin} &= 150 - 0.30(150) - 0.66(150) \\
&= 150 - 45 - 99 \\
&= 6
\end{align*}

Leverage falls from 3.00 to about 2.02, at a cost of \$6 million a year — a quarter of the \$24 million expected underwriting profit. Whether that is worth it depends on the reinsurer's credit quality and on how a rating agency treats the \$22.5 million of relief, which it may reverse.

Which Treaty Moves Which Measure? An insurer is choosing between a 25\% quota share and a catastrophe excess of loss treaty. Which key measures does each improve?

Answer

• Quota share: cuts premium-to-surplus and, over time, reserves-to-surplus; gives statutory surplus relief; cedes profit proportionally; adds reinsurance recoverables and therefore credit risk. In Canada, ceded liabilities reduce the MCT requirement only if the reinsurer is registered or the cession is collateralised.
• Catastrophe excess of loss: barely changes premium leverage, but cuts the PML, the catastrophe capital charges (the Earthquake Exposure Risk Margin in the MCT, the catastrophe component of RBC) and earnings volatility — the measures a rating agency stresses.

A leverage problem calls for the quota share; a tail problem for the excess of loss. Buying the wrong one improves a ratio nobody was worried about.