Financial service companies especially insurers need few operating assets to generate revenue but are required to hold equity capital at levels sufficient to support their operations. For that reason unlike the non financial service firms for which turnover ratios are calculated relative to assets insurers’ turnover is more appropriately evaluated relative to equity.

Turnover ratios inform on earnings quality for numerous reasons. The low revenue ratio may recommend that equity is overstated either because the insurer understated its liabilities or contra assets (loss reserve, liability for future policy benefits, tax valuation allowance), over capitalized expenditures (including operating expenses) or understated amortization or write downs (investment assets). Low turnover ratio may as well imply that the insurer does not use its equity efficiently.

This ratio, which reflects net asset turnover, is measured as follows:

For service companies employee skills are a particularly important resource. Accordingly the efficiency of this resource as measured using average revenue per employee is an important performance metric. The ratio of recurring revenue to the number of employees also informs on the value of human capital. Recurring revenue is calculated by subtracting realized gains and losses from reported revenue.

Recurring Revenue per Employee is measured as follows:

Where reserve development is the current year adjustment to the prior year’s reserve. Inferences made using this ratio are typically based on its time series properties such as the average value, trend or standard deviation over recent years.

The primary expense recognized by PC insurers is losses and loss expenses. Measuring this expense involves significant uncertainty and discretion which often results in a large measurement error. Over time as losses are paid and new information is obtained insurers revise the estimate of total incurred losses and this adjustment called reserve development; it is included in the reported losses and loss expenses. Because the adjustment is both unrelated to current coverage and quite volatile, some analysts exclude it from the losses and loss expenses when analyzing underwriting profitability.

This ratio is measured as follows:

Still considering the time series properties of the reserve development ratio is informative. To the extent that measurement error in loss reserving is correlated over time, past adjustments to the loss reserve inform on the precision of the reported cost of current coverage. Compared to other insurers an insurer with a sequence of positive adjustments to the reserve may be more likely to understate the losses and loss expenses associated with current coverage and an insurer with a history of large adjustments may be more likely to have large error in the reported cost of current coverage. Moreover even if loss recognition for current coverage is adequate to the extent that adjustments of inadequate past reserves are applied gradually, examining the time series of the reserve development ratio may help predict future development with respect to past coverage which will be included in the future reported losses and loss expenses.

The reserve development ratio can be calculated using either information from the Loss Reserve Development schedule or from the footnote disclosure of the Reconciliation of Claim and Claim Adjustment Expense Reserves.

The combined ratio and its components measure the underwriting profitability of insurance companies. Policy holder share ratio is not worth mentioning for the PC insurance industry overall constituting less than one percentage point in recent years. The loss ratio is the mainly significant element fluctuating between 50 and 70 percentage points. In compare the loss expense ratio and the underwriting expense ratio are quite stable constituting about 12 and 26 percentage points respectively.

The loss ratio and loss expense ratio are often aggregated together and referred to as the loss and loss expense ratio or simply the loss ratio. Conceptually the loss and loss expense ratio should indicate the average cost of insurance protection per each dollar of net premiums earned during the period. However losses and loss expenses reflect not just the cost of protection provided during the year but also the adjustment to the previous year balance of the loss reserve. This adjustment is due to changes in loss estimates (the net redundancy / deficiency) and accrued interest on discounted reserves such as settled workers’ compensation. In addition unlike the premiums which reflect current dollars, losses and loss expenses generally measure undiscounted future payments. This causes an overstatement of the loss and loss expense ratio, particularly for long tail liability lines. Therefore, a potentially more informative measure of current profitability can be calculated by undoing the impact of changes in estimates and discount amortization related to prior year reserves from the losses and loss expenses, and discounting losses and loss expenses related to current period coverage. This can be done using loss development disclosures.

The combined ratio and combined ratio components are defined as follows:

The underwriting expense ratio measures operational efficiency in underwriting. Particularly this ratio represents the percentage of a company’s net premiums earned that went toward underwriting expenses such as commissions to agents and brokers, state and municipal taxes, salaries, other operating costs and employee benefits. A substitute calculation of underwriting expense ratio is to divide the SAP measure of underwriting expenses by net premiums written. This metric compares underwriting expenses to net premiums written rather than earned because SAP treats policy acquisition costs as an expense rather than amortizable cost.

