What is the combined ratio (short definition)
– The combined ratio is a common insurance-industry metric that summarizes underwriting profitability. It compares what an insurer pays out for claims and operating costs to the premiums it has earned. A combined ratio below 100% implies the insurer’s underwriting operation is making money; above 100% implies underwriting losses (though investment income can still produce overall profit).
Formula — simple and expanded
– Core formula:
Combined ratio = (Incurred losses + Expenses) / Earned premiums
– Expressed as a percentage: multiply the fraction by 100.
– Relationship to other ratios:
Combined ratio = Loss ratio + Expense ratio,
where Loss ratio = Incurred losses / Earned premiums,
and Expense ratio = Underwriting expenses / (earned or written premiums depending on the basis).
Step-by-step checklist to compute and interpret a combined ratio
1. Identify the period and basis (financial/statutory year or trade basis).
2. Gather incurred losses and loss-adjustment expenses (LAE) for that period.
3. Gather the underwriting or operating expenses to include (commissions, salaries, overhead).
4. Obtain earned premiums for the same period. If using trade basis, you may instead use net written premiums for the expense portion—check company reporting.
5. Compute: (Incurred losses + Expenses) ÷ Earned premiums → convert to percentage.
6. Interpret:
– 100%: underwriting loss (premiums do not fully cover claims and expenses).
– Consider investment income separately before judging overall company profitability.
7. Examine components separately (loss ratio and expense ratio) to understand drivers.
Worked numeric examples
Example A — simple underwriting result
– Suppose an insurer earned $1,000 in premiums during a year.
– It paid $800 in claims and claim-related costs and $150 in underwriting/operating expenses.
– Combined ratio = (800 + 150) / 1,000 = 950 / 1,000 = 0.95 → 95%.
– Interpretation: underwriting produced a 5% margin (100% − 95% = 5%). Investment income could add further profit.
Example B — financial-basis and trade-basis illustration
– Inputs:
– Incurred losses + LAE = $15 million
– Incurred underwriting expenses = $10 million
– Earned premiums = $25 million
– Net written premiums = $30 million
– Financial-basis combined ratio:
= (15 + 10) / 25 = 25 / 25 = 1.00 → 100%
– Trade-basis combined ratio (loss portion on earned premiums, expense portion on written premiums):
= (15 / 25) + (10 / 30)
= 0.60 + 0.3333 = 0.9333 → 93.33% (≈ 93%)
Key differences and what each part tells you
– Loss ratio (incurred losses / earned premiums): shows how costly claims are relative to the coverage sold. High loss ratio → claims are consuming a large share of premiums.
– Expense ratio: measures how efficiently the company operates and acquires business (commissions, administration, marketing).
– Combined ratio (loss + expense): gives an integrated view of underwriting performance without including investment returns.
Limitations and cautions
– No investment income: the combined ratio excludes investment returns on the insurer’s reserves; a company with a combined ratio >100% can still report net profit if investment income is strong.
– Accounting and basis differences: “earned” versus “written” premiums and what counts as incurred expenses vary by reporting method or jurisdiction; compare like with like when benchmarking companies.
– One-period snapshot: catastrophic events or reserve development can skew a single-period combined ratio; examine multi-year trends and reserve changes.
– Component analysis required: the headline combined ratio can conceal whether problems are driven by poor underwriting (losses) or high operating costs (expenses).
Quick checklist for comparing insurers
– Confirm you’re using the same basis (financial vs trade) across companies.
– Look at loss and expense ratios separately, not just the combined ratio.
– Check whether unusual items (catastrophes, reserve adjustments) affected the period.
– Compare combined ratio to industry averages and the company’s historical trend.
– Factor in investment income when assessing total profitability.
Reputable sources for further reading
– Investopedia — “Combined Ratio” (overview and examples): https://www.investopedia.com/terms/c/combinedratio.asp
– Insurance Information Institute — resources on underwriting and profitability: https://www.iii.org
– National Association of Insurance Commissioners (NAIC) — insurance accounting and financial reporting guidance: https://www.naic.org
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized investment advice. Always consult qualified professionals and company filings before making financial decisions.