What Is the Investment Income Ratio?
The investment income ratio is the ratio of an insurance company’s net investment income to its earned premiums. The investment income ratio compares the income that an insurance company brings in from its investment activities rather than its operations. It is used to determine the profitability of an insurance company's investments.
Understanding the Investment Income Ratio
Insurance companies have two main sources of revenue: premiums from underwriting activities and returns on investment income. Insurance companies invest premiums in order to generate a profit.
Insurers invest in a wide array of assets and must balance the desire to earn a higher return through riskier investments with the need to maintain liquidity in order to cover the liabilities associated with claims made against the policies that they underwrite. Insurers invest in stocks, bonds, real estate, and a number of other asset classes.
The investment income ratio is used in the calculation of an insurance company’s overall operating ratio, which is a measurement of the insurer’s overall performance. The overall operating ratio is equal to the combined ratio (the sum of the loss ratio and expense ratio) less the investment income ratio. An operating ratio below 100 indicates that the insurer is generating a profit from its operations.
Net investment income is used as the numerator because it removes the expenses associated with generating the investment income. The denominator of the investment income ratio is earned premiums rather than written premiums. Using written premiums would make the denominator larger, but would mean that the calculation was including premiums that are still considered a liability. Earned premiums are used when calculating an insurer’s after-tax net income.
The amount of investment income that a company can bring in is affected by the type of insurance being offered. Policies that cover long-tail risks, such as liability and malpractice insurance, have a greater gap between when premiums are collected and when claims are paid. This gives the insurer more time to invest premiums, and thus more time to make a higher investment return.
Investment Income Ratio Calculation
The investment income calculation is as follows:
Investment Income Ratio = Capital Gains + Interest Income - Administrative Fees / Earned Premiums
For example, consider an insurance company reporting its performance for the year. It invested in a portfolio of growth stocks and corporate bonds. The growth stocks realized a capital gain of $100,000 and the corporate bonds maintained their value and paid out $20,000 in interest. The insurance company paid $15,000 in administrative fees and had earned premiums of $500,000.
Using the formula, the insurance company's investment income ratio is:
Investment Income Ratio = ($100,000 + $20,000 - $15,000) / $500,000 = 21%