What it means
Insurers hold assets to back the promises they have made to policyholders. Whatever remains after setting aside enough to meet those promises is the free portion, and the ratio expresses that surplus relative to the liabilities or to total assets.
It matters because an insurer with a thin cushion has little room to invest in higher-returning assets or to survive a bad claims year. Regulators, rating agencies and brokers all use the measure as an early screen before digging into detail.
The calculation looks simple, but the inputs are heavily judgemental. Liabilities depend on actuarial assumptions about mortality, lapse rates and discount rates, and small changes in those assumptions can move the ratio by several percentage points.
There are two common denominators, which is a frequent source of confusion. Dividing free assets by liabilities gives a higher figure than dividing by total assets, so ratios should only be compared when the same basis is used.
Modern solvency regimes have largely replaced it with risk-based capital measures such as the solvency coverage ratio. The free asset ratio survives as a plain-English summary, useful precisely because it needs no model to understand.
In practice
Real-world examples.
Example
An insurance broker screening providers for a corporate pension scheme ranks five insurers by free asset ratio. Two report ratios above 12% while one sits at 4%, and the broker drops the weakest from the shortlist pending a discussion of its capital plans.
Example
A life insurer's ratio falls from 11% to 6% after a year in which falling bond yields inflate the present value of its liabilities. The board suspends its share buyback programme and issues subordinated debt to rebuild the cushion before the next reporting date.
Example
A ratings analyst compares two insurers quoting 10% and 9%, then discovers that the first measures free assets against liabilities and the second against total assets. Restating the second on the liabilities basis lifts it to 9.9%, so the apparent gap almost disappears.
Formula
Calculation
Free assets = total admissible assets - total liabilities
Free asset ratio = free assets / total liabilities, or on the alternative basis, free assets / total assets
Consider a fictional life insurer with total admissible assets of $4,000,000,000 and total liabilities, including policyholder reserves, of $3,600,000,000.
Free assets are $4,000,000,000 - $3,600,000,000 = $400,000,000.
On the liabilities basis the ratio is $400,000,000 / $3,600,000,000 = 11.1%. On the total assets basis it is $400,000,000 / $4,000,000,000 = 10.0%, which is why the basis must always be stated alongside the number.
Now suppose a market fall cuts assets to $3,900,000,000 while a lower discount rate pushes liabilities up to $3,700,000,000. Free assets drop to $200,000,000 and the ratio on the liabilities basis falls to $200,000,000 / $3,700,000,000 = 5.4%, a sharp weakening from modest moves on both sides.Case study
Seen in the real world.
Thornbury Mutual Life is a fictional insurer invented for this illustration. It reports total admissible assets of $2,500,000,000 and liabilities of $2,250,000,000, giving free assets of $250,000,000 and a free asset ratio on the liabilities basis of $250,000,000 / $2,250,000,000 = 11.1%.
A sustained fall in interest rates then raises the present value of its liabilities by 8% to $2,430,000,000, while its bond-heavy asset portfolio gains only 3% to $2,575,000,000. Free assets shrink to $2,575,000,000 - $2,430,000,000 = $145,000,000 and the ratio drops to $145,000,000 / $2,430,000,000 = 6.0%, close to the level at which its regulator asks for a recovery plan.
The board responds by shifting $200,000,000 out of equities into bonds that better match the timing of its liabilities, and by closing a loss-making annuity line to new business. A year later liabilities of $2,400,000,000 against assets of $2,640,000,000 give free assets of $240,000,000 and a ratio of 10.0%, showing that the measure moves on both sides of the balance sheet.
Watch out
Common mistakes.
- Comparing ratios across insurers without checking whether the denominator used is liabilities or total assets.
- Reading the ratio as a measure of profitability, when it describes the cushion available rather than the returns being earned.
- Ignoring the actuarial assumptions behind the liability figure, which can swing the ratio without any real change in the underlying business.
Questions
People also ask.
What counts as a healthy free asset ratio?
There is no universal threshold, but life insurers have historically been seen as comfortable somewhere in the region of 8% to 15% on the liabilities basis.
Why do falling interest rates hurt the ratio?
Lower rates raise the present value of future claim payments, so liabilities grow faster than the asset side and the surplus is squeezed.
Has it been replaced by anything?
Largely yes, by risk-based solvency coverage ratios comparing eligible capital with a modelled capital requirement, though the free asset ratio survives as a useful plain summary.
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