Monday, April 16, 2007

Insurance Business Part 2

How to calculate loss ratio?

Loss ratio = loss and loss reserves expenses divided by net premiums earned

How to calculate expense ratio?

Expense ratio = underwriting expenses or anything that is related to selling the insurance divided by net premiums earned.

These two formulas will determine to underwriting performance of an insurance business. The ratios will reflect the disciplinary level and effectiveness of an underwriter. Since most insurance policies are commodity-like, insurers generally lack pricing power. In fact, any business which is commodity-like lacks pricing power and what distinguish the best from the rest lies in cost for most commodity-like business. The low-cost producer will hold the advantage. But in insurance, it lies in both cost and also the ability to make use of the float which ultimately determines the cost of capital. As a result, with the intense competition in pricing, most people don’t care who writes their policy as long as the price is cheap. Thus, insurance prices function in the manner of supply and demand. When times are good, insurers make underwriting profits, and loss ratios decrease. Because of the smaller losses, some insurers driven by short-term greed, increase capacity by writing more policies, without consideration for future risk. The increase in supply results in decrease in prices. Eventually, the cycle turns and losses increases. The turkey came home to roast for those insurers who wrote a lot of policies at low prices and left holding the baggage. It is almost akin to the stock market working during the boom-bust cycle.

Investors should thus look for insurers who stay discipline, boom or bust. When loss ratios are low and insurance prices are soft, the disciplined insurers cut back on premium growth, even if it means foregoing short-term profits – again similar to the workings of value investors. So when the underwriting cycle turns, the undisciplined insurers will be saddled with large losses. Some even go bust. The resulting decrease in capacity means tantalizing profits for disciplines insurers who patiently wait for better pricing. You could see that after 9/11, the disciplined insurers reap the rewards justly because they could write better policy priced at a higher price when the other undisciplined insurers are left with little room to write policy after a catastrophe.

Loss and underwriting expense ratios are used to interpret the underwriting experience of property & casualty insurance companies. Loss and loss adjustment expenses (LAE), on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses, on a statutory basis, are stated as a percentage of premiums written rather than earned because most underwriting expenses are incurred when policies are written and not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratio are less than 100%.

Unlike many other forms of contractual obligations, LAE often do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total LAE payments to be made by periods, as shown below for example, are estimates.
Total Within 1 year 1-3 years 4-5 years More than 5 years
LAE US$1,022,603 $622,305 $319,277 $33,691 $7,330

LAE are for the payment for both reported and unreported claims. Loss reserves are estimation based upon case to case evaluation of the type of claim involved and the expected development of such claims. The amount of loss reserves and LAE reserves for unreported claims can be determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

The company’s ultimate liability may be greater or less than the stated loss reserves. Reserves are closed monitored and are analyzed quarterly by the company’s acturial consultants. The company may or may not discount to a present value that portion of its loss reserves expected to be paid in future periods. However, the tax reform Act of 1996 does require the company to discount loss reserves for federal income tax purposes.

LAE reserves are typically comprised of 1) claims reported or known as case reserves (CR) in the industry, and 2) reserves for losses that have occurred but for which claims have not yet been reported, referred to as incurred but not reported reserves (IBNR), which includes a provision for expected future development on case reserves. CR are estimation based on the experience and knowledge of claims staff regarding the nature and potential cost of each claim and are adjusted as additional information becomes known or payments are made. IBNR is derived by subtracting paid loss and LAE and CR from the ultimate loss and LAE.

Ultimate loss and LAE are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can be reasonably be expected to persist in the future. In forecasting ultimate loss and LAE with respect to any line of insurance, past experience with respect to that line of insurance is the primary source, but cannot be relied upon in isolation.

Uncertainties in estimating ultimate loss and LAE are magnified by the time lag between when a claim actually occurs and when it’s reported and settled. This time lag is referred to as the “claim-tail.” The claim-tail for most property coverage are typically fairly short, in the absence of litigation, and settled no more than a few years after occurrence. In contrast, claim-tails for casualty are usually very long, occasionally extending for decades. Casualty claims are susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment which contributes to the extended claim-tails. Claim-tails for reinsurers could be further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices. During the long claims reporting and settlement period, additional facts regarding to the coverage written in the prior accident years, as well as about actual claims and trends may become known, and as a result, the insurer may adjust its reserve. If management determines that an adjustment is appropriate, the adjustment is booked in the accounting period in which such determination is made accounting with GAAP. Accordingly, should reserves need to be increased or decreased in the future from accounts currently established, future results of operations would be negatively or positively impacted, respectively.

Last but not least, the last factor to consider is the premiums to surplus ration. Statutory requirement indicates that this ratio should be no greater than 3 to 1. This is calculated by dividing the net premiums written by the policyholders’ surplus. In effect, this is a measure to curb overwriting of insurance.

Hopefully, all these discussion would have shed some light for those who are intrigued on how to evaluate an insurance business.

No comments: