Combined Ratio? What the heck is that?

Every industry has it's own set of metrics and insurance is no different. I was in a meeting this morning and happened upon a new employee who had no idea what combined ratio was so after the meeting I spent some time explaining this key measure of insurance company performance. The folks at IRMI.com define combined ratio this way:

The sum of two ratios, one calculated by dividing incurred losses plus loss adjustment expense (LAE) by earned premiums (the calendar year loss ratio), and the other calculated by dividing all other expenses by either written or earned premiums (i.e., trade basis or statutory basis expense ratio). When applied to a company's overall results, the combined ratio is also referred to as the composite, or statutory, ratio. Used in both insurance and reinsurance, a combined ratio below 100 percent is indicative of an underwriting profit.

This definition is absolutely correct but unless you are an insurance professional it might as well be Latin in terms of helping folks new to our industry understand what combined ratio really means. My favorite definition, shared by a former CEO of our company, is perhaps a little simpler to understand:

The cost of claims plus operating expenses divided by premium.

 An overly simple example might help. If an insurance company has $1,000 in claims and a $1,000 in operating expenses (the light bill, salaries, overhead, etc.) and collects premium of $2,000 the combined ratio would be 100%:

($1,000 + $1,000)/$2000 = 100%

In other words, for every dollar of premium collected, the insurance company spent one dollar in combined claims and operating expense. In the example above, if the insurance company had actually collected $2,500 in premium while incurring $2,000 in claims and operating expense the combined ratio would be 80% ($2,000/$2,500) and the insurance company would have made a profit of 20 cents on every dollar. Conversely, if the insurance company had only collected $1,900 in premium the combined ratio would have been 105% which means the insurance company would be spending 5 cents more on claims and operating expense than it was collecting per dollar of premium. 

Its important to realize that insurance companies can still make money even if their combined ratio is higher than 100%. If you know how you are probably already working in the insurance industry but for those who don't know the answer, it's not complicated or rocket science. The dollar of premium collected by the insurance company doesn't immediately get spent on claims or operating expense. Until it does get spent that dollar is being invested and as long as the return on the investment is greater than the extra 5% in the 105% example above the insurance company still makes money. 

Insurancejournal.com indicates that the combined ratio for the workers' compensation insurance industry in 2013 was 101%. That said, combined ratios vary dramatically between companies and even between states. Our employees are kept aware of Pinnacol's combined ratio as one measure of how we are doing as a company but for new employees, as for those outside our industry, it is sometimes challenging to understand what some of these metrics mean and why they are important!