A Financial Benchmarking Initiative Primer This primer explains financial benchmarks included in AGRiP s Financial Benchmarking Initiative (FBI). Leverage Ratios Measure operating stability and reasonableness of growth. Retention Ratios Measure the risk allocation between pool and reinsurer. Profitability Ratios Measure the results of operations. Liquidity & Expense Ratios Measure operational efficiency and liquidity. Which Increasing Increasing Direction Net Position Contributions Leverage Ratios is Better? will be: will be: Contribution Leverage Lower Better Worse Reserve Leverage Lower Better Change in Net Position Lower* Net Leverage Lower Better Liability Leverage Lower Better Investment Leverage Lower Better Retention Ratios Retention Ratio (Health, Liability, Property, Workers' Compensation) Lower Profitability Ratios Loss Ratio Lower Better* Combined Ratio Lower Better* Portfolio Yield Higher Operating Ratio Lower Better* Liquidity & Operational Ratios Liabilities to Assets Lower Expense to Net Position Lower Better One Year Reserve Development Lower* Better *In some circumstances, there could be good reason for having a different goal than indicated. The intent of financial benchmarking is not to understand the right financial circumstance for a pool. Rather, the goal is to share information about how your pool s financial performance aligns to wider industry performance, so you can evaluate why differences might exist and consciously determine appropriate financial metrics for your operations. Because each public entity pool operates within a unique set of regulatory requirements and market dynamics that have evolved over time, it may be perfectly legitimate for a pool to operate differently than the norms indicated by financial benchmarking.
Contribution Leverage = Net Contributions are a pool s primary revenue, and Net Position (which might also be called member equity" or surplus ) is a pool s cushion for absorbing losses greater than expected. The Contribution Leverage ratio measures the degree of protection the pool s Net Position provides relative to contributions it expects to write. This is one way to measure changes or challenges if pool contributions change dramatically from one year to the next against a fairly stable Net Position, which is generally much slower to change. This could be the case if a pool was growing very fast with new members, but their surplus was relatively low based upon historical membership. The surplus could be at risk if new members risk profiles turn out to be different than historical trends, or if there s a dramatic shift in loss expectations for any other reason. Within the insurance industry, a range of 0 to 3.0 is generally acceptable, meaning the insurer can write up to $3 of contribution for every $1 of its surplus. Because pools tend to grow slowly and methodically, generally want to provide long term stability for their members, and tend to price to risk, most pools operate with Contribution Leverage ratios that are very low by insurance industry standards. For example, think of a pool that had $44 million in contributions last year, with member equity of $25 million. The pool s Contribution Leverage ratio is 1.8, which means it is writing 80 percent more contributions than it has protective surplus. This ratio implies a low risk to the pool s Net Position. Some pools have member equity that is greater than their annual contributions, which makes for a very low Contribution Leverage ratio (less than 1.0). 1. The Contribution Leverage ratio is calculated net of excess insurance or reinsurance, so pools will want to be cognizant of receivables and the quality of their reinsurers. Inadequate or insufficient reinsurance could adversely affect a pool s solvency, even if the Contribution Leverage ratio appears reasonable. 2. If the pool has multiple lines of business, consider reviewing this ratio on a consolidated basis and separated by line of business. Together, the each line of business contribution ratio will strengthen the leverage of all lines combined. 3. Pools with stable profits may be better able to sustain higher Contribution Leverages without undue risk than those pools with unstable profitability. 4. In review of a pool s distribution between property and casualty business, those with larger portions towards long tail lines (such as workers compensation) will likely maintain lower Contribution Leverages, on average. Because ultimate losses are harder to estimate for long tail lines, the greater variability is often anchored with a larger cushion.
