Combined Ratio

Core Description

• The Combined Ratio is a key metric used by insurers to evaluate the underwriting profitability of their core insurance operations, independent of investment income.
• A ratio below 100% typically signifies an underwriting profit, while a ratio above 100% signals loss and potential pricing or risk-management concerns.
• Accurate assessment requires normalizing for factors such as reserve movements, catastrophes, reinsurance, and growth effects to avoid common misinterpretations.

Definition and Background

The Combined Ratio is a foundational financial metric in the non-life (property and casualty) insurance industry, designed to measure the effectiveness and profitability of an insurer's underwriting practices. This ratio is expressed as a percentage and is calculated by combining an insurer’s incurred losses, loss adjustment expenses (LAE), and underwriting expenses (often including policyholder dividends when applicable), all divided by earned premiums for a specified period.

Historical Context

The use of the Combined Ratio dates back to the 19th century marine and fire insurance markets, where underwriters needed a means of tracking whether their core business—excluding investment returns—was profitable. Over decades, the ratio was standardized, especially in statutory reporting and global regulatory frameworks. This measure became a widely recognized indicator for the insurance industry, used globally for both internal benchmarking and external reporting. Major international rating agencies, regulators, equity analysts, and insurers rely on the Combined Ratio for discipline in product pricing, capital allocation, and performance comparison.

By focusing solely on underwriting activities, the Combined Ratio excludes investment income, capital gains, and taxes, offering a clear view of insurance operations. The metric gained significant prominence during periods of market stress and catastrophe-driven volatility, which highlighted the need for clear distinctions between operating results and investment or macroeconomic events.

Calculation Methods and Applications

The Combined Ratio is calculated as follows:

Formula:
Combined Ratio (%) = [(Incurred Losses + Loss Adjustment Expenses + Underwriting Expenses + Policyholder Dividends) ÷ Earned Premium] × 100

Key Components:

• Incurred Losses: The amount paid in claims plus changes in claim reserves (including both reported claims and those yet to be reported).
• Loss Adjustment Expenses (LAE): Costs associated with investigating and settling claims, including legal fees and administrative expenses.
• Underwriting Expenses: Costs related to acquiring and underwriting policies such as commissions, marketing, salaries, IT, and administrative overhead.
• Policyholder Dividends (if applicable): Some mutual insurers pay dividends to policyholders, which, when included, increase the ratio.
• Earned Premium: The proportion of premium that applies to the period for which the risk has been carried by the insurer, as opposed to total written premiums.

Application of the Combined Ratio

Interpreting the Ratio:

• Below 100%: Indicates the insurer is generating an underwriting profit—premiums are sufficient to cover claims and related expenses.
• Exactly 100%: The insurer is breaking even from an underwriting perspective.
• Above 100%: Underwriting loss—claims and expenses exceed premiums earned (excluding investment income).

Insurers, investors, rating agencies, and regulators use the Combined Ratio for a wide range of analytical purposes. It serves as an internal management tool for pricing, assessing existing underwriting portfolios, and guiding decisions on capital allocation. Externally, it is used for peer comparison and can serve as an early warning signal for deteriorating profitability, potentially prompting corrective action.

Example Calculation:
If an insurer has earned premiums of USD 1,000,000,000, incurred losses of USD 620,000,000, loss adjustment expenses of USD 80,000,000, underwriting expenses of USD 270,000,000, and policyholder dividends of USD 10,000,000:

Combined Ratio = (620,000,000 + 80,000,000 + 270,000,000 + 10,000,000) / 1,000,000,000 = 98.0%

This 98% result implies the insurer achieved a 2% margin on core insurance operations before factoring in investment income.

Net vs Gross Ratios:

• Gross Ratio: Uses figures before reinsurance recoveries and cessions, revealing the raw business quality.
• Net Ratio: Adjusts for ceded premiums and reinsurance recoveries, providing a more accurate view of retained risk and results after risk-transfer arrangements.

Comparison, Advantages, and Common Misconceptions

Comparison with Other Ratios

Combined Ratio vs. Loss Ratio

• Loss Ratio: Reflects the portion of earned premium consumed by incurred losses and loss adjustment expenses.
• Combined Ratio: Adds underwriting and administrative expenses (and sometimes dividends), offering a more comprehensive view of underwriting performance.

Combined Ratio vs. Expense Ratio

• Expense Ratio: Focuses solely on cost efficiency in acquiring and servicing policies (commissions, salaries, admin costs).
• Combined Ratio: Includes both loss and expense components, serving as a comprehensive underwriting profitability measure.

Combined Ratio vs. Operating Ratio

• Operating Ratio: Combines the Combined Ratio with the impact of investment income, offering insight into overall profitability.

Combined Ratio vs. ROE (Return on Equity)

• ROE: Encompasses the insurer’s net income, including investment returns, taxes, and leverage, relative to equity.
• Combined Ratio: Maintains focus on underwriting results only, before investment outcomes.

Advantages

• Clarity: Isolates underwriting results without including investment performance.
• Comparability: Facilitates benchmarking across products, time periods, and companies.
• Sensitivity: Reacts quickly to changes in claims, expenses, or pricing adequacy.
• Actionable: Enables management to detect early concerns in underwriting or reserving practices.

Common Misconceptions

Mistaking the Combined Ratio for Total Profitability:
It measures only the insurance operations of the company—an insurer could report a combined ratio above 100% and still be profitable overall if investment returns are robust.

Assuming 100% Equals True Break-even in All Markets:
In low-interest-rate environments, a ratio even below 100% may not be sufficient as investment returns are lower; in high-return environments, a slightly higher ratio may be tolerable.

