In the second part of a regular series, AM Best explains the limitations of the solvencymargin as an analytical tool

As with the combined ratio discussed last month, the solvency margin is frequently used as an analytical shorthand, allowing analysts to relate the capital base of the insurer to the amount of underwriting risk the insurer appears to take.

However, as with the combined ratio, there are a large number of additional factors that need to be borne in mind when interpreting the solvency margin in any given case. Indeed, there are so many issues impacting on an insurer's true capital adequacy that are not reflected in the solvency margin that AM Best does not use this as its primary measure of capital adequacy.

In this article we will discuss the main limitations of the solvency margin. Next month we will discuss how AM Best addresses these issues in its financial strength rating process.

The solvency margin is the ratio between net written premium and shareholder funds.

Net written premium is the total premium written in the underwriting year minus the premium ceded to reinsurers.

Shareholder funds simply means the difference between the value of the insurer's assets and its technical (insurance related) and other liabilities. The term is generally used even for mutual companies notwithstanding the fact that these have no shareholders.

Confusingly, in different countries the convention as to whether to express this with the premium value as the numerator or the denominator varies. In the UK the tradition has been to have the premium value as the denominator. But, internationally, it is more often the numerator and that is the convention we use here.

Convention example:
For premium of £1bn and shareholder funds of £400m

UK convention 400/1,000 Thus solvency margin = 0.4 or 40%

International convention* 1,000/400 Thus solvency margin = 2.5 or 250%

* Used in this report

However expressed, the principle of the solvency margin is straightforward. That is to take a measure of the risk the insurer is taking (net written premium) and compare that to the risk capital it has available to take that risk (shareholder funds). Traditionally, for a large, diversified company something between 200% and 300% (two to three times net premium to shareholder funds) has been considered a prudent level.

The problem with this approach is that net written premium is not necessarily a good measure of the risks an insurer is taking. In addition, considerable analysis needs to be done before the reported shareholder funds can be considered a good measure of the insurer's risk capital.

Inherent risks
To understand the limitations of the solvency margin it is important to have a full perspective of the main sources of risk for an insurer. Broadly these can be divided into three main types:

  • The risks being taken within current underwriting operations
  • The risks inherent in business written in previous years
  • The risk that assets may reduce in value.

    The drawback is that neither asset values, nor historical underwriting risks, are reflected in the net written premium value and, hence, are not included in the solvency margin calculation. The simplified example above illustrates the potential importance of this:

    Shareholder funds of the insurer are simply the difference between the value of the assets and the value of the liabilities. In this example £400m. However, if the value of assets were to fall, or the value of liabilities rise, then the amount of shareholder funds would clearly reduce.

    The effect of this potential fluctuation on the apparent solvency of the insurer can be dramatic. If an insurer has a balance sheet as described in the previous example, and net written premium of £1bn, the solvency margin would be 250% - in the middle of the traditionally acceptable range. But, if the value of the insurer's equity investments fell by 25% (£100m), shareholder funds would drop from £400m to £300m and the solvency margin would deteriorate from 250% to 333%. Moreover, if the actuaries were to conclude that reserves were insufficient then the value of liabilities would increase. If a 20% increase in reserves were required (£120m) then this would reduce shareholder funds further to £180m. The solvency margin would then be 555%.

    Crucial component
    Although the likelihood of these two balance sheet adjustments occurring at the same time is uncommon, it is by no means impossible. The example illustrates a crucial component of insurer capital adequacy analysis. Namely, there needs to be sufficient capital, not just to support current underwriting (the risks that the solvency margin calculation seeks to reflect), but also to carry the risk of reductions in asset values or required increases in reserves.

    As identified, there are significant risks to an insurer's solvency that are largely unrelated to current premium income. However, the net written premium value itself also has significant limitations as a measure of current underwriting risk.

    The main drawback is the assumption that all premium represents the same degree of risk to the insurer's capital. This, self evidently, is not the case. Some lines of business show relatively little deviation in loss levels over time (subject to catastrophic losses, see below). In these circumstances a ratio of net written premium to shareholder funds of more than three times could well be prudent. Conversely, inherently volatile lines of business can require substantially more capital for the insurer to operate with the same degree of prudence. These inadequacies are further compounded by the fact that different insurers will set different levels of premium for the same type of risk. Some may significantly underprice the risk.

    So, the mix of business lines, the adequacy of pricing, the mix of geographic exposure and the overall diversity of the portfolio (usually at least in part related to the size of the insurer) have a major impact on what is, in practice, a prudent relationship between net written premium and shareholders' funds.

    Moreover, even for normally low risk lines, the potential impact of rare catastrophic losses needs to be considered (for example, a storm every 100 years).

    This leads directly to the issue of reinsurance protection. The solvency margin reflects net written premiums. Insurers will seek to lay off some of the risks highlighted above via reinsurance. But, the nature of this reinsurance protection can and does vary widely. Some insurers may buy considerable amounts of protection such that what may appear to be quite risky lines of business are, in practice, much less volatile (for the insurer). Conversely, if an insurer writes largely low risk lines, but buys little catastrophe protection the actual risk profile of their book could be significantly higher.

    Sudden increase
    While this would seem to suggest that, for solvency purposes, more reinsurance is best, this too is not as simple as it might at first appear. If reinsurers routinely lose money on an insurer's business, sooner or later protection will cease to be available or become prohibitively expensive. Since it can be very difficult, in practice, for an insurer to radically change its book this can lead to a sudden increase in the risk profile of the insurer. In addition, reinsurers can and do go bust. The greater the reliance on reinsurance, the greater the size of reinsurance recoverables in the balance sheet and, hence, the greater the exposure to reinsurer failure.

    The solvency margin does not reflect either the risk of falling asset values, or of inadequate reserves. The relative riskiness of different lines of business is not part of the calculation. Nor is the overall degree of diversification or concentration that the insurer has. Finally the exposure to catastrophic events and overall dependence on reinsurance protection is ignored.

    So, why consider the solvency margin at all? It's a good question.

    Any form of ratio analysis has its limitations. The crucial thing is to understand what the limitations are and then interpret the ratio in the light of these.

    If the analyst has a good understanding of the insurer's current underwriting portfolio, its asset mix and likely reserve adequacy, then the ratio can provide a useful perspective, particularly in comparison with its peers. Certainly, a strong solvency margin for any given insurer is better than a weak one.

    It is in order to achieve the best possible understanding of these underlying factors that AM Best's interactive ratings of financial strength reflect detailed interviews with an insurer's senior management.

    No analytical process can be perfect, but the information and insight we get from these interviews is used to help create a much more sophisticated measure of capital adequacy that seeks to clarify the total risk profile of the insurer.

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