Understanding Solvency Ratio

Before you select any insurance provider - be it vehicle, health or life insurer, make sure that you judge the financial strength of the company by looking at its Solvency Ratio.

What Is a Solvency Ratio?

A solvency ratio is a key metric used to measure an enterprise’s ability to meet its long-term debt obligations. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.

Why to study Solvency Ratio?

Insurers receive hundreds of claims from their customers regularly. To process all these claims and pay the monetary benefit to the beneficiaries, the company needs to be financially stable and have adequate funds. The solvency ratio is a simple indicator to know how good or bad the financial strength of an insurer is. An insurer with a high solvency ratio has more chances of fulfilling its commitment of paying your beneficiary the sum assured in case of your demise.

Solvency Ratio is a comprehensive measure

A solvency ratio is one of many metrics used to determine whether a company can stay solvent in the long term. This ratio is not only useful for insurance companies but is also very useful for assessing the financial strength of a company while evaluating a company to buy its shares.

A solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow, rather than net income, by adding back depreciation and other non-cash expenses to assess a company’s capacity to stay afloat. 

In finance, the solvency ratio measures a company's cash flow compared to its liabilities:

Solvency ratio = (net income + depreciation) / liabilities

In insurance, the solvency ratio is most often defined as:

Solvency ratio = net assets / net premium written

The amount of premium written is a better measure than the total amount insured because the level of premiums is linked to the likelihood of claims.

What should be the ideal Solvency Ratio

Different countries use different methodologies to calculate the solvency ratio and have different requirements. For example, in India, insurers are required to maintain a minimum ratio of 1.5; the higher the ratio, the stronger the company.

Solvency ratios vary from industry to industry. A company’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation. A company needs to be compared to its peers, particularly the strong companies in its industry, to determine if the ratio is an acceptable one or not.

For example, an airline company will have more debt than a technology firm just by the nature of its business. An airline company has to buy planes, pay for hangar space, and buy jet fuel; costs that are significantly more than a technology company will ever have to face.

Solvency Ratios vs. Liquidity Ratios

Solvency ratios and liquidity ratios are similar but have some important differences. Both of these categories of financial ratios will indicate the health of a company. The main difference is that solvency ratios offer a longer-term outlook on a company whereas liquidity ratios focus on the shorter term.

Solvency ratios look at all assets of a company, including long-term debts such as bonds with maturities longer than a year. Liquidity ratios, on the other hand, look at just the most liquid assets, such as cash and marketable securities, and how those can be used to cover upcoming obligations in the near term.

I you are looking at the financial strength of an insurance company, or long-term strength of any other company, go for Solvency Ratio tracking. Only if you are looking at short term investment in a company that you should give more importance to liquidity ratios.

[Recommended book: Autobiography of a Stock]

Summary

So, next time when you go out to buy your life insurance, or non-life insurance (health insurance, vehicle insurance, travel insurance or home insurance) policy, make sure you check out the Solvency Ratio of the company with which you are trusting with so many premiums. The higher the solvency ratio of the company, the higher financial strength it has. 

Now, also remember that a high solvency ratio just tells you about the company's financial strength but not at all about its intent to pay your claims. To judge the intent of a company to pay its claims, it is also a good practice to look at their Claims Settlement Ratio.

[Recommended Blogpost: Most Critical Factor in selecting a Life Insurance Company]

Regards,

Manoj Arora
Official Website