How to read the balance sheet of general insurance companies?

In our previous story of this series, we decoded how general insurers present their profitability through revenue and profit and loss statements. We now examine their balance sheet and explain how to interpret its key components—liabilites and assets.

Before delving into what an insurer's liabilities and assets are, let's first understand how they are presented in the balance sheet. Unlike other businesses, an insurer's liabilities and assets are not presented distinctly. Rather, the balance sheet is divided into two sections: sources of funds and application of funds.

The company's liabilities and equity together represent the sources of funds. This combination shows the total funds the insurer has at its disposal. Application of funds, meanwhile, depicts how the insurer deploys the funds sourced through equity and liabilities. Hence, this section essentially reflects the asset side of the business (adjusted for current liabilities). We elaborate on this later. Let's first quickly understand what counts as liabilities and assets for a general insurer.

Understanding liabilities

The key components:

• Outstanding claims: This is the primary liability and represents the amount insurers owe to policyholders for filed claims that haven't been settled. Since claims can arise anytime, they are typically classified as current liabilities. High outstanding claims can indicate a growing policy volume or delays in claim settlements, potentially hinting at operational inefficiencies or even lenient underwriting standards. In ICICI Lombard 's FY24 balance sheet, for instance, outstanding claims constituted 59 and 75 per cent of total and current liabilities, respectively.
  
• Unearned premium reserve: This is another liability on an insurer's balance sheet, representing premiums received for coverage not yet provided. In short, it is that portion of received premiums that corresponds to the remaining duration of active policies. Since these premiums relate to coverage for future periods, they are considered unearned until the coverage period has passed. They are, thus, kept aside as reserves (often listed as provisions ) to ensure future claims related to active policies are comfortably met.
  
• Other liabilities: These include agent balances (like commission fees due to insurance agents), amounts due to other insurers, premiums received in advance, and short-term borrowings. Together, they reflect the short-term obligations required to manage operations.

Note that high outstanding claims or a large unearned premium reserve can signal either a growing business or potential risk. Assessing whether these liabilities are well-managed (with reserves) and supported by disciplined underwriting is crucial for gauging financial health.

Understanding equity

The key components:

• Fair value change account: This component reflects unrealised gains or losses from changes in the market value of investments held by the insurer. While these gains or losses are unrealised, they directly impact the insurer's financial position and capital adequacy. It is recorded under policyholders' funds or shareholders' funds, depending on the investment source, as part of reserves or equity.
  
• Share capital: This is the initial funding from shareholders, providing a stable base for the insurer to operate, meet regulatory capital requirements, and manage risks effectively.
  
• Reserves and surplus: Accumulated from retained earnings, these reserves are set aside to cover unexpected losses, fund expansions, or meet regulatory requirements. This surplus strengthens the insurer's balance sheet, enabling long-term growth and resilience in challenging market conditions.

Understanding assets

The key components:

• Investments: This is typically the largest asset for general insurers. Insurers invest premiums and shareholder funds in various asset classes like bonds, equities, and real estate to generate returns. In FY24, ICICI Lombard's investments made up 77 per cent of total assets, illustrating the importance of investment returns for profitability in a competitive business like insurance. However, investments tied to policyholder funds are critical to covering claims and should be managed conservatively.
  
• Fixed assets and cash balances: Fixed assets include tangible resources like office spaces, equipment, and technology essential to operations, while cash and bank balances provide liquidity to meet short-term obligations.
  
• Advances and accrued income: These fall under current assets and may include receivables like outstanding premiums, accrued investment income, and other short-term receivables that enhance cash flow and support operational needs. Accrued income from investments represents the portion of investment returns that have been earned but not yet received by the insurer.

How to read the balance sheet

Sources of funds (where the money comes from using liabilities and equity) and application of funds (where the money is deployed as assets like investments) always match in the balance sheet as every source of funds must have a corresponding application.

Importantly, in the application of funds section, current liabilities (like outstanding claims) and provisions (unearned premium reserve) are deducted from current assets to arrive at net current assets as can be seen in the balance sheet of ICICI Lombard given below.

Often, net current assets are negative as insurers quickly invest cash inflows from premiums to maximise returns. This results in current liabilities exceeding current assets, hence the negative balance.

Your takeaway

Key balance sheet items like outstanding claims, investments, and reserves offer insights into general insurers' operational resilience and long-term profitability. In our next story of this series, we'll dive into the various financial metrics (like the combined ratio and solvency ratio) of general insurers that connect their financial statements and provide a more granular assessment of their business and operations. Stay tuned!

Also read: Inside the general insurance business

This article was originally published on November 26, 2024.