An insurance company's solvency ratio is the quantity of its capital in relation to all the risk it has accepted, which is all liabilities reduced from total assets. In other words, solvency measures how much the corporation has versus how much it owes. It is a basic indicator of an insurer's financial stability and ability to pay claims. It is similar to a bank's capital adequacy ratio in that it assists investors in determining the company's ability to meet its obligations.
It is important to note that solvency and liquidity are not synonymous. Liquidity measures a company's ability to pay a short-term debt, whereas solvency measures its ability to pay all debt, including long-term debt. It indicates the firm's long-term viability.
How is Solvency Ratio Calculated?
The calculation of the solvency ratio uses the following formula:
Solvency Ratio = (Net Income + Depreciation) / Liabilities
The solvency ratio formula compares a company's cash flow against the money it owes as the total sum assured. The higher the solvency ratio, the more assets there are compared to obligations.
Why is checking the Solvency Ratio important?
Checking the solvency ratio of an insurance company is essential while purchasing any life insurance plan, as it tracks the cash outflows and inflows of insurance companies, along with their overall liabilities. The ratio helps customers decide on suitable insurance companies which can settle claims and take care of financial responsibilities smoothly. Higher solvency ratios indicate better chances and abilities to pay claims and manage financial costs and responsibilities. The higher the solvency ratio, the better it is for policyholders as well. On the other hand, a lower solvency ratio means that the insurance company is likely to grapple with financial commitments while failing to settle claims simultaneously.
Insurance companies receive innumerable claims regularly. Hence, paying claims and taking care of other financial responsibilities requires suitable financial capabilities.
Let's look at an example to see what it means:
Neha obtained a life insurance policy from an insurer. In case of her unfortunate demise, the insurance company promises to pay a sum assured as the death benefit to her nominee(s). Let's say such a tragedy comes to pass, and her nominee files a claim. If the company's solvency ratio is low, then it might struggle to make the payout, as the number of claims at any given point is always high. Thus, to ensure that your nominee is financially secure in your absence, you must check the solvency ratio of the insurance company, among other factors.
What is the IRDAI's mandate on Solvency Ratio?
The IRDAI takes the solvency ratio as a key parameter, mandating the maintenance of a ratio of 1.5 for every insurance company with a solvency margin of 150%. It is something that every insurer should abide by. Customers should always check the solvency ratio with care if they purchase insurance. It matters since the inability of an insurance company to settle claims swiftly and tackle financial responsibilities defeats the core purpose of insurance at multiple levels.
While the Claim Settlement Ratio and Turn Around Time are vital aspects to consider when selecting an insurance company, you should also keep the Solvency Ratio in mind. A term insurance policy is your way of ensuring your family's future in your absence. So make sure you make an educated decision.
Chirag Iyer - BFSI Enthusiast
Chirag is a writer and an avid reader who loves to drink coffee! His other interests include boxing, karate, and singing.
