What is Loss Ratio?
The 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.
Loss Ratio Formula
The loss ratio is calculated as losses incurred in claims (pays to the insured for damages when the risk event happens) plus adjustment expenses (incurred by the insurance company for investigating and settling an insurance claimAn Insurance ClaimAn insurance claim refers to the demand by the policyholder to the insurance provider for compensating losses incurred due to an event covered by the policy. The company either validates or denies the claim based on their assessment and nature of the incurred losses.) divided by the premiums earned during the period.
For example, if an insurer collects $120,000 in premiums and pays $60,000 in claims and adjustment expenses. The loss ratio for the insurer will be calculated as $60,000/$120,000 = 50%.
Understanding Loss Ratio
Loss Ratio gives a first-hand estimate of the profitability of the insurance company from its core business. It is like calculating gross margins (the difference between revenue and direct costsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. like raw materials and fuel) for other businesses. The gross margin tells you what a manufacturing or service business makes from its core business without factoring in the other operating and administrative overheadsAdministrative OverheadsAdministrative overheads are expenses that are not directly linked to the production & distribution of goods & services but are indirect in nature, such as expenses incurred in the policy formulation, employee cost, legal and audit fees, telephone and electricity expenses..
Insurance companies make money and stay solvent when they pay out (claims) lesser than what they collect (premiums) in a particular period. When an insurance company is regularly paying out a higher proportion of premiums in losses, it can run into financial trouble, lose its capital, and default on future claims. Therefore, it is always advisable for insurance companies to maintain adequate loss ratios to continue to be in the business.
This ratio differs across insurance sectors, and some sectors may have a higher ratio than the other sectors. For example, property and casualty insurance tend to have a lower loss ratio than health insurance.
Types of Loss Ratio in Insurance
The following are two types –
#1 – Medical Loss Ratio
It is generally used in health insurance and is stated as the ratio of healthcare claims paid to premiums received. Health insurers in the united states are mandated to spend 80% of the premiums received towards claims and activities that improve the quality of care. Failing the condition, the insurers have to give the excess funds back to the consumers.
#2 – Commercial Insurance Loss Ratio
This is meant for the insured, wherein the insured is required to maintain an adequate loss ratio, failing which the business risksBusiness RisksBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand. non-renewal of insurance or increased premium for the cover. For example, a furniture store pays $3,000 in premium to ensure the inventory, and a hailstorm causes the damage of $4000, the ratio for one year becomes $4000/$3000 or 133%. In this case, the insurer will look at the long-term claim history of the insured and take a call on increasing the premium or not renewing the policy.
Real Life Example of Loss Ratio
Farmers insurance posted a loss ratio of 155% while Allstate corp posted a ratio of 257%.
Why Loss Ratio is Useful?
Below are some of the reasons why loss ratios are useful in insurance industry –
- It helps to determine the profitability of the insurance company.
- Comparison of loss ratios amongst different insurance companies can give us useful insights into the businesses and differences in business models of these companies.
- This ratio helps to determine the premiums of future policies as the companies take regular feedback for issued policies and tweak pricing to stay competitive and profitable.
- Different insurance companies will have different loss ratios depending on the kind of losses they cover.
- This ratio may fluctuate from period to period due to reasons under or beyond the control of the insurer.
- The insurance companies pay the loss adjustment expenses, even though it eats into their profits, to ensure that they do not pay for fraudulent claims.
- Fraudulent claims sometimes shore up this ratio for insurance companies, even though they use various checks to rightly dishonor fraudulent claims.
- The insurance companies can also get the reimbursement of loss adjustment expenses in case of some commercial liability policies.
- Loss ratios are always used in conjunction with combined ratios to measure the overall outflow relative to the inflow.
This has been a guide to what is a loss ratio, and it’s a definition. Here we discuss how to calculate loss ratio along with its formula, types, examples and usefulness. You can more about finance from the following articles –