Loss And Loss-Adjustment Reserves To Policyholders' Surplus Ratio

What Is Loss And Loss-Adjustment Reserves To Policyholders' Surplus Ratio?

Loss and loss-adjustment reserves to policyholders' surplus ratio is the ratio of an insurer’s reserves set aside for unpaid losses. This may also include the cost of investigation and adjusting for losses to its assets after accounting for liabilities.

Also called the reserves to policyholders’ surplus, the ratio indicates how much risk each dollar of surplus supports. The ratio is usually expressed as a percentage.

Understanding Loss And Loss-Adjustment Reserves To Policyholders' Surplus Ratio

Insurance companies set aside a reserve to cover potential liabilities from claims made on policies that they underwrite. The reserves are based on an estimate of the losses an insurer may face over a period of time; this means that the reserves could be adequate, or the reserves may fall short of covering its liabilities. Estimating the amount of reserves that are necessary requires actuarial projections based upon the types of policies underwritten.

Insurers have several goals when processing a claim: ensure that they comply with the contract benefits outlined in the policies that they underwrite, limit the prevalence and impact of fraudulent claims, and make a profit from the premiums they receive. Insurers must maintain a high enough reserve in order to meet projected liabilities. The higher the ratio of loss and loss-adjustment reserves to policyholders’ surplus, the more reliant the insurer is on policyholder surplus to cover its potential liabilities (and the greater risk it has of becoming insolvent). If the number and extent of filed claims exceed the estimated amount set aside in the reserve, the insurer will have to eat into its profits to pay out claims.

Regulators pay attention to loss and loss-adjustment reserves to policyholders’ surplus ratio because it is an indicator of potential solvency issues—especially if the ratio is high. According to the National Association of Insurance Commissioners (NAIC), a ratio of less than 200% is considered acceptable. If a number of insurers have ratios greater than what is considered acceptable, this could be an indicator that the insurers may be reaching too deep into reserves to pay out profits.

The NAIC's Regulatory Information System (IRIS) is a collection of analytical solvency tools and databases designed to provide state insurance departments with an analysis of the financial condition of insurers operating within their respective states. In many states, consumers can also access IRIS data for insurers operating there.

Note that these ratios can vary widely from year to year; a high ratio isn't necessarily a sign that an insurer is or will become insolvent.

Loss And Loss-Adjustment Reserves To Policyholders' Surplus Ratio in Practice

At the end of the year, insurance companies are required to submit their financial information to insurance regulators. Part of the reports submitted includes changes to the reserves for losses and loss adjustment expenses over the course of the year. There may also be changes to the surplus from the policies owned by the insured (or the company's policyholders' surplus). If there are changes to the gross reserves for losses and loss adjustment expenses, the company's ratio for loss and loss-adjustment reserves to policyholders' surplus would also be adjusted for that year.

Insurers set aside this reserve to pay for losses, including the costs of assessing and evaluating claims. Essentially, it is like an insurance company's rainy day fund. A government regulatory board can decide to close a company down if it is found that it is unlikely to be able to provide the services that it has promised to its clients. By setting aside present earnings for future losses, insurance companies ensure they can provide coverage over a long period of time. When an insurance company submits its financial information to insurance regulators, those regulators evaluate them to make sure they can pay for future claims. The loss and loss-adjustment reserves to policyholders' surplus ratio is a strong indicator of a company's financial solvency.