Reserve Leverage = Risk transfer represents a unique product and pricing structure as compared to most business transactions. Typically, businesses sell items that have precise costs. However, final costs in risk transfer relationship are not known for years or possibly decades which makes understanding potential ramifications of long term costs all the more important for pools. On a pool s annual balance sheet, the unknown part of risk transfer costs include case reserves and reserves for claims that are Incurred But Not Reported (IBNR). Reserves exist as a liability to the pool at the evaluation date of its financial statement. The Reserve Leverage ratio measures the relative size of those liabilities by comparing a pool s Loss Reserves to its Net Position, to estimate the pool s ability to absorb larger than expected losses. Generally speaking, the lower the ratio, the more financially able the pool is to absorb costs in excess of booked reserves. Reserving practices vary from pool to pool, so Reserve Leverage ratios will also vary. Higher ratios, although equating to more reserves per unit of Net Position, could also signify conservative reserving practices to smooth volatility for members and accommodate unexpected reserve development in longer tailed lines of coverage such as workers compensation. For a pool with Loss Reserves of $27 million and Net Position of $25 million, the Reserve Leverage ratio is 1.1. Interpreting this ratio, and only taking loss reserves into perspective, this pool could withstand an incorrect reserve estimate by over 100 percent. As with any ratio, monitoring pool performance over time and by multiple metrics is a good idea. 1. For this ratio, the amount of Loss Reserves includes Loss Adjustment Expense (LAE). 2. If the pool has multiple lines of business, consider reviewing this ratio on a consolidated basis and separated by line of business. Together, each line of business contribution ratio will strengthen the leverage of all lines combined. 3. In review of a pool s distribution between property and liability business, those with larger portions towards long tail lines (such as workers compensation) generally maintain lower Reserve Leverages. Because ultimate losses are harder to estimate for long tail lines, the greater variability is often anchored with a larger cushion. 4. Pools with stable profits may be better able to sustain higher Contribution Leverages without undue risk than those pools with unstable profitability. 5. Because the reserves used to calculate this ratio are net of reinsurance, pools also carefully monitor reinsurance recoverables. Uncollectible reinsurance could substantially increase this ratio and affect the pool s financial strength.
Change in Net Position The Change in Net Position ratio is a relatively straightforward formula that measures an important financial indicator year over year change in a pool s financial condition. A pool s Net Position reflects its bottom line after all financial transactions in a reporting year have been accounted. Factors that could impact Net Position include contribution changes, unrealized capital gains or losses, investment gains or losses, reinsurance recoverables, accounting changes, dividends, etc. A pool with a Net Position of $25 million in the current year and a prior year Net Position of $24 million has a Change in Net Position of 4 percent. This pool has improved its financial position to withstand unexpected losses or other costs that could impact its operation. Increasing Net Position is generally welcomed, although it could suggest underwriting that is susceptible to competition or losses uncharacteristically less than expected. Although a decrease in Net Position signals a weakening financial position, it does not necessarily point to a problem. For instance, a pool may have a negative Change in Net Position ratio after release of a dividend to meet its surplus target. Public entity pools tend to have a narrow range of Change in Net Position, typically from 5 to +15 percent. Common insurance industry Change in Net Position ratio results are wider, between 10 to +25 percent. The high end of the insurance range (+25 percent) may be monitored by regulators because a commercial insurance company might post large increases to surplus just before insolvency, usually related to the shifting of capital from other companies within a group, significant growth, or mergers and acquisitions. 1. Because Change in Net Position is done net of reinsurance, pools will want to monitor reinsurance contracts and the quality of their reinsurers. Inadequate and insufficient reinsurance could adversely affect the risk levels of a pool s solvency.
Net Leverage + The Net Leverage ratio is a combination of two prior benchmarks. This metric is typically reviewed in the context of an unlikely case scenario the worst case in which both deficient reserves and inadequate pricing are found to exist. A pool s Net Position (which might also be called member equity or surplus ) is a cushion for absorbing the impact of inadequate pricing or inadequate reserves. But if both these deficiencies are identified, the strain on Net Position is magnified. Even if both the individual ratios are within typical industry ranges and appear reasonable, combining the two into the Net Leverage ratio could flag an important warning. As an example, a pool with the Contribution Leverage ratio of 1.8 and the Reserve Leverage ratio of 1.1 would have a Net Leverage ratio of 2.9. 1. If the pool has multiple lines of business, consider reviewing this ratio on a consolidated basis and separated by line of business. Together, the each line of business contribution ratio will strengthen the leverage of all lines combined. 2. In review of a pool s distribution between property and liability business, those with larger portions towards long tail lines (such as workers compensation) should generally maintain lower Net Leverages. Because ultimate losses are harder to estimate for long tail lines, the greater variability is often anchored with a larger cushion. 3. Net Leverage is calculated net of reinsurance. Pools will generally want to monitor the amount of reinsurance recoverables from their risk transfer contracts. Uncollectible reinsurance could increase the reserve portion of this ratio (possibly substantially) and affect the pool s financial strength.
