What Is the Combined Ratio?
The combined ratio, also known as the combined ratio after policyholder dividends ratio, is a crucial metric used by insurance companies to determine their profitability relative to their operational activities. This ratio is computed by adding the incurred losses and operational expenses together, then dividing this total by the premiums earned over the same period. Essentially, the combined ratio tells us how much money an insurance company is spending compared to how much it’s earning.
Formula for the Combined Ratio
Combined Ratio = (Incurred Losses + Expenses) / Earned Premium
Significance of the Combined Ratio
The combined ratio holds a mirror up to the cash flow dynamics of an insurance company, focusing on outflows such as dividends, expenses, and losses. This detail-oriented metric captures the insurer’s underwriting discipline as well as its operational efficiency. With the combined ratio, a figure below 100% indicates underwriting profit (income exceeds outflows), while a figure above 100% suggests underwriting loss (outflows exceed income). However, don’t be fooled by figures crossing the 100% mark—insurance companies can still turn a profit by earning through investments, which this ratio doesn’t account for.
Key Takeaways
- Comprehensive Measure: It’s like a Swiss Army knife for insurance profitability, folding in all operational and risk costs.
- Underwriting Performance: A combined ratio below 100% is the financial ’thumbs up’ signaling underwriting profitability.
- Exclusion of Investment Income: Investment returns don’t party with regular earnings in this ratio, giving a pure look at operational efficacy.
Examples and Application
Suppose an insurer garners $1,000 in policy premiums but expends $800 on claims and $150 on operating expenses. Its combined ratio would be:
Combined Ratio = (800 + 150) / 1,000 = 95%
A 95% ratio tells us the insurer is not just surviving; it’s thriving, keeping a neat 5% as operational profit. In contrast, a combined ratio of 105% would indicate a slight operational loss.
Related Terms
- Loss Ratio: Focuses solely on losses to premiums. It’s the lean diet version of the combined ratio.
- Expense Ratio: Looks at operational expenses against earned premiums. When concerned only with the cost of doing business, this ratio takes the stage.
- Operating Ratio: Combines loss and expense ratios, adding a dash of investment income into the mix for a rounded view of overall performance.
Further Reading
- “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein: Dive into the evolution of risk management which heavily influences insurance metrics.
- “The Economics of Insurance” by K. H. Borch: A deep dive into the foundations and modern applications of insurance economics, with a nod to profitability metrics like the combined ratio.
With numbers that speak louder than words, the combined ratio continues to be the tell-tale heart of an insurance company’s financial narrative, pulsing vital signs of operational health or warnings of potential downturns. In the grand bazaar of insurance metrics, the combined ratio is like that seasoned shopkeeper who knows the cost of everything and the value of prudential management.
