Combined ratio: Meaning, Criticisms & Real-World Uses

What Is Combined Ratio?

The combined ratio is a key metric in the insurance financial metrics category, specifically used by property and casualty insurers to assess their underwriting profitability. It represents the percentage of each premium dollar that an insurer spends on claims and expenses, excluding investment income. This ratio provides a direct look at the efficiency of an insurer's core operations, indicating whether the company is making an underwriting profitability or loss from its insurance activities. A combined ratio below 100% signifies an underwriting profit, meaning the insurer collected more in premiums than it paid out in claims and operating costs. Conversely, a ratio above 100% indicates an underwriting loss.

History and Origin

The evolution of financial metrics like the combined ratio is closely tied to the development of insurance regulation and the need for standardized financial reporting within the industry. In the United States, the National Association of Insurance Commissioners (NAIC) was established in 1871 to coordinate supervision among states, with a significant emphasis on insurers' financial condition. Over the years, the NAIC has developed uniform solvency systems, risk-focused processes, and standardized statutory accounting practices, which necessitate clear reporting of underwriting results⁸, ⁹, ¹⁰. The combined ratio became a crucial tool for regulators and analysts to evaluate an insurer's operational health, independent of its investment performance. The NAIC continues to provide detailed analysis reports on the property and casualty insurance industry, relying on such metrics to inform regulatory oversight and help assess industry trends⁷.

Key Takeaways

The combined ratio measures an insurance company's underwriting profitability by aggregating its loss ratio and expense ratio.
A ratio below 100% indicates an underwriting profit, signifying that the insurer's core insurance operations are profitable.
A ratio above 100% indicates an underwriting loss, meaning the insurer spent more on claims and expenses than it earned in premiums.
The combined ratio does not account for investment income, focusing solely on the efficiency of underwriting and claims management.
It is a critical metric for evaluating an insurer's operational efficiency and risk management.

Formula and Calculation

The combined ratio is calculated by adding the incurred losses and underwriting expenses, and then dividing that sum by the earned premiums.

The formula is expressed as:

\text{Combined Ratio} = \frac{\text{Incurred Losses} + \text{Loss Adjustment Expenses} + \text{Underwriting Expenses}}{\text{Earned Premiums}}

Alternatively, it can be calculated as the sum of the loss ratio and the expense ratio:

\text{Combined Ratio} = \text{Loss Ratio} + \text{Expense Ratio}

Where:

Incurred Losses: The total amount of money an insurer has paid or expects to pay for claims within a specific period.
Loss Adjustment Expenses (LAE): The costs associated with investigating, defending, and settling claims.
Underwriting Expenses: The costs of acquiring and servicing insurance policies, such as commissions, marketing, and administrative costs. These are often referred to as operating expenses in this context.
Earned Premiums: The portion of premiums for which the insurer has provided coverage during the period. Premiums are typically collected in advance, and only the portion corresponding to the expired coverage period is considered "earned."

Interpreting the Combined Ratio

Interpreting the combined ratio is straightforward for assessing an insurer's core business performance. A combined ratio of exactly 100% means the insurer broke even on its underwriting activities, with premiums exactly covering losses and expenses. A ratio less than 100% is considered favorable, indicating that the insurer generated an underwriting profit. For example, a combined ratio of 90% means the insurer earned a 10% profit from its underwriting activities. This allows the insurer to be profitable even before considering investment income from its float, which is the pool of premiums collected but not yet paid out in claims.

Conversely, a combined ratio greater than 100% signifies an underwriting loss. A ratio of 105%, for instance, means the insurer spent $1.05 for every $1.00 it earned in premiums through its core insurance operations. While an underwriting loss might seem negative, an insurer can still achieve overall net income if its investment income offsets the underwriting loss. However, consistently high combined ratios often signal inefficiencies in pricing, claims management, or expense control, which may warrant closer scrutiny by analysts and regulators.

Hypothetical Example

Consider "SafeGuard Insurance Co." for a given fiscal year.

Earned Premiums: SafeGuard Insurance Co. earned $500 million in premiums.
Incurred Losses and Loss Adjustment Expenses: The company paid out $300 million in policyholder claims and associated loss adjustment expenses.
Underwriting Expenses: SafeGuard incurred $150 million in underwriting and administrative expenses.

Using the formula:

\text{Combined Ratio} = \frac{(\$300 \text{ million} + \$150 \text{ million})}{\$500 \text{ million}}

\text{Combined Ratio} = \frac{\$450 \text{ million}}{\$500 \text{ million}}

\text{Combined Ratio} = 0.90 \text{ or } 90\%

In this hypothetical example, SafeGuard Insurance Co. has a combined ratio of 90%. This means that for every dollar of premium earned, the company spent $0.90 on claims and expenses, resulting in a $0.10 underwriting profit per premium dollar. This indicates strong operational efficiency.

