The combined ratio is a fundamental metric used in the insurance industry to assess the overall profitability and underwriting performance of an insurance company. It is calculated by dividing the sum of the incurred losses and expenses by the earned premiums during a specific period. The resulting ratio provides insights into the company's ability to generate profits from its underwriting activities.
To calculate the combined ratio, several components are considered. These components can be broadly categorized into two main groups: loss ratio components and expense ratio components.
1. Loss Ratio Components:
The loss ratio represents the proportion of incurred losses to earned premiums and is a key component of the combined ratio. It measures the company's ability to accurately estimate and price risks. The loss ratio is calculated by dividing the incurred losses by the earned premiums. Incurred losses include both paid losses and changes in reserves for reported and unreported claims. Earned premiums refer to the portion of premiums that corresponds to the coverage period.
2. Expense Ratio Components:
The expense ratio reflects the operating efficiency of an insurance company and includes various expenses associated with underwriting and policy administration. It is calculated by dividing the underwriting expenses by the earned premiums. Underwriting expenses consist of acquisition
costs, such as commissions paid to agents or brokers, as well as other operational expenses like salaries, rent, and utilities.
The expense ratio also considers policy acquisition costs, which are the expenses incurred in acquiring new policies. These costs include marketing
expenses, agent commissions, and other costs related to policy issuance.
Additionally, general administrative expenses are taken into account when calculating the expense ratio. These expenses encompass overhead costs such as salaries of administrative staff, rent, utilities, and other administrative expenses.
By combining the loss ratio and expense ratio, the combined ratio provides a comprehensive view of an insurance company's overall underwriting performance. A combined ratio below 100% indicates that the company is generating an underwriting profit, while a ratio above 100% suggests an underwriting loss.
It is important to note that the combined ratio does not consider investment income
or other non-underwriting sources of revenue. Therefore, it primarily focuses on the core underwriting activities of the insurance company. A lower combined ratio indicates better underwriting performance and higher profitability, while a higher ratio suggests potential challenges in managing risks and expenses.
Insurance companies closely monitor their combined ratios to assess their financial health, identify areas for improvement, and make informed business
decisions. By analyzing the components of the combined ratio, insurers can pinpoint specific areas that require attention, such as claims management, expense control, or pricing strategies.
In summary, the combined ratio is calculated by dividing the sum of incurred losses and expenses by earned premiums. It incorporates both loss ratio components (incurred losses) and expense ratio components (underwriting expenses). This metric provides valuable insights into an insurance company's underwriting profitability and operational efficiency, helping insurers make informed decisions to enhance their financial performance.