Understanding The Combined Ratio: A Key Metric In Insurance Performance Evaluation

The combined ratio is a metric used to evaluate the profitability and financial health of an insurance company. It is calculated by adding the loss ratio and expense ratio, or by dividing the sum of incurred losses and expenses by the earned premium. The combined ratio measures whether an insurance company is earning more revenue from its collected premiums relative to the claims it pays out. A combined ratio below 100% indicates that the company is making an underwriting profit, while a ratio above 100% means that the company is paying out more in claims than it is receiving from premiums.

How to calculate the combined ratio

The combined ratio is a metric used to evaluate the profitability and financial health of an insurance company. It is calculated by adding the loss ratio and the expense ratio. The loss ratio is calculated by dividing incurred losses, including loss adjustment expenses, by earned premiums. The expense ratio is calculated by dividing the incurred underwriting expenses by net written premiums.

• Identify the incurred losses: These are the money paid out by the insurance company for claims.
• Calculate the loss adjustment expenses: These are the expenses associated with investigating and settling claims.
• Determine the incurred underwriting expenses: These are the expenses related to acquiring new policies, such as agents' sales commissions, insurance staff salaries, marketing expenses, and other overhead costs.
• Calculate the earned premiums: These are the total premiums collected by the insurance company during the period.
• Calculate the loss ratio: Divide the sum of incurred losses and loss adjustment expenses by the earned premiums.
• Calculate the expense ratio: Divide the incurred underwriting expenses by the net written premiums.
• Find the combined ratio: Add the loss ratio and the expense ratio.

For example, let's consider an insurance company with the following figures:

• Incurred losses: $7,500,000
• Loss adjustment expenses: $3,000,000
• Incurred underwriting expenses: $1,200,000
• Earned premiums: $10,000,000
• Net written premiums: $12,000,000

• Calculate the loss ratio: ($7,500,000 + $3,000,000) / $10,000,000 = 1.05
• Calculate the expense ratio: $1,200,000 / $12,000,000 = 0.1
• Find the combined ratio: 1.05 + 0.1 = 1.15

So, the combined ratio for this insurance company is 115%, indicating that the company is paying out more in claims and expenses than it is receiving in premiums.

It is important to note that the combined ratio is typically expressed as a percentage, and a ratio below 100% indicates profitability, while a ratio above 100% suggests that the company is paying out more than it is earning.

The importance of the combined ratio

The combined ratio is a critical metric for evaluating the financial health and profitability of an insurance company. It provides a comprehensive view of an insurer's performance, profitability, and underwriting policies. This metric is essential for various stakeholders, including investors, analysts, consumers, and regulators. Here's why the combined ratio is important:

Assessing Profitability:

The combined ratio is a profitability metric unique to the insurance industry. It measures whether an insurance company is earning more in revenues from collected premiums than it pays out in claims. A combined ratio below 100% indicates that the company is making an underwriting profit, while a ratio above 100% suggests the company is paying out more in claims than it receives in premiums.

Evaluating Financial Health:

The metric offers a quick summary of an insurance company's financial health. It helps investors, analysts, and consumers understand the insurer's profitability and financial stability. A lower combined ratio generally indicates better financial performance, as it means the company is paying out less in claims and expenses relative to the premiums it collects.

Insight into Underwriting:

The combined ratio provides valuable insight into an insurer's underwriting policies and discipline. It helps stakeholders assess how well the company is pricing its policies and managing risk. A low combined ratio suggests prudent underwriting practices, while a consistently high ratio may indicate that the company is paying out more in claims than it should, potentially impacting its financial health.

Regulatory Oversight:

Regulators use the combined ratio to perform regulatory oversight of insurance companies. It helps them assess if an insurance company is managing its risk appropriately and has the financial capacity to pay claims. This oversight helps maintain the stability and integrity of the insurance industry.

Investment Decisions:

Investors use the combined ratio to make informed investment decisions when considering insurance companies. While the combined ratio doesn't include investment income, it provides a clear picture of the company's underwriting profitability. Investors can then factor in investment income to get a comprehensive view of the company's overall profitability.

Benchmarking and Improvement:

The combined ratio allows insurance companies to benchmark themselves against their peers and identify areas for improvement. Companies aim for a low combined ratio, and by analyzing its components, they can identify ways to improve underwriting practices, claims processing efficiency, and operational costs.

In summary, the combined ratio is a critical tool for assessing the financial health and profitability of insurance companies. It provides valuable insights into underwriting practices, claims payouts, and operational efficiency. This metric helps investors, regulators, and consumers make informed decisions and ensures the stability and transparency of the insurance industry.

