Definition of Combined Ratio for Insurance Business
A measure of profitability used by an insurance company to indicate how well it is performing in its daily operations.
The combined ratio is defined as
The sum of incurred losses and operating expenses measured as a percentage of earned premium.
The combined ratio is comprised of the claims ratio and the expense ratio.
The claims ratio is claims owed as a percentage of revenue earned from premiums.
The expense ratio is operating costs as a percentage of revenue earned from premiums.
The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by earned premium.
It is a measure of the profitability of the insurer. (The ratio is typically expressed as a percentage.)
The combined ratio shows the underwriting profitability of the insurer. A ratio below 100% indicates that the company is making underwriting profit while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums.
‘Combined Ratio Calculated as:
“Combined Ratio”= “Incurred Loses + Expanses” /”Earned Premium”
DEFINITION of ‘Earned Premium’
The amount of total premiums collected by an insurance company over a period that have been earned based on the ratio of the time passed on the policies to their effective life. This pro-rated amount of “paid in advance” premiums have been earned and now belong to the insurer.
Shashi Explains ‘Earned Premium’
The premium that a policyholder pays for an insurance contract is not immediately recognized as earnings by the insurer. While the policyholder has met his or her obligation by paying for the policy and thus the benefits that he or she could receive, an insurer has only just begun its obligation when it receives the premium. When the premium is first received it is considered an unearned premium, and is not recognized as profit. As time passes, however, the insurer incrementally changes the status of the premium from “unearned” to “earned”. Until the policy end date is reached the insurer is responsible for any claims made, and only when that date is reached will the entirety of the premium be considered profit.
There are two different methods for calculating earned premiums: the accounting method and the exposure method.
The accounting method is more commonly used, and is how earned premium is shown on the majority of insurers’ corporate income statements. The calculation used in this method involves dividing the total premium by 365, and multiplying this by the number of days that have elapsed. For example, an insurer who receives a 1000 premium on a policy that has been in effect for 100 days would have an earned premium of 273.97 (1,000 / 365 * 100).
The exposure method does not take into account the date that a premium was booked, and instead looks at how premiums were exposed to losses over a given period of time. It is the more complicated method, and involves examining the portion of unearned premium exposed to loss during the period being calculated. The exposure method involves the examination of different risk scenarios (using historical data) that may occur over a period of time – from high risk to low risk scenarios – and applies the resulting exposure to premiums earned.
DEFINITION of ‘Losses Incurred’
Benefits paid to policyholders during the current year, plus changes to loss reserves from the previous year. Losses incurred represents profit that an insurance company will not make from its underwriting activities, since funds are being paid to policyholders based on the coverage outlined in their insurance contracts. This statistics is typically viewed by calendar year.
Shashi Explains ‘Losses Incurred’
For insurers, an ideal world would have them underwrite new insurance policies, collect premiums, and never have to pay out benefits. But this is not how insurance works in the real world. Policyholders make claims when accidents happen, and insurers must investigate and pay for those claims if they are found to be accurate.
The amount of losses incurred may vary from year to year. For example, a flood last year may have resulted in an increased number of homeowner policy claims, but no flood this year means that incurred losses are lower. Insurance companies set aside a reserve to cover liabilities from claims made on policies that they underwrite. The reserves are based on a forecast of the losses an insurer may face over a period of time, meaning that the reserves could be adequate or may fall short of covering its liabilities. Estimating the amount of reserves requires actuarial projections based upon the types of policies underwritten.
Insurers have several goals when processing a claim: ensure that they comply with the contract benefits outlined in the policies that they underwrite, limit the prevalence and impact of fraudulent claims, and make a profit from the premiums they receive. Insurers must maintain a high enough reserve in order to meet projected liabilities, but if the loss reserves are not high enough the surplus will have to be dipped into. If the insurer goes through its loss reserves and policyholders’ surplus it will be close to insolvency.
Shashi Explains ‘Incurred Losses’
Incurred Losses’ is a term used in the insurance industry to describe the losses incurred by an insurance company by the payment of claims, the re-evaluation of claims already in the company’s books and any negative or positive changes in loss reserves in a particular calendar year.