The Underwriting Expense Ratio measures efficiency by comparing the amount of losses incurred while making a sale and issuing a policy to the amount of premiums for all policies sold in a certain accounting period. It calculates the percentage of written premiums that go toward paying expenses associated with a new policy before any claims are paid out. The smaller the numerator (underwriting expenses), the lower the ratio. Therefore, by minimizing underwriting expenses, a company can improve efficiency. Of the 4 companies I researched, Dakota Truck Underwriters were the most efficient in this area with a ratio of 19.5%. Drivers Insurance Company had the largest Underwriting Expense Ratio, despite having the lowest amount of underwriting expenses relative to the other 4 companies. However, their ratio was the largest because they had the least amount of premiums written. While calculating all 4 ratios, I found that the Daily Underwriters of America and Discover Property & Casualty Insurance Company did not have any Total Other Income. Perhaps this is why their ratios were larger than Dakota Truck Underwriters.
The Loss Adjustment Expense Ratio also measures efficiency, but does so by calculating the percentage of earned premiums that are used to pay claim costs other than the claim itself. These consist of attorney’s fees, acquiring expert witnesses for trial purposes, hiring a claims department, etc. Much like the Underwriting Expense Ratio, it is best to minimize this ratio by minimizing the amount of adjustment costs and maximizing the amount of earned premiums through sales. In my report, the Daily Underwriters of America did the best job at this task. And surprisingly, Dakota Truck Underwriters had the highest ratio. Each of the other 4 companies had a lower LAE Ratio compared to their Underwriting Expense Ratio. Dakota Truck Underwriters’ was 3.6% higher. Perhaps because they concentrate on reducing Underwriting Expenses, they are not so concerned with minimizing LAE. This would be an area they need to work on in order to increase their efficiency.
Comparing Loss Ratios (Pure Loss and Losses including LAE)
These ratios measure the percentage of premiums that go toward paying claims (and adjusting them if LAE is included). They are related directly to the idea of minimizing the cost of risk. A firm wants to offset unexpected increases in losses with cash inflows, hedging arrangements, and other risk transfers. By doing so, they reduce cash outflows and increase the value of their firm. The lower the amount of losses, the smaller percentage of cash inflows from premiums must be used to pay them. By carefully planning for expected and unexpected losses, a firm can free up premium funds for use in other financial operations and increased profitability. In my report, Discover Company had the highest amount of incurred losses (not including LAE), but their Pure Loss Ratio was second highest to Drivers Company. This is because Drivers does a much smaller amount of business compared to Discover Company in earned premiums. Daily Underwriters of America had the lowest Pure Loss Ratio as well as the lowest Loss Including LAE Ratio. The do the best job of balancing cash inflows with cash outflows. Dakota and Drivers had extremely high Loss including LAE Ratios, 83.8% and 82.6% respectively, meaning that over 80% of the money they collect in earned premiums is going right back out toward paying and adjusting claims. This does not leave them as much room for profitability as the other 2 firms. This explains why they both had the lowest Investment Ratios as well, to be discussed later in my analysis.
Comparing Combined Ratios (Trade Basis)
Combined Ratios are the most commonly used “measure of profitability” for particular companies in the industry. Put simply, they measure costs relative to premiums. A Combined Ratio of less than 100% illustrates an underwriting profit for a firm, while a ratio of over 100% indicates an underwriting loss. If a company is profitable, it means that they collected or earned more in premiums than they paid out in claims and expenses. If they experience a loss, they’re claim pay-outs and expenses are larger than the money they bring in from premiums. The Trade Basis Combined Ratio can be calculated by adding a firm’s Loss Ratio and Expense Ratio. It measures a firm’s total costs(loss + LAE + Underwriting Exp.) vs. their total revenues(Premiums Written and Earned). Only 1 of the firms I am reporting on experienced an underwriting profit! With a ratio of 71.4%, the Daily Underwriters of America do a very efficient job of minimizing costs and maximizing revenues. All 3 of the other firms had ratios of over 100%, Drivers Company having the largest with 114.0%. Discover and Dakota had very similar costs and revenues in number, meaning they do around the same amount of business. Drivers’ numbers were much smaller, perhaps explaining their overall lowest relative efficiency level. However, it is safe to say that no matter how large or small your company, you must concentrate above all things to reduce costs and increase premiums sold.
