What is Combined Ratio?

1142 reads · Last updated: December 5, 2024

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.

Definition

The combined ratio, also known as the 'combined ratio after policyholder dividends,' is a profitability metric used by insurance companies to assess their operational performance. It is calculated by dividing the sum of incurred losses and expenses by the earned premiums. A combined ratio below 100% typically indicates that the company is profitable in its underwriting operations, while a ratio above 100% may suggest a loss.

Origin

The concept of the combined ratio originated in the insurance industry as a standard for measuring the financial health of insurance companies. As the insurance market became more complex and competitive, the combined ratio emerged as a crucial tool for evaluating the operational efficiency and profitability of insurers.

Categories and Features

The combined ratio is primarily divided into two components: the loss ratio and the expense ratio. The loss ratio is the ratio of incurred losses to earned premiums, reflecting the company's expenditure on claims. The expense ratio is the ratio of operating expenses to earned premiums, indicating the costs associated with management and sales. The advantage of the combined ratio lies in its simplicity and directness, providing a quick snapshot of an insurer's underwriting profitability. However, it has limitations, such as not accounting for investment income.

Case Studies

Case Study 1: AIG (American International Group) experienced a combined ratio exceeding 100% during the 2008 financial crisis, indicating losses in its underwriting business. Through restructuring and improved risk management, AIG reduced its combined ratio to around 90% in subsequent years, restoring profitability. Case Study 2: Munich Re, a German reinsurance company, saw its combined ratio rise to 98% in 2019 due to frequent natural disasters, yet it remained profitable, demonstrating effective risk diversification strategies.

Common Issues

Investors often misunderstand the direct relationship between the combined ratio and a company's overall profitability. It is important to note that the combined ratio only reflects the profitability of underwriting operations and does not include investment income. Therefore, a combined ratio above 100% does not necessarily mean the company is overall unprofitable, especially if investment returns are high.

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