It's our favorite time of month -- Metric Time!!
This month's topic is measuring liquidity for insurance companies. Liquidity is an insurer’s ability to meet cash outflows such as payment of claims and benefits, repayment of liabilities and funding of loans. There are various measures of an insurer’s liquidity. The Insurance Regulatory Information System, or IRIS, which provides guidelines to U.S. insurance companies regarding their financial solvency, measures an important liquidity ratio called the total liabilities to liquid assets ratio.
Who uses it?
An insurer’s actual or perceived liquidity by policyholders and business partners is of critical importance. If liquidity is insufficient, it indicates that the business might face difficulties in meeting its immediate financial obligations. This can, in turn, affect the company's business operations and profitability, and confidence of policyholders and others.
How is it measured?
A key measure used by insurance companies is the total liabilities to liquid assets ratio. For example, say a company’s total cash and investments were one billion dollars as of the balance sheet date. Let’s assume that only 95 percent of their total investments are liquid and convertible to cash. That gives us liquid assets of nine hundred and fifty million dollars. Their total liabilities, say, were nine hundred and forty million dollars. In this case, their total liability to liquid assets ratio is 99 percent, which is their total liabilities divided by their liquid assets. This means that for every dollar of liquid investment, they have ninety nine cents of liabilities to cover.
What’s in it?
Liquid assets include items like cash and cash equivalents, investments in common and preferred stocks, bonds, mortgage loans, and all other invested assets that can be quickly converted to cash. It excludes investments in parent companies, subsidiaries, and affiliates. Total liabilities include loss reserves, accounts payable and other liabilities and debt.
Why is it important?
It’s a key measurement that gives cues to the management on its liquidity and long term solvency. Management is very focused on this metric, as many insolvencies have been preceded by a decreasing trend in liquidity.
What drives it?
The investment strategies and policies will decide on how much liquidity is available for payment of total liabilities. A conservative insurer may choose to have a ratio lesser than 100%, versus an aggressive insurer, who may choose to have a higher ratio.
What's the goal?
The goal is to have sufficient liquidity to meet all obligations. A ratio higher than 100 percent, using the measure of total liabilities to liquid assets, means that the company may not be able to meet its liabilities in case of an emergency, but a very low ratio also indicates that the company has money in cash or low risk investments that potentially could be put to better use. Each company therefore will have a pre-established target for this ratio. Per the IRIS, an acceptable target is below 105 percent.
For a deeper discussion on Financial Metrics, Operational KPIs and how they drive sales, see our previous blog post at www.finlistics.com/blog