International Journal of Advanced Science and Technology

Vol. 29, No. 1, (2020), pp. 1234 - 1242

Insurance Financial Soundness Indicator- Caramel Model

M.Surya1, Dr.B.Sudha2

1Department of Commerce, Alagappa University, Karaikudi

2
Department of Banking Management, Alagappa University, Karaikudi
Email Id : suryam9088@yahoo.com1 & sudha.pooja.78@gmail.com2

Abstract

Insurance has become anoteworthy and vibrant part of the financial services
in almost all the developed and some developing nations. Insurance is a tool of
savings which could boost the economic growth and could contribute to efficient
resource allocation if governed properly. The benefit of transfer of risk over
insurance services could proficiently help in reducing transaction costs, generating
liquidity and facilitate economies of scale in investment. A team of International
Monetary Fund (IMF) presented a paper that explored insurance as a source of
financial system vulnerability who proposed some key indicators which could be
used for the surveillance of financial soundness of insurance companies because
ofthe risk factors in it. Thus, the researcher in this paper has tried to describethe core
set of the CARAMELS[Capital adequacy, Asset quality, Reinsurance and Actuarial
issues, Management soundness, Earnings/Profitability, Liquidity and Sensitivity to
market risk] Model which is a financial soundness indicator of life and non-life
insurance companies that includes the use of quantitative factors affecting the
financial position of the insurance company.

Keyword:. FSI, IMF, CARAMELS, Capital Adequacy, Asset Quality and

Reinsurance.

1. Introduction

Insurance has become a noteworthy and vibrant part of the financial services
in almost all the developed and some developing nations. Insurance is a tool of
savings which could boost the economic growth and could contribute to efficient
resource allocation if governed properly. The benefit of transfer of risk over
insurance services could proficiently help in reducing transaction costs, generating
liquidity and facilitate economies of scale in investment. Assessing the financial
health of an individual insurer or insurance sector as a whole is a difficult task.
Therefore the overall financial performance of a company depends on many factors,
where some are difficult to quantify, that is; quality of its management,
organisational structure and system control of the company. In the International
Monetary Fund (IMF) a team presented a paper that explored insurance as a source
of financial system vulnerability that proposed key indicators which could be used
for surveillance of financial soundness of insurance companies as a whole because
of the risk factors in it.Thus, the working paper of IMF had suggested two set of
indicators for measuring the financial soundness of the life and non-life insurance
companies which are core and encouraged set.

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The IMF-Background paper (2003) had recommended significant Financial
Soundness Indicators (FSI‟s) for the financial institutions including both Life and
Non-Life Insurance Industry. The paper had presented a CARAMELS [Capital
adequacy, Asset quality, Reinsurance and Actuarial issues, Management
soundness, Earnings/Profitability, Liquidity and Sensitivity to market risk]
Framework which includesa number of different ratios with the use of those
quantitative factors that affect the financial position of the insurance company. This
model gives a deep study on the use of various ratio analyses to reflect the position
of the insurance companies.

2. Statement of The Problem

Insurance companies are in the core business of managing risk of

individuals and corporate in the Indian industry which needs a deep analysis on the
various factors affecting its financial performances. So for analysing the working of
insurance company different financial indicators are well explained in the
CARAMELS model that helps in analysing the Capital adequacy, Asset quality,
Reinsurance and Actuarial issues, Management soundness, Earnings/Profitability,
Liquidity and Sensitivity to market riskof the insurance company under different
ratios. It helps the analyser to study the financial position of the insurance company
more efficiently and to compare the financial performance of one insurance
company with another and also helps to show the growing trends of the company.

3. Objective of The Study

The prime objective of this research paper is to study in detail thecore set of
CARAMELS frameworkin the insurance sector.

