Combined Ratio

The combined ratio is a key financial metric used in the insurance industry to evaluate an insurer’s underwriting performance and overall operational efficiency. It measures the relationship between the costs incurred in underwriting insurance policies (including claims and expenses) and the premiums earned from those policies. Expressed as a percentage, the combined ratio is fundamental in assessing whether an insurance company is making an underwriting profit or loss.

Definition and Interpretation

The combined ratio is calculated as the sum of the loss ratio and the expense ratio:
Combined Ratio = Loss Ratio + Expense Ratio\textbf{Combined Ratio = Loss Ratio + Expense Ratio}Combined Ratio = Loss Ratio + Expense Ratio
Where:

• Loss Ratio represents the proportion of premium income paid out in claims and related expenses.
• Expense Ratio represents the proportion of premium income consumed by operating and administrative costs.

A combined ratio below 100% indicates that the insurer is earning an underwriting profit—meaning premium income exceeds claims and expenses. Conversely, a ratio above 100% signifies an underwriting loss, where claims and expenses surpass earned premiums.
For example, if an insurer’s loss ratio is 70% and expense ratio is 25%, the combined ratio is 95%. This means that for every £100 of premium earned, £95 is spent on claims and operating costs, leaving £5 as an underwriting profit.

Components of the Combined Ratio

1. Loss Ratio
   • Calculated as:

     Loss Ratio=Incurred Losses + Loss Adjustment ExpensesEarned Premiums×100\text{Loss Ratio} = \frac{\text{Incurred Losses + Loss Adjustment Expenses}}{\text{Earned Premiums}} \times 100Loss Ratio=Earned PremiumsIncurred Losses + Loss Adjustment Expenses​×100

   • Reflects the proportion of income paid to policyholders for claims and related handling costs. A high loss ratio may indicate poor underwriting practices, inadequate pricing, or an unusual frequency of claims.
2. Expense Ratio
   • Calculated as:

     Expense Ratio=Underwriting and Operating ExpensesWritten or Earned Premiums×100\text{Expense Ratio} = \frac{\text{Underwriting and Operating Expenses}}{\text{Written or Earned Premiums}} \times 100Expense Ratio=Written or Earned PremiumsUnderwriting and Operating Expenses​×100

   • Includes commissions, administrative costs, marketing expenses, and salaries. A low expense ratio suggests efficient management and cost control.

These two ratios together provide a comprehensive view of an insurer’s operational effectiveness before considering investment income.

Significance in Insurance Analysis

The combined ratio is a core indicator of underwriting profitability. It enables stakeholders—including regulators, analysts, and investors—to assess whether an insurer’s core business of risk underwriting is financially sustainable.

• Combined Ratio < 100%: Underwriting profit. The insurer collects more in premiums than it pays in claims and expenses.
• Combined Ratio = 100%: Breakeven. Premiums exactly cover claims and expenses.
• Combined Ratio > 100%: Underwriting loss. The insurer relies on investment income to remain profitable.

Insurance companies often sustain overall profitability even with a combined ratio above 100%, due to substantial investment income from premiums held during the policy period (a practice known as float income).

Types of Combined Ratios

There are several variations of the combined ratio used for detailed analysis:

• Gross Combined Ratio: Based on gross premiums written, including reinsurance effects.
• Net Combined Ratio: Adjusted for reinsurance recoveries and costs, showing the insurer’s retained risk.
• Operating Ratio: Includes investment income by subtracting the investment yield ratio from the combined ratio to give a more comprehensive profitability measure.

Operating Ratio = Combined Ratio – Investment Income Ratio\text{Operating Ratio = Combined Ratio – Investment Income Ratio}Operating Ratio = Combined Ratio – Investment Income Ratio
This refined ratio helps evaluate whether an insurer remains profitable after considering both underwriting and investment activities.

Factors Influencing the Combined Ratio

The combined ratio is affected by a variety of factors, including:

• Claims Frequency and Severity: A rise in claim numbers or larger claim amounts increases the loss ratio.
• Underwriting Standards: Sound risk assessment and premium pricing improve the ratio.
• Expense Management: Efficient operations, digital automation, and cost control lower the expense ratio.
• Reinsurance Arrangements: Transferring part of the risk can reduce claim volatility but may increase reinsurance costs.
• Market Competition: Intense competition can drive down premiums, pushing up the ratio.
• Regulatory Requirements: Compliance costs and taxes influence the expense ratio.

Role in Financial Evaluation

For analysts and investors, the combined ratio is a vital measure of how effectively an insurer manages its underwriting operations independently of external investment income. It provides a more accurate reflection of core business performance than net profit figures alone.
For instance:

• A low combined ratio (e.g., 85–95%) indicates prudent underwriting, controlled expenses, and potentially strong market positioning.
• A high combined ratio (above 105%) may signal inefficiencies, underpriced policies, or adverse claim trends, prompting managerial review or re-pricing strategies.

Comparisons of combined ratios across insurers and time periods reveal trends in industry performance and competitive strength.

Use in Reinsurance and Market Practice

Reinsurers and underwriters use the combined ratio to negotiate contracts and evaluate portfolio profitability. It serves as a benchmark for premium pricing and helps determine whether underwriting strategies align with risk appetite. In global reinsurance markets, maintaining a combined ratio below 100% over time is considered a hallmark of disciplined underwriting.

Advantages and Limitations

Advantages:

• Offers a simple, clear measure of underwriting profitability.
• Enables comparison across insurers, business lines, and periods.
• Serves as an early warning indicator of deteriorating performance.

Limitations:

• Excludes investment income, which may offset underwriting losses.
• Can be distorted by short-term claim spikes or catastrophe losses.
• May not fully reflect differences in accounting methods or reinsurance structures.