Loss Ratio vs. Combined Ratio: An Overview
The loss ratio and combined ratio are used to measure the profitability of an insurance company. The loss ratio measures the total incurred losses in relation to the total collected insurance premiums, while the combined ratio measures the incurred losses and expenses in relation to the total collected premiums.
- The loss ratio and combined ratio are used to measure the profitability of an insurance company.
- The loss ratio measures the total incurred losses in relation to the total collected insurance premiums.
- The combined ratio measures the incurred losses as well as expenses in relation to the total collected premiums.
The loss ratio is calculated by dividing the total incurred losses by the total collected insurance premiums. The lower the ratio, the more profitable the insurance company, and vice versa. If the loss ratio is above 1, or 100%, the insurance company is unprofitable and maybe in poor financial health because it is paying out more in claims than it is receiving in premiums. For example, say the incurred losses, or paid-out claims, of insurance company ABC are $5 million and the collected premiums are $3 million. The loss ratio is 1.67, or 167%; therefore, the company is in poor financial health and unprofitable because it is paying more in claims than it receives in revenues.
Enterprises that have a commercial property and liability policies are expected to maintain loss ratios above a certain level. Otherwise, they may face premium increases and cancellations from their insurer. For example, take a small dealer of used commercial equipment, who pays $20,000 in annual premiums to ensure their inventory. A hailstorm causes $25,000 in damages, for which the business owner submits a claim. The insured's one-year loss ratio becomes $25,000 / $20,000, or 125%.
In order to ascertain what kind of premium increase is warranted, carriers may review claims history and loss ratios for the past five years. If the insured has a very brief tenure with the insurer, the company may decide that the commercial equipment dealer presents an unacceptable future risk. At that juncture, the carrier may choose not to renew the policy.
A combined ratio measures the money flowing out of an insurance company in the form of dividends, expenses, and losses. Losses indicate the insurer's discipline in underwriting policies.
The combined ratio is usually expressed as a percentage. A ratio below 100% indicates that the company is making underwriting profit, while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums. Even if the combined ratio is above 100%, a company can potentially still be profitable because the ratio does not include investment income.
The combined ratio is calculated by summing the incurred losses and expenses and dividing the sum by the total earned premiums.
For example, suppose insurance company XYZ pays out $7 million in claims, has $5 million in expenses, and its total revenue from collected premiums is $60 million. The combined ratio of company XYZ is 0.20, or 20%. Therefore, the company is considered profitable and in good financial health.
The two ratios are different because the combined ratio takes expenses into account, unlike the loss ratio. Thus, the two ratios should not be compared to each other when evaluating the profitability of an insurance company.