For investors conducting fundamental analyses of insurance companies, leverage can have multiple definitions. Insurance leverage is a term that refers to the ratio of deferred insurance liabilities to shareholder equity. A more universal definition of financial leverage is captured by the debt-to-equity ratio. Both definitions draw on balance sheet items, and both are important tools for understanding the financial strength of insurance companies.
As with any other type of company, the debt-to-equity ratio is an important metric used to measure leverage and assess financial well-being for insurance firms. Debt-to-equity is calculated by dividing total liabilities by total shareholders' equity. Insurers offer risk management services and are financed by investors, holders of corporate debt and customers. As such, their capital structure is necessarily different from that of companies that produce tangible goods or offer other types of services. Debt-to-equity loses explanatory power when used to compare dissimilar companies or industries.
Another popular method of measuring insurance leverage is the premium-to-surplus ratio, calculated by dividing net written premiums during the year by surplus at end of the year. The surplus is equal to the amount by which policy holder assets exceed policy holder liabilities. Premiums that have already been paid for future coverage are recorded as deferred liabilities on an insurance company's balance sheet, and surplus is analogous to equity in the debt-to-equity ratio. The premium-to-surplus ratio tells investors how well an insurer can handle above-average losses, and a smaller value indicates a lower risk position. This is an industry-specific measure of leverage tailored to insurer operations.