Comparing Investment Ratios
Measurers of Insurance Firm performance prefer to separate investment operations from insurance operations when determining profitability. However, since investment funds are generated from underwriting and a company factors these funds into their premium tables, a simple investments/assets percentage would not be accurate in the insurance industry. This is the reason for the Investment Ratio. It calculates the percentage of a firm’s total amount of premiums that are used to generate capital through investments. In my findings, Discover Company had an astoundingly large Investment Ratio with 18.5%! This is close to 10% greater than the next largest investment ratio for a company in my report. An easy comparison to make here would be between Discover and Dakota. They have about the same amount in earned premiums, but Discover raised over $3 million more dollars in investments in 2002 than Dakota. It would be reasonable to assume that Drivers’ firm objectives hold generating investments through premiums as a high priority. However, as their Trade Basis Combined Ratio illustrates, this does not make them the most profitable firm. This is something they need to consider when evaluating their own level of efficiency. As aforementioned in my analysis, Dakota and Drivers had extremely high Loss including LAE Ratios, 83.8% and 82.6% respectively. Since such a large portion of the money they collect in earned premiums is going right back out toward paying and adjusting claims, they are not able to generate as many investment funds as other companies. This explains why they both had the lowest Investment Ratios.
Comparing Operating Ratios
The Operating Ratio measures profits relative to premiums. Loosely, it measures Losses + Expenses – Investment Income/Premiums, i.e. (costs-earnings)/premiums. If you were to subtract a firm’s Operating Ratio from 100%, you would calculate the firm’s profits as a percentage of their premiums. While all the other ratios in this project measure very specialized financial aspects of an insurance company, the Operating Ratio takes into account a firm’s overall performance in the marketplace. Consequently, it says the most about a company’s operations, i.e. how they use the money they collect in premiums to generate profits and make their firm more valuable. In my findings, Drivers Insurance Company had the highest Operating Ratio. Despite their lacking in other ratio measures in this project, they seem to have the most overall successful operational strategy. On the opposite end of the spectrum are the Daily Underwriters of America, who had the lowest Operating Ratio by far. This is also surprising because so far in my analysis, they seem to be the strongest firm. My deduction from both of these findings is that these firms are concentrating on only one aspect of the insurance efficiency measurement scale. Despite their efforts to excel in one area, they are not efficient across the board.
Comparing Kenney Ratios
The Kenney Ratio takes into account an insurer’s accounting capital, or surplus. Surplus is the amount of money that an insurance company holds to reduce the risk of insolvency. A company’s surplus is obtained by subtracting the firm’s Policyholder Liabilities from their Assets. The Kenney Ratio measures the net premiums written to policyholder surplus, i.e. what portion of a company’s capital would be used if they were to pay out the cash value of every policy on their books at one time. It is one of the most popular consumer ratios to determine a firm’s staying power. The most alarming Kenney Ratio that I calculated was Dakota’s ratio of 197.0%! This means that they have almost twice their amount of capital written to premiums, making their probability of insolvency very large. The other ratio I calculated over 100% was Drivers’ at 103.6%. They are still at risk for insolvency, but not as much as Dakota Truck Underwriters. The Daily Underwriters of America had the lowest Kenny ratio with 65.5%. This would be much more appealing to a consumer shopping around for a Property/Casualty Insurer. I am not sure why Dakota and Drivers allow for such little accounting capital. It could be caused by rising underwriting losses and extreme price competition, which are the major causes for the current Hard Market in the Insurance Industry.
Final Commentary
Different sets of accounting principles are used for financial and insurance regulators. Insurance Financial Statements are much more conservative than most other Financial Statements, meaning that they don’t make the company look any stronger than it is. This is partly because of heavy regulation, but also because of actuarial activities that avoid underestimated losses and overstated profits. It is better to overestimate losses because it boosts profit figures for the following accounting period when the money not spent on losses and expenses can be added to profits/surplus. Also, investment income percentages have decreased since 1997 because companies don’t want to risk having a Combined Ratio of more than 100%. These facts, as well as the aspects of the current Hard Market, affect every firm’s operating procedures. Consequently, measures of performance and profitability fluctuate greatly from firm to firm. This project was an excellent illustration of that. Although the ratios for the Daily Underwriters of America make it seem like they are the most efficient firm, there are still areas that they lack in. Furthermore, Drivers Insurance Company might have seemed like the weakest firm in the Ratio Percentage column, but their smaller numbers make it possibly unfair to compare them to their larger competitors. In summary, measuring an insurance company’s performance is a very complicated task, as is comparing one firm to another based on those ratios.
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