Different lines of business have intrinsically differing underwriting expense ratios. For example boiler and machinery insurance which requires a corps of skilled inspectors is a high expense ratio line. Completely not underwriting expense ratios for group health insurance are quite low. Because the underwriting expense ratio is an important determinant of overall profitability and insurers attempt to set premium rates at levels adequate to generate profits, differences in the underwriting expense ratio across business lines imply opposite differences in the loss ratio. This correlation however is far from perfect. High underwriting expense ratio may be offset by a long tail which allows insurers to generate significant investment income. Of course realized profitability is generally different from expectations.

The combined ratio reflects both the cost of protection and the cost of generating and maintaining the business. When the combined ratio is under 100% underwriting results are considered profitable; when the combined ratio is over 100% underwriting results are considered unprofitable. However as mentioned above the combined ratio understates true underwriting profitability by measuring losses undiscounted. Stated differently the combined ratio does not reflect the investment profits that insurers generate on the float.

Net premiums written is equal to direct insurance and reinsurance assumed during the period less reinsurance ceded. In the circumstance of analyzing profitability this ratio measures the efficiency with which the insurer uses its capital resources to generate business insurers with relatively low ratios are not fully utilizing their capital. However a relatively low underwriting leverage ratio is not always bad. Aggressive underwriting may lead to significant losses especially in soft markets. Also, insurers with low leverage ratios have more room for growth without having to dilute existing shareholders. Importantly the leverage ratio also measures the company’s exposure to pricing errors in its current book of business. Potential losses due to under pricing of policies are related to the amount of net business written while policyholder surplus measures the cushion available to absorb such losses.

Underwriting leverage is measured as follows:

Where net gains (losses) is the sum of realized gains (losses) plus the change in unrealized gains. Investment return has the two mechanisms: investment yield and net capital gains. Unlike the investment yield which reflects risk and historical performance the investment return measures current performance. However this measure has its own short comings. Gains and losses are often due to unpredictable market fluctuations in interest rates or other macro variables and not to superior performance. The related gains and the losses are extremely volatile and are typically transitory. In addition to the extent that insurers engage in asset liability management gains or losses on investments are at least partially offset by unrecognized gains or losses on liabilities.

The investment return is measured as follows:

Recurring ROE (Return on Equity) is a summary measure of recurring profitability from all business activities. Recurring income excludes One Time Items and so Recurring ROE (Return on Equity) is more persistent than ROE (Return on Equity). Moreover if One Time Items are really transitory or at least substantially less persistent than Recurring Income, Recurring Return on Equity ROE may facilitate more precise predictions of future ROE (Return on Equity) than ROE (Return on Equity) itself. Accordingly the relationship between equity value and profitability should be stronger when profitability is measured using Recurring ROE (Return on Equity) instead of ROE (Return on Equity).

One Time Items which are removed from comprehensive income available to common share holders in measuring recurring income, generally include other comprehensive income extraordinary items, income from discontinued operations, impairment charges, asset write downs, restructuring charges, realized gains and losses, and other items which are deemed to be relatively transitory, net of related income taxes. For essentially all insurers, a primary source of transitory items is realized gains and losses on investments. For PC insurers a potentially large transitory item is also included in the losses and loss expenses. In addition to the current cost of coverage, losses and loss expenses include the adjustment to the previous year balance of the loss reserve. This correction is comparatively momentary because it reflects the impact of changes in estimates.

Recurring ROE (Return on Equity) is measured as follows:

The same arguments that motivate most analysts to exclude transitory items from earnings, lead some analysts to exclude AOCI (Accumulated Other Comprehensive Income) from book value when measuring ROE (Return on Equity) or the price to book ratio. For insurers, AOCI (Accumulated Other Comprehensive Income) often cause significant volatility in ROE (Return on Equity), similar to the effect of transitory earnings items on reported income. Still excluding AOCI (Accumulated Other Comprehensive Income) is problematic for the following reason. A primary motivation for the removal of transitory earnings from reported income is that they are optional, that is management might have deliberately engaged in the transactions that generated those items. Thus, excluding transitory earnings items provides a measure of non discretionary real earnings. In contrast removing AOCI (Accumulated Other Comprehensive Income) actually makes the resulting book value discretionary. For example selling a security with unrealized gains reduces AOCI (Accumulated Other Comprehensive Income) and increases ex-AOCI book value but does not change total book value.