The limitations of the combined ratio

The combined ratio is a profitability metric used by insurance companies to assess their financial health and performance. It is calculated by adding the loss ratio and the expense ratio, and it is expressed as a percentage. While it is a useful indicator, the combined ratio has several limitations:

• Exclusion of Investment Income: The combined ratio does not factor in the investment income of insurance companies, which can be a significant source of revenue. As a result, it may not provide an accurate representation of the company's overall profitability.
• Potential for Profit Above 100%: A combined ratio above 100% indicates that an insurance company is paying out more in claims than it is receiving in premiums, suggesting unprofitability. However, this does not consider potential profits from investing premiums, which means the company could still be profitable even with a combined ratio above 100%.
• False Sense of Financial Health: Policyholders may misinterpret a favourable combined ratio as an indicator of excellent financial health, when in reality, the insurance company could be manipulating the ratio in financial statements to provide a false impression.
• Overemphasis on Monetary Aspects: The combined ratio focuses solely on monetary aspects, neglecting the qualitative aspects of a firm's operations. This limitation may provide an incomplete picture of the company's performance and financial health.
• Manipulation of Components: Insurance companies can make specific changes to their financial statements to improve the components of the combined ratio, potentially distorting the true financial picture.
• Lack of Comprehensive Analysis: While the combined ratio is useful for assessing profitability, it does not provide a comprehensive analysis of an insurance company's financial health. It is important to examine other financial metrics and ratios to gain a complete understanding.

The difference between the combined ratio and the loss ratio

The combined ratio and the loss ratio are both measures used to assess an insurance company's profitability and sustainability. However, there are several differences between the two ratios.

The loss ratio measures the total incurred losses in relation to the total collected insurance premiums. It is calculated by dividing the total incurred losses by the total collected insurance premiums. A low loss ratio indicates a high level of profitability for the company, while a high ratio indicates a loss.

On the other hand, the combined ratio measures the incurred losses and expenses in relation to the total collected premiums. It is calculated by summing the incurred losses and expenses and dividing the sum by the total earned premiums. The combined ratio is essentially the sum of the loss ratio and the expense ratio.

While the loss ratio compares the total amount of incurred losses to the total of earned premiums, the combined ratio compares the total amount of incurred losses and expenses to the total amount of earned premiums. In other words, when calculating the loss ratio, it does not account for other administrative and miscellaneous expenses incurred during the course of examining claims and paying premiums.

The combined ratio is typically expressed as a percentage. A ratio below 100% indicates that the company is making an underwriting profit, while a ratio above 100% means that the company is paying out more money in claims than it is receiving from premiums.

For example, if an insurer collects $1,000 in policy premiums and pays out $800 in claims and claim-related expenses, plus another $150 in operating expenses, it would have a combined ratio of (800 + 150) / 1,000 = 95%.

It is important to note that even if the combined ratio is above 100%, a company can still be profitable because the ratio does not include investment income. Therefore, the combined ratio may not provide an accurate representation of the company's true financial state.

How to improve the combined ratio

The combined ratio is a profitability metric used by insurance companies to assess their financial health and performance. It is calculated by adding the loss ratio and expense ratio, or by dividing the total sum of incurred losses and expenses by the earned premium. A combined ratio below 100% indicates that an insurance company is profitable, while a ratio above 100% means that it is paying out more in claims than it is earning in premiums.

• Support the underwriting function: Underwriters play a critical role in risk pricing. By improving their understanding of what they are insuring and investing in their capabilities (e.g. through formal training), insurance companies can make more accurate assessments of risk. Advanced analytics solutions can also help improve pricing accuracy.
• Improve efficiency in claim processing: Quicker and more efficient claim processing will reduce the loss and expense ratio, increase revenue, and improve customer satisfaction. This can be achieved through digitization, automation, and the use of technologies such as chatbots.
• Reduce procurement and administrative costs: Procurement and administrative costs make up a significant portion of insurers' expenses. By optimizing vendor networks, eliminating redundant hardware/software, and negotiating improved rates, insurance companies can reduce these costs and improve their combined ratio.
• Focus on revenue growth, customer engagement, and productivity: Insurance companies need to transform their traditional operating models and approaches to increase revenue growth, engage and retain customers, and maximize profitability. This includes updating technology to support business strategies and goals, such as real-time insurance personalization and telematics for UBI.
• Reduce admin expenses: By reducing the operational costs associated with taking payments, insurance companies can lower their combined ratio. This includes reducing credit card processing fees and compliance costs, as well as streamlining the reconciliation process.

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