If you are going to buy an insurance policy, don’t just check the policy details but also some important factors such as the solvency ratio of your insurer.
In this article, we will explain the solvency ratio, its types, the significance of the solvency ratio, and how it can impact your insurance policy.
What Is a Solvency Ratio?
The solvency ratio is a vital financial metric that measures an insurance company’s ability to cover its liabilities (claims) and other obligations with its assets. In other words, the solvency ratio indicates whether the insurance company has enough financial resources to meet all its commitments.
How is the Solvency Ratio Calculated?
The solvency ratio in insurance is typically calculated by the formula:
Solvency Ratio = (Net Income + Depreciation) ÷ Liabilities
A solvency ratio of less than one indicates financial weakness and such an insurer may find it difficult to settle the claims of policyholders. Therefore, while buying health insurance or life insurance policies, you must look for insurance companies that have a high solvency ratio. It reduces the chances of claim rejection or delay in claim settlement.
Why is Checking the Solvency Ratio Important?
It is very crucial to know the solvency ratio of your insurance company because it tells its financial health and stability to meet all the claims with ease for the policies it has issued. This ratio helps consumers select the best insurer as it tells the financial strength of the company to handle claims and financial activities with ease. The higher the solvency ratio higher the chances of paying the claims.
Types of Solvency Ratios
Four important types of solvency ratios help to determine an insurance company’s ability to meet its obligations.
- Debt-to-asset ratio: Most people refer to it as or use this as the primary solvency ratio. It computes an insurance company’s debt about its total assets or earnings and is calculated by dividing liabilities by assets.
- Debt-to-equity ratio: This is calculated by dividing the total debt by the total equity. It helps assess the proportion between the debt and equity in the capital structure.
- Interest coverage ratio: This metric shows a company’s ability to pay off its long-term debt obligations. In other words, how many times can its current income be used to pay off its current interest payable?
Interest coverage ratio: EBIT/Total interest expense - Equity ratio: This ratio is calculated by dividing the total equity or share value of the company by the total assets. It indicates how much of a company’s assets have been generated by issuing equity shares rather than by taking on debt. The lower the ratio, the more debt a company has used to pay for its assets.
Solvency Ratio vs Liquidity Ratio
Although both solvency and liquidity ratios help assess an organisation’s financial health and stability, they are fundamentally different. Let’s compare liquidity and solvency ratios.
Solvency Ratio
- The solvency ratio measures the company’s ability to meet long-term obligations, i.e., for periods beyond one year.
- It indicates whether a company’s assets are sufficient to cover long-term liabilities and whether the company can withstand economic downturns and financial difficulties.
- Common solvency ratios include debt-to-asset ratio, interest coverage ratio, equity ratio, and debt-to-equity ratio.
Liquidity ratio
- Liquidity ratios are used to measure a company’s ability to meet short-term financial obligations using readily available assets like cash and cash equivalents
- It is specifically used to measure a company’s liquidity requirements, typically within the next year.
- Common liquidity ratios include the current ratio and quick ratio.
Examples of Solvency Ratios
Following are some solvency ratio examples:
Debt-to-Equity Ratio
Suppose a company has a long-term liability of ₹120 crore and shareholder’s equity of ₹75 crore.
Debt-to-equity ratio= 120,00,00,000 / 75,00,00,000 = 1.6
The debt-to-equity ratio in this example is 1.6 times, indicating that for every rupee of equity, the company has ₹1.6 in debt.
Interest Coverage Ratio
Suppose a company has earnings before interest and taxes (EBIT) of ₹12 crore and interest expenses of ₹80 lakh.
Interest coverage ratio = 12,00,00,000 / 80,00,000 = 15
The interest coverage ratio of 15 indicates that the company is earning 15 times higher than its interest expenses, which means it can easily cover interest payments.
IRDAI Mandate on Solvency Ratio
The Insurance Regulatory and Development Authority of India (IRDAI) mandates solvency ratios for insurance companies operating in India. To safeguard the interest of Indian policyholders, IRDAI mandates a solvency ratio of 1.5 times for every insurance company with a solvency margin of 150%.
Where to Find Solvency Ratio?
You can find an insurance company’s solvency ratio from the following sources:
IRDAI Website: The Insurance Regulatory and Development Authority of India (IRDAI) requires insurance companies to report their solvency ratios regularly. You can access this information directly from the IRDAI website under the section for regulatory filings or disclosures.
Insurance Company Websites: Many insurance companies provide financial information and key performance indicators, including solvency ratios, on their websites. Look for sections such as investor relations, financials, or regulatory disclosures.
Conclusion
When purchasing a life insurance policy, the solvency ratio is an important metric to consider. It not only helps you choose the right insurer but it also gives you the peace of mind that your claims will be processed in a timely and smooth manner when required. Therefore, It’s crucial to assess this ratio when selecting insurance policies to ensure comprehensive protection for both you and your family.