One of the most commonly cited metrics of a (re)insurance company’s success—and perhaps a term those new to the industry are unfamiliar with—is the combined ratio. Put simply, a combined ratio is a measure of an insurance company’s profitability expressed in terms of the ratio of total costs divided by total revenue—which for insurance companies translates to incurred losses plus expenses divided by earned premiums:
Combined Ratio = (Incurred Losses + Expenses)/Earned Premiums
In this post, we’ll discuss how to interpret combined ratios, walk through the steps for calculating them, and then touch on some related metrics.
The Meaning Behind Combined Ratios
A combined ratio of more than 100% means that an insurance company had more losses plus expenses than earned premiums and lost money on its operations. Conversely, a combined ratio of less than 100% means that a company had more earned premiums than losses plus expenses and is operating in the black, while a combined ratio of exactly 100% is the break-even point.
Combined ratios are seen as a good measure of an insurance company’s financial health because they examine profitability only from the standpoint of the company’s insurance operations. Insurance companies, however, don’t just make money from charging their customers premiums—revenue also comes from investment income in stocks, bonds, the core business of selling insurance policies. So a company can have a combined ratio above 100% but still be profitable overall because there could be sizable additional revenues from investments.
Calculating the Metric and Defining Key Terms
The more detailed formula for combined ratio breaks out expenses to include the following:
Combined Ratio = (Incurred Losses + Loss Adjustment Expenses + Other Underwriting Expenses)/Earned Premiums
Incurred Losses refers to actual monies paid out in claims plus the change in “loss reserves.” Loss reserves are liabilities—these are claims that have occurred, but have not been paid out yet by an insurer. The exact dollar amount of claims can take days to years to determine, and so loss reserves are estimates of what the future cost of claims will be. Note that these incurred losses are not to be confused with probabilistic losses in the context of catastrophe modeling!
Expenses refers to the costs of operating an insurance company, and Loss Adjustment Expenses refers to the variable costs associated with investigating and settling each claim, and can include everything from claims adjusters salaries to legal fees. Insurers also set aside reserves (“loss adjustment expense reserves”), which are liabilities for expenses that have incurred, but have not yet been paid to settle claims.
Other Underwriting Expenses are expenses related to underwriting and consist of agents’ sales commissions, insurance staff salaries, marketing expenses, and other overheard expenses.
Premiums, as you likely know, refers to the money that someone pays for an insurance policy. Insurance companies recognize revenue as Earned Premiums proportionally as time passes during the life a policy (and not when premiums are written or received).
Related Insurance Metrics You Now Already Know
The combined ratio formula comprises two related ratios that you can now derive quite easily. A loss ratio or “claims ratio,” is simply the ratio of incurred losses from claims plus the cost of settling claims to earned premiums: Loss Ratio = (Incurred Losses + Loss Adjustment Expenses)/Earned Premiums). This ratio provides insight into the quality of the policies an insurance company writes and the rates it charges.
Expense ratio is the ratio of underwriting expenses to earned premiums (Expense Ratio = Expenses/Premiums). It tells you how efficient an insurance company’s operations are at bringing in premium.
In today’s reinsurance market, it’s been reported that combined ratios for property/casualty increased by about 4 points in 2016 to 99% and that we’re in what is often referred to as a “soft” reinsurance market. In a future post, we will take a look at the cyclical nature of the (re)insurance industry, and talk through some of the reasons for why we’re in such a soft market.