Reviewed by Sep 30, 2020| Updated on
It is a ratio of an insurance firm's gross premiums written less reinsurance ceded to its policyholders' surplus. In simple words, it is a calculation of how many losses an insurer can consume from claims.
When processing a claim, insurers will have several priorities. This is to make sure they comply with the benefits of the contract as specified in the policies that they underwrite, to reduce the occurrence and effect of fraudulent claims, and to generate profit from the premiums they get.
Insurers should maintain a sufficiently high reserve to cover the expected obligations. But if the provisions for losses are not sufficiently high, the insurer will have to tap into its surplus. If the insurer goes into his funds and the surplus of the policyholders for claims, it will be similar to insolvency.
The greater the ratio of loss and loss-adjustment provisions to the surplus of the policyholders, the more reliant the insurer is on the surplus of the policyholders to cover its potential liabilities, and the greater the risk of becoming insolvent.
If the number and extent of claims filed exceed the estimated amount set aside in reserve, the insurer would have to use its net profit to ensure the claims are paid out.
Regulators observe the net premiums written on the surplus ratio of policyholders because it is an indication of probable solvency issues, particularly when the ratio is high. The standard range for the ratio can be up to 300%, according to the National Association of Insurance Commissioners (NAIC).
Regulators must analyze whether this ratio is for a multi-line or a mono-line organization. In the case of a multi-line organization, certain lines may have low ratios and be relatively safe, while other line ratios may be trouble-free. Insurers offering policies which provide long-term benefits, such as workers' compensation policies, want a lower ratio.
The greater the surplus of the policyholder, the greater assets are in comparison to the liabilities. In the parlance of insurance, liabilities are the benefits an insurer owes to his policyholders. In order to achieve a return while maintaining liquidity, an insurer can increase the gap between liabilities and assets. This can be done by effectively managing the risks associated with the underwriting of new policies, reducing claim losses, and investing its premiums.