Financial Analysis for Insurance Companies

What you'll learn

• How insurers make money from underwriting and investments
• Key metrics: loss ratio, expense ratio, combined ratio, and underwriting margin
• How reserves, float, and reinsurance affect profitability and risk
• Life vs. property & casualty (P&C) metrics: persistency, VNB, reserve development
• How to calculate earned premiums, combined ratio, and reserve coverage step-by-step
• How to spot underwriting cycles, pricing power, and risk-based capital signals
• Practical ways to compare insurers and avoid common pitfalls

Concept explanation

Insurance companies sell promises. Policyholders pay premiums today, and insurers may pay claims in the future. This timing gap creates two profit streams: underwriting profit or loss from the insurance business itself, and investment income on the money held before claims are paid. The key to analyzing insurers is understanding how these streams interact over time.

Underwriting revolves around three ingredients: premiums, claims, and expenses. Premiums are the price of insurance coverage. Claims (or losses) are what the insurer pays out when events occur. Expenses include acquisition costs (commissions, marketing), administrative costs, and taxes. Because claims often occur long after premiums are collected, insurers set aside reserves to cover expected future payouts.

Investment income comes from investing the float—the pool of funds generated by premiums received but not yet paid out as claims or expenses. Insurers typically invest in bonds to match expected claim payments. The quality, duration, and yield of this portfolio influence results significantly, especially in low or rising interest rate environments.

Finally, reinsurance allows insurers to transfer part of their risk to other insurers. It helps smooth results, protect capital during catastrophes, and manage growth. But it also reduces net premiums and can hide underlying risk selection if not analyzed carefully.

Why it matters

Insurers’ accounting can feel counterintuitive compared to typical businesses. Revenue recognition is unique: premiums are recognized as earned over the coverage period, not all at once. Claims may be estimated years in advance, making reserve adequacy a pivotal factor. Small assumption changes can materially shift reported profits.

For investors, this means headline earnings can be noisy. A 95% combined ratio can mask weak reserve practices, while a 102% combined ratio might still be acceptable if investment income is strong and reserves are conservative. Context matters: product mix, underwriting cycle, catastrophe exposure, and reinvestment yields all shape sustainable returns on equity.

The sector also bifurcates: P&C insurers focus on short- to medium-tail risks like auto or homeowners, while life insurers focus on long-duration liabilities like annuities and protection products. Each requires different metrics and risk lenses. Understanding these differences helps you compare insurers appropriately and avoid apples-to-oranges mistakes.

Calculation method

Below are core insurance metrics and how to compute them.

1. Premiums: written vs. earned

• Written premium: the total premium of policies issued in the period
• Earned premium: the portion of written premium that relates to the time already elapsed on the policies

Example: A 12-month policy with $1,200 written on Jan 1 earns$100 per month. After 3 months, earned premium is $300; unearned is$900.

2. Loss ratio

Measures claims cost relative to earned premium.

Incurred losses include paid claims plus change in loss reserves.

Example: Earned premium $1,000; incurred losses$650 ⇒ Loss Ratio = 65%.

3. Expense ratio

Measures underwriting expenses relative to earned premium.

Underwriting expenses include acquisition (commissions), general and administrative, and premium taxes.

Example: Underwriting expenses $320; earned premium$1,000 ⇒ Expense Ratio = 32%.

4. Combined ratio

Sum of loss and expense ratios. Below 100% indicates underwriting profit before investment income.

Example: 65% + 32% = 97% combined ratio.

Underwriting margin (pre-investment):

In the example: 1 - 0.97 = 3%.

5. Reserve coverage and development (P&C)

• Loss reserves: estimate of future claim payments for events already occurred
• Reserve coverage ratio:

• Reserve development: change in prior-year reserves after actual claims emerge

Positive development (release) boosts earnings; adverse development reduces earnings.

6. Float and investment yield

• Float approximates funds available to invest that are financed by policyholders.

• Portfolio yield measures investment income efficiency.

7. Risk-based capital (RBC) and solvency

• RBC ratio indicates capital adequacy relative to risk profile.