4. Caramels Framework

The IMF-Background paper (2003) proposed by Das, Davies and Podpiera

had recommended significant Financial Soundness Indicators (FSI‟s) for the
financial institutions including both Life and Non-Life Insurance Industry. The
paper had presented a CARAMELS [Capital adequacy, Asset quality, Reinsurance
and Actuarial issues, Management soundness, Earnings/Profitability, Liquidity and
Sensitivity to market risk] Framework which includes a number of different ratios
with the use of those quantitative factors that affect the financial position of the
insurance business.This framework is analogous to the CAMELS framework for
the banking sector. Thus, the core set indicators highlighted in table-1 are those
which are considered necessary for adequate surveillance of the insurance sector
whereas, another set called the encouraged set includes those additional indicators
that are useful in monitoring more specific areas of susceptibility.
Table 1: Insurance Financial Soundness Indicators: CARAMELS model (Core Set)
Category Indicator Non-life Life
C-Capital Net premium/Capital X
Adequacy Capital/total assets X
Capital/technical reserves X
A- Asset quality (Real estate + unquoted equities + X X
debtors)/total assets

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Receivables/(Gross premium + X X
reinsurance recoveries)
Equities/total assets X X
Nonperforming loans to total gross X
loans
RA-Reinsurance Risk retention ratio (net premium/gross X X
and actuarial issues premium)
Net technical reserves/average of net X
claims paid in last three years
Net technical reserves/average of net X
premium received in last three years
M- Management Gross premium/number of employees X X
soundness
Assets per employee (total X X
assets/number of employees)
E- Earnings and Loss ratio (net claims/net premium) X
profitability
Expense ratio (expense/net premium) X X
Combined ratio = loss ratio + expense X
ratio
Revisions to technical X
reserves/technical reserves
Investment income/net premium X

Investment income/investment assets X

Return on equity (ROE) X X
L- Liquidity Liquid assets/current liabilities X X
S- Sensitivity to Net open foreign exchange X X
market risk position/capital
Duration of assets and liabilities X
Source: Compiled from IMF Working Paper on „Insurance and Issues in
Financial Soundness, WP/03/138 (2003)
Note: Relevance to life or non-life segment of Insurance is indicated by „X‟.

4.1 Capital Adequacy

From the above table of insurance FSI, „C‟ stands for Capital adequacy that
expresses two ratios for Non-life insurance company and one indicator for the life
insurance. Hence, prudential standards have accentuated on the importance of the
adequate capitalization and solvency as the crucial areas to know the financial
position of the company and to keep a strict watch on the insurance companies
which viewed that the capital adequacy is the main indicator of financial soundness
of an insurance company. Capital adequacy means that the company must have
minimum capital so that it may be financially sound to make their payments on time
but unfortunately there are no internationally accepted standards for insurance
companies with regard to the capital adequacy whereas in case of banking sector the
norms of RBI had prescribed a 9% of capital to risk weighted asset ratio. The
Insurance Laws (Amendment) Act 2015 according to sec 2(8A) mentions that the
minimum paid-up capital requirement should be Rs.100 crore in case of insurance

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business.
The insurance company must have enough capital to fund its losses arising
out of the claims made by the insured to protect against the fear of becoming
bankrupt. It also promotes the stability and the efficiency of the financial system of
the company. So the insurance regulator has asked the insurance companies to
maintain a minimum ratio of 1.5 as margin of solvency ratio that is excess of assets
over liabilities which is monitored on the quarterly basis.
Capital Adequacy Ratio: This ratio is calculated by using the following
formulas:
a) Net premium to Capital= Net premium/Capital
b) Share Capital to Total Assets Ratio= Share Capital/ Total Assets
c) Share Capital to Technical Reserve Ratio = Share Capital/ Mathematical
Reserves
Whereas
 Share Capital = Equity share capital + Reserve and surplus –Debit balance
of policyholders account– Debit balance of shareholders
account–Miscellaneous expenditure.
 Total Assets = Fixed assets + Current assets + Investments.
 Technical Reserves are taken after the allocation of Bonus.
4.1.1 Net Premium to Capital
The premium necessary to cover only anticipated losses, before loading to
cover other expenses. The amount of premium minus the agent's commission is
known as Net Premium. In Non-life insurers there are two capital adequacy ratios
within the core set: net premium/capital and capital/total assets. Net Premium is the
appropriate proxy for the quantum of retained indemnity risk.This ratio is easy to
calculate which require only information available from the sources. But it also
needs to be interpreted with knowledge of the risk characteristics of the business
that the company shows.
4.1.2 Capital to Total Assets Ratio
The capital to total assets ratio determines the proportion of capital in the
total assets of the company, which shows the growth in the assets base and the
efficiency of the company in utilizing the capital in creation of assets. It also implies
that how much assets are being funded by the capital of the company. Perhaps,
because of the absence of minimum and maximum ratio requirement, it is
preferable that lower ratio is preferred which indicates better and strong assets base
provided that the company is meeting with the minimum capital requirement. It is
indeed important that a higher ratio may prove better from short term point of view
but in the long run it is better that the company has lower ratio indicating towards
stronger assets base of the company.
4.1.3 Capital to Technical Reserves Ratio
A provision made for a specific purpose is called as reserve. Such specific
purposes might include the payment to be made for unforeseen circumstances,
meeting claims, any sudden expenditure needed for running of business etc. which
helps in the smooth functioning of the business without disconcerting the profit and
loss position of the company. Whereas, Surplus is the additional amount in profit
and loss account after paying for dividends, bonus, taxes etc. In insurance such
reserve and surplus are made so that the insurer is at ease to pay the claims made by
the insured. Insurance companies create reserves and surplus to pay the liabilities
arising from claims out of the policies that they offer. However there are no set

