Combined Ratio: Definition, What It Measures, Formula, Examples

What Is the Combined Ratio?

The combined ratio, also called "the combined ratio after policyholder dividends ratio," is a measure of profitability used by an insurance company to gauge how well it is performing in its daily operations. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by the earned premium.

The Formula for the Combined Ratio Is

 $\begin{aligned} &\text{Combined Ratio} = \frac{ \text{Incurred Losses} + \text{Expenses} }{ \text{Earned Premium} } \\ \end{aligned}$​Combined Ratio=Earned PremiumIncurred Losses+Expenses​​

What Does the Combined Ratio Tell You?

The combined ratio measures the money flowing out of an insurance company in the form of dividends, expenses, and losses. Losses indicate the insurer's discipline in underwriting policies. The expense ratio gauges the efficiency of an insurer and how well it uses its resources to drive top-line growth. The combined ratio is arguably the most important of these three ratios because it provides a comprehensive measure of an insurer's profitability.

The combined ratio is typically expressed as a percentage. A ratio below 100 percent indicates that the company is making an underwriting profit, while a ratio above 100 percent means that it is paying out more money in claims that it is receiving from premiums. Even if the combined ratio is above 100 percent, a company can potentially still be profitable because the ratio does not include investment income.

Many insurance companies believe that the combined ratio is the best way to measure success because it does not include investment income and only includes profit earned through efficient management. This is important to note since a portion of dividends will be invested in equities, bonds, and other securities. The investment income ratio (investment income divided by net premiums earned) takes investment income into account and is used in the calculation of the overall operating ratio.

Examples of the Combined Ratio

As a hypothetical example, if an insurer collects $1,000 in policy premiums and pays out $800 in claims and claim-related expenses, plus another $150 in operating expenses, it would have a combined ratio of (800 + 150) / 1,000 = 95%.

Let's take another example: insurance company ZYX has incurred underwriting expenses of $10 million, incurred losses and loss adjustment expenses of $15 million, net written premiums of $30 million and earned premiums of $25 million. We can calculate ZYX's financial basis combined ratio by adding the incurred losses and loss adjustment expenses with the incurred underwriting expenses. The financial basis combined ratio is 1, or 100% (($10 million + $15 million) / $25 million).

The financial basis gives a snapshot of the current year's statutory financial statements. We can also calculate the combined ratio on a trade basis, where you divide the incurred losses and loss adjustment expenses by earned premiums and add to the incurred underwriting expenses divided by net written premiums. The trade basis combined ratio of insurance company XYZ is 0.93, or 93% = ($15 million / $25 million + $10 million / $30 million).

The Difference Between the Combined Ratio and the Loss Ratio

The loss ratio measures the total incurred losses in relation to the total collected insurance premiums, while the combined ratio measures the incurred losses and expenses in relation to the total collected premiums. The combined ratio is essentially calculated by adding the loss ratio and expense ratio.

The loss ratio is calculated by dividing the total incurred losses by the total collected insurance premiums. The lower the ratio, the more profitable the insurance company and vice versa. If the loss ratio is above 1, or 100%, the insurance company is likely to be unprofitable and may be in poor financial health because it is paying out more in claims than it is receiving in premiums.

Limitations of the Combined Ratio

The components of the combined ratio each tell a story and should be examined both together and separately in order to understand what is driving the insurer to be profitable or unprofitable. Policy dividends are generated from the premiums generated from the insurer’s underwriting activities.

The loss and loss-adjustment ratio demonstrate how much it costs the insurer to offer one dollar of protection. The expense ratio shows how expensive it is to generate new business since it takes into account commissions, salaries, overhead, benefits, and operating costs. (For related reading, see "How Do I Calculate the Combined Ratio?")