Common thresholds: regulators watch closely as ratios approach intervention levels. Many high-quality insurers target RBC well above 300%.

8. Life insurance specifics: persistency, APE, and VNB

• Persistency: percentage of policies remaining in force after a period; 1 - surrender rate

• APE (Annualized Premium Equivalent) standardizes new business volume.

• VNB / VNB margin reflects the present value of expected future profits from new business.

Higher persistency and positive experience variances (mortality, morbidity, expenses) typically lift VNB.

Case study

Assume a mid-sized P&C insurer with the following for the year:

• Gross written premium (GWP): $5,000m
• Ceded written premium (reinsurance): $1,000m ⇒ Net written premium (NWP):$4,000m
• Unearned premium increased by $200m
• Earned premium (net):

• Paid losses: $2,100m; loss reserves increased by$250m ⇒ Incurred losses = $2,350m

• Underwriting expenses (acquisition + G&A + taxes): $1,200m

• Combined ratio:

• Underwriting margin:

• Net investment income: $420m; average invested assets:$12,000m

• Float estimate: unearned premiums $1,600m; loss reserves$5,000m; other liabilities $200m; receivables$600m

• Prior-year reserves were $4,800m; actual losses on that year were$4,950m

Interpretation:

• Strong underwriting: a 93.4% combined ratio implies core discipline
• Investment tailwind is moderate with 3.5% yield on a large float
• Adverse reserve development of $150m is a yellow flag—dig into which lines drove it (e.g., commercial auto, liability)
• Reinsurance use is material (20% of GWP); assess cost vs. protection during catastrophes

Practical applications

Screening and comparison

• Prefer insurers with multi-year average combined ratios below 100% and low volatility across cycles
• Check reserve development over 5-10 years: frequent adverse development suggests weak pricing or optimistic reserving
• Evaluate RBC ratio and trends. Healthy buffers reduce downside risk and support dividends/buybacks
• Compare investment portfolio duration and credit quality to liability profile. Mismatch risk can bite when rates move

Cycle awareness

• P&C pricing is cyclical. Tight capacity after large catastrophes often leads to rate hardening and better combined ratios
• Track management commentary on rate increases, exposure growth, and loss cost inflation. If pricing outpaces loss trends, margins expand

Reinsurance strategy

• High ceded ratios can stabilize results but also mask weak underwriting if terms are expensive
• Review catastrophe covers, retention levels, and reinstatement terms. A cheap combined ratio obtained by ceding too much may depress long-run ROE

Life insurance focus

• Monitor persistency: rising surrenders may reflect product mispricing or rate-sensitive lapses
• Track VNB and VNB margin by product. Shifts toward capital-light, fee-based products (e.g., asset management, protection) can lift returns
• Assess assumptions: mortality, morbidity, expenses, and discount rates. Experience gains should be recurring, not one-off

Investment income and rates

• In rising rate environments, new money yields can lift future investment income even if current yields lag
• Beware unrealized losses in bond portfolios under fair value accounting. Understand capital impacts and asset-liability duration matching

Valuation shortcuts

• P&C: Price-to-book alongside sustainable ROE and combined ratio history. Strong franchises often command P/B premiums
• Life: Embedded Value and VNB multiples where disclosed. Cross-check with P/B and return profile

Common misconceptions

Summary

Glossary

Written Premium: Total premium from policies issued during a period, before earning over time.

Earned Premium: Portion of written premium recognized as revenue for coverage already provided.

Loss Ratio: Incurred losses divided by earned premium; measures claims cost.

Expense Ratio: Underwriting expenses divided by earned premium.

Combined Ratio: Loss ratio plus expense ratio; under 100% indicates underwriting profit.

Reserves: Liabilities set aside for future claim payments on events already occurred.

Reserve Development: Adjustments to prior-year reserves as actual claims emerge.

Float: Funds held between collecting premiums and paying claims, available to invest.

RBC Ratio: Risk-based capital ratio measuring capital relative to risk.

Persistency: Percentage of policies that remain in force over time (life insurance).

APE: Annualized Premium Equivalent; a standard measure of new business volume.

VNB: Value of New Business; present value of expected profits from new policies.