Net Leverage (Insurance): What It is, How It Works

What Is Net Leverage (Insurance)?

Net leverage is the sum of an insurance company’s net written premiums ratio and its net liability ratio. Net leverage is used to determine how exposed an insurer is to pricing and claims estimation errors. It is used as a gauge of the insurance company's financial health.

How Net Leverage (Insurance) Is Used

An insurance company balances two goals: investing the premiums it receives from underwriting activities so as to return a profit, and limiting its risk exposure created by the policies that it underwrites. Insurers may cede premiums to reinsurance companies in order to move some of the risks to the reinsurer. This would remove a portion of the liabilities off the primary insurer's balance sheet. 

Net leverage is a type of leverage ratio. Unlike gross leverage, net leverage does not include ceded reinsurance leverage. Net leverage is calculated as: (net written premiums / policyholders’ surplus) + (net liabilities / policyholders’ surplus). The net leverage ratio shows how exposed the insurer is to errors in claim estimation. A high value indicates that the insurance company is more reliant on having adequate reserve funds.

An insurer's net leverage shows how efficiently it has managed its reserves (from the policyholders' surplus) to address claims. The goal is to have adequate surplus reserves to be able to pay all possible claims while still retaining a profit. This outcome is achieved by controlling the number of underwriting activities, so it won't threaten to deplete the company's reserves. Net written premium should not be too high above the policyholders' surplus, the assets an insurer owns minus its liabilities.

An acceptable net leverage ratio depends on what type of insurance a company underwrites, though the desired range typically falls below 6.0. An insurer’s net leverage will typically be lower than its gross leverage because the net leverage ratio does not include those items that have been ceded to a reinsurance company. The gross leverage ratio is, therefore, a more conservative ratio.

Other types of leverage ratios used in the insurance industry include gross leverage, reinsurance recoverables to policyholders’ surplus, and Best’s Capital Adequacy Relativity (BCAR).

Net Leverage (Insurance) and Ratings Agencies

Ratings agencies typically look at a number of different financial ratios when determining the health of an insurance company. These ratios are calculated through an examination of the insurer’s balance sheet. In addition to net leverage, a ratings agency will also look at the return on assets, retention ratio, gross premiums written, and the amount and type of assets.

Leverage ratios are important given that companies rely on a mixture of equity and debt to finance their operations, and knowing the amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come due. Ratings agencies will compare those values against the values of similar insurance companies and the industry as a whole.