What Are Adjusted Earnings?
Adjusted earnings is a metric used in the insurance industry to evaluate financial performance. Adjusted earnings equals the sum of profits and increases in loss reserves, new business, deficiency reserves, deferred tax liabilities, and capital gains from the previous time period to the current time period. Adjusted earnings provides a measurement of how current performance compares with performance in previous years.
- Adjusted earnings is a metric used in the insurance industry to evaluate financial performance.
- Adjusted earnings equals profits, increases in loss reserves, new business, deficiency reserves, deferred tax liabilities, and capital gains.
- Adjusted earnings is a helpful metric because it excludes earnings distortions such as a one-time gain or loss from the sale of an asset.
Understanding Adjusted Earnings
Investors and regulators can examine the performance of an insurance company in a number of ways, and they often use multiple analytical approaches to ensure a thorough review of an insurance company. Adjusted earnings helps provide a measurement of an insurance company's financial performance so that it can be compared to other insurers in the industry. Adjusted earnings allows the evaluation of core earnings by stripping out certain one-off items, such as a one-time gain or loss from the sale of an asset.
Calculating adjusted earnings can vary according to the type of insurance being sold. Because outside investors do not have access to the same amount of information as internal employees, it can be difficult to ascertain an insurer’s adjusted earnings. Approaches may vary according to how they examine expenses and premiums. An insurance premium is the money paid to an insurer by the policyholder, which is typically on a monthly basis.
A property and casualty insurance company, for example, will calculate adjusted earnings by taking the sum of its net income (or profit), catastrophe reserves, and reserves for price changes, then subtracting gains or losses from investment activities. Reserves, such as catastrophe reserves, is a pool of money held by the insurer in case of a catastrophe hazard, or a destructive event such as as a hurricane or flood. On the other hand, a life insurance company might subtract capital transactions, such as increases in capital or money, from increases in premiums written.
A qualitative analysis involves analysis of a company's growth prospects and performance based on non-quantifiable information, such as management expertise and industry cycles. A qualitative analysis of an insurance company would likely show how a company plans on growing in the future, how it compensates employees and manages its tax obligations. The analysis would also evaluate how effective the management team is at running the operations of the business.
A quantitative analysis, which involves a mathematical approach to earnings, shows how a company manages its investments, how it determines the premiums to charge for policies that it underwrites,
Quantitative analysis also helps show how a company manages risk through reinsurance treaties, which are insurance policies purchased by an insurer from another insurer. The company that issues or cedes the insurance policies to another insurer is essentially passing or ceding the risk of claims being filed on those policies. The company buying the policies is called the reinsurer and in return, gets paid the premiums from those policies minus a portion that's paid back to the cedent insurer.
If properly managed, reducing risk can help insurers minimize damage due to claims and enhance earnings. If the policies are not ceded properly, or the reinsurer takes on too many risky policies, it can be a sign that the earnings will suffer if claims are filed against those policies. Managing the proper balance of income and risk from reinsurance treaties is an important driver of adjusted earnings.
Quantitative analysis also shows how much it requires to retain business and acquire new customers. Investors will also look at the insurer’s adjusted earnings and adjusted book value, which the value of the company after liquidating all of its assets and paying off all of its liabilities or debts. Book value is essentially the net worth of the company.
Adjusted earnings should not be used solely to evaluate a company's financial performance but rather combined with other financial metrics.
Benefits of Adjusted Earnings
In general, adjusted earnings could be regarded as an indicator of the value of a business to new owners. The metric is used to assess different aspects of the financial strength of a company. This is necessary because unadjusted earnings statements based on generally accepted accounting principles (GAAP) don't always reflect the true financial performance of a company. The Securities and Exchange Commission (SEC), which regulates financial reporting for companies, requires public companies to use GAAP accounting for their reported financial statements.
However, adjusted earnings metrics are not GAAP-compliant and will show different earnings numbers than unadjusted earnings. Earnings or net income is GAAP compliant and represents the bottom line profit for a company, meaning all expenses and costs have been subtracted from revenue. On the other hand, calculating adjusted earnings would involve adding or subtracting financial items to or from net income to arrive at the earnings from running the core business.
For example, a company might write-down an asset or restructure its organization. These actions are typically large, one-time costs that distort a company's profits. In other words, the write-down would decrease net income. An "adjusted" earnings number would exclude nonrecurring items, meaning the write-down cost would be added back into earnings to help show how well the company is performing without any distortions from one-time transactions.
As a result, adjusted earnings can be used in tandem with GAAP-compliant earnings, such as net income, to arrive at a more comprehensive understanding of an insurance company's financial performance.