There are many factors to examine when considering an investment in, or buying policy from an insurance company. However, the focus of this write-up is using publicly available information, mainly financial statements, to discern the financial health of insurance companies, and their ability to meet ongoing obligations to policyholders, employees and also offer adequate return to shareholders.
We will continue from the series that started last week on how insurance companies should be properly analysed by establishing and interpreting relationships among key measures from their financial statements.
Growing earned premium (net premium income) and managing expenses are at the heart of value creation for every insurance company. I wrote on the various measure of premium in previous article, please permit me to classify expenses normally incurred by an insurance company into two major buckets called “direct and indirect expenses”.
Direct expenses should increase (or decrease) in proportion to the number and value of policies written by the insurance company. A major example is net claims expense, which is expressed as a percentage of the earned premium in a measure called loss ratio. The lower the loss ratio, the more efficient the insurer is at underwriting or managing risk policies.
Another example is acquisition cost, otherwise known as commission expense paid to intermediaries such as brokers and agents. Acquisition cost is expressed as a percentage of earned premium in a key measure known as underwriting expense ratio. Its common practise among some insurance companies to add the above two measures of direct expenses in a ratio called total underwriting expense ratio.
You will observed we have not mentioned reinsurance expense until now. Reinsurance expense has been deducted from the gross premium income to arrive at the earned premium (net premium income).
Last week, I wrote that reinsurance is undertaken as part of business and risk management strategy of an insurance company, after a careful analysis of their risk appetite and underwriting capacity based on their shareholders’ fund.
I must admit this area is contentious, cessions (reinsurance) have been sources of distortions and margin losses in the opinion of some other experts in the industry. We will return to this topic in future write-ups.
Indirect expenses are otherwise called overheads or management expenses. They include every other expense excluding those already discussed above. Management or overhead expenses include employee costs, depreciation and amortisation, finance cost, auditor’s remuneration, directors’ emoluments and advertising spend.
Management expenses are also expressed as a percentage of the earned premium (Net Premium Income) in a key measure known as the Expense ratio. The lower the ratio, the better efficiency it indicates.
Putting all together, the “direct and indirect costs” is added together in a key measure known as the combined ratio, which expressed total underwriting and expense costs as a percentage of the earned premium.
The combined ratio is therefore an important measure of efficiency among insurance operators. It shows how an efficient insurance company is able to underwrite “good” policies as well as control the underwriting and management expenses. The lower the ratio the better efficiency it indicates.
You can now understand my bewilderment when Nairametrics wrote “Ensure Insurance Spent 80% of Revenues on Expenses”. What expense do you mean here? Is this the combined ratio so I can BUY or the Expense ratio so I can SELL?
Afolabi Lawal works within the Finance Function of AIICO Insurance Plc, he is an avid reader and a contributor on nairametrics.
This article is a well laid out explanation such which a layman would understand and interprete perfectly. So then, from this article and from a logical conclusion,it will be right to say that if the various costs can be lowered, a company will end up making more profit. In doing that,the cost-drivers should be looked into more closely.
I will then like to highlight some two cost-drivers that are closely linked, which if great thought is put, insurance firms can increase thier profitability. One is “Net claim expenses” and the other is “Acquisition cost” (Commission).
It is no news that agents/brokers go extra miles to win businesses with the ultimate mission to generate them commission. However, in the course of winning businesses,salient factors are negligently ignored or ignorantly overlooked thus through pressure,persuation or delibrate cover-up,make underwriters accept more bad risk businesses than good risk ones hence leading to higher Net Claim Expenses which unfortuantely is after the firm must have paid commissions on the said businesses.
Only if and when these two major cost-drivers are efficiently managed can Insurance companies increase thier profitability.
Many thanks Sola, you’re spot on. Underwriters must carry out sufficient investigation when underwriting large or special risks. Good underwriting skills is a pre-requisite for efficient claims management.