Insurance Solvency: Ratio & Methods to Determine

June 1, 2022

With over 92% of Americans having health insurance and almost everyone having at least one type of insurance from one of the 6,000 insurance companies, it is clear that the choice of your insurer is crucial. The range of carriers is staggering, making selection a nightmare for those unprepared.

Whether you are seeking life insurance, auto insurance, or even dental insurance, not only should you find the carrier that would satisfy your needs at a reasonable price, but – most importantly – you have to make sure that the insurer has the financial capacity to provide you with the coverage should the insurance case occur. In other words, you have to make sure that your insurance company is solvent.

Now, it’s not easy to dig that deep, but the good news is, you may not even need to. All insurance companies send reports to the overseeing governmental bodies, which then determine their solvency along with ratings that you can use.

That said, you don’t want to rely on a third party, no matter how credible it looks, do you? It’s always better to know the ropes yourself, huh? If so, continue reading: we’ll dissect all major components of insurance solvency in the lines below.

Insurance Solvency – Ratio Formula

Solvency ratio = Company’s Capital / Company’s Contractual Obligations

Showing whether your insurance company can pay what they owe you, insurance solvency is a backbone of the operation of any insurance company, whether it is engaged in health insurance, homeowners insurance, auto insurance, or even bizarre insurance like, say, feet insurance.

More often than not, insurance solvency is determined by the solvency ratio of a company (1.5 is a bare minimum).

Solvency Ratio Definition

Simply put, a solvency ratio is the ratio of the company’s assets to the amount of money it needs to pay to its clients. This includes the amount of risk the insurer takes (the less risk it takes, the higher the premium), as well as its reserve fund and reinsurance contracts.

More Methods to Determine the Company’s Solvency

Aside from a solvency ratio, which is the main way to determine the solvency of an insurance company, there are a few other solvency ratios that may come in handy:

  • Interest Coverage Ratio* = Earnings Before Interest and Taxes – Interest Expenses
  • Debt to Asset Ratio** = Total Debt / Total Assets
  • Equity Ratio* = Total Shareholder Equity/ Total Assets
  • Debt to Equity Ratio** = Outstanding Debt/ Equity

* the higher the ratio, the healthier the company.

** the lower the ratio, the healthier the company.

Here’s How Insurance Companies Achieve Solvency

There are simple and more complex methods and mechanisms behind achieving and keeping solvency, which vary depending on the insurer, but most carries base it on:

  • Well-calculated underwriting. The very process of calculating risk always stays behind the scenes, but that’s the most important aspect of the question. With the emergence of computer technologies and big data, the process of risk assessment became partially automated and much more accurate (though it’s not a guarantee per se that insurance companies are except for emergencies like unforeseen simultaneous claims). However, the ever-increasing competition in insurance balances things out, not letting insurers go over the top with premiums or worsen the conditions of the policies they sell.
  • Ample monetary reserves. It goes without saying that insurance companies must have enough money in reserves so that they can pay their obligations. What’s more, all states require carriers to have a minimum amount of easily accessible money. Here’s a thing you may not be aware of, though: most insurance companies do not just keep their profit from premiums but invest in different financial instruments, from stocks to bonds to cryptocurrencies, where profit is not guaranteed. This means that companies that invest mustn’t overinvest, keeping their liquidity ratio – the ability to sell liquid securities or cash to pay their contractual obligations – high enough.
  • Through-through reinsurance contracts. As a backup measure, insurance companies conclude contracts with reinsurers, which are other insurance companies helping the former to mitigate risks by spreading it among a larger pool of insurers. It’s very unlikely for all companies in the pool to face unforeseen claims, so reinsurance contracts do work most of the time, including disasters and catastrophic events.

On top of internal solvency measures, every insurance company strives to occupy a decent position in the solvency lists – also known as credit ratings – of rating agencies. These ratings are composed mostly by private companies, but that doesn’t make them less valuable and influential. Healthy financial reports are a priceless marketing instrument for insurers as they boost the credibility of the latter in the customers’ eyes by outlining the financial climate of the company in layman terms.

Insurance Margin as an Important Indicator of a Company’s Solvency

Contrary to popular opinion, insurance companies are not just keeping the float (the money they receive from premiums) intact – they invest into financial instruments. Otherwise, they would have much fewer interested shareholders.

As an investment company, any insurer is characterized by numerous indicators, of which the most substantial is insurance margin:

Insurance Margin = Insurance Profit / Net Earned Premium (NEP)

While insurance profit is the profit made on premiums, net earned premium is:

NEP = Gross Earned Premium (GEP) – Reinsurance Costs

GEP is the amount of all premiums paid to the insurer in a year.

Now, the formulas may not seem too straightforward, but the main point is, insurance margin indicates the profitability of an insurance company from the investor’s standpoint. While any insurance company can suffer underwriting losses in a given financial year, those with high insurance margins will still be profitable. In other words, the higher the insurance margin, the better the financial health of the insurer.

But What If the Insurance Company Is Not Solvent?

Whether insurance companies work either independently or provide insurance services on behalf of the government – as is the case with, for example, Medicare Advantage plans – their solvency is always overseen by the state. Whenever the solvency of this or that insurer is questioned, the government activates the so-called receivership, putting the company under state control, which eventually leads to the necessary structural changes in the company.

Whether the changes are major or minor, they must make the insurer solvent, and if they fail, then the state may liquidate the insurance company while paying immediate claims using the money from a special guaranty fund – the mandatory insurance structure in most states – and from selling the company’s contracts to solvent insurers.

Wrap-Up

It’s easy to perceive insurance as overly controlled by the state and burdened by countless requirements (obligatory income statements and more), but that actually helps maintain the reliable and trustworthy image of the industry. An average client may quickly get lost amidst myriads of terms and rules, but at the end of the day, the only thing he or she wants is that the guarantees provided by the contract are guaranteed.

Insurance Solvency: Ratio & Methods to Determine 1

Oleksandr Rohovnin is a Content Marketer at Phonexa.com and an expert contributor to CoverExplore. His passion is digital marketing, innovative technologies, tech industries, and – above all – distilling vast amounts of complex information into engrossing narratives anyone can relate to. At CoverExplore, Oleksandr stokes passion for auto insurance and the automotive industry in general in every story he curates.

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