Combined Ratio

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,

Combined Ratio = Underwriting Loss Ratio + Expense Ratio
Combined-Ratio

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Combined Ratio (wallstreetmojo.com)

where,

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

Underwriting Expenses are expenses linked to underwriting and comprise of 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 one is a calculation derived 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 as a composite ratio. It is used by 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 morecompanies.

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. combined ratio is calculated by summing up the losses incurred and adjustment 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 ratio of adjustment of losses by premium earned and the ratio of underwriting expense by net premium written.

Calculation of Combined Ratio

combined ratio example 1
  • =$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

Disadvantages

Limitations

Having many advantages, it also has certain limitations. The various elements that make build 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 as well as together as a whole to determine the company’s financial performance accurately.

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 in relation to the total premium collected by the business.
  • It is the most effective and most straightforward way to measure how profitable the company is
  • It 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 cases of trade basis combined ratio, the insurance company pays less than the premiums it receives. Alternatively, when we take into consideration the financial basis combined ratio, the insurance company is paying out the equivalent amount as the premiums it receives.
  • A healthy combined ratio in the field of insurance sectors is generally considered to be in the range of 75% to 90%. It indicates a large part of premium earned is used to cover up 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 to know 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 have understood now 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.

This article has been a guide to Combined Ratio and its definition. Here we discuss the formula for calculation of combined ratio in insurance along with its example, advantages, and disadvantages. You may also have a look at these articles below to learn more about financial analysis –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *