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,
- 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..
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. 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’.companies.
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.
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
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.
- It gives a better picture of how efficiently premium levels were set.
- It indicates the management of a company where the company is making a profit or not i.e., if the earning is more /less then payments.
- It is the best way to calculate the profit since it does not take into account 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. measures the efficiency of the company on the standard of its underwriting methodology. In contrast, expense ratio measures how well proper is the overall operation of the company.
- 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. because it excludes the investment income. These companies earn a good source of income from investments in bonds, stocks, and other financial instruments that are outside their core business.
- It is made up of many components. We tend to focus just on the CR number and miss about 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. .
- 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. to improve the components of the combined ratio, and thus this ratio ends up nothing but window dressing.
- It only takes into consideration the monetary aspects of the firm and ignores the qualitative aspects.
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.
- 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.
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 –