The combined ratio is a calculation used in insurance companies that shows how profitable a firm is. It is calculated by adding up all the incurred losses and expenses, and then dividing that total by all the money earned from premiums.
The combined ratio is usually expressed as a percentage, i.e. operating costs plus claims as a percentage of premium income.
If it is less than 100% the company is making a profit in its underwriting operations. Even a combined ratio of more than 100% might still mean the insurance company is making an overall profit if it has significant investment income.
An insurance company’s combined ratio tells us how profitable it is.
Combined ratio focuses on underwriting profitability
Experts say the combined ratio is the best calculation to determine whether a company is making a profit, because it excludes investment income and just focuses on the firm’s underwriting operations.
In order to provide a service to its customers and remain profitable, an insurance company has to be able to bring in more revenue from premiums than it is paying out. A company that can continuously make a profit from its underwriting business is more likely to thrive and be around for a long time.
Lets imagine an insurance company pays out $70 in claims and expenses related to those claims, plus another $20 in operating expenses, for every $100 it collects in premiums, it would have a combined ratio of 90% – which means it is profitable.
According to the FT Lexicon, combined ratio is:
“The ratio between the amount of money that an insurance company receives from customers in premiums, and the amount that it has to pay out when people make claims.”
This graph shows how bad things became for casualty insurers (malpractice insurers). The combined ratio remained well over 100% for many years, peaking in 2001. (Data Source: graphoftheweek.org)
If you are thinking of buying shares in insurance companies, carefully look at the combined ratios of several firms, and pick the most profitable ones.
Don’t just look at the combined ratio of a single year in each company – get data on their underwriting profitability over several years.
Video – Combined Ratios Explained