Practical Applications

The combined ratio is a fundamental analytical tool across various facets of the financial world, particularly within the insurance sector. Analysts and investors use it to gauge the health and efficiency of an insurer's core business, independent of its investment prowess. A low combined ratio often indicates a well-managed company with effective underwriting standards and efficient claims processing. For example, recent reports showed insurers like Allstate and Arch Capital achieving combined ratios below 100%, signaling strong underwriting performance and contributing to their profitability⁴, ⁵, ⁶. This metric is also crucial for competitive analysis, allowing stakeholders to compare the operational efficiency of different insurers within the same market segment.

Furthermore, regulatory bodies, such as the National Association of Insurance Commissioners (NAIC) in the U.S., closely monitor combined ratios as part of their solvency oversight. State insurance departments use this and other financial ratios to assess an insurer's financial stability and ensure it can meet its obligations to policyholders³. It plays a role in determining an insurer's capital requirements and overall financial soundness, which is a key aspect of insurance supervision by both state regulators and, in some cases, the Federal Reserve for larger, more complex insurance holding companies¹, ².

Limitations and Criticisms

While the combined ratio is a powerful indicator of underwriting performance, it has certain limitations. A primary criticism is that it does not account for investment income. Insurers generate significant revenue from investing the premiums they collect before claims are paid. A company might have an underwriting loss (combined ratio above 100%) but still be highly profitable overall due to substantial investment returns. Therefore, relying solely on the combined ratio can sometimes paint an incomplete picture of an insurer's total financial health. This necessitates considering other metrics, such as the operating ratio, which integrates investment income.

Another limitation is its backward-looking nature; it reflects past performance and may not accurately predict future profitability, especially in volatile markets or during periods of significant catastrophic losses. Unusual events, such as major hurricanes or widespread economic downturns, can dramatically inflate the loss component of the ratio, making a single period's combined ratio less representative of an insurer's long-term operational efficiency. Furthermore, accounting practices for incurred losses and loss adjustment expenses can involve estimates, which might introduce some variability or potential for manipulation, though regulatory oversight aims to standardize these practices.

Combined Ratio vs. Operating Ratio

The combined ratio and the operating ratio are both important financial metrics used in the insurance industry, but they differ significantly in what they measure. The combined ratio focuses exclusively on an insurer's underwriting profitability. It calculates the sum of incurred losses, loss adjustment expenses, and underwriting expenses as a percentage of earned premiums. Its primary purpose is to show how effectively an insurer manages its core insurance operations—that is, how well it prices policies, controls expenses, and handles claims. It explicitly excludes any income generated from the insurer's investment portfolio.

In contrast, the operating ratio provides a more comprehensive view of an insurer's overall profitability by taking into account both underwriting performance and investment income. It is typically calculated by subtracting investment income from the combined ratio, or by dividing the total expenses (including losses and underwriting costs) minus investment income by earned premiums. The operating ratio aims to show an insurer's total efficiency, reflecting the reality that many insurers rely on investment income to supplement or even drive their overall return on capital, particularly if their underwriting results are marginal or negative. Therefore, while the combined ratio assesses operational efficiency, the operating ratio provides a broader measure of an insurer's complete financial performance.

FAQs

What does a combined ratio of 95% mean?

A combined ratio of 95% means that for every $1.00 in premiums an insurer earned, it spent $0.95 on claims incurred, loss adjustment expenses, and underwriting expenses. The remaining $0.05 is the underwriting profit.

Why is the combined ratio important for insurers?

The combined ratio is crucial because it measures an insurer's operational efficiency and profitability from its core business of writing policies and paying claims. It helps management identify areas for improvement in expense management or underwriting practices, directly impacting their competitive position and long-term viability.

Does the combined ratio include investment income?

No, the combined ratio specifically excludes investment income. It is designed to evaluate an insurer's underwriting performance in isolation from the returns generated by its investment portfolio, which is often a significant source of profit for insurance companies. To see total profitability including investment income, the operating ratio is used.

What is a good combined ratio?

A combined ratio below 100% is generally considered good, as it indicates an underwriting profit. The lower the ratio below 100%, the more profitable an insurer's underwriting operations are. Anything above 100% signals an underwriting loss.

How do insurers improve their combined ratio?

Insurers can improve their combined ratio by implementing more rigorous underwriting standards to select better risks, effectively managing claims to reduce payout amounts, and controlling administrative and acquisition costs. They might also adjust premium pricing to better reflect the risks undertaken.