An insurance company’s profitability is reliant on a multitude of factors, but one measure that effectively encapsulates their performance is known as the "combined ratio". Adding up the incurred losses and expenses, and dividing them by the earned premium, gives us this ratio.
Picture this as tracing the money trail flowing out of an insurance company in the form of dividends, expenses and losses. The combined ratio thus becomes an invaluable tool, offering a comprehensive insight into an insurer's financial well-being. The losses highlight an insurer's discipline in underwriting policies, while the expense ratio measures how effectively it utilizes its resources for growth.
Traditionally, the combined ratio is represented as a percentage. A ratio under 100 percent signifies an underwriting profit for the company, while a ratio over 100 percent means the company is paying out more in claims than it's receiving in premiums. Interestingly, a company can still be profitable even with a combined ratio over 100 percent, as the ratio does not consider investment income.
Many insurance companies advocate for the combined ratio as a performance yardstick because it only incorporates profit earned through efficient management, excluding investment income. This is particularly relevant as a part of the dividends is typically invested in equities, bonds, and other securities.
For instance, let's consider an insurer that accumulates $1,000 in policy premiums and disburses $800 in claims plus $150 in operational expenses. The combined ratio calculates to 95% ((800 + 150) / 1,000).
Now, consider insurance company ZYX, which has encountered $10 million in underwriting expenses and $15 million in losses. With net written premiums of $30 million and earned premiums of $25 million, ZYX's financial basis combined ratio is exactly 100% (($10 million + $15 million) / $25 million).
These ratios provide a glimpse into the annual statutory financial statements, giving an understanding of the financial health of insurance companies.
A comprehensive overview of an insurance company's performance can be given by the combined ratio through understanding its two primary components: the loss ratio and the expense ratio. These ratios illustrate vital information about how much an insurance company is spending per dollar of protection, as well as the cost of generating new business. Together, they provide a nuanced idea of the profitability or lack thereof of an insurance company.