Liability Leverage = The Reserve Leverage measures one element of a pool s liabilities, namely the unknown portion of ultimate losses (case reserve and IBNR). But a pool s total liabilities, as shown on its balance sheet, also includes such items as unearned contributions, accrued expenses, long and short term debentures, reinsurance recoverables, etc. The Liability Leverage ratio measures the proportion of these total liabilities as compared to Net Position. In other words, the Liability Leverage ratio is very similar to the Reserve Leverage ratio, but with additional liabilities. The Liability Leverage ratio is basically a measure of how much of a pool s Net Position can support its total liabilities. The smaller the ratio, the more financially secure the pool. The Liability Leverage ratio is typically higher than the Reserve Leverage ratio. For a pool with a Net Position of $25 million and net liabilities of $38 million, the Liability Leverage is 1.52. The pool s current Net Position can support a variation in net liabilities of up to 52 percent. Although a pool cannot decrease the amount of liabilities it has, it can make an effort to bolster Net Position to lower this ratio, if desired. 1. If the pool has multiple lines of business, consider reviewing this ratio on a consolidated basis. By consolidating lines of business, a degree of group leverage can be measured. 2. Those pools with a greater portion of their overall book in longer tail lines of business will generally have higher ratios (given their higher level of reserves). Shorter tailed lines concentrated pools will tend to have lower Liability Leverage ratios. 3. Because Liability Leverage is calculated net of reinsurance, pools will want to monitor the amount of reinsurance contracts and the quality of their reinsurers. Inadequate and insufficient reinsurance could adversely affect the risk levels of a pool s solvency.
Investment Leverage = This ratio measures exposure to a pool s Net Position as the result of changes to value in its investment portfolio. A pool with $40 million of invested assets and a Net Position of $25 million would have an Investment Leverage ratio of 1.60; or, said another way, for each $1.60 of invested assets the pool has $1 of Net Position (or surplus or member equity ). Examined in conjunction with the Portfolio Yield, the Investment Leverage ratio can profile the level of risk a pool s Net Position has to market fluctuations in other words, how much of its total Net Position is subject to market fluctuations of invested assets. For instance, if the stock market suffers a severe depression, the Net Position of a pool with affected invested assets could decrease and the pool s overall financial ability to sustain other volatility (such as in contribution or reserves) might be hindered. The allocation of a pool s invested assets is a key consideration when interpreting the Investment Leverage ratio. If the invested assets have a large proportion of equities, there will be greater volatility upon equity market swings. The Investment Leverage ratio, like other financial ratios, cannot be examined or interpreted in a vacuum. 1. The Investment Leverage ratio is one of the more complicated benchmarks to interpret because investment parameters and allocations may dramatically impact a pool s results and goals. It s a good idea to look at this ratio in conjunction with your overall investment philosophy and with advice from professional investment advisors.
Retention Ratio A pool s per occurrence retention is the total loss per risk a pool retains on its balance sheet as a liability, not including ceded risk to a reinsurer or excess insurer or taking members deductibles into consideration. When that risk is measured against Net Position (which might also be called member equity or surplus ), the pool can evaluate the adequacy of its surplus to withstand multiple large losses within its retention. A general rule of thumb for the commercial insurance industry is that no retained occurrence should expose more than ten percent of the carrier s Net Position, which equates to a Retention Ratio of 10:1 or just 10. Pools may be more conservative than insurance companies in order to preserve long term stability for members, which means Retention Ratios of pools could frequently be greater than 10, even as high as 70. As an example, a monoline pool has $25 million in Net Position with a retention of $750,000 per occurrence. The Retention Ratio is 33. Thirty three is a promising outcome, since the pool could sustain 33 retention level losses before surplus was completely drained. Results above 70 percent might suggest the pool could take on more risk or a higher retention level. Results at the low end of the range say 10 suggest a pool may want to consider decreasing its retention or work to increase Net Position. But, again, each pool s circumstances and needs will vary and could be outside these general considerations. In soft markets when reinsurance is cheaper per unit, it may be favorable to carry a lower per occurrence retention (and therefore a higher Retention Ratio). Of course, there are many factors that could come into play for any pool s net retention analysis, such as growing or shrinking membership, statutory limits on Net Position or surplus, changing reinsurer relationships, and more. 1. Retentions usually vary by line of business. Ideally, it would be valuable to independently calculate the Retention Ratio of each line of business separately. 2. The Retention Ratio is based on a pool s net exposure to loss after reinsurance or excess insurance has been considered. 3. A pool s retention level is generally established based upon actuarial analysis, to assure its appropriateness for overall pool operations and financial goals.