Another more legitimate argument for the exclusion of AOCI (Accumulated Other Comprehensive Income) from book value is that excluding AOCI (Accumulated Other Comprehensive Income) mitigates distortions caused by the mixed attributes model historical cost and fair value currently used. Specifically most insurers’ investments are classified as available for sale and reported at reasonable value with unrealized gains and losses incorporated in AOCI (Accumulated Other Comprehensive Income). In contrast, the reserves liabilities that these investments are expected to settle are generally not marked to market. Because the values of investments and reserve liabilities are positively correlated, the inclusion of unrealized investment gains and losses in AOCI (Accumulated Other Comprehensive Income) causes an artificial volatility in book value.

The operating ratio measures a company’s overall operational profitability from underwriting and investment activities. This ratio excludes other operating income and expenses capital gains and losses and income taxes. An operating ratio greater than 100% suggests that the company is unable to generate profits from its underwriting and investment activities.

The net investment income ratio measures the income contribution of the float. Because the float results from insurance activities this component of income should also be considered when evaluating the profitability of insurance operations. However the net investment income ratio and accordingly the operating ratio often provide a poor indication of current profitability. Net investment income is earned primarily on funds obtained in prior years. Thus for growing companies net investment income understates the contribution of the current float and vice-verse for insurers experiencing a decline in the insurance book. Changes in the average tail of the policies or in investment opportunities add further noise. Therefore a better approach for evaluating the income contribution of the float is to estimate the extent to which the current losses and loss expenses are overstated.

The operating ratio is defined as follows:

One Time ROE (Return on Equity) measures the impact of transitory items on shareholders’ profitability. This ratio is informative about Recurring ROE (Return on Equity) for two reasons.

First it may indicate a bias in Recurring Income. For example, frequent write downs or disposal losses suggest that the firm uses aggressive accounting policies, implying that Recurring Income is overstated.

Second negative One Time Items increase future Recurring ROE (Return on Equity) by reducing equity the denominator of future ROE and increasing future income. For example DAC write down reduces future amortization, an OTTI (Other than temporary impairment) of investments increases future net gains and restructuring charges reduce future operating expenses.

One Time Return on Equity (ROE) is defined as follows:

This ratio measures the profitability of investments and so purports to reflect investment success. However the investment yield may not necessarily indicate investment performance for at least four reasons which are explained below.

First Reason, high risk investments typically have high yields while low risk investments have low yields. Such as compared to LH insurers, PC insurers invest in shorter term higher credit quality and more liquid debt securities and therefore have lower investment yields. Thus when analyzing investment performance the yield should be considered in relation to the riskiness of the investments.

Second Reason, most investment assets are reported at fair value and so any success or failure in selecting investments is reflected in their book value which serves as the denominator in the yield calculation. Such as if an insurer acquires securities that offer abnormal risk adjusted yields the fair value of those securities will subsequently increase, bringing the investment yield back to more normal levels. This effect is particularly strong for long term investments; for short or intermediate term investments, the denominator effect is relatively small and thus the investment yield may still reflect investment performance.

Third Reason, any investment performance that is captured by the yield is historical, because most investments were made in prior years and net investment income is measured using the effective interest rates. Thus for the investment yield the statement past performance may not be indicative of future results, can be rephrased as current performance may not be indicative of current results.

The investment yield is measured as follows:

Fourth Reason, in periods of substantial changes in investments either due to growth decline or changes in asset mix, the measured investment yield may contain significant error. Such changes affect investment income but do not change the denominator. This error can be mitigated by adjusting the denominator for changes in invested assets during the year using quarterly financial information. Insurers report an estimate of the investment yield which is calculated using quarterly or in some cases, monthly, weekly, or even daily average invested assets.

An alternative approach for measuring the investment yield is to use the amortized cost of investments instead of their book value. This calculation provides a better indication of investment performance because the denominator is based on the invested amount. Still the calculated yield reflects past not current investment performance.

Investment yields may also inform on accounting quality. In particular an abnormally low investment yield may suggest that reported investments are overstated. This concern is especially relevant for investments whose estimated fair values are highly discretionary, as is often the case with illiquid long term, low credit quality or option loaded instruments. In such cases management might overstate the reported fair value or avoid recognizing impairment.

Return on Equity (ROE) measures the return per dollar of equity investment. This is the summary to calculate of profitability from all business activities. The price to book ratio is greater than one if and only if expected Return on Equity (ROE) is greater than the cost of equity capital. That is to the level that equity calculates the amount invested by shareholders and Return on Equity (ROE) measures the profitability of that investment, firms generate value if and only if Return on Equity (ROE) is greater than the cost of equity capital. Because the cost of equity capital depends on the riskiness of the investment when analyzing profitability Return on Equity (ROE) should be interpreted in relation to equity risk.

