What is net (insurance) leverage?
Net leverage is the sum of an insurance company’s net indebtedness written premiums report and sound net liability ratio. Net leverage is used to determine an insurer’s degree of exposure to errors in pricing and loss estimation. It is used as an indicator of the financial health of the insurance company.
Key points to remember
- An insurer’s net leverage shows how effectively it has managed its reserves to meet claims.
- The equation for net leverage is (net written premiums / insured surplus) + (net liabilities / insured surplus)
- Net indebtedness is used in conjunction with other indebtedness ratios such as gross indebtedness, reinsurance recoverables and Best’s relativity of capital adequacy (BCAR).
- Unlike the gross leverage ratio, the net leverage ratio does not include items that have been ceded to a reinsurance company.
Use of net leverage (insurance)
An insurance company reconciles two objectives: to invest bonuses it receives from underwriting activities in order to generate a profit and limit its exposure to the risk created by the policies it writes. Insurers may cede premiums to reinsurance companies in order to transfer part of the risks to the reinsurer. This would remove some of the Passives outside the main insurer balance sheet.
Net leverage is a type of leverage report. Contrary to gross leverage, net leverage does not include ceded reinsurance leverage. Net leverage is calculated as follows: (net written premiums / policyholder surplus) + (net liabilities / policyholder surplus). The net leverage ratio shows how exposed the insurer is to loss estimation errors. A high value indicates that the insurance company is more dependent on having Reserve funds.
An insurer’s net leverage shows how effectively it has managed its reserves (from policyholder surplus) to meet claims. The goal is to have sufficient excess reserves to be able to pay all possible claims while maintaining a profit. This is achieved by controlling the number of underwriting activities, so that it does not threaten to deplete the company’s reserves. The net written premium should not be too high above policyholder surplus, the assets an insurer owns minus its liabilities.
An acceptable net leverage ratio depends on the type of insurance a company carries, although the desired range is generally below 6.0. An insurer’s net debt will generally be less than its gross debt because the net debt ratio does not include items that have been ceded to a reinsurance company. The gross leverage ratio is therefore more conservative report.
Net leverage (insurance) and rating agencies
Rating agencies typically look at a number of different financial ratios when determining the health of an insurance company. These ratios are calculated from a review of the insurer’s balance sheet. In addition to net leverage, a rating agency will also consider the return on assets, retention ratethe gross premiums written, as well as the amount and type of assets.
Leverage ratios are important as companies rely on a mix of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in assessing whether it can repay its debts as they come due. Rating agencies will compare these values to the values of similar insurance companies and the industry as a whole.