What it means
When an insurer sells a policy, it takes on the risk of paying claims in the future. Net premiums written is the total premium from new and renewed policies in the period after paying reinsurers to take on some of the risk.
It is a good indicator of how much risk the company is keeping. Policyholders' surplus is what remains when you subtract an insurer's liabilities from its assets, as measured under insurance accounting rules.
Think of it as the equity of an insurance company, the cushion that protects customers if claims turn out worse than expected. The bigger the cushion, the more shock the insurer can absorb.
Dividing the first figure by the second gives a leverage ratio. If the ratio is 1.0, the insurer writes $1 of premium for every $1 of surplus, and if it is 3.0, it writes $3.
This is a little like a bank's debt-to-equity ratio, applied to the underwriting side of the business. Regulators in many places and rating agencies look at the ratio together with other measures.
A rule of thumb that has often been quoted is that a ratio above about 3 to 1 deserves closer attention, though the right level depends on the type of insurance. Property and casualty lines with uncertain claims usually need lower ratios than lines with very predictable claims.
The nuance is that the ratio looks only at premiums and not at the quality of the risks. An insurer writing low-risk policies can be safe at a higher ratio, while one writing volatile risks might be in trouble at a low one.
Analysts therefore combine it with reserve adequacy, reinsurance quality and the combined ratio. For a non-specialist, the ratio is best read as a speed limit on growth.
An insurer that wants to double its premium income either needs to double its capital or buy more reinsurance to pass the extra risk on. This is why fast-growing insurers so often announce capital raises at the same time as expansion plans.
In practice
Real-world examples.
Example
A regional motor insurer writes $300,000,000 of net premiums and holds $120,000,000 of surplus. Its ratio is 2.5. The chief financial officer tells the board that growth beyond $360,000,000 would push the ratio to 3.0 unless more capital is raised.
Example
A rating analyst reviewing a marine insurer sees net premiums written of $45,000,000 and surplus of $90,000,000, a ratio of 0.5. She notes that the company has a conservative balance sheet but may be earning a low return on its capital. She asks management whether it plans to grow or return capital to shareholders.
Example
A start-up insurer in the cyber risk market raises $50,000,000 of new capital. The management plan is to write up to $100,000,000 of net premiums in its first full year, a ratio of 2.0. Investors use this limit to judge how fast the company can safely expand.
Formula
Calculation
Net premiums written to policyholders' surplus = net premiums written / policyholders' surplus
An insurer writes $240,000,000 of gross premiums and cedes $60,000,000 to reinsurers, so net premiums written are $240,000,000 - $60,000,000 = $180,000,000. Its policyholders' surplus is $90,000,000. The ratio is $180,000,000 / $90,000,000 = 2.0, or 2 to 1. If the insurer grows premiums to $270,000,000 net while surplus stays at $90,000,000, the ratio rises to 3.0.Case study
Seen in the real world.
Harbour Mutual Assurance is a fictional property insurer used here for illustration only. In this illustrative story, its sales team signed a large number of new commercial policies, lifting net premiums written from $150,000,000 to $330,000,000 in one year. Surplus meanwhile held at $100,000,000 because of a series of storm losses.
The ratio jumped from 1.5 to 3.3, and the rating agency warned that a downgrade was possible. The board responded by buying more reinsurance, which cut net premiums written to $270,000,000, and by raising $30,000,000 of new capital. These steps brought the ratio down to $270,000,000 / $130,000,000, about 2.1, and the rating was kept.
Watch out
Common mistakes.
- Using gross premiums instead of net premiums written. The ratio is meant to show the risk kept after reinsurance.
- Treating one threshold as a rule for all insurers. Acceptable levels vary with the line of business and the quality of reinsurance.
- Reading a low ratio as always good. A very low ratio can mean the company is under-using its capital and earning weak returns.
Questions
People also ask.
Is this the same as a combined ratio?
No, the combined ratio measures underwriting profitability, while this ratio measures how leveraged the premium volume is against capital.
Why is it called policyholders' surplus?
Because under insurance accounting, the surplus is the cushion that stands behind the policyholders' claims.
Does it apply to life insurers?
It is mainly used for property and casualty insurers, since life insurers rely on different capital measures.
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