What is 'Combined Ratio'
Combined ratio, also called "the combined ratio after policyholder dividends ratio," is a measure of profitability used by an insurance company to gauge how well it is performing in its daily operations. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by earned premium.
BREAKING DOWN 'Combined Ratio'
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 expense ratio gauges the efficiency of an insurer and how well it uses its resources to drive top-line growth. The combined ratio is arguably the most important of these three ratios because it provides a comprehensive measure of an insurer's profitability.
Combined ratio is typically expressed as a percentage. A ratio below 100 percent indicates that the company is making underwriting profit, while a ratio above 100 percent means that it is paying out more money in claims that it is receiving from premiums. Even if the combined ratio is above 100 percent, a company can potentially still be profitable because the ratio does not include investment income.
For example, if an insurer collects $1,000 in premiums and pays out $800 in claims and claim-related expenses, plus another $150 in operating expenses, it would have a combined ratio of 95 percent.
Many insurance companies believe that the combined ratio is the best way to measure success because it does not include investment income and only includes profit earned through efficient management. This is important to note since a portion of dividends will be invested in equities, bonds, and other securities. The investment income ratio (investment income divided by net premiums earned) takes investment income into account, and is used in the calculation of the overall operating ratio.
Combined Ratio Components Examined Together and Individually
The components of the combined ratio each tell a story and should be examined both together and separately in order to understand what is driving the insurer to be profitable or unprofitable. Dividends are generated from the premiums generated from the insurer’s underwriting activities. The loss and loss-adjustment ratio demonstrates how much it costs the insurer to offer one dollar of protection. The expense ratio shows how expensive it is to generate new business, since it takes into account commissions, salaries, overhead, benefits and operating costs.