Loss Ratio & The Loss Ratio is a pool s net incurred losses and Loss Adjustment Expense (LAE) relative to its net contributions, usually presented on a calendar year basis. As with many benchmarks, the Loss Ratio is calculated net of reinsurance. For example, a pool with $31 million in net incurred losses, $2 million in LAE, and $44 million in net contributions has a 75 percent Loss Ratio. When the pool s expense ratio of about 20 percent is factored in, it would have a Combined Ratio of 95 percent. Losses and their associated costs (LAE) are the largest expense component of any pool or insurer. Monitoring Loss Ratios is one way to assess all aspects of pool operations and financial stability. To fully understand your pool s Loss Ratio results over time, there are many factors to consider, including the period of time over which losses are paid (and any offsetting investment income), the frequency and severity of the lines of coverage being offered, the adequacy of pricing, the amount of loss control measures, and other nuances in a pool s operation. Confidence level calculations and practices can have a big impact on the Loss Ratio. Funding to a higher confidence level naturally increase the contribution (i.e., the denominator of the ratio), and thus creates a smaller Loss Ratio compared to those pools that fund contributions at the expected level (i.e., 50 55 percent confidence level). 1. The incurred amounts used in the Loss Ratio do not include Incurred But Not Reported (IBNR), and therefore are not meant to measure an estimated Ultimate Loss Ratio. 2. Confidence level funding practices can have meaningful impact on Loss Ratios. 3. The Loss Ratio is calculated net of reinsurance. Inadequate reinsurance could adversely affect the risk levels of a pool s solvency.
Combined Ratio & The Combined Ratio is a basic measure of overall underwriting results in a year. Pooling is much more complex than this ratio allows, with factors such as investment income, IBNR for long tail lines of business, and inflationary forces all having impact. Even so, paying attention to the Combined Ratio provides useful insight. As an example, a pool with $44 million in contributions, $33 million in incurred loss and LAE, and $11 million in overhead expenses, will have a Combined Ratio of 100 percent. Results above 100 percent indicate overall loss for the year, while below 100 percent indicates contributions greater than losses and expense costs in the year. 1. The Combined Ratio does not include investment income. 2. Because the Combined Ratio is calculated net of reinsurance, consider the amount of reinsurance contracts and the quality of pooling reinsurers. Inadequate and insufficient reinsurance could adversely affect the risk levels of a pool s solvency.
Portfolio Yield = The Portfolio Yield is the percentage of investment income in relation to the size of a pool s invested asset portfolio. A portfolio with $50 million in Invested Assets generating $1.5 million of investment income has a Portfolio Yield of 3 percent. Investment income is a critical element to a pool s business model, and can be used to bolster loss reserves and/or surplus, offset contributions needed from members, pay dividends, or fund projects and programs for members. Knowing the pool s average Portfolio Yield helps manage expectations for and possible uses of future investment income. A portfolio with high yield might seem attractive, but with additional expected yield comes higher volatility in investment performance meaning there could be a loss of investment income in any given year. For this reason, some public entity pools are statutorily restricted to low yielding investment vehicles as a protection from volatility, and therefore usually have a lower Portfolio Yield than commercial insurance companies. The insurance industry range of 3.0 to 6.5 percent Portfolio Yield over time is considered standard, but comes with swings up and down that can be unpredictable. The portfolio range for public entity pools is typically narrower, with lesser chance of any year having notably better or worse results. Investment income as used in this ratio is considered net of portfolio management expenses. Higher yielding portfolios, such as actively managed accounts and equity funds, typically carry a higher fee structure; while low yielding bond portfolios tend to carry a lower fee structure. 1. Because Portfolio Yield can vary one year to the next, calculating 3 year or 5 year rolling averages may be a useful exercise. 2. Looking at Portfolio Yield in conjunction with portfolio management expenses is also useful. 3. Statutory restrictions and guidance may vary widely from pool to pool.
Operating Ratio & Like the Combined Ratio, a pool s Operating Ratio is a rudimentary measure of financial stability and solvency. The benefit of using an Operating Ratio measure rather than Combined Ratio is that it takes investment income into consideration. This is an important factor to consider, in particular for workers compensation where a claim can continue to be paid for 20, 30, or even 40 plus years. As an example, a pool with $44 million in contributions, $33 million in incurred loss and LAE, $11 million in overhead expenses, and $1.5 million of investment income will have an Operating Ratio of 97 percent. A low Operating Ratio implies loss and expense costs less than contributions and investment income. A Loss Ratio in excess of 100 percent may be the result of greater than expected losses, unfavorable loss development or reserve strengthening, changes in expenses, or unfavorable investment results. It is probably more important to understand the factors behind a pool s Operating Ratio and any changes that have occurred, than to know the Operating Ratio itself. No single financial measure is a reliable indicator of a pool s overall solvency or financial well being, so pools are encouraged to evaluate multiple measures and to evaluate year over year performance to watch for important shifts or changes. 1. Because the Operating Ratio is calculated net of reinsurance, pools will want to consider the amount of reinsurance contracts and the quality of their reinsurers. Inadequate and insufficient reinsurance could adversely affect the risk levels of a pool s solvency.
