What is Loss Ratio?
The loss ratio is generally used in the insurance industry and is expressed as a percentage, representing the ratio of losses incurred in claims plus adjustment expenses relative to the premiums earned during the period.
- Premiums Collected: Premium is the amount paid by the insured to the insurance company periodically or at once to buy the risk cover.
- Claims: Claims are what the insurance company pays to the insured for damages when the risk event happens.
- Adjustment Expenses: Adjustment expenses are the costs incurred by the insurance company for investigating and settling an insurance claim.
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 risks 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.
Loss Ratio Insurance Formula
The loss ratio is calculated as losses incurred in claims plus adjustment expenses divided by the premiums earned during the period.
Examples of Loss Ratio
Let’s discuss some examples.
An insurer collects $120,000 in premiums and pays $60,000 in claims and adjustment expenses. The loss ratio for the insurer will be $60,000/$120,000 = 50%.
Property and casualty insurance companies sometimes have a high loss ratio in case the insured properties experience devastating events like floods, cyclones, or hailstorms. In such situations, these ratios surpass the 100% mark, and the companies pay much higher than the premium they collected in that period. According to a report, in 2018, most property and casualty insurers reported such ratios above 100%, one of them posted a ratio of more than 250%.
Farmers insurance posted a loss ratio of 155% while Allstate corp posted a ratio of 257%.
Implications of Loss Ratio for Insurance Companies
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.
Benefit Expense Ratio
The benefit expense ratio is calculated by dividing the expenses incurred by the insurance companies to underwrite policies by the total premiums received during a particular period. Like loss ratio, this ratio also has to be in control if the insurance company does not want to risk its profitability and solvency.
The combined ratio is the sum of the loss ratio and benefits expense ratio. It determines the total outgo in a period as compared to the total inflow from premiums. The insurance companies should carefully maintain this ratio as well to remain in the business for a long time.
Some of the advantages of loss ratio are as follows:
- 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.
- It is an important metric to track in the insurance industry. It 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 costs 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 overheads.
- However, loss ratios cannot be looked at in isolation; one needs to look at the combined ratio to figure out the entire picture. The companies also make returns on the float, which is the cumulative premiums they have retained from previous years.
- The float helps these companies pay out the claims and expenses when the costs are higher than the premiums collected. The return from float helps companies maintain profitability and also provides a cushion in the times when they pay out high claims and expenses.
This has been a guide to what is a loss ratio, and it’s a definition. Here we discuss types (Medical & Commercial Insurance Loss Ratio) and formula to calculate gross ratio along with examples and advantages. You can more about finance from the following articles –