Demystifying the Combined Ratio: Meaning, Measurements, Formula, and Illustrations

The combined ratio is a key financial metric used in the insurance industry to assess the profitability and operational efficiency of an insurance company. It provides insights into an insurer's underwriting performance and its ability to manage claims and expenses. Here, we'll demystify the combined ratio by explaining its meaning, measurements, formula, and providing illustrations.

Meaning:The combined ratio is a measure of an insurance company's overall underwriting profitability. It expresses the relationship between premiums earned, claims incurred, and underwriting expenses. A combined ratio below 100% indicates profitable underwriting, while a ratio above 100% suggests an underwriting loss.

Measurements:The combined ratio typically comprises three components:

1. Loss Ratio (LR): This represents the percentage of premiums earned that an insurer pays out in claims. A lower loss ratio indicates that the insurer is effectively managing its claims.

2. Expense Ratio (ER): This measures the percentage of premiums earned spent on underwriting expenses, such as employee salaries, commissions, and administrative costs. A lower expense ratio suggests efficient cost management.

3. Combined Ratio (CR): The combined ratio is the sum of the loss ratio and expense ratio. It reflects the total percentage of premiums used to cover claims and expenses. A combined ratio below 100% indicates profitability.

Formula:The combined ratio is calculated using the following formula:

Combined Ratio (CR) = Loss Ratio (LR) + Expense Ratio (ER)

Illustrations:

1. Company A: Let's consider an insurance company, Company A, which has the following metrics for a specific period:

   • Premiums earned: $10 million
   • Claims incurred: $4 million
   • Underwriting expenses: $2 million

   Calculating the components:

   • Loss Ratio (LR) = ($4 million / $10 million) * 100% = 40%
   • Expense Ratio (ER) = ($2 million / $10 million) * 100% = 20%
   • Combined Ratio (CR) = LR (40%) + ER (20%) = 60%

   A combined ratio of 60% indicates that Company A is operating efficiently, with a 40% profit margin from underwriting activities.

2. Company B: Now, let's consider Company B with the following metrics:

   • Premiums earned: $12 million
   • Claims incurred: $8 million
   • Underwriting expenses: $3 million

   Calculating the components:

   • Loss Ratio (LR) = ($8 million / $12 million) * 100% = 66.67%
   • Expense Ratio (ER) = ($3 million / $12 million) * 100% = 25%
   • Combined Ratio (CR) = LR (66.67%) + ER (25%) = 91.67%

   A combined ratio of 91.67% indicates that Company B is experiencing an underwriting loss as it's spending more on claims and expenses than it's earning in premiums.

Interpretation:

• A combined ratio below 100% suggests profitable underwriting operations. Lower combined ratios indicate better profitability.
• A combined ratio exceeding 100% indicates an underwriting loss, meaning that the insurer is paying out more in claims and expenses than it's collecting in premiums.
• Insurers strive to maintain a combined ratio below 100% to ensure profitability in their core underwriting operations. If the combined ratio consistently exceeds 100%, it may indicate a need for operational improvements or premium rate adjustments.

In summary, the combined ratio is a fundamental metric in the insurance industry that helps assess underwriting performance and profitability. It's crucial for insurance companies to closely monitor and manage their combined ratios to ensure financial sustainability.