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 is combined with the loss ratio to give an insurance company's combined ratio.
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 are the new business brought in by the company, while net premiums earned may include both new business and recurring business from existing policies.
A Precursor to Overall Profitability
The expense ratio can be used to compare companies and analyze a company's performance over time. An expense ratio under 100% signifies the insurance company is either earning or writing more premiums than it is paying out in expenses to generate and/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. (For related reading, see: What is the usual profit margin for a company in the insurance sector?)