An insurance company's loss ratio is calculated to show the relationship between incurred losses and earned premiums. Insurance companies with very high loss ratios may need to raise premiums to stay solvent and ensure their ability to pay future claims. When the loss ratio is very low, it means that consumers are paying too much for the benefit received. Underwriters and investors use the loss ratio for various purposes.
What is Loss Ratio?
The loss ratio is expressed as a percentage. The incurred losses are divided by the earned premiums. Incurred losses are actual paid claims plus loss reserves. The loss reserves are liabilities due to known losses that have not yet been paid by the insurer. Earned premiums are the portion earned of the total premiums allocated over the life of the policy. For example, if an insurance company collected $100,000 in premiums and paid $70,000 in claims, they would have a loss ratio of 70 percent. Another firm who collected $100,000 and paid $95,000 in claims would have a loss ratio of 95 percent. A higher loss ratio means lower profits for the insurance company and is, therefore, a problem for underwriters and investors alike. The loss ratio is a simplified look at an insurance company's financial health. A more comprehensive overview is the combined ratio, which examines both the loss ratio and the expense ratio.
The Combined Ratio
The combined ratio looks at both losses and expenses. Expenses refer to loss adjustment expenses and underwriting costs. Loss adjustment expenses include those expenses needed to investigate and execute claims. Underwriting costs include staff salaries, marketing and other overhead costs. The combined ratio essentially adds together the percentages calculated from the loss ratio and the expense ratio to show profitability. An insurance company with a loss ratio of over 100 percent is losing money and must raise premiums or risk being unable to meet future liability payments. A lower loss ratio means higher profits.
Who Needs to Know?
Underwriters are particularly interested in the loss ratio. When the claims loss ratio is too high, either the premiums must rise or certain insured groups must be denied coverage. In the insurance industry, this is referred to as a hardening of the market. Health insurance companies must pay special attention to the ratio. Under the Health Care Reform law, they must have a loss ratio of at least 80 percent or refund some premiums to policyholders. Investors are also interested in the loss ratio. They may use the combined loss ratio as one of many metrics to compare insurance companies for investment decisions.