The combined ratio is a quick and simple way to measure the profitability and financial health of an insurance company. The combined ratio measures whether the insurance company is earning more revenues from its collected premiums relative to the claims it pays out.

The combined ratio is calculated by adding the loss ratio and expense ratio. The former is calculated by dividing the incurred losses, including the loss adjustment expense, by earned premiums. Under a trade basis, the expense ratio is calculated by dividing the incurred underwriting expenses by the net written premiums. On a financial basis, the expense ratio is calculated by dividing the incurred underwriting expenses by the earned premiums.

Key Takeaways

  • The combined ratio is a quick and simple way to measure the profitability and financial health of an insurance company.
  • The combined ratio measures whether the insurance company is earning more revenues from its collected premiums relative to the claims it pays out.
  • The combined ratio is calculated by adding the loss ratio and expense ratio.
  • Under the trade basis combined ratio, the insurance company is paying out less than the premiums it receives. Conversely, under the financial basis combined ratio, the insurance company is paying out the same amount as the premiums it receives.

For example, insurance company ZYX has incurred underwriting expenses of $10 million, incurred losses and loss adjustment expenses of $15 million, net written premiums of $30 million and earned premiums of $25 million.

Calculate ZYX's financial basis combined ratio by adding the incurred losses and loss adjustment expenses with the incurred underwriting expenses. The financial basis combined ratio is 1, or 100% (($10 million + $15 million)/$25 million). The financial basis gives a snapshot of the current year's statutory financial statements.

You can also calculate the combined ratio on a trade basis, where you divide the incurred losses and loss adjustment expenses by earned premiums and add to the incurred underwriting expenses divided by net written premiums. The trade basis combined ratio of insurance company XYZ is 0.93, or 93% ($15 million/$25 million + $10 million/$30 million).

Under the trade basis combined ratio, the insurance company is paying out less than the premiums it receives. Conversely, under the financial basis combined ratio, the insurance company is paying out the same amount as the premiums it receives.

Why Combined Ratio are Important

Many investors place too much emphasis on losses when examining an insurance company's financials. News headlines trumpet the effect a natural disaster such as a blizzard or a hurricane will have on an insurance company's profits, incorrectly making it appear as though a singular event is the only factor determining a company's long-term viability. On the other hand, combined ratios offer a more accurate projection of a company's health over the long haul.