Combined Ratio – A tool insurers use to measure performance
Picture an insurance company that incurred losses and spent more in underwriting expenses than it received in premiums. Now, that’s a troublesome sight! These are the types of financial dilemmas the combined ratio is meant to help avoid.
TL;DR
- The combined ratio is the sum of the loss ratio and expense ratio.
- It’s a crucial metric for gauging an insurer’s efficiency and financial health.
- Misunderstanding or miscalculating the combined ratio can lead to an inaccurate assessment of an insurance company’s profitability.
- Navigating the combined ratio becomes easier once you understand its components and derivations.
What is Combined Ratio in Insurance?
Think of combined ratio like a financial scorecard for insurers. The more precise the game, the better the score.
From a client’s viewpoint, the combined ratio provides a snapshot of an insurer’s financial stability and efficiency. It includes both claims expenses (incurred losses, loss adjustment expenses) and the costs to acquire, write, and renew policies (underwriting expenses).
On a more technical level, it’s found on the underwriting portion of an insurer’s financial statements. The combined ratio is calculated by adding the loss ratio (incurred losses plus loss adjustment expenses divided by earned premiums) and the expense ratio (underwriting expenses divided by written premiums). It represents the amount of every premium dollar that an insurer spends on claims and business expenses.
Key Related Terms to Know
- Loss Ratio – The percentage of premiums paid out as claims by the insurer.
- Expense Ratio – The percentage of premiums used to cover insurance company expenses, excluding losses.
- Incurred Losses – The total amount an insurance company pays on claims.
- Earned Premiums – The portion of an insurance company’s written premiums equal to the coverage provided during a policy period.
- Underwriting Expenses – Costs incurred by an insurer to underwrite insurance policies.
- Operating Ratio– A version of the combined ratio that includes income from investments and other sources.
Common Questions About Combined Ratio
What does the combined ratio tell us?
The combined ratio provides insights into the profitability and efficiency of an insurer’s underwriting operations. If the combined ratio is below 100%, the insurer is generating an underwriting profit from its operations. If the ratio is above 100%, the insurer is paying out more in claims and expenses than it is earning in premiums.
How is the combined ratio calculated?
The combined ratio calculation involves adding the loss ratio (incurred losses and loss adjustment expenses divided by earned premiums) and the expense ratio (underwriting expenses divided by written premiums).
When does the combined ratio indicate an unprofitable business?
A combined ratio above 100% generally signifies that an insurer’s underwriting business is unprofitable. The company is paying out more in claims and expenses than it’s receiving in premiums.
Can an insurer still be profitable with a combined ratio over 100%?
Yes, an insurer can still be profitable with a combined ratio over 100% if it has substantial investment income. Despite incurring an underwriting loss, they can offset these losses with earnings from investments.
Combined Ratio vs. Operating Ratio
At the core, the combined ratio and operating ratio both offer a glance into an insurer’s profitability. However, while the combined ratio focuses solely on the underwriting operations, the operating ratio also considers investment income and other income streams.
Comparison Area | Combined Ratio | Operating Ratio
|
Primary use case | Measures the profitability of underwriting operations | Presents a fuller picture of insurer’s earnings |
Coverage / concept type | Underwriting focus | Underwriting plus investments |
Typical exclusions | Investment income | – |
Who is most affected by errors | Insurers, business owners, financial analysts | Insurers, investors, financial analysts |
Common mistakes | Misinterpretation, incorrect calculations | Overlooking income from sources other than underwriting |
Real Claim Examples Involving Combined Ratio
Scenario 1: An insurer had earned premiums of $300 million, incurred losses of $180 million, and underwriting expenses of $90 million. The combined ratio was 90%, indicating a profitable underwriting business despite the significant incurred losses.
Scenario 2: An insurance company reported a combined ratio of 110%. While it looked unprofitable at first glance, the insurer had substantial investment income that compensated for the underwriting losses.
Scenario 3: An insurer had a combined ratio of 75%. While it seemed incredibly efficient, deeper investigation revealed that they had been under-reserving for potential future claims, skewing the ratio.
Limitations and Common Mistakes
- The combined ratio doesn’t include investment income, a significant source of profit for many insurers.
- The ratio overlooks variations across different lines of insurance within the same company.
- Despite appearing profitable with a combined ratio below 100%, the insurer may be under-reserving for claims.
- Misinterpreting a combined ratio over 100% as always unprofitable is a common error.
How to Explain Combined Ratio to Clients
Personal Lines client “Think of the combined ratio like a report card for insurance companies. It tells us how well they’re doing in handling their claims and expenses. A score below 100 is like an A-grade, meaning they’re spending less than what they earn in premiums.”
Small Business Owner “The combined ratio gives you an idea about an insurer’s financial health. A good score, less than 100, means they’re making profit from their basic insurance business, which could mean stability for your policy in the long-run.”
CFO or Risk Manager “Combined ratio is a key metric for insurers, representing the percentage of premium dollars they spend on claims and expenses. A ratio over 100% indicates an underwriting loss—though they can still turn a profit if they have substantial investment income.”