Combined Ratio

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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[1]

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 a property or casualty insurer [2].

Combined Ratio Formula

\(\frac{Incurred\ losses + Expenses}{Earned\ premium}\) [3]

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 1O5 %. 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. In fact, 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 reffered to as the operating ratio [4]."

References

Footnotes

  1. D. Skipton, 2015, p. 21
  2. Government Accountability Office, 2010, p. 74
  3. CFA Institute, 2018, p. 279
  4. J. C. Hull 2012, p. 53

Author: Aleksandra Walawska