Non-life insurance (also called property and casualty insurance in the USA and general insurance in the UK) typically covers a wide range of insurable events that includes damages to an automobile in an accident and financial loss caused by fire on real property. It also includes third party liability insurance which covers losses caused by a policyholder due to injury of another person and business insurance which covers financial and economic losses arising from property damages, product and professional liability. This list is not exhaustive.
How do (non-life) insurers measure whether they are making a profit or loss on their insurance operations? The most common measure used for this purpose is called the Combined Ratio.
Here is an example showing how this ratio is calculated.
During the last three months ending March 1, 2018 a non-life insurer reports the followng information:
Total premium = 100,000;
Total expenses incurred in obtaining the premium = 25,000;
Total cost of claims from policyholders = 70,000.
The following two key ratios are calculated:
Expense Ratio = 25,000 / 100,000 = 25%
Claims Ratio = 70,000 / 100,000 = 70%
We now obtain the combined ratio as follows:
Combined Ratio = Expense Ratio + Claims Ratio = 25% + 70% = 95%
How is this value interpreted?
If an insurer reports a combined ratio with a value lower than 100%, then it has made a profit in its insurance business. On the other hand, if the combined ratio has a value higher than 100%, then the insurer has made a loss. In our previous example, a combined ratio of 95% means that the insurer made a profit of 5%.
Key Takeaway
A combined ratio with a value higher than 100% means that the insurer has made a loss. This loss may arise from two main sources:
a) inefficient insurance operations leading to too high expenses;
b) too frequent or severe policyholders’ claims.