Combined Ratio

The most important indicator of profitability in the insurance business is known as the combined ratio, which is the cost of claims plus the other cost of claims, divided by the total collected premiums. The formula helps to measure the performance of insurance companies

The calculation of loss ratio insurance costs plus compensation modification costs about net received premiums. An increasing loss ratio means rising insurance costs relative to the premiums, which may be due to higher claim costs, decreased premium revenue, or a combination of both. The cost ratio calculates the level of operating expenditure underwriting relative to the net premiums earned and is a measure of quality underwriting. The combined ratio is an approximate indicator of the underwriting efficiency of.:

• property insurer
• casualty insurer.

Combined Ratio Formula

According to a US insurance company "combined ratio determined by dividing losses and expenses incurred by net premium earned":

${\frac {Incurred\ losses+Expenses}{Earned\ premium}}$

Ratios determined by insurers

"Suppose that for a particular category of policies in a particular year the loss ratio is 75% and the expense ratio is 30%. The combined ratio is then 105 %. Sometimes a small dividend is paid to policyholders. Suppose that this is 1% of premiums. When this is taken into account we obtain what is referred to as the combined ratio after dividends. This is 106% in our example. This number suggests that the insurance company has lost 6% before tax on the policies being considered. This may not be the case.

Premiums are generally paid by policyholders at the beginning of a year and payouts on claims are made during the year or after the end of the year. The insurance company is, therefore, able to earn interest on the premiums during the time that elapses between the receipt of premiums and payouts. Suppose that, in our example, investment income is 9% of premiums received. When the investment income is taken into account, a ratio of 106-9 = 97% is obtained. This is referred to as the operating ratio ."

Examples of Combined Ratio

• A large health insurance company has a combined ratio of 95%, which means that the company is operating at a 5% profit margin. This means that for every dollar of premiums the company collects, it earns five cents of profit.
• A property and casualty insurance company has a combined ratio of 110%. This means that the company is operating at a 10% loss margin, meaning that for every dollar of premiums collected, the company loses ten cents.
• An automobile insurance company has a combined ratio of 85%. This means that the company is operating at a 15% profit margin. For every dollar of premiums collected, the company earns fifteen cents of profit.

Advantages of Combined Ratio

The Combined Ratio is a useful tool for assessing the profitability of an insurance company. It helps to measure the performance of an insurance company by comparing the total claims and other operating expenses to the total collected premiums. The following are some of the advantages of the Combined Ratio:

• The Combined Ratio allows insurers to compare the cost of claims and other expenses to the total collected premiums, making it easier to identify areas for improvement.
• The Combined Ratio helps insurers to measure their profitability and identify potential problems, allowing them to make informed decisions about their business.
• The Combined Ratio provides a single metric for measuring the performance of an insurance company over time, allowing insurers to track their performance and adjust their operations accordingly.
• The Combined Ratio helps insurers to assess their risk levels and better manage their assets, allowing them to remain competitive in the market.
• The Combined Ratio provides a simple, easy-to-understand metric for insurers to use in order to compare their performance to that of their peers.

Limitations of Combined Ratio

The combined ratio is a useful tool for evaluating the performance of an insurance company, however, it has some limitations. These include:

• It does not take into account the total costs of running the business, such as administrative expenses, advertising and sales costs.
• It does not consider the company's investment income, which can be a significant source of revenue.
• It does not factor in the impact of inflation or other economic factors on the cost of claims.
• It cannot be used to evaluate the long-term profitability of an insurance company, as it does not measure the sustainability of the company's financial results.
• It does not provide insight into the underlying drivers of the company's performance, such as the effectiveness of its underwriting and pricing strategies.

Other approaches related to Combined Ratio

The Combined Ratio is a useful tool to measure the performance of insurance companies, but there are other approaches that can be used to assess profitability in the insurance business. These include:

• Loss Ratio: This measure is the total amount of losses paid out divided by the total amount of premiums paid, and gives a good indication of the costs associated with providing insurance.
• Expense Ratio: This ratio measures the operating expenses of an insurance company, such as salaries, commissions, and other overhead costs, as a percentage of the total premiums collected.
• Investment Income Ratio: This ratio measures the income generated from investments by the insurance company, such as interest, dividends, and capital gains, as a percentage of the total premiums collected.
• Return on Equity (ROE): This measure shows the net income generated from the insurance business divided by the equity of the company, and gives a good indication of the overall profitability of the business.

In summary, the Combined Ratio is an important tool to measure profitability in the insurance business, but other approaches such as the Loss Ratio, Expense Ratio, Investment Income Ratio, and Return on Equity (ROE) can also be used to assess the performance of an insurance company.

Combined Ratio — recommended articles

Return on sales — Cost-income ratio — Gross margin in retail industry — Berry Ratio — Basic earnings power — Return on investment — Operating expense ratio — Net income — Economic income

References

• CFA Institute, (2018)., CFA Program Curriculum 2019 Level I Volumes 1-6 Box Set, John Wiley & Sons, United States of America
• Hull J. C., (2012), Risk Management and Financial Institutions, John Wiley & Sons, United States of America
• J. D. Cummins, B. Venard, (2007)., Handbook of International Insurance: Between Global Dynamics and Local Contingencies, Springer Science & Business Media, United States of America
• Saporito P. L., (2014), Applied Insurance Analytics: A Framework for Driving More Value from Data Assets, Technologies, and Tools, FT Press, United States of America
• Skipton D., (2015), The Claims Game: The Tricks and Deceptive Tactics Insurance Companies Use to Underpay or Deny Your Claim, Lulu.com, United States of America
• U. S. Government Accountability Office, (2010)., Troubled Asset Relief Program: Update of Government Assistance Provided to AIG, Diane Publishing, United States of America

Footnotes

Author: Aleksandra Walawska