Why solvency ratio matters

By Priyadarshini Dembla |  22-09-14 | 
 
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About the Author
Priyadarshini Dembla is a research associate with Morningstar. She would like to hear from you, but she cannot provide individual-portfolio or financial-planning advice.

Ever wonder how likely you are to get your money back should the insurance company fail? Imagine a situation where a massive earthquake or natural calamity in a region puts a huge burden on the insurance company. The insurer is obligated to pay the claims, but what if it genuinely cannot? What if the company becomes insolvent?

That is why the solvency ratio is a crucial component to consider when deciding whom to select as an insurer.

The solvency ratio of an insurance company is the size of its capital relative to all the risk it has taken, which is all liabilities subtracted from total assets. In other words, solvency is a measurement of how much the company has in assets versus how much it owes. It is a basic measure of how financially sound an insurer is and its ability to pay claims. It helps investors measure the company’s ability to meet its obligations and is similar to the capital adequacy ratio of banks.

Worth mentioning here is that solvency and liquidity are not the same. Liquidity is a measure of a firm’s ability to pay short-term debt, while solvency is the ability to pay all debt including long-term debt. It is an indicator of the firm’s long-term survival. 

How the solvency ratio is calculated

The solvency ratio is derived out of the solvency margin (available solvency margin to required solvency margin) which is basically the amount by which the assets of the insurer exceed its liabilities. However it is not as simple as it appears. The Insurance Regulatory and Development Authority, or IRDA, has prescribed methods of valuation of assets and liabilities. Based on these guidelines, the life insurance companies have to prepare a statement of solvency margin every quarter.

In India, insurers are required to maintain a minimum solvency ratio of 1.50. Insurance players whose solvency ratios are dangerously close to this minimum level are closely watched by the insurance regulator, the IRDA. However, as per the draft exposure issued by IRDA in February 2013, it was proposed that the insurance companies be required to maintain a solvency ratio of 1.45 from fiscal 2013-14. Simultaneously, as per international practices, the IRDA has also proposed a move towards a risk-based solvency approach to discourage insurance companies from investing in riskier assets.

How individuals can access the data

Solvency ratios are available in the annual report published on the IRDA website. As on March 2013, all the 24 life insurers complied with the stipulated requirement of the solvency ratio of which Life Insurance Corporation of India, or LIC, had the lowest solvency ratio among its peers at 1.52 while Bajaj Allianz had the highest solvency ratio of 6.34 in the life insurance space.

Insurer
March 2012 March 2013
LIC 1.54 1.54
HDFC Standard 1.88 2.17
ICICI Prudential 3.71 3.96
ING Life 2.16 1.8
Kotak Mahindra 5.34 5.21
Reliance 3.53 4.29
SBI Life 5.34 2.15
Bajaj Allianz 5.15 4.23
Birla Sun Life 2.99 2.67
Max Life 1.65 2.07
Source: IRDA Annual report 2013

While the solvency ratio is a crucial aspect, it should not be viewed in isolation, but in conjunction with other factors. No doubt, a higher solvency ratio is definitely good for the policyholder as this gives him a sense of comfort that the liabilities are backed by assets more than the mandatory limit set by the IRDA. But it could also be the case that in the short run, a particular company has garnered additional investment assets or accumulated profits which have still not been put to use. And as the number of policy holders increases, this will change.

By and large, the higher the solvency ratio the stronger the promise.

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BHADRESHKUMAR RENUKA
Dec 10 2015 05:29 PM
madam ,
you have written all but havent shown that the value of solvency ratio should be high or low for a good company?
one cant conclude anything from your above writing.
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