Confusing Calendar-Year and Accident-Year Ratios:
Calendar-year ratios include impacts from reserve releases and catastrophe losses from prior years, while accident-year ratios aim to isolate current-year events.

Ignoring Reserve Movements and Business Mix:
Reserve releases might temporarily improve the ratio, while strengthening reserves could worsen the ratio in the short term but support long-term stability.

Mixing Net and Gross Ratios Without Clarification:
Direct comparison between net and gross ratios can be misleading due to differing reinsurance effects.

Practical Guide

Understanding the nuance of the Combined Ratio is essential for both experienced investors and those new to insurance company analysis. The following is a guide for using the Combined Ratio effectively:

Step-by-Step Guide to Using Combined Ratio

1. Ensure Consistent Definitions

• Use incurred losses (paid claims plus change in reserves).
• Include all relevant expenses and, where applicable, policyholder dividends.
• Use earned premiums rather than written premiums for accurate period matching.

2. Adjust for One-Offs and Structural Factors

• Normalize for unusual catastrophe losses (such as hurricanes) by referencing ex-cat ratios where available.
• Adjust for the impact of prior-year reserve development.
• Clearly identify the impact of reinsurance (state whether using gross or net figures).

3. Compare Over Multiple Periods and with Peers

• Review multi-year averages to understand cycle effects and sustainability.
• Break down by business line and geography for detailed analysis.
• Benchmark against comparable companies and industry averages.

4. Integrate with Other Metrics

• Use in combination with ROE, operating ratio, and reserve development indicators for a comprehensive assessment.
• Consider the stability of the ratio alongside pricing trends and claims frequency or severity.

Real-World Case Study (Fictional Example)

Suppose “Atlantic Shield Insurance,” a property and casualty insurer, reports the following for the most recent fiscal year:

• Earned Premium: USD 2,000,000,000
• Incurred Losses: USD 1,220,000,000
• Loss Adjustment Expenses: USD 140,000,000
• Underwriting Expenses: USD 530,000,000
• Policyholder Dividends: USD 20,000,000

Calculation:

Combined Ratio = (1,220,000,000 + 140,000,000 + 530,000,000 + 20,000,000) / 2,000,000,000 = 95.5%

Interpretation:A 95.5% combined ratio suggests Atlantic Shield Insurance achieved a 4.5% underwriting margin before investment income. If the previous year’s combined ratio was 103%, this improvement may reflect changes in underwriting practices or the effects of reinsurance, provided it is not due only to reserve releases or favorable catastrophe developments.

Practical Insights:

• For insurers: Maintaining combined ratios persistently below 100% helps support growth, capital levels, and rating agency perceptions.
• For investors: Focus on ratio stability and transparent management communication on factors such as catastrophe events or reserve changes.
• For analysts: Compare net-of-reinsurance ratios for retained risk and ensure consistent use of methodology across periods.

This scenario is fictional and provided solely for illustrative purposes; it should not be considered investment advice.

Resources for Learning and Improvement

• Casualty Actuarial Society (CAS): Offers various primers and readings on loss and expense analysis.
• National Association of Insurance Commissioners (NAIC): Provides statutory guidance and industry data on combined ratio reporting.
• AM Best and S&P Reports: Include peer-group and line-of-business benchmarking and specific details about company combined ratios.
• Munich Re Sigma / Swiss Re Reports: Provide in-depth analyses of industry cycles, catastrophe impacts, and normalized ratios for global insurers.
• Academic Publications: Search for articles covering insurance metrics, underwriting cycles, and risk management practices.
• Insurer Financial Statements: Examine annual reports or equivalent disclosures for calculation details, reserve movements, and segment breakdowns.

FAQs

What exactly does the Combined Ratio measure?

It measures the profitability of an insurer’s core underwriting operations by comparing costs (claims, expenses, and sometimes dividends) to earned premium, excluding investment income.

Why is a Combined Ratio below 100% important?

A ratio below 100% indicates that premiums exceed claims and expenses, signifying an underwriting profit before considering investment returns.

What is the difference between net and gross Combined Ratios?

Gross ratios are calculated before accounting for reinsurance effects, while net ratios adjust for premiums ceded to, and claims recovered from, reinsurance contracts.

Can an insurer be profitable with a Combined Ratio above 100%?

Yes, if investment income is sufficient, an insurer may report an overall profit even when the Combined Ratio shows an underwriting loss.

How often should investors and managers look at the Combined Ratio?

It is generally reviewed on a rolling annual or trailing twelve-month basis, considering seasonality and volatility, and compared to multi-year averages for context.

Do different types of insurance have different Combined Ratio norms?

Yes. For example, catastrophe-prone property lines may exhibit greater volatility in their ratios compared to health or auto insurance. Consider context and product mix when making comparisons.

Why should Combined Ratios be normalized for catastrophes and reserves?

Catastrophe losses and reserve movements can distort results; normalizing provides a clearer view of underlying operating performance.

Conclusion

The Combined Ratio remains a foundational metric for assessing underwriting profitability and risk management discipline in property and casualty insurance. Its strength lies in its ability to provide a straightforward, transparent view of insurance operations, without the influence of investment returns. For effective use, it is important to consistently define its components, adjust for one-off impacts, compare against peers and across periods, and incorporate it alongside other performance measures.

Understanding the Combined Ratio’s capabilities and limitations supports informed decision-making by insurers, regulators, investors, and risk managers. By deploying this metric as a diagnostic tool and benchmarking reference, companies and stakeholders can promote sustainable growth and guard against adverse trends in the evolving insurance sector.