What is the Combined Ratio
The combined ratio is a key performance metric used in the insurance industry to measure underwriting profitability. It helps determine how efficiently an insurance company is operating based on its core insurance activities, excluding investment income.
Expressed as a percentage, the combined ratio compares the sum of incurred losses and expenses to earned premiums. A ratio below 100% indicates that the company is making an underwriting profit, while a ratio above 100% means it's operating at a loss.
This ratio is widely used by analysts, insurers, and investors to assess the health and efficiency of an insurer's underwriting operations. It offers a quick snapshot of how well a company is managing risk and expenses.
How to Calculate the Combined Ratio
The combined ratio is calculated using the following formula:
Combined Ratio = (Incurred Losses + Expenses) / Earned Premiums × 100
Incurred losses include the claims paid out and any changes in reserves for future claims. Expenses typically consist of administrative costs, commissions, and other operational expenses. Earned premiums are the portion of premiums that relate to the coverage provided during a specific period.
Example: Suppose an insurance company has incurred losses of $40 million, expenses of $30 million, and earned premiums of $100 million. The combined ratio would be:
(40M + 30M) / 100M × 100 = 70%
This result indicates a strong underwriting performance, as the company spends only 70 cents to earn every dollar of premium, leaving room for profit.
Why Use the Combined Ratio
The combined ratio is valuable because it isolates underwriting performance from investment returns. Insurance companies often invest collected premiums, but the combined ratio focuses only on core business efficiency.
This makes it easier to evaluate whether an insurer is actually profitable from underwriting activities or simply relying on investment gains to cover underwriting losses. It promotes transparency and helps stakeholders assess real performance.
Additionally, the combined ratio helps management identify operational inefficiencies. A rising ratio could point to growing claims, increased expenses, or underpriced policies—all issues that may require strategic adjustments.
Interpreting the Combined Ratio
Interpreting the combined ratio involves understanding the threshold of 100%. A ratio under 100% means the company is earning more in premiums than it spends on claims and expenses, indicating an underwriting profit.
A ratio over 100% suggests the insurer is losing money on its underwriting operations and must rely on investment income to remain profitable. A consistent ratio below 100% is generally a positive indicator of financial stability.
However, even a combined ratio slightly above 100% isn't always cause for concern if the company has strong investment returns or if it's an anomaly due to a major catastrophe. Trends over time provide better insights than a single value.
Practical Applications
Insurance executives use the combined ratio to guide underwriting strategy, monitor departmental efficiency, and set pricing for new policies. A low combined ratio may allow for competitive pricing, while a high ratio may signal the need for higher premiums or cost reduction.
Investors also analyze the combined ratio when evaluating insurance stocks. It offers a snapshot of operational soundness and helps compare performance between companies in the sector.
Regulators may use the combined ratio to assess the financial health of insurers, ensuring they remain solvent and able to meet claims obligations. A persistently high ratio may lead to increased scrutiny.
Conclusion
The combined ratio is a fundamental measure of an insurance company’s operational success. It reveals how efficiently an insurer is managing its claims and expenses relative to the premiums it earns.
By excluding investment performance, the combined ratio allows for a clear evaluation of underwriting profitability. It serves as a key decision-making tool for executives, investors, and regulators alike.
Consistent monitoring and analysis of the combined ratio help ensure long-term sustainability and profitability in a highly competitive and risk-sensitive industry.