Performance evaluation of financial institutions substantially differs from one of other traditional entities. To reformulate both the inputs and outputs of these firms are capital, hence, their financial statements, be it an income statement or balance sheet, bear their unique set of characteristics not observable in manufacturing, mining or any other industry. Furthermore, the variances within the sector, for instance public banks and mutual funds, are just as considerable as with completely different industries. Therefore, the assessment of financial sector firm’s performance requires thorough and extensive research to uncover the underlying phenomena oftentimes overlooked by prompt skimming.

Insurance is by far one the most distinctive industries. Having its modern history dating back a few hundred years, the former evolved and was shaped into the elaborate practice that nowadays constitutes an integral part of any economy. Insurance as many other sectors has its sources of direct and indirect income. The former is generated by underwriting activities, meaning it is the gross written premiums payable by the policyholders for their coverages. The indirect income is mainly formed by the firms’ investments and their yielded returns. The appraisal of insurance firm’s profitability primarily focuses on these two figures and their relation to other indicators.

Direct income

Direct income or the revenue of an insurance firm is significant proportion of total income. However, the net income it generates is far more modest than the gross figure. If one disregards the general and administrative overheads that insurance firms bear, substantially most of the expenses left are incurred for the sake of the former’s main operations: indemnities, claim regulation expenses, etc. Simply put insurance firm’s direct activity, provision of insurance, produces the majority of its inflows and outflows. A decent measure of a company’s profitability is its underwriting income in absolute terms. On first this appears as a mere vanity metric that does not highlight any important information to its users. However, when critically evaluating a company’s performance and acknowledging that the final end result for this kind of entities is the bottom line, the underwriting income in dollars becomes far more relevant than some of the other indicators mentioned in this article.

Underwriting Income = Gross Written Premiums – ( Incurred Expenses + Paid Out Claims )

Another handy measure of an insurance company’s performance is loss ratio, which is the fraction of paid out claims and premiums for a given time period. This swift and easy ratio is widely used not only for the entire firm’s or a specific division’s evaluation, but also for the appraisal of a single insurance policy. While renewing their contracts in force, insurers meticulously appraise the profitability of one specific contract for B2C and the portfolio for B2B customers, only after which a final renewal decision is made. Surely this process is not that easy and straightforward: it rather requires multidisciplinary approach as well as accurate prediction approximation polished with years of industry specific experience. A practical procedure that facilitates the latter is benchmarking. This significantly reduces the time spent on each contract and ensures standardization across all affairs of the entity.

Loss Ratio = Paid Out Claims / Gross Written Premiums

Loss ratioInsurance Type
80%MTPL (commercial)
71%Property & BI
69%General liability
84%Medical malpractice
81%Personal accident (commercial)

The third performance assessment indicator for an insurance firm is expense ratio. On the contrary of loss ratio that measures the profitability of a given contract or portfolio regarding the indemnities, expense ratio rather focuses on the acquisition and somewhat other peripheral aspects of insurance contracts. These costs include, but are not limited to agent fees, advertisements, amounts payable to reinsurance partners, etc. In other words, expense ratio shows how efficiently an insurance firm converges its resources into income-bearing contracts. Oftentimes, companies have their cost cards prepared beforehand and do not measure each ledger separately to get the actual figures as the difference is negligible.

Expense Ratio = Incurred Expenses / Gross Written Premiums

The final indicator that measures the firm’s underwriting performance is combined ratio. As the name implies it is a combination of markers discussed previously. To calculate the combined ratio, one needs to divide the sum of indemnities and direct expenses over the gross premiums for a given period or just add up loss and expense ratios. Due to this measure being comparatively balanced, it more accurately depicts the performance of the insurance firms, as its two components are complementary to each other.

Combined Ratio = Loss Ratio + Expense Ratio = ( Incurred Expenses + Paid Out Claims ) / Gross Written Premiums

Currently, the golden standard of combined ratio is 100%. Any figure lower indicates that the insurance firm is not yet mature and has room for growth. In other words, the entity has not managed to utilize its full capacity and has slack resources. In any case, combined ratio higher 1 implies that the insurance firm loses money from its underwriting activities. The direct income is negative, and decreases the passive investment income that the company generates.

Indirect income

The other contributor of an insurance firm’s profit is the indirect income, which mainly consists of investments. To prevent losses due to time value of money as well as ensure additional incremental income on so-to-say frozen assets, companies purchase financial instruments such as corporate or government bonds, stocks, treasury bills and traditional low yield deposits. In these transactions the income is generated not only by the rendered dividends or interest payouts, but also by the capital gains in disposals of the aforementioned assets.

The main evaluating measure used is the investment income margin got by the fraction of investing income and closing investment balance (sometimes the average of opening and closing balances is used). This shows the average profitability of an insurance firm’s investment portfolio.

Investment Income Margin = Net Investment Income / CB of Investments

Generally, firms invest in wide range of instruments to ensure the diversification of assets and derisk their portfolios. The average balance sheet structure of insurance firm consists of:

While this is a standard practice for developed entities, insurance firms in transitional economic environment have considerably different proportions. For instance, Armenia entities have significantly less investments in stocks and bonds, which can be explained by limited development of capital markets. On the contrary, these entities prefer investments in deposits, which is less than 1% in matured economies. These investment mediums secure high yielding income with minimal risk.

In conclusion: both efficient investing and underwriting activities are key for insurance firm’s success. That is why it is important to closely investigate each when evaluating a firm’s performance. While this process is more straightforward for investing activities and entail a simple ratio or absolute figure comparison, underwriting operations require industry specific knowledge to accurately appraise each outflow account. For the assessment of the latter, loss, expense and combined ratios are used.



    About the author

    Underwriting Assistant, Ingo Armenia ICJSC
    Master of Science in Economics (AUA), Bachelor of Arts in Business (AUA)
    Experience in Insurance – since 2020