What are the Key Ratios Related to Life Insurance?

Life insurance serves as a vital tool in safeguarding your family's financial well-being when you're not around. In this article, we will explore the concept of life insurance in detail. We'll also take a closer look at some key ratios related to life insurance. These ratios help us understand the financial strength of insurance companies and evaluate their operations in a more refined manner.

What is Life Insurance?

Life insurance is a contract between an insurer (insurance company) and the insured (policyholder). When the insured person passes away, the insurer pays a sum of money to one or more named beneficiaries of the insured person. The policyholder has to pay insurance premiums during their lifetime. You can pay the insurance premiums upfront as a lump sum or in recurring payments over time, usually monthly and yearly.

Types of Life Insurance Policies

The two most common types of life insurance policies are:

1. Term Life Insurance Policy

Term Insurance is a type of life insurance that provides financial protection for a fixed period of time. If the policyholder suddenly passes away during this period, their family members (or nominees) will receive a death benefit. Term insurance is a relatively low-cost way to ensure your family's financial security if something were to happen to you.

A 20-year-old healthy individual can secure a cover of up to ₹1 crore for his dependents for the next 25+ years if he pays a fixed, minimal amount (even less than ₹500) every month to a reputable insurance company. However, unlike whole life insurance, term insurance does not provide maturity benefits. The insurance company will not pay a lump-sum amount when your term insurance policy matures.

2. Permanent Life Insurance Policy

A Permanent Life Insurance Policy offers coverage for your entire lifetime, as long as you continue to pay the premiums. When you purchase a permanent life insurance policy, a portion of your premium payments go toward the cost of insurance, while the remaining portion is invested by the insurance company. Over time, the cash value of your policy grows, and you can access this cash value through policy loans or withdrawals while you're alive. It provides a death benefit to your beneficiaries when you pass away.

Key Ratios Related to Life Insurance

A life insurance policy is only as good as the financial strength of an insurer. You can use the following key ratios to analyse the financial strength of an insurance company.

1. Persistency Ratio

This ratio helps you understand how persistent customers have been in renewing their coverage year after year. This tells about its customers’ loyalty and whether they have been paying their premium without default. We can judge if the company has been delivering product quality over the years using this metric. It is measured at regular intervals like the 13th month, 25th month, 37th month and 61st month. A higher persistency ratio of any company tells you that it has been able to contain a large pool of satisfied clients.

We calculate Persistency Ratio as the ratio of the number of total policies sold to the number of policies renewed at a given time. The closer the ratio is to 1, the better. The persistency ratio will never be lower than 1.

For example, if a company issues 100 policies, but only 80 of those policies get renewed, then the persistency ratio will be 100:80.

2. Claim Settlement Ratio

Claim Settlement Ratio is one of the most important ratios that one should look into before buying insurance. It tells what percentage of the total claims filed by the customers have been settled by the organisation. People prefer insurance companies that settle claims quickly and pay out the benefits, rather than those that take a long time to do so. The higher the claim settlement ratio, the better.

The claim settlement ratio is typically calculated on a yearly basis.

3. Solvency Ratio

Solvency Ratio tells whether an insurance company has the money to settle all claims at liquidation. According to the Insurance Regulatory and Development Authority of India (IRDAI), every insurance entity needs to maintain a minimum solvency margin of 1.5 or 150%. Higher solvency ratios indicate more capability of paying insurance claims during uncertain times which gives more confidence to an insured person.

4. Loss Ratio

Loss Ratio is a measurement of a company’s loss during a certain year. It shows the total amount of claims dispensed as a percentage of the total premium earned in that year. An increasing loss ratio tells that the company is in a situation of disbursing more payments, but is not able to earn premiums at a similarly high rate. Thus, a higher loss ratio indicates financial trouble for the company.

5. Expense Ratio

In the insurance Industry, the expense ratio is a profitability measure. It is calculated by dividing the expenses associated with acquiring, underwriting, and servicing premiums by the net premium earned. The expenses can include advertising, employee wages, and commissions for the sales force. The expense ratio signifies an insurance company's efficiency before factoring in claims on its policies and investment gains or losses. It offers a clear view of how well an insurer manages its overheads and operational costs in relation to the revenue generated from premiums.

6. Combined Ratio

The combined ratio is also a measure of profitability to measure an insurer’s performance in its daily operations. It is calculated by taking the sum of incurred losses and expenses and then dividing them by the earned premium. The combined ratio measures the money flowing out of an insurance company as dividends, expenses and losses. Losses indicate the insurer's discipline in underwriting policies. A ratio below 100% indicates that the company is making an underwriting profit, while a ratio above 100% means that it is paying out more money in claims than premium receipts.

7. Investment Yield Ratio

This ratio measures the average return on the company’s invested assets before and after capital gains and losses. Both realized and unrealized capital gains are considered while calculating the investment yield (including capital gains).

8. Premium Growth Ratio

The premium growth ratio indicates growth in the business undertaken by the insurance company. This ratio is calculated by dividing the difference between the gross premium written (GPW) in the current and previous years by the GPW in the previous year. [GPW is the total amount of premiums an insurance company receives from policyholders for their insurance policies. It's like the total bill customers pay to the insurance company for coverage.]

In conclusion, key ratios related to life insurance offer valuable insights into the financial health, risk management practices, and overall performance of life insurance companies. From the solvency ratio that assesses an insurer's stability to the expense and loss ratios that reveal its operational efficiency and claims handling capabilities, these metrics serve as vital tools for making informed decisions in the complex world of life insurance.