What is a Combined Ratio?

The combined ratio is a simplified measure used by an insurance company to evaluate its profitability as well as financial health as a way of measuring its day-to-day performance. The combined ratio is calculated by dividing the sum of claim-related losses and expenses by earned premium. The earned premium is the money that an insurance company collects in advance in lieu of guaranteed coverage. 

Combined Ratio = (Claim-related Losses + Expenses) / Earned Premium. 

From the above formula, it can be inferred that the combined ratio is inversely proportional to the profitability of an insurance company. Thus, it is in the best interest of the company to maintain a low combined ratio of losses and expenses relative to premiums earned, so as to maximize its profitability.

How is a Combined Ratio Used?

The combined ratio gives a fairly accurate estimate of the cash outflow of an insurance company. Typically, the cash outflow includes disbursed dividends, claim-related losses and general business expenses. As such, the combined ratio has proved indispensable in evaluating the efficiency of the insurer in driving revenue growth. The combined ratio is usually indicated as a percentage - an insurance firm that has a combined ratio below 100% can be said to have made an underwriting profit, i.e. the total sum of money paid out in claims plus the amount spent as business expenses is lesser than the total amount received in premiums from customers. Similarly, if the combined ratio exceeds 100%, the firm is making a loss, i.e. the total sum of money paid out in claims plus the amount spent as business expenses is greater than the total amount received in premiums. It is important to note here that apart from the actual monies paid out in claims, the incurred losses of an insurance firm should also include the change in loss reserves. Loss reserves are claims that have not been paid out yet by the insurer. Expenses include general expenses (i.e. the costs a business incurs as part of its daily operations), loss adjustment expenses (i.e. the various expenses associated with investigating and settling claims), and miscellaneous underwriting expenses. A premium is the fee that a customer pays for insurance coverage during the signing of the insurance contract. Such a premium is considered unearned by the insurance firm at the time of payment. With the expiration of phases of the coverage period, the insurance firm converts a matching portion of the unearned premium into earned premium, thus reducing the total unearned premium amount. Combined ratios are generally considered a reliable standard for measurement of an insurance company's financial health. This is because combined ratios typically evaluate profitability solely from the perspective of the company's insurance operations. However, insurance firms have several other sources of revenue besides customers premiums. Insurance firms earn a sizeable portion of their revenues from investments in stocks, bonds, and other financial instruments outside their core business of selling insurance policies. As such, there are instances where a company that has a combined ratio greater than 100% is still able to make a profit from investment income.

Illustration of Combined Ratio

Let us consider an insurance firm C1. Now, suppose C1 has collected $10,000 in insurance premiums, paid out $7,500 in claims and spent $3,000 towards operating expenses. In this instance, C1s combined ratio can be calculated as follows. Combined ratio of C1 = ($7,500 + $3,000) / $10,000 = $10,500 / $10,000 = 105%. In the above example, C1 is making an underwriting loss since its combined ratio is greater than 100%. Now, let us consider another example. Insurance firm C2 has incurred underwriting expenses worth $7,000, paid out $1000 in claims and lost $1500 as loss adjustment expenses. If C2 earns $10,000 in premiums during the same period, then its combined ratio can be calculated as follows. Combined ratio of C2 = ($7000 + $1,000 + $1,500) / $10,000 = $9,500 / $10,000 = 95%. Thus, in the above example, C2 is making an underwriting profit since its combined ratio is less than 100%.

Limitations of Combined Ratio

Notwithstanding its several advantages, the combined ratio does have its limitations. The various components that make up the combined ratio (losses, expenses and earned premium) each serves as an indicator of the potential for profitability or the risk of unprofitability. As such, it is necessary to scrutinize these components individually as well as collectively in order to correctly evaluate the company's financial performance.

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