PROFITABILITY TEST TESTS 4 AND 4A FIVE-YEAR AND ONE-YEAR OPERATING RATIOS The operating ratio is a comprehensive measure of the profitability of a company's insurance business. Over the long run, the profitability of the business is a principal determinant of the company's financial solidity and solvency. DESCRIPTION OF THE CALCULATION Although the operating ratio is one of the more difficult ratios to calculate, the calculation is based on a simple concept. There are three key elements in operating profitability: losses, expenses, and the investment income from funds supplied by insurance operations. Operating profits consist of the difference between premium and the net result of these three factors. Therefore, as diagramed in Exhibit IX, the operating ratio is the net result of three component ratios: Loss ratio Expense ratio Investment income ratio. The loss ratio is the total of losses, loss adjustment expenses, and policyholder dividends taken as a percentage of net premium earned. The expense ratio is equal to underwriting expenses (net of other income) divided by net premium written. The sum of these two ratios is the combined ratio. From this combined ratio is subtracted the investment income ratio: net investment income earned on funds contributed by policyholders, taken as a percentage of net premium earned. Investment income is earned on the total invested assets. One portion of these assets has been provided by policyholders (as indicated by liabilities such as reserves for losses and unearned premium). The other portion 99-073 0 78 - 15 has been provided by stockholders and the retention of profits (as indicated by surplus). Only the income earned on policyholders' funds is counted toward the profitability of the insurance business. If the total investment income were included, the resulting ratio would not measure the profitability of the insurance business per se, and the results obtained for companies with little premium in relation to investment income would be meaningless. To determine what portion of investment income is earned on policyholder funds, investment income is multiplied by the ratio between policyholder funds and invested assets. Policyholder funds are calculated as the difference between invested assets and adjusted surplus. For this test, stated surplus is adjusted in three ways. First, the excess of statutory over case basis reserves is added to surplus. Second, surplus is decreased or increased by the estimated reserve deficiency or redundancy, which is the average of the numerators of the three reserve tests. Third, surplus is increased by the amount of deferred acquisition expenses. This amount is calculated by multiplying the unearned premium reserve by the ratio between acquisition expenses and net premium written. Acquisition expenses include commissions; taxes, licenses and fees; and half of other underwriting expenses. The only difference between the five- and one-year operating ratios is that for the five-year ratio, the total amounts for the period are used in calculating the loss and expense ratios. The calculation has been simpli fied by using the current year investment income ratio in place of a fiveyear calculation. Because of the general stability of investment income, the results obtained in this manner normally do not differ materially from the results obtained through the more lengthy calculation. If the net premium written or earned in the current year is zero or negative, the one-year operating ratio is no calculated. The five-year ratio is not calculated in the total net premium written or earned for the five-year period or for the current year is zero or negative. The calculation of the five-year and one-year operating ratios is laid out in the work sheets in Appendix A. APPROXIMATE CALCULATION OF FIVE-YEAR OPERATING In order to calculate the five-year perating ratio, association blanks for the years 1969 throneh 1973 are needed. Due to the fact that a new data processing company has begun calculating the test results this year, only the 1972 and 1973 blanks are centrally available. However, the 1972 five-year and one-year operating ratios are also available for most companies. With this information it has been possible to make a reasonable approximation of the five-year operating ratio for 1973. The approximate five-year operating ratios included in the 1973 test results have been calculated as follows: First, an approximate four-year ratio for the period 1968 through 1971 was obtained from the five-year and one-year ratios calculated for 1972. This was done by adding to the 1972 five-year ratio one-quarter of the difference between that ratio and the 1972 one-year ratio. Second, the 1972 and 1973 association blanks were used to calculate a two-year operating ratio, as described above. Finally, the two-year ratio for 1972 and 1973 and the four-year ratio for 1968 through 1971 were averaged (with equal weights) to approximate the five-year ratio for 1969 through 1973. If the operating ratios for 1972 are not available for a company, or if net premium earned during 1973 was zero or negative, no five-year operating ratio will be calculated for 1973. The calculation of the one-year operating ratio for 1973 was not prevented by the lack of annual statements for earlier years and has been made as described in the work sheets for Test 4A in Appendix A. The work sheets for Test 4 show the manner in which the five-year ratio should be calculated if all the required annual statements are available. INTERPRETATION OF TEST RESULTS The usual range for the five-year and one-year operating ratios is less than 100 percent. In 1972, 17 percent of all companies had test scores above this bench mark on the five-year test (Exhibit X) and 12 percent on the one-year test (Exhibit XI). Of companies becoming insolvent during the past five years, 57 percent had five-year operating ratios in excess of the bench mark in the third year before insolvency, and 77 percent exceeded the bench mark in their final year. If either the five-year or the one-year operating ratio is above the 100 percent bench mark, further analysis should be aimed at determining the trend in the company's profitability and the possible reasons for the high operating ratio. For priority companies, the trend in the operating ratio is |