Insurance companies operate to protect consumers against loss. But like any profitable venture, an insurance company first protects its own bottom line. It does this, in part, through making sure that its underwriting profit ratio remains within a certain range. Called the combined ratio insurance formula, this calculation divides the losses and expenses by something called the earned premium.
Combined Ratio Formula
Before you can calculate the value of your underwriting profit ratio, you must first understand what earned premium is. An earned premium is the in-advance monies paid to you as an insurance company in exchange for coverage. You’ll total up all of the premiums you received during a set time period in order to arrive at the earned premium amount. To calculate the earned premium, you’ll total up the premiums for that period, then divide it by 365, then multiply that number by the number of days that have passed.
Once you have the earned premium, you can incorporate it into the combined ratio formula. The formula is Combined Ratio = Incurred Losses plus Expenses divided by Earned Premium. The figure you get will be expressed as a percentage and the goal, of course, is to have a ratio below 100. That means you’re operating at a profit rather than a loss. The lower you can get that number, the better. But just because your ratio falls above 100 doesn’t mean you’re operating at a loss. Your combined ratio amount doesn’t include investment income.
Combined Ratio Versus Loss Ratio
The combined ratio insurance formula is only one of two methods used to gauge the profitability of an agency. The loss ratio eliminates expenses from the equation and merely looks at the company’s losses in relation to the premiums collected. This will help you determine your underwriting profit ratio so that you can decide whether you’re charging enough in premiums to offset your losses. To figure the loss ratio, you’ll divide the total number of losses by the total amount in collected insurance premiums. The loss ratio should be 1, or 100 percent, or under if you’re profitable, or paying out less in claims than you’re collecting.
Many insurers choose to raise rates on members after a certain number of losses, but when this happens varies from one company to another. At one time, insurers followed the Insurance Services Office’s standard by increasing premiums by 20 to 40 percent of the base rate after a claim, but that is no longer the case. On average today, most insurers raise rates at least 20 percent after an accident, but it can be much higher in some states.
Incurred Losses and Expenses
Like any business, insurance companies will have expenses, both in the form of operating expenses and the cost of doing business. For the insurance industry, usually the biggest expense is related to paying out the claims of customers. It’s unrealistic to believe that the vast majority of customers will pay premiums in perpetuity and never have a single claim. The goal is to keep those payouts low when compared to premiums, which is where using the combined ratio insurance formula can come in handy.
When calculating the combined ratio formula, though, it’s important to also pay attention to expenses, since those are weighed just as heavily as incurred losses during each timeframe. To reduce expenses, it’s important to first be aware of what those expenses are. Like any business, an insurance agency can cut costs by reducing staffing, shrinking office size and, interestingly, cutting your own business insurance costs. Even a few small cutbacks can help you drop that combined ratio down without raising rates across the board for policyholders.
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.