8 key ratios to assess how healthy your general insurance company really is

In our previous story of this series, we decoded the balance sheet components of general insurance companies and examined how to interpret them. We now delve into the key metrics and ratios that can help you evaluate their operations and financial health. Let's begin.

1) Gross direct premium income (GDPI)

Premiums are the primary source of revenue for insurance companies. Gross direct premium income (GDPI) is the total premium companies collect before paying any reinsurance costs (premiums paid to other insurers to share risk). It reflects the company's growth potential, distribution network strength, and ability to attract customers.

While high GDPI growth signals business expansion, investors must scrutinise the drivers of this growth. You should consider whether policies are being sold with robust underwriting standards, or is the insurer prioritising volume over quality. Rapid growth driven by underpricing risks can lead to future claims exceeding premiums earned.

2) Net premium and retention ratio

After paying the reinsurer, the insurance company keeps the remaining premium. It is called the net premium and it reflects the income directly retained by the company. The premium retention ratio (net premium divided by gross premium) reveals how much of the risk the insurance company is keeping for itself, as opposed to passing it on to other insurers through reinsurance.

A high retention ratio means the company is keeping a larger share of the risk. This shows that they are confident in handling the claims that may arise. But, if too many claims arise, the company could also face significant financial strain.

A low retention ratio means the company is passing more of the risk to others, reducing its exposure to large losses. This could be a sign that the company is more cautious and less willing to take on too much risk. For instance, ICICI Lombard and GoDigit reported FY24 retention ratios of 71 per cent and 85 per cent, respectively, demonstrating differing risk management strategies.

3) Loss ratio

The loss ratio (claims incurred divided by premiums earned) measures how much money an insurance company is paying out in claims compared to the money it is earning in premiums. It essentially captures how the insurer prices risk.

A lower loss ratio is desirable, indicating that premiums earned exceed claims paid. If it's consistently low and stable, it indicates disciplined underwriting and prudent risk management. But an extremely low loss ratio could also suggest that the company might not be paying out enough to its policyholders, which could impact customer satisfaction.

A high loss ratio means the company is paying out a large portion of the premiums it collects in claims. This could indicate that the company is struggling to control its costs or has taken on too much risk.

When calculating the loss ratio, insurers consider not just the claims they've already paid but also the expected future claims, which are part of the 'incurred claims'.

These incurred claims have two components or reserves: Incurred But Not Reported (IBNR), which is the money the insurer sets aside to cover claims that have happened but haven't been reported yet. For example, someone might have had an accident but hasn't filed the claim yet. The insurer still expects to pay for it, so it keeps money aside for this potential future claim.

The other is Incurred But Not Enough Reported (IBNER). This is the money set aside for claims that have been reported, but the insurer thinks the costs might end up being higher than initially estimated. For example, the insurer might have estimated a claim of Rs 5,000, but the actual cost turns out to be Rs 8,000. The insurer keeps extra money aside for this possible difference.

If an insurer is cautious and sets aside enough of these two reserves for future claims, it reflects a more conservative approach to risk. It might make their loss ratio appear higher, but this is a safety measure to ensure they have enough funds to cover future claims.

4) Expense ratio

The expense ratio (operating expenses divided by premiums earned) is a measure of how much an insurance company spends on operating costs relative to the money it earns from premiums. It evaluates the insurer's operational efficiency. This metric considers costs directly related to running the insurance business, such as commissions, salaries, rent, and marketing.

A lower expense ratio is better, as it indicates cost-effective operations. Efficient insurers often leverage technology to streamline processes, reduce overheads, and improve customer service.

During FY21-24, GoDigit's median expense ratio stood at about 47 per cent, higher than ICICI Lombard's 34 per cent, highlighting differences in operational efficiency.

5) Combined ratio

The combined ratio (loss ratio plus expense ratio) offers a holistic view of an insurer's operational health, showing whether it is generating an underwriting profit. A ratio below 100 per cent indicates that premiums cover both claims and operating expenses.

A combined ratio above 100 per cent suggests underwriting losses, necessitating reliance on investment income for profitability. Indian insurers often face challenges due to intense price competition and low insurance penetration, leading to combined ratios exceeding 100 per cent. For instance, ICICI Lombard's median combined ratio for FY21-24 was 104 per cent. It was 109 per cent for GoDigit.

Monitoring trends in the combined ratio helps assess whether the underwriting discipline is improving over time.

6) Return on equity (ROE)

ROE (net profit divided by average shareholders' equity) measures how well an insurance company is using the money invested by its shareholders to generate profits.

Key drivers of ROE:

There are a few important factors that affect a company's ROE:

• Cost of funds: When premiums exceed claims and expenses, it means the company is making an underwriting profit. Simply put, its premium income is enough to cover claims and other costs, leading to no requirement to arrange extra funds. This makes its cost of funds zero and consequently leads to higher net profit and ROE.
  
• Investment returns: Insurance companies invest the money they hold from premiums to earn additional returns. This money is usually invested in assets like stocks, bonds, or other financial assets. The more profitable these investments are, the higher the overall profits. But investment returns are market-sensitive, requiring a balanced and conservative approach to long-term asset allocation.
  
• Leverage: Leverage refers to how much the insurance company relies on the float (advance premiums) compared to its own equity (money from shareholders). If the company has a high float-to-equity ratio, it means the company is using a lot of policyholders' money (premiums) to generate profits, which can increase ROE.

Let's understand the above with an example. ICICI Lombard reported a combined ratio of 103 per cent in FY24, resulting in an underwriting loss of 3 per cent. So, its underwriting didn't make money, but it still earned money elsewhere. The company earned 8 per cent return from its investments, which helped boost its overall profitability despite the underwriting loss. So, the company's effective return on its float comes at 5 per cent (investment returns minus underwriting losses).

Additionally, it has an investment leverage of around four times, meaning its float is four times than its own equity, leading to a superior return on equity (ROE) of around 19 per cent (return on float x leverage).

7) Technical reserves to premiums ratio

This metric indicates the reserves maintained to cover future claims relative to premiums earned. A higher ratio reflects conservative risk management and financial strength.

For instance, during FY21-24, the median reserve-to-premium ratio for ICICI Lombard and GoDigit stood at 2.3 and 1.4 times, respectively, depicting differences in approaches and financial strength.

8) Solvency ratio

The solvency ratio is a measure of an insurance company's ability to meet its long-term debt and other financial obligations. In simple terms, it tells us whether the company has enough assets to cover the claims it might need to pay in the future, and whether it can stay financially stable. The IRDAI mandates a minimum ratio of 1.5 times, but higher ratios are preferred for added safety.

Your takeaway

Evaluating general insurance companies requires understanding the interplay between underwriting profitability, operational efficiency, investment income, and leverage. Key metrics such as combined ratio, ROE, and solvency ratio offer insights into financial health and sustainability.

Also read: Decoding revenue and P&L statements of general insurers

This article was originally published on December 02, 2024.