What it means
Insurers receive premiums before they pay claims, and some claims take years to settle. At each reporting date, the insurer must estimate what it still owes and put that amount into loss reserves, along with a reserve for loss adjustment expenses (the cost of investigating, defending and settling claims).
These reserves are liabilities, and they are based on judgement. Policyholders' surplus is what remains after subtracting liabilities from assets.
It is the cushion that protects policyholders if claims turn out higher than expected, and it is the insurer's equivalent of shareholders' equity (the owners' stake in the business). Where an insurer is owned by its policyholders, the term is still used.
The ratio divides the total loss and loss adjustment reserves by the surplus. A ratio of 2.0 (or 200%) means reserves are twice as large as the cushion, so a reserve increase of 50% would wipe out the entire surplus.
Higher ratios therefore signal greater sensitivity to reserve errors. Reserve risk is especially significant for insurers writing long-tail lines such as liability or workers' compensation, where claims can take many years to develop.
For such insurers the ratio is naturally higher than for short-tail lines such as motor physical damage. Comparisons should therefore be made between similar insurers.
Analysts look at the level of the ratio, its trend over several years and whether past reserve estimates were later adjusted upward. A rising ratio, adverse reserve development and falling surplus together are warning signs.
Regulators in many markets use similar measures as early-warning tests, together with premiums written to surplus and risk-based capital calculations. No single ratio proves an insurer is sound or unsound, but a cluster of unfavourable readings usually prompts questions.
Management can respond by raising capital, buying reinsurance or reducing growth in the riskiest lines.
In practice
Real-world examples.
Example
A rating analyst reviewing a workers' compensation insurer calculates a ratio of 3.1 and compares it with 2.2 for the industry group. She asks management how reliable its past reserve estimates have been and whether the mix of business has shifted towards longer-tail lines. She also asks for a table showing how prior-year reserves developed, which helps her judge whether the ratio is flattering.
Example
An insurance regulator screens all licensed insurers in a region each year. A ratio that jumps from 1.8 to 2.9 triggers a closer look at the insurer's reserving and capital. Examiners ask for the actuary's report and compare the insurer's assumptions with those of similar companies.
Example
A chief financial officer of a small insurer considers a reinsurance deal to reduce the ratio ahead of a rating review, so that the firm presents a more comfortable cushion. The reinsurance cost is weighed against the benefit of a stronger rating, which can influence how much new business the insurer can write.
Formula
Calculation
Ratio = (Loss reserves + Loss adjustment expense reserves) / Policyholders' surplus
Suppose an insurer reports loss reserves of $200,000,000, loss adjustment expense reserves of $40,000,000 and policyholders' surplus of $100,000,000.
Total reserves = $200,000,000 + $40,000,000 = $240,000,000.
Ratio = $240,000,000 / $100,000,000 = 2.4, or 240%.
If reserves later prove 10% too low, the insurer must add 10% x $240,000,000 = $24,000,000, which would cut surplus from $100,000,000 to $76,000,000, an effect of 24% of the surplus.Case study
Seen in the real world.
Keystone Mutual Casualty is an illustrative, fictional insurer that writes commercial liability cover. Over three years its premiums grew quickly, and reserves rose from $150,000,000 to $330,000,000, while surplus increased only from $110,000,000 to $120,000,000.
The ratio therefore climbed from 1.36 to 2.75. The chief actuary warned the board that if the newest business turned out to be 15% more costly, the extra reserve of $49,500,000 would eat up more than 40% of surplus.
The board slowed growth, bought additional reinsurance and added $20,000,000 of capital. In this fictional story the ratio drifted down to 2.2 over two years, and the insurer avoided a rating downgrade. The chief actuary now presents the ratio to the board each quarter alongside the reserve development table.
Watch out
Common mistakes.
- Reading a high ratio as proof of weakness, when long-tail insurers naturally carry higher reserves relative to surplus.
- Forgetting that reserves are estimates, so the ratio is only as reliable as the underlying actuarial work.
- Comparing ratios between insurers writing very different lines of business, which distorts the picture.
Questions
People also ask.
What is policyholders' surplus?
It is the insurer's assets minus its liabilities, the financial cushion available to absorb unexpected claims.
Why include loss adjustment expense reserves?
Because settling claims costs money, including investigators, lawyers and adjusters, and these costs will have to be paid in future.
Does a lower ratio always mean a safer insurer?
Not necessarily, as it can result from under-reserving, so it should be read alongside how past reserve estimates have turned out.
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