It's critical that property-casualty insurance companies focus on the "economic combined ratio" as a key measure of profitability in the current low-interest rate environment, according to a new study by Swiss Re.

The reason the combined ratio is assuming new importance in measuring profitability is that the contribution of underwriting to overall profitability over the last 10 years for p-c insurers worldwide was "small," the study said.

The new study--"Measuring Underwriting Profitability of the Nonlife Insurance Industry"--introduced the economic combined ratio as an alternative measure of underwriting profitability.

The traditional combined ratio is the combination of the expense ratio and underwriting ratio (the ratio of expenses and underwriting gain or loss per dollar of premium).

The economic combined ratio adds clarity to the profitability of adding the business at the point of underwriting it, according to an official of Swiss Re in New York. It does this by isolating the underwriting results of a certain year, avoiding the mingling with reserve additions or releases for prior years, as traditional business-year underwriting figures do, authors of the paper contend.

As calculated by Swiss Re, the economic combined ratio equals:

o The economic claims ratio (net present value of claims incurred in the accident year, adjusted for random catastrophe losses divided by net present value of premiums earned)...

o Plus the economic expense ratio (net present value of expenses divided by net present value of premiums written)...

o Plus the economic policyholder dividend ratio (net present value of policyholders' dividend divided by net present value of premium earned).

As a result of poor underwriting performance, the study found that nonlife insurers faced difficulties during the last 10 years in earning their cost of capital.

Results in Japan, Canada, France, Germany and the United Kingdom indicate that the economic combined ratios for other countries were by and large consistent with those of the U.S., according to the study.

In all the countries examined, the 10-year average economic underwriting margins before taxes were positive, implying a positive profit contribution from insurers' underwriting activities.

Nevertheless, the study said that "since profits must also cover tax and capital costs, the margins obtained in the period 1994-2004 hardly allowed the insurance industry to earn its underwriting cost of capital."

In 2004, business across the board was profitable. Underwriting contributed 6-to-9 percent of premiums to overall profitability in the U.S., the U.K., Germany and France.

The study found that introducing the economic combined ratio to the conventional combined ratio has several advantages. One is that it isolates the underwriting results of a certain year, avoiding a mingling with reserve additions or releases for prior years, as with traditional business-year underwriting figures.

Another is that it adjusts for distortions due to catastrophic losses, while also incorporating the time value of money by discounting future cash flows, particularly future claims payments.

The economic combined ratio provides new insights into insurance cycles, the study said. For example, using the economic combined ratio to analyze U.S. p-c industry figures for 1994-2004 demonstrates that U.S. economic underwriting profitability deteriorated from 1994 to 1997, although the reported business-year combined ratio improved.

The study also shows that despite what the combined ratio says, the low point for the 10-year underwriting in the U.S was in 2000, rather than in 2001.

Using the economic combined ratio on U.S. statistics indicates the years 1998-2001 were considerably worse than indicated by the conventional business-year combined ratio.

Using the new system with U.S. statistics shows that profitability in 2003-2004 was comparable to 1994-1995, despite a combined ratio 5 percentage points lower. This is because the current low interest rate environment reduces the impact of discounting for future claims payments.

While the years 1994-1997 and 2002-2004 were profitable in the countries studied--although often only moderately so--the period 1998-2001 exhibited poor underwriting performance, according to the study. Thanks to substantially improved underwriting results in the period 2001-2004, economic underwriting profitability was restored to the level of 1994-1997.

Special Reports /

Insurers Should Measure By 'Econ Combined Ratio'

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