What it means
Insurers collect premiums now and pay claims later, sometimes much later. To make sure they can honour claims even after bad years, they need a financial cushion known as policyholders' surplus, which is the difference between assets and liabilities.
The Kenney rule gives a quick way to see whether that cushion is large enough for the volume of business. The rule is attributed to an insurance analyst named Roger Kenney, who proposed a simple relationship between premium volume and surplus for property and casualty insurers.
The 2 to 1 limit is a guide, not a legal minimum, and regulators and rating agencies use more detailed methods today. It remains a convenient shorthand in conversation.
A related part of the rule compares reserves for unearned premiums (premiums received for cover that has not yet been provided) with surplus, aiming for roughly a 1 to 1 relationship. The logic is that if an insurer had to take over or close out its policies, the surplus should be able to absorb the cost of doing so.
Most commentary on the rule, however, focuses on the premium-to-surplus ratio. The ratio is useful because growth in premiums uses up capital.
If an insurer doubles its premium income without adding to surplus, its ratio doubles and its safety margin shrinks. Analysts therefore watch the ratio when a company expands quickly or when a bad year has reduced surplus.
The rule has limits. It does not reflect the type of business written, since a company writing risky long-tail liability cover needs more capital than one writing simple short-term policies.
It also ignores reinsurance and investment risk, so modern capital standards look at many more factors.
In practice
Real-world examples.
Example
An insurance broker is choosing between two carriers for a client's liability policy. One carrier has a premium-to-surplus ratio of 1.2 and the other of 3.1. The broker prefers the first, because the second has less capital relative to the cover it sells.
Example
A start-up insurer plans to grow premiums rapidly. Its finance director builds a plan showing how much extra capital is needed each year to keep the ratio at or below 2. Investors see exactly how much funding must come with growth.
Example
A credit analyst reviews an insurer after a year of heavy catastrophe claims. Surplus has fallen from $80,000,000 to $60,000,000 while premiums stayed at $110,000,000, lifting the ratio from about 1.4 to about 1.8. She flags a thinner cushion but notes it is still within the rule.
Formula
Calculation
Premium-to-surplus ratio = net premiums written / policyholders' surplus. The Kenney guideline is a ratio of 2.0 or less.
Suppose an insurer writes net premiums of $90,000,000 in a year and has surplus of $50,000,000. The ratio is 90,000,000 / 50,000,000 = 1.8, which is below 2.0, so it passes the rule of thumb. If the insurer grew premiums to $120,000,000 without adding capital, the ratio would be 120,000,000 / 50,000,000 = 2.4, which breaches the guideline. To get back to 2.0 at that premium level it would need surplus of 120,000,000 / 2 = $60,000,000, so it would have to add $10,000,000.Case study
Seen in the real world.
Cedar Ridge Mutual is an illustrative, fictional property insurer that decided to expand into commercial cover. Its managing director wanted to double premiums from $60,000,000 to $120,000,000 within two years, and she asked the finance team whether the company could afford it.
The finance team compared the plan to the Kenney rule. With surplus at $45,000,000 the ratio would rise from about 1.3 to 2.7, well above the guideline, so the business needed roughly $15,000,000 of extra surplus to reach the 2 to 1 level.
The illustrative outcome was a phased plan. The company grew premiums by 50% in the first year, retained profits and bought extra reinsurance, and then reviewed the ratio again before taking the next step.
Watch out
Common mistakes.
- Treating the 2 to 1 limit as a legal requirement, when it is a rule of thumb that regulators do not apply as a fixed test.
- Using gross premiums rather than net premiums written, which ignores the risk passed to reinsurers and overstates the ratio.
- Assuming a low ratio means an insurer is safe, when poor reserving, weak investments or catastrophe exposure can still threaten it.
Questions
People also ask.
Who created the Kenney rule?
It is attributed to an insurance analyst named Roger Kenney, and it has become a standard shorthand in property and casualty insurance analysis.
Does the rule apply to life insurers?
It was designed for property and casualty insurers, and life insurers are usually assessed with different capital measures because their liabilities run over much longer periods.
What happens if an insurer exceeds the ratio?
Nothing automatic happens, but analysts and rating agencies will ask for an explanation and may look for additional capital or reduced growth.
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