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limits as to how much reserve should be created by the insurance companies yet
they should create reserves equal to the amount of losses which might arise from the
number of policies issued during the year. Such estimation of actual losses should
be made by these insurance companies through actuaries appointed by them.
Therefore the reserve should be high enough to cover the projected liabilities.

4.2 Asset Quality

Asset quality means the quality of assets of the company which absorbs the
financial strength of the company.As mentioned in the above table, it includes four
asset quality indicators that are (real estate+unquoted equities +debtors) to total
assets ratio, debtors to (gross premium+reinsurance recoveries ratio), equities to
total assets ratio and non-performing loans to total gross loans. In these ratios,
equities are implied as paid-up capital of the company and total assets as the total
application of funds minus the debit balance of profit and loss account. This ratio
indicates the amount of total assets funded by equity capital of the company. Higher
asset quality ratio is preferable so that the company„s financial soundness is
retained and it does not call for insolvency as higher amount would be funded by
equity capital of the firm. In distinction to this lower ratio imply towards lower
margin of safety as there is more risk of losing money in case of bad quality of
assets which might held up the profitability of the business.

4.3 Reinsurance and Actuarial Issues

As per the IMF working paper the financial soundness indicators of
insurance companies include the reinsurance and actuarial issues that could be
evaluated through the use of three ratios. One is risk retention ratio that is measured
from dividing net premium by gross premium; the second ratio is the Net technical
reserves to average of net claims paid in last three years and the third ratio is net
technical reserves to average of net premium received in last three years.
4.3.1 Risk Retention Ratio:
This ratio assists as an indicator of insurance risk management policy of the
insurance company. It is worked out by dividing the Net premium by Gross
premium. That is,
Risk Retention Ratio=Net Premium/Gross Premium x 100
Where, Net Premium = Gross premium – Reinsurance ceded +
Reinsurance accepted
This risk retention ratio indicates the efficiency of the company in
underwriting its insurance premium and how much risk is passed onto the
reinsurers. The difference between the gross premium and net premium shows the
amount of risk which is being transferred onto the reinsurer. The greater amount
shows more risk is passed onto the reinsurer and vice-versa and also indicates the
risk bearing capacity of the company. It is obtained by dividing net premium to
gross premium.Gross premium is the sum of direct premium and assumed premium
written before the effect of ceded reinsurance and net premium is the amount
obtained after deducting reinsurance ceded and adding reinsurance accepted from
and to gross premium amount.
4.3.2 Net Technical Reserves to Average of Net Premium Received in
Last Three Years
Net Technical Reserves to Average of Net Premium (ANP)Received in
Last
Three Years Ratio: The ratio is an indicator of adequate Mathematical

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Reserves.
The formula used for calculating this ratio is as follows:
Net Technical Reserves/ Average of Net Premium Received in Last Three
Years
Whereas:
 Net Technical Reserves are after the allocation of bonus.
 Average net premium received in last three years =
Net premium of year 1+ Net premium of year 2 + Net premium of year 3
3
 Net premium = Premium received – Reinsurance ceded + Reinsurance
accepted.
This ratio shows the amount of reserves created out of the average of net
premium earned in last three years. The ratio is indicative of the development of
reserves of the insurance companies over the years. It takes into account as to how
much fund has been allocated for future purposes out of the average earnings of the
last three years. Here reserves and surpluses are taken as technical reserves and the
average of net premium earned in the last three years are taken for evaluation.

