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Most American companies apply generally-accepted accounting principles, or GAAP, when determining their expenses. Insurance companies, however, adhere to a set of standards known as "statutory accounting." Statutory accounting principles are regarded as more conservative than GAAP, since most insurance companies must pay out benefits or claims to their policyholders. These different approaches lead to different methods of calculating expenses and their related ratios.
Functions of Statutory Expense Ratio
Insurance companies calculate the statutory expense ratio by dividing their underwriting expenses by the amount of the net written premium. The underwriting expenses are determined by adding the total costs involved in acquiring policyholders to the total cost involved in policy underwriting. The net premiums are found by deducting sales commissions and reinsurance costs from gross premium revenue. The ratio determines the level of expense each insurer incurs when underwriting a standard policy.
Applications of Statutory Expense Ratio
The statutory expense ratio, when added to the statutory loss ratio, forms the statutory combined ratio. The statutory combined ratio is the primary measurement of underwriting profitability employed in the property and casualty insurance industry. A statutory combined ratio below 100 percent shows that the company is making a profit in its underwriting operations. A ratio above 100 percent means that the company is paying out higher amounts in claims that it receives from premium payments.
Functions of GAAP Expense Ratio
The primary difference between the statutory expense ratio and the GAAP expense ratio lies in the denominator. The statutory expense ratio divides the underwriting expenses by the net written premium amount. The GAAP expense ratio divides the underwriting expenses by the net earned premium amount. Insurance companies find the net premium earned under GAAP by adjusting net annual premiums based on the insurance underwriter's unearned premium liability.
Applications of GAAP Expense Ratio
The calculation of the GAAP expense ratio allows publicly-traded insurance companies to show the relationship between underwriting expenses and revenues on their required financial statements. Investors, financial analysts and government regulators require publicly-traded companies to use GAAP when creating their financial statements, including income statements, balance sheets and statements of shareholder equity. The GAAP expense ratio shows investors how well the insurer has assessed the underwriting expenses and how much of their revenue goes toward paying claims and benefits.
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