As per IRDA’s mandate, insurance companies must maintain a minimum solvency ratio of 1.5. It indicates that the company is in a position to meet its long-term liabilities.
What is Solvency Ratio in Insurance: Meaning, Formula & Types
When purchasing an insurance policy, you need to consider a few things about the insurer, such as customer reviews, claim settlement ratio, etc. Among those, the solvency ratio is one of the most important factors which depicts a company's financial health.
This article will define solvency ratio and discuss its types, calculation method and limitations.
What is a Solvency Ratio?
Understanding Solvency Ratios
As the term suggests, the solvency ratio shows a company's ability to stay 'solvent.' This ratio takes the company's cash flow into account rather than its net earnings. The ratio focuses on depreciation & other non-monetary expenses to measure the company’s solvency and determine how long it can stay afloat financially.
The solvency ratio differs from one industry to another. Hence, one should assess it while comparing it to that of the competitors in the same industry.
For insurance companies, the solvency ratio denotes the company’s cash flow as compared to the amount it owes to the policyholders. The higher the ratio, the more readily it will be able to settle insurance claims.
What are the Types of Solvency Ratios?
1. Debt-to-Asset Ratio
A company’s debt-to-asset ratio shows how much of that company’s assets are funded by debts. For example, if a firm’s debt to asset ratio is 0.5. This means for every ₹1 of debt, there are ₹2 worth of assets. The formula to calculate debt-to-asset ratio is:
Debt to asset ratio = debt/assets
2. Interest Coverage Ratio
This ratio is the most reliable as it shows a company’s ability to pay off its long-term debts or obligations. To put it in another way, it shows the number of times a company can pay off its current interest payable with its income. The formula for calculating the interest coverage ratio is as follows:
Interest coverage ratio = EBIT / interest expenses
Here, EBIT means ‘earnings before interest and tax payments.’
An interest coverage ratio lower than 1.5 seems to indicate financial trouble for that company.
3. Equity Ratio
You can compute this ratio by dividing a company's total equity or shares value by the value of its assets. This ratio is an effective way of assessing how efficiently a firm can function without loans or debts. In other words, it shows how independently a company’s equities can fund its assets.
The higher the ratio, the lesser the company’s liabilities and debts. The formula for calculating this ratio is:
Equity ratio = equity / assets
Solvency Ratios vs Liquidity Ratios
Solvency ratio and liquidity ratio are somehow similar in nature but have their fundamental differences. These are two very significant metrics that reflect a company's financial health. The key difference is that the solvency ratio focuses more on long term obligations, and the liquidity ratio focuses on short term goals.
Here is a table of comparison between solvency ratio and liquidity ratio:
|Reflects long term stability
|Reflects short term stability
|Takes into account all assets and inventory
|Focuses on cash and similar assets
|A company with a high solvency ratio can cover long term obligations well but how well it will be able to perform under sudden needs is uncertain.
|A company with a high liquidity ratio can confidently cover sudden crunches but how well it can tackle long term obligations is uncertain.
What are the Limitations of Solvency Ratios?
Although the solvency ratio of a company is an important metric to comprehend its financial position and how it is going to perform in the long term, it has its limitations.
It is not possible to assess how a company is performing financially with just one ratio. Instead, you need to calculate multiple ratios and compare them with the industry standards to actually come to a solid conclusion.
A solvency ratio might not always be relevant. In a specific type of industry, you need to compare the solvency ratio of a company with that of some of the leading firms to check whether it's alarming or not.
Even if you put together all the ratios, they won’t tell you everything you need to know about a company’s economy. For example, long term investments take time to bear fruits, but that doesn't mean it was not a good investment. Also, the ratio won't tell you how exactly debts are being used by the company.
How is Solvency Ratio Calculated?
The solvency ratio is based on a company's cash flows which consider non-cash expenses and depreciation against its debts and financial obligations. The formula to calculate solvency ratio of a business is:
Solvency Ratio = (Net income + Depreciation) /Liabilities
Hence, it is quite evident that the higher the value of the assets against the liabilities, the higher will be the ratio.
Solvency ratio is an important aspect for determining an insurance company’s financial health. By measuring a firm’s actual cash flow instead of the net income, it offers a real picture of the insurer’s ability to meet its long-term obligations. Make sure to check the solvency ratio of an insurer to know how easily it can settle your claims.
FAQs About Solvency Ratio in Insurance
The solvency margin is an additional amount of capital an insurance company must keep as a backup plan for emergencies. It should be above the value of the claims that the company will most likely incur.
A high solvency ratio means the insurer has higher chances or assurance of settling your claims. This helps a policyholder put their faith in you rather than all the other options available in the market.
Important Guides related to Life Insurance
- This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
- All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
- Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.