4.4 Management Soundness

Management soundness reflects the efficiency of the working personnel of
the company. It means how efficient and sound the employees of the company are.
The ratio used to evaluate the management soundness throws light on the
operational efficiency of these employees meaning thereby how well and how good
are they at decision making which is ultimately bearing fruits to the business. The
cost effectiveness and proper utilization of funds means that the management of the
company is sound. It is important to keep a watch on the management soundness for
financial stability of the company. In this category, it has two ratios to evaluate the
management soundness of the insurance companies. The first ratio is gross
premium to number of employee; and second ratio is assets per employee.
4.4.1 Gross Premium to Number of Employees Ratio
Gross premium is the sum of direct premium and assumed premium written
before the effect of ceded reinsurance. Here the numbers of employees are taken as
total number of agents including both the individual and corporate agents.
Generally premium collection is the task of agents although efficiency of the
company depends upon all the marketing channels plus the staff force. Gross
premium to number of employee‟s ratio is considered for measuring the
management efficiency of the company. Higher the ratio, the better the efficiency of
the management of the company that is higher amount of gross premium per
number of agents at a point of time.
4.4.2 Assets Per Employee Ratio
Total assets reflect the overall strength of the company which is computed
as the total application of funds minus debit balance in profit and loss account.
Number of employees is the staff strength taken from the annual reports of
respective life insurers. Higher the ratio better is the position of the company
meaning there by that the employees of the company are able to bear higher returns
to the company. It also indicates that the employees are efficient to build a strong
position of the company.

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4.5 Earnings and ProfitAbility Analysis
Earnings and profitability of any company reflect the strength of its
existence in the market. Earnings are the key and arguably the only long term source
of capital. When there is Low profitability it will lead for solvency problems. This
ratio analysisgives the capacityof the insurers in creating earnings by this means
showing the profitability position in the market. It is of utmost importance so that
the various companies working in the industry could be compared and judged upon
their profitability position. As proposed by IMF working paper there were
numerous ratios to evaluate namely expense to net premium ratio, return on equity
ratio, return on assets ratio and earnings per employee ratio to measure the
performance insurance companies.
4.5.1 Expense to Net Premium Ratio
The expense ratio reveals the strength of the business in earning a net
premium and how much the company has incurred in underwriting the net
premium. When there areless expensesand high profitsthe management of the
company will show the efficiency and profitability. A lower ratio is preferable as it
gives way to a higher margin of profits and the strong financial position of the
company. To evaluate the performance of life insurers the researcher has
subcategorized the expense as a total expense and operating expense and has
evaluated the ratio as total expense to net premium ratio and operating expense to
net premium ratio.
4.5.2 Total Expense to Net Premium Ratio
The total expense to the net premium ratio implies the amount of
expenditure done to underwrite net premium by the company. It also implies the
capability of the company in being cost-efficient and effective to obtain the net
premium. The amount of total expense includes the expenses done towards the
insurance business as operating expenses, commission expenses, and other
expenses. Net premium is the amount obtained after deducting reinsurance ceded
and adding reinsurance accepted from and to the gross premium amount. Lower the
ratio, greater the profitability. Hence lower ratio is considered better as it means that
in underwriting net premium the company was cost-efficient and it had to spend less
in doing so.
4.5.3 Operating Expense to Net Premium Ratio
The operating expense to net premium ratio indicates the number of
operating expenses incurred in underwriting net premiums. Lower the ratio, better
the profitability of the company. Therefore, the operating expense is taken as the
amount of operating expenses related to insurance business and the net premium is
the amount obtained after deducting reinsurance ceded and adding reinsurance
accepted from and to the gross premium amount.
4.5.4 Return on Equity Ratio
Return on equity ratio is one of the analyses of earnings and profitability of
the company where it is assessed that how much the company is earning out of the
capital invested as equity. It measures the efficiency of the management of the
company is utilizing its equity share capital to generate net profits. The ratio also
implies the efficiency of the company is utilizing the equity shareholders‟ funds in
the business operations. The higher the ratio, the better it is. A higher ratio signifies
the profitability of the business and more dividends to the equity shareholders. It is
calculated by dividing the net profit with equity share capital. Here net profit is
profit after tax and equity share capital is the capital invested as paid-up equity.

