Deconstructing Risk

Using Ratios to Connect Underwriting, Investments, and Profitability

Ratio analysis is a cornerstone of financial and strategic analysis for good reason. Many useful ratios exist for analyzing and comparing P&C insurance company financials, and in this paper we will review a framework that deconstructs the profitability measure Return on Surplus (RoS) into four widely used subsidiary ratios that provide insight into the specific sources of insurer profitability. These sources include underwriting profitability, underwriting leverage, investment yield, and investment leverage. In addition to demonstrating the basics of this analysis, we will also review the distributions of these ratios among AM Best rated companies, and look for relationships between them and the resulting Financial Strength Rating assigned (with the caveat that such ratings include many factors, not just those being reviewed here).

Return on Surplus (calculated as Net Income divided by Average Surplus) is a primary measure of a insurer’s profitability, and makes for useful comparison both across time and across companies. However, on its own it doesn’t tell us much about where profits are coming from, how sustainable they are, or how risky the company is. For that we need to separate this summary measure into its component parts. These correspond to the two main sources of insurer returns: underwriting and investments, with each being further divided into a measure of profitability and a measure of leverage relative to surplus. We’ll begin by discussing the underwriting side of the equation.


Underwriting profitability is measured by the combined ratio, or ratio of underwriting expenses to revenues1. This is typically scaled so that a value of 100 corresponds to breakeven, with a higher value indicating losses and a value less than 100 indicating profits. For our purposes, we subtract this ratio from 100 to arrive at a measure of underwriting gains divided by premiums earned, which is simply underwriting profit margin. For example, a company with an 88 combined ratio has 100 – 88 = 12% u/w profit margin.

Next we must consider leverage, or the relative scale of underwriting operations compared to the surplus base supporting them. The standard measure of underwriting leverage is Net Premium Written (NPW)/surplus, but for the sake of consistency we use the very similar measure Net Premiums Earned (NPE) / surplus. This acts as a multiplier on the underwriting profit margin in determining its effect on RoS.

When underwriting profit margin and leverage are combined, the result can be thought of as the contribution of underwriting operations to total RoS.


P&C insurers hold significant investments in bonds, common stocks, and other asset classes. These provide significant interest and dividend income plus realized gains on sales. We divide net investment income (including both interest and dividends from all sources) plus realized gain/loss plus the change in unrealized gain/loss marked through to surplus (primarily market value changes on common stock), by average invested assets.

Once again we complement profitability with leverage. For investments this is measured as average invested assets divided by average surplus.

As before we multiply profitability and leverage together, with the result being total investment returns over surplus, which is the investment contribution to the bottom line.

By breaking RoS down into the two separate sources of return and leverage, we get a much clearer insight into the structure of the company’s earnings. The profitability measures illustrate the degree to which the company is effectively managing its underwriting operations and investment portfolio to produce a competitive return, and the leverage measures indicate how aggressive they are being in terms of taking on underwriting & investment risk relative to available surplus. Observing the trends in these measures over time can give us insight into an insurer’s strategic direction, and help managers evaluate how well they’re executing on their intended strategic priorities.


So how do these measures look in practice? To illustrate their analytical value we’ve collected statistics for a group of A.M. Best rated companies2. Generically we would expect the higher-rated companies to show higher profitability measures for both underwriting and investments, and most likely lower-to-flat leverage measures, since lower leverage implies a stronger balance sheet but also potentially lower profitability. Here are 3-year trailing averages for the companies we examined:

With minor exceptions our hypotheses hold true. Stronger ratings correspond almost linearly with higher profitability measures. Leverage is a little more mixed, but generally shows lower underwriting leverage (i.e. more surplus per dollar of premiums) for higher-rated companies, and approximately flat financial leverage across all ratings. It’s worth noting that B++ rated companies actually produce underwriting losses on average over the three year period ending 2015, and relied on investment income to achieve profitability. This illustrates the intensity of underwriting competition in recent years, even among strong and well-run companies. It also illustrates the importance of using the proper analytical techniques if we are to understand the sources of risk and return in an insurer’s operations.

As a final closing note, we should clarify that there are several important income and balance sheet items that are excluded from the analysis above, which may cause the figures shown to differ from other reported industry statistics. In particular, we do not include any consideration of dividends (policyholder or stockholder), other income/expense categories like financing charges, or taxes. These can all be material to financial results, but due to their discretionary and/or non-operating nature we have excluded them as outside the scope of our current purposes.


Notes:1. Combined ratio is sometimes calculated as (Losses / NPE) + (Expenses / NPW), but we use the alternate method as it is guaranteed to normalize a breakeven underwriting result to a value of 100.2. Specifically, our data covers a total of 1,150 AM Best-rated P&C insurers rated at least B++ as of 12/31/15 and having at least $1M in net premiums earned in calendar 2015. All data sourced from SNL.3. We use the term “investment margin” as distinct from “investment yield” to reflect the fact that our measure also includes realized gains and unrealized gains on mark-to-market assets.

Written by:

Peter Wirtala, CFA
Insurance Strategist 

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