Operating Ratio – Profitability with a Combined Loss & Expense Ratio > 100
Copyright 2024, Charles F. Barr, Esq.
In the 1980s and 90s “cash flow underwriting” was a pejorative term. If the combined loss and expense ratio of an insurer exceeded 100% for an “accident year” it meant there was no profit from the premium collected from that year’s policies. The analysis stopped there. This was very much an “underwriting purist” point of view. This paper suggests that a fuller understanding and measurement of operating success is gained from the Operating Ratio, which includes investment income by deducting the Investment Ratio (asset side success) from the Combined Ratio (the fortuitous liability side) and any Dividend Ratio (if mutual insurer or participating policy dividends are paid).
A further step is to examine the role of “insurance company float” in driving insurer profits. Float is premium money collected, then invested while temporarily held as reserves for Loss & LAE, before being paid out as claims years later (or added to policyholders surplus). Insurers writing long-tail casualty business hold and invest these “premiums morphing into reserves and generating income” the longest.
Float can generate investment returns for the insurer to both: enhance income and match it to its policy obligations (i.e. pay the bills as they come due); and create opportunities to essentially become a “strategic investment fund”. This fund perspective allows an insurer to profit further by taking strategic investment positions or purchasing subsidiaries (which, in turn, might generate more float to invest). A strategic investor-insurer can benefit on this “investment portfolio” basis in addition to the investments providing net income and standalone benefits for the insurer’s operations as merely “an invested asset”. Think of Berkshire Hathaway’s prominent use of insurance float purely in its business as an asset-picker, not merely as an insurer.
If substantial float allows the insurer’s investment side to substantially contribute to earnings, achieving an underwriting break-even with a Combined Ratio of 100 means there is zero cost to obtaining float for investment. If the Combined Ratio is under 100, Berkshire Hathaway refers to that as “being paid (the underwriting profit) to hold free money to invest”.
Reserves for Loss and Loss Adjustment Expense (LAE) for an Accident Year capture losses occurring within that specific January to December period. Each loss forever belongs in only one Accident Year. That year’s best estimate of reserves will change with each year’s re-estimate until all claims incurred in that year are paid in full. Loss & LAE reserves for a Calendar Year (e.g. 2023) include losses from that 2023 Accident Year plus the net changes occurring during 2023 to earlier estimates from all prior Accident Years. Once set, Calendar Year reserves and year-end financial results do not change for 2023, unless restated for an accounting reason (rare). The insurer’s annual statement (Yellow Book) states the Calendar Year financial condition for 2023.
The Combined Ratio consists of Loss & LAE divided by earned premiums (the Loss Ratio) plus all other expenses from operations divided by written premiums (the Expense Ratio). A Combined Ratio greater than 100 indicates an underwriting loss for the year – which result are “internally financed” (perhaps temporarily) by either a deduction from policyholders surplus or by utilizing investment income until the self-financing from that year materializes.
Investment income is generated by investing money from three possible sources: premiums collected (possibly taking 90 days from policy inception date); that year’s and prior years’ reserves for Loss & LAE; and policyholders surplus.
Each underwriting year’s business is intended to be “self-financing”, i.e. approximately 60-65% of the year’s aggregate premium is ear-marked for that year’s Loss & LAE and 35% for that year’s general expenses (including acquisition costs = commission or brokerage). Claims do occur during that year but might not be reported for several years and can take more years to be fully paid. In anticipation of this delayed reporting and eventual liquidation and the uncertainty of estimating during the policy year the claims’ ultimate costs, an Accident Year will add to reported/estimated Loss & LAE an estimate of Incurred But Not Reported (IBNR) Loss & LAE.
Thus, the first estimate of an Accident Year result will approximate 65% (or whatever the chosen “loss pick” is for each line of business), even if few claims were reported or estimated during that 12-month period. This avoids incorrectly reporting premature and unlikely “profits” based solely on the reported claims during the first twelve months, which could implicate a premature/incorrect federal income tax obligation. Conversely, over-estimating IBNR Loss & LAE can postpone profits and delay a tax obligation. (There is no state income taxation of insurers; they pay tax on premiums at the state’s specified rate in lieu of income tax.)
Further, Calendar Year IBNR includes changes in Loss & LAE reserves during the year arising from prior Accident Years’ many re-estimated results. Meaning, Calendar Year IBNR includes adverse development (increasing reserves) and favorable development (reducing reserves), not just newly-reported claims. The Yellow Book contains details on over ten years of reserve re-estimates.
An illustrative Loss Ratio of 65% combined with an illustrative Expense Ratio of 35% would generate a break-even Combined Ratio of 100%. But if 9% is earned on invested cash (from that year’s premiums or its Loss & LAE), the insurer would have a 9% Investment Ratio (investment income divided by earned premiums). Thus, a Combined Ratio of 100 minus an Investment Ratio of 9% yields an Operating Ratio of 91%. Strictly from issuing policies in that one year. A Combined Ratio of 109% with a 9% Investment Ratio could become a break-even Operating Ratio of 100% for that Accident Year.
There is one last ratio to consider if the insurer is a mutual company, which rewards all policyholders for a good year’s results, or is a stock company which elects to pay dividends to “participating policyholders” based upon the results of a line of business (e.g. workers compensation). This Dividend Ratio consists of the policyholder dividends paid divided by earned premium. Mutual insurers don’t have stockholders or owners; their policyholders don’t “own” the company but are granted certain contractual rights which include the opportunity for all to receive a “policyholders’ dividend” based upon financial results of the company. Similarly, a “participating plan policyholder” which purchases a “participating” WC or other policy (where a voluntary dividend based on good results might be declared by the insurer’s Board) might receive a policyholders’ dividend based upon the profitability of the policy.
Such policyholder dividends (from a mutual insurer or from particular policies of any insurer) are an additional expense. Thus, the Operating Ratio of such an insurer is equal to: the Combined Ratio; plus the Dividend Ratio; minus the Investment Ratio. Again, an Operating Ratio below 100 makes the insurer profitable.
The longer an insurer is in business, the greater is the investment income from: (1) the flow of new and renewal premiums; (2) the amount of reserves for Loss & LAE being held year to year until paid as claims or released to surplus; and (3) the increasing policyholders surplus from lower claim payments. Each source of investment income increases the Calendar Year’s Investment Ratio (asset), which offsets the Combined Ratio (liability) and any Dividend Ratio (liability), which reduces the Operating Ratio (toward break-even or profitability).
An insurer can sustain many years of a Combined Ratio over 100 (i.e. “losing” money on each underwriting year) yet be quite profitable due to investment income producing an Operating Ratio under 100. Thus, an ongoing insurer has greater opportunity to self-finance each Accident Year’s results by using THAT year’s premiums or by offsetting Calendar Year results via investment income from earlier years’ premiums, held reserves and policyholders surplus.
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