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4.5.5 Earnings Per Employee
Earnings per employee are a ratio of profitability analysis through which the
efficiency of each person employed in a company can be measured that determines
the productivity of a company. It also specifies how the efficient human resource of
a company is working to generate profits or how well the company is utilizing its
human resources to generate such profits which points out the skill of the employed
personnel of a company. Higher the ratio, better the position of the company as well
as better the efficiency of the firm.
4.5.6 Return on Assets Ratio
Return on assets (ROA) ratio explicates the capability of the company in
earning a net profit on utilizing its total assets. It is premeditated by dividing net
profit by the total assets of the company. Here, the net profit is the profit after tax
and total assets are the total application of funds minus debit balance in profit and
loss account. ROA also implies the intensity of the company„s capital base which is
further utilized in generating profits. A higher ratio is desirableas it indicates that
the company is using its assets in effective way which gives higher profits than the
money invested in assets. In other words, the return on assets ratio is an indication
of the company„s efficiency in managing its assets to earn net profits. It helps the
investors in knowing the wellness of the company in a way that how profoundly the
business is being run by the management of the company.

4.6 Liquidity
In the insurance business, the timing of insurance claims is uncertain. One
cannot predict as to when the insured could claim for its insurance policy. It is
therefore on this ground the insurer should be ready, enough to pay out its uncertain
claims. So, the insurer must also consider the frequency of the claims and
understand the relentlessness of the business. Hence, an insurance company should
look into its liquidity position. It should maintain its liquidity level to meet out its
uncertain and unpredictable obligations. Liquidity is a position where the payee
stands ready to pay out as soon as possible (basically within one year). In insurance,
the insurer has to settle the claims at the maturity of the period of the policy
undertaken, the time of which is known but at times of uncertain happenings, one
has to call for its liquid assets to pay for it. Thus, as compared to banks it is not a
severe problem in insurance but to maintain the firm‟s credibility, share and
reputation in the market it should have a sound liquidity position. Further, a loss of
confidence in the case of insurance business almost causes policyholders to cancel
cover, demand a return of unexpired premium and might switch over the other
insurance company. The company needs to pay attention that a high degree of
liquidity is also threatening as the assets might lie idle and unnecessary funds get
tied up in currents assets. Therefore it is necessary to strike a balance between high
and lack of liquidity.
4.6.1 Liquid Assets to Current Liabilities
An asset is said to be in liquid when it is converted into cash instantly or
reasonably without a loss of value. Cash is deliberated to be the most liquid asset
and other assets are debtors, bill receivables and marketable securities. As per the
IMF working paper, liquid assets include cash and cash equivalents, government
bonds and quoted corporate bonds and equities. Current liabilities are all those debts
that willmature within one year. Itconsist of creditors, bills payable, accrued
expenses, short term bank loans, income tax liability and long term debt maturing in
the current year. Generally, liquid assets to current liabilities ratio of 1:1 are

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considered satisfactory and result in the better financial condition of a firm.

4.7 Sensitivity to Market Risk

There are two indicators in the Sensitivity to market risk category of the core
set, which measures the insurer‟s exposure to foreign exchange and interest rate
risks. Net open foreign exchange position/capital and Duration of assets and
liabilities are the two ratios that help in analysing the market risk of the company.
Insurer‟s held and manages significant portfolios of assets that are invested to cover
future claims and returns to shareholders.

5. Conclusion

Assessing the financial health of an individual insurer or insurance sector as

a whole is a difficult task. So it needs to take both the quantitative and qualitative
indicators to achieve the acceptable degree of reliability. Therefore the team of IMF
paper publishers has recommended several indicators to analyse the health of the
insurance sector which is known as CARAMEL model. This is a ratio analysis of
various categories in the model dealing with Capital Adequacy, Asset Quality,
Reinsurance, and Actuarial issues, Management soundness, Earnings/Profitability
and Liquidity. It helps in monitoring and controlling the financial performance of
the insurance company insisting on the occurrence of the problems. The user must
be aware of the data accuracy and the underlying assumptions to regulate and
operate the insurance business.

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