Liabilities to Assets = The Liability to Assets ratio measures how much a pool owes in relation to its assets, with a slight variation. For this ratio, a pool will look to liquid assets, or those investments that can be sold relatively quickly with little to no loss in value. This benchmark can provide a rough estimate of financial implications if liquidation of the pool becomes necessary for any reason. Typical pool investments considered liquid include cash, treasury bills, money market instruments, government and municipal bonds, etc. These investments are commonly found under Current Assets on a pool s Balance Sheet. If a pool has $38 million in total liabilities with $45 million in Liquid Assets, the Liabilities to Asset ratio is 84 percent. A pool with a high ratio (realizing there s no common definition of high ) might focus attention on reserve adequacy, as well as proper valuation, mix, and liquidity of assets to assure it will be financially strong enough to meet its obligations. Any benchmark presents perspective based upon only a snapshot in time, and the Liabilities to Asset ratio for a pool could change substantially if there were an extreme shift in direction of global or national market exchanges. Long term averages and consistent monitoring will always reveal greater meaning than pegging pool performance on any one ratio at any singular point in time. 1. If the Total Liabilities to Liquid Assets ratio is increasing, it could signal financial matters that need attention. Tracking results year over year is an important consideration.
Expense to Net Position This metric is NOT measuring expense ratio in the traditional sense, which is usually defined as expenses divided by contributions. Rather, non loss expense (net of reinsurance) is the administrative and operational cost of running the pool, reduced for (1) reinsurance costs, (2) incurred losses, and (3) Loss Adjustment Expenses (LAE). This benchmark ratio compares the administrative and operational expense costs to a pool s Net Position, rather than to its contribution level. A pool with a Net Position of $25 million might have $44 million in total operational expenses on its Income Statement, with incurred losses of $31 million, LAE at $2 million, and reinsurance policies costing the pool $3 million. The pool s non loss Expense to Net Position ratio would be 32 percent. By measuring the amount of administrative and operational expenses to the pool s Net Position, which may be a proxy to the pool s overall size, it may be easier to compare expense costs to similarly sized pools around the country. 1. Pools have a wide range of expense loads, depending on such factors as geography, loss control efforts, advocacy efforts, administrative structure, agent compensation, etc. 2. Using Net Position as a proxy to a pool s size is not a perfect relationship, as some pools have different philosophical approaches to Net Position. Depending on financial and surplus policies set by a pool, this ratio might vary dramatically among pools that otherwise seem similar.
One Year Reserve Development & & The One Year Reserve Development ratio seeks to measure the development of reserves (the unknown ) in relation to the size of a pool s Net Position (or surplus or member equity ). Within the commercial insurance industry, this ratio might be used to look for red flag markers of possible insolvency due to inadequate reserving. Although the word reserve is used here, the figures in the numerator are based upon incurred losses. By using the current year incurred losses minus prior year incurred losses, the ratio examines changes in reserves as well as changes in paid loss amounts and newly reported claims. A pool with $60 million of incurred loss and LAE currently, compared to $56.5 million of incurred loss and LAE for the same set of coverage years from last year, has a $3.5 million increase in reserve development. This pool has reserve development of 14 percent. If a reserve development ratio is positive, reserves are said to be deficient because the prior reserve levels need to be increased. If the ratio is negative, reserves might be referred to as redundant. Monitoring this ratio over time helps evaluate financial stability or viability of a pool s book of business. General guidance from the commercial insurance industry suggests reserve development above 20 percent in that market is indicative of possible financial problems. 1. Because the One Year Reserve Development is calculated net of reinsurance, pools will want to consider the amount of reinsurance contracts and the quality of their reinsurers. Inadequate and insufficient reinsurance could adversely affect the risk levels of a pool s solvency. 2. For pools with deficient reserves, further analysis can help determine which line of business and which fund years resulted in the deficiency. 3. If the pool s ratio results consistently show adverse development, the pool may be intentionally understating its reserves such that deficiencies are appearing as losses paid. 4. Significant increases in this ratio might be indicative of reserve strengthening, while significant decreases might be indicative of current reserve understatements.