The expense ratio in the insurance industry is a measure of profitability calculated by dividing the expenses associated with acquiring, underwriting, and servicing premiums by the net premiums earned by the insurance company.
The expenses can include advertising, employee wages, and commissions for the sales force. The expense ratio signifies an insurance company's efficiency before factoring in claims on its policies and investment gains or losses.
- The expense ratio compares an insurance company's expenses incurred when underwriting a policy to the revenues it expects to receive from it.
- Insurers may calculate the expense ratio using net premiums written that fall under either GAAP or statutory accounting best practices and guidance.
- The expense ratio is a key piece of the combined ratio, which is the industry standard for measuring insurer efficiency and profitability.
Two Different Methods
There are two ways to calculate expense ratios. Insurance companies typically use statutory accounting as opposed to generally accepted accounting principles (GAAP) accounting to calculate their expense ratios, as statutory accounting yields more conservative ratios.
Although the expenses are the same in both ratios, statutory accounting uses the net premiums written during the period in the denominator to get the expense ratio.
GAAP accounting uses the net premiums earned during the period. Net premiums written represent the new business brought in by the company, while net premiums earned may include both new business and recurring business from existing policies.
Health Insurance and the Expense Ratio
Since the Affordable Care Act (ACA) was passed in 2010, the so-called 80/20 Rule was enacted, which applies to health insurers. Known as the medical cost ratio (MCR), the rule states that health insurance carriers must return 80% (or up to 85% depending on the size of the plan) of health insurance premium income to pay for healthcare services to the policyholders.
More recently, the Trump administration released changes to the 80/20 Rule. As of 2020, individual states can adjust the 80% level to entice insurance providers to underwrite policies in their state.
A Precursor to Overall Profitability
The expense ratio can hence be used to compare companies and analyze a company's performance over time. An expense ratio under 100% signifies that the insurance company is either earning or writing more premiums than it is paying out in expenses to generate or support these premiums. Although its expense ratio can be stellar, the overall profitability of an insurance company is affected by its loss ratio, investment income, and other gains and losses.
Thus, the expense ratio is not a measure of ending profitability. Instead, it is a precursor to finding an insurance company's overall profitability.