What Is the Gross Leverage Ratio?
Let me explain the gross leverage ratio directly to you: it's the sum of an insurance company’s net premiums written ratio, net liability ratio, and ceded reinsurance ratio. You use this ratio to figure out how exposed an insurer is to pricing and estimation errors, plus its reliance on reinsurance companies.
Key Takeaways
Here's what you need to know: the gross leverage ratio adds up those three ratios I mentioned for the insurance company. It's one of several ratios that help analyze if a company can meet its financial obligations. Think of it as a starting point for understanding an insurer's exposure to errors in pricing and estimation. Also, the net leverage ratio is typically lower and more accurate than the gross one.
Understanding the Gross Leverage Ratio
The ideal gross leverage ratio varies by the type of insurance you're dealing with, but it usually stays below 5.0 for property insurers and 7.0 for liability ones. You'll find that an insurer's gross leverage is higher than its net leverage because it factors in ceded reinsurance. Other ratios in this space include net leverage, reinsurance recoverables to policyholders’ surplus, and Best’s Capital Adequacy Ratio (BCAR).
Something important to note: the gross leverage ratio can sometimes paint a scarier picture of an insurer's situation than reality, all because it includes ceded reinsurance.
As an insurance company, you have to balance investing premiums for profit while limiting risk from the policies you underwrite. That's why insurers often cede premiums to reinsurance companies to offload some risks. Credit rating agencies examine various financial ratios from the balance sheet to assess an insurer's health, and the gross leverage ratio is just one of them. These leverage ratios matter because companies mix equity and debt for operations, and you need to know if they can handle due payments.
Insurers might target a specific gross leverage ratio, much like a central bank sets interest rates. In certain cases, like using debt for acquisitions, they might accept a higher ratio.
Gross Leverage Ratio vs. Net Leverage Ratio
Consider the gross leverage ratio as your first rough gauge of an insurer's exposure to pricing and estimation errors. The net leverage ratio gives a better estimate, though it's harder to calculate in practice. Normally, the gross version is higher, so it overestimates the exposure. To understand this, look at how it's defined.
The gross leverage ratio is net premiums written ratio plus net liability ratio plus ceded reinsurance ratio. You can express it as (net premiums written / policyholders’ surplus) + (net liabilities / policyholders’ surplus) + (ceded reinsurance / policyholders’ surplus), or simply (net premiums written + net liabilities + ceded reinsurance) / policyholders’ surplus. Since net premiums written plus ceded reinsurance equals premiums written, it simplifies to (premiums written + net liabilities) / policyholders’ surplus.
You only need three data points for this: premiums written, net liabilities, and policyholders’ surplus. But it often overestimates liability because most insurers depend on bigger firms for reinsurance during disasters.
Take a homeowners insurance company in a flood-prone area—they might cede premiums to cover themselves if flooding hits. You might see 'flood damage' as an add-on in your policy, where that extra premium goes to a reinsurance firm. This ceded part isn't typically the insurer's direct exposure.
Ceded reinsurance deals happen between big companies, making them tricky to pin down sometimes. Once you have it, subtract it from premiums written to get net premiums written. The net leverage ratio is then net premiums written ratio plus net liability ratio, or (net premiums written + net liabilities) / policyholders’ surplus.
Overall, the net leverage ratio is lower and more accurate than the gross one. That said, reinsurance firms can fail too, so the gross ratio shows the worst-case scenario where the insurer can't count on reinsurance.
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