Combined Ratio

The combined ratio is the main measure of underwriting performance for insurers that write property, casualty and other general insurance. It expresses the cost of claims and of running the business as a percentage of premium. A ratio below 100% means that the insurer earned more in premium than it paid out in claims and expenses, an underwriting profit. A ratio above 100% means an underwriting loss.

The measure isolates the insurance operation from investment activity. An insurer holds premiums for some time before paying claims and earns investment income on them, so a company can be profitable overall with a combined ratio a little above 100%. Analysts, managers, rating agencies and regulators nevertheless treat the ratio as the first test of whether risks are being priced adequately through insurance underwriting.

The standard calculation is:

• Incurred claims are claims paid in the period plus the change in reserves for outstanding claims, together with the loss adjustment expense (LAE) of handling them.
• Expenses are the costs of acquiring and administering business: commissions, staff, systems, premium taxes and other overheads.
• Earned premium is the part of premium that relates to cover provided during the period.

The ratio is the sum of two components. The loss ratio is incurred claims divided by earned premium. The expense ratio is expenses divided by premium; under United States statutory reporting it is taken against written premium, while most other reporting uses earned premium throughout.

Suppose an insurer has earned premium of 1,000 million, incurred claims and adjustment expenses of 650 million, and underwriting expenses of 280 million. The loss ratio is 65%, the expense ratio is 28% and the combined ratio is 93%. The insurer made an underwriting profit equal to 7% of premium, or 70 million.

Several factors move the combined ratio from year to year:

• Pricing. Premium rates rise and fall with competition, in what is known as the underwriting cycle. Inadequate rates show up as higher loss ratios in later periods.
• Claims frequency and severity. Inflation in repair, medical and legal costs raises the average claim.
• Catastrophes. Storms, earthquakes and other large events cause sharp swings. Insurers often report the ratio with and without catastrophe losses.
• Reserve development. Changes to estimates for earlier years, produced by claims reserving, add to or subtract from the current year's ratio. A reserve release lowers it.
• Expenses. Distribution costs depend on the sales channel, with direct sales generally cheaper than sales through intermediaries.
• Reinsurance. The ratio can be shown gross or net of reinsurance cession; protection bought from reinsurers reduces volatility at the cost of ceded premium.
• Business mix. Long-tail liability lines are often written at ratios above 100% because premiums are invested for many years before claims are paid, while short-tail property lines need lower ratios.

The accident-year combined ratio includes only claims arising from events in the current year and excludes the effect of revisions to earlier years. The calendar-year ratio includes those revisions. Comparing the two shows how much of a result comes from current business and how much from releases or strengthening of old reserves.

The operating ratio subtracts investment income, expressed as a percentage of earned premium, from the combined ratio, giving a view of total profitability before tax. When interest rates are high, insurers can tolerate higher combined ratios; when they are low, underwriting discipline matters more. Some markets also deduct policyholder dividends. Under IFRS 17, companies report insurance revenue and insurance service expenses in a new format, and many now publish a combined ratio on that basis, which can differ from earlier figures because of discounting and changes in what counts as revenue.

A lower ratio is better, but the appropriate level depends on the line of business. Personal motor and household insurers in mature markets typically operate in the mid to high nineties. Speciality and reinsurance businesses aim lower in normal years to compensate for occasional very large losses. A ratio far below the market may indicate superior risk selection, or reserves that will later prove too low.

The ratio should be read over several years. A single good year may reflect the absence of catastrophes and nothing more. Profit relative to capital, measured by return on equity, depends also on investment returns, leverage and tax.

The combined ratio depends on estimates. Incurred claims include reserves for claims not yet settled and for incurred but not reported (IBNR) claims, so optimistic reserving flatters the ratio until the shortfall is recognised. Efficient claims administration lowers the cost of handling but cannot correct inadequate pricing.

Definitions differ between companies and accounting regimes, particularly on whether claims are discounted, which expenses are included, and whether figures are net of reinsurance, so comparisons need care. The ratio also ignores the time value of money and the capital needed to support the business. It is not used for life insurance, where long-term savings and investment components make other measures more suitable. The protection a company holds against volatile results, including instruments such as a catastrophe bond, and the size of its policyholder surplus, complete the picture of underwriting strength.