Combined Ratio In Insurance Definition Formula Calculation

Combined Ratio in Insurance Definition

The combined ratio, which is generally used in the insurance sector (especially in property and casualty sectors), is the measure of profitability to understand how an insurance company is performing in its daily operations and is by the addition of two ratios, i.e., underwriting loss ratio and expense ratio.

Combined Ratio Formula

Combined Ratio Formula is represented as below,

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where,

Underwriting Loss Ratio = (Claims paid + Net loss reserves) /Net premium earnedExpense Ratio = Underwriting expenses including commissions /net premium written

Underwriting Expenses are expenses linked to underwriting and comprise agents’ sales commissions, insurance staff salaries, marketing expenses, and other overhead expensesOverhead ExpensesOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more.

Components of Combined Ratio in Insurance

It constitutes the sum of two ratios. The first is calculated by dividing loss incurred plus loss adjustment expense (LAE) by premiums earned, i.e., the calendar year loss ratio). And the second one is calculated by dividing all other expensesAll Other ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more by the written or earned premiums, i.e., statutory basis expense ratio. When the resultant is applied towards the final result of a company, the combined ratio is also termed a composite ratio. Both insurance and reinsurance Reinsurance Reinsurance is a tool used by the insurance companies to reduce their claim liability by getting some of it insured by another company. It helps prevent insurance companies from insolvency. The company insuring the claims is called the ‘Reinsurer’ and the company getting insured is called the ‘Ceding company’.read more companies use it.

Example of Combined Ratio in Insurance

Let us assume ABZ Ltd. is an insurance company. The company’s overall underwriting expense is calculated to be $50 million. It has incurred a loss, and also adjustment made towards it is $75.The company’s net premium written stands at $200 million, and in the year, it has earned an overall premium of $150 million.

Solution

ABZ Ltd.’s combined ratio is calculated by summing up the losses incurred and adjustments made towards it and dividing the resultant with the premium earned. Thus the financial basis combined ratio is 0.83, or 83% (i.e. $50 million + $75 million)/$150 million.

To calculate the combined ratio on a trade basis, sum up the adjustment ratio of losses by premium earned and the ratio of underwriting expenses by net premium written.

Calculation of Combined Ratio

=$0.50+$0.33=$0.83

The trade basis combined ratio of ABZ Ltd. thus stands to be 0.83, or 83%, i.e., $75 million/$150 million + $50 million/$150 million.

Combined Ratio – Practical Scenario

The combined ratio is usually considered as a measure of the profitability of an insurance company; It is indicated in a %, and if it is more than 100%, it means that the company is paying more than it is earning, while if it is less than 100%, it means that it is earning more than what it is paying.

Advantages

It gives a better picture of how efficiently premium levels were set.It indicates the company’s management where the company is making a profit or not, i.e., if the earnings is more /less than payments. It is the best way to calculate the profit since it does not consider the investment income and only concentrates on underwriting operations.Both the components of the combined ratio can be explained separately. The underwriting loss ratioLoss RatioThe loss ratio depicts the insurance company’s percentage loss on claim settlement compared to the premium received during a particular period. A higher ratio is a matter of concern for the insurer.read more measures the company’s efficiency on the standard of its underwriting methodology. In contrast, the expense ratio measures how well proper the company’s overall operation is.

Disadvantages

It does not give the entire picture about the profitability of the companyProfitability Of The CompanyProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more because it excludes the investment income. These companies earn a good source of income from investments in bonds, stocks, and other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more that are outside their core business.It is made up of many components. We tend to focus just on the CR number and miss analyzing the components it is made up of.We cannot tell if the CR is more significant than 100%, which means a company is not profitable because it may happen the company is making a fair amount of profit from other investment incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more.The firm can make specific changes to its financial statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more to improve the components of the combined ratio, and thus this ratio ends up nothing but window dressing.It only considers the monetary aspects of the firm and ignores the qualitative aspects.

Limitations

Having many advantages, it also has certain limitations. The various elements that make up the combined ratio (losses, expenses, and earned premium) each act as a benchmark of the potential for profitability or the risk of loss. Thus, it is necessary to understand these components individually and together to accurately determine the company’s financial performance.

Important Points

It is used to measure the profitability of an insurance company, specifically property and casualty-based insurance companies.The combined ratio measures the losses made and expenses about the total premium collected by the business.It is the most effective and most straightforward way to measure how profitable the company isIt is a way to measure if premiums collected as revenue are more than the claim-related payment it has to pay.It is the easiest way to measure if the business or company is financially healthy or not.It is determined by summing up the loss ratio and expense ratio.In trade basis combined ratio cases, the insurance company pays less than its premiums. Alternatively, when we consider the financial basis combined ratio, the insurance company pays the equivalent amount as the premiums it receives.A healthy combined ratio in insurance sectors is generally considered to be in the range of 75% to 90%. It indicates that a large part of the premium earned is used to cover the actual risk.

Conclusion

To conclude, we can tell that calculating the combined ratio is easy once we know where to get the numbers from. The biggest hint is knowing the meaning and discovering where to locate the numbers in the financial reports. It can be challenging if we don’t know what and where to look.

We now understand how combined ratios can support us to identify which insurance companies are profitable and those that are not good enough. It is a ratio that applies to mostly property-casualty insurance companies. We have a different set of ratios that apply to life insurance companies.