In addition to measuring historical performance, Return on Equity (ROE) helps predict future earnings changes, especially because of its mean-reversion property. That is high Return on Equity (ROE) is on average followed by lower Return on Equity (ROE) and therefore earnings declines and low Return on Equity (ROE) is on average followed by higher Return on Equity (ROE) and earnings increases.

The mean reversion tendency of Return on Equity (ROE) is due to both economic forces and accounting effects. Competition among firms’ entry and exit of firms and diffusion of new ideas or practices drive abnormal levels of profitability to the mean. Earnings reinvestment and the infusion of new capital cause further convergence. When the profitability is unusual, reinvested earnings and new capital investments are likely to earn more normal levels of profitability compared to existing capital, driving future Return on Equity (ROE) toward the mean. This reflects the profitability of both new and existing capital. The trend of ROE (Return on Equity) to revert toward the mean is also due to transitory earnings items such as one time economic shocks, realized gains and losses mark to market gains and losses, and leverage effects. These items which often cause an abnormal level of Return on Equity (ROE) in a given year generally have smaller effects on subsequent Return on Equity (ROE) due to their transitory nature.

Return on Equity (ROE) is measured as follows:

For low Return on Equity (ROE) mean reversion is due to real options and accounting distortions in addition to the above factors. Abandonment options and other real options allow firms to discontinue or restructure low profitability projects, reducing the duration of negative 124 profitability shocks. In contrast firms generally do not discontinue or restructure successful projects. Accounting distortions inducing Return on Equity (ROE) reversion include the impact of conservatism and big bath charges. It is accounting convention which requires an immediate recognition of losses but delayed recognition of profits; losses are often recognized when anticipated while profits are recognized when earned. Big bath charges are often recognized by managers in periods of particularly low performance or following management change to facilitate the reporting of higher earnings in future periods. These items cause mean reversion in Return on Equity (ROE) because they result in transitory declines in earnings followed by subsequent earnings increases. For instance an insurer may overstate a restructuring reserve and later release it into earnings or it may write down DAC to lower future amortization. Moreover the reduction in equity the denominator used in future Return on Equity (ROE) calculations further contributes to the subsequent increase in Return on Equity (ROE). Consistent with these arguments mean reversion is empirically stronger for low Return on Equity (ROE) compared to high Return on Equity (ROE).

Although Return on Equity (ROE) reverts toward the mean the revision is protracted and incomplete with cross sectional differences in profitability often persisting for many years. This is due to cross sectional differences in risk, the impact of accounting conservatism, conservative accounting principles increase steady state Return on Equity (ROE) due to the understatement of equity and persistent differences in economic profitability.

The pace of Return on Equity (ROE) mean reversion varies significantly across firms and over time. Therefore to effectively utilize the mean reversion property of Return on Equity (ROE) in predicting earnings and estimating equity value, it is important to consider factors that affect the rate of Return on Equity (ROE) mean reversion. The tendency of Return on Equity (ROE) to revert toward the mean is particularly strong under the following circumstances:

• The gap between current and normal profitability is large
• The relative magnitude of transitory items is high
• The relative magnitude of reinvested earnings and new capital investments is high
• Profitability is low (mean reversion from below the mean is generally faster than reversion from above the mean)
• Return on Equity (ROE) is highly volatile which implies that abnormal levels of Return on Equity (ROE) are likely due to temporary shocks

In addition the characteristics of the company and the environment in which it operates affect the persistence of economic profitability e.g. firm size, barriers to entry, market share and fragmented versus concentrated industry.

 

Ratios used to evaluate profitability include three returns Return On Equity, Recurring Return On Equity and One-Time Return On Equity. Abbreviation of Return On Equity is ROE. These ratios are relevant for fundamentally all firms but particularly vital when analyzing insurers and the other financial service companies. Additionally ratios specifically used in analyzing insurers contain the combined and operating ratios and their components insurers, investment yield, underwriting leverage and investment return. Later we discuss each of these ratios as well as a measure of labor productivity returns and revenue per employee which is an important driver of the profitability for insurers and other companies for which skilled employees are very important. Other measures that are applicable for evaluating profitability, primarily net asset turnover are discussed in the accounting quality articles.

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