How do we determine if the insurance companies we invest in make money? Is there some secret formula or hidden clues in the financial reports? In a word, yes. The ratio refers to the combined ratio and can reveal everything to us.

Well, maybe not all, but quite a bit if we know where to look and how to interpret the numbers.

Part of the fun of learning more about insurance companies is seeing what makes them tick. Or to see how they make money.

Property & Casualty insurance companies will make money differently than Life insurance companies.

Keep this in mind as we further investigate the combined ratio’s intricacies.

One note of caution: the combined ratio will not work with life insurance companies. How life insurance companies make money is different from property & casualty.

In today’s post, we will learn:

- What is the Combined Ratio?
- Combined Ratio Terms
- How to Calculate the Combined Ratio
- Combined Ratio Calculations with Examples

**What is the Combined Ratio?**

**According to Investopedia:**

“*The combined ratio is a measure of profitability used by an insurance company to gauge how well it is performing in its daily operations*.”

We can calculate the combined ratio by taking the sum of the incurred losses and expenses and dividing them by the earned premium.

Thus we get the formula:

**Combined Ratio = Incurred Losses + Expenses / Earned premiums**

Analysts and investors alike usually express this ratio as a percentage. If it is less than 100%, the company profits from its underwriting operations.

A combined ratio of 100% might still mean the company is profitable, especially if it makes significant income from its investment portfolio.

Insurance experts say the combined ratio remains the best way to determine whether or not a company continues to make a profit. The combined ratio remains the best calculation because it excludes investment income.

It only concentrates on underwriting operations.

Insurance companies must bring in more revenue from premiums than they pay in claims. In simple terms, they must bring in more than they pay out.

Otherwise, they will not be profitable. If the companies are not profitable, then the company will not be around long.

An insurance company can profit and thrives from its underwriting business for a long time, and the company remains more likely to hang around for a long time.

Long-lasting investments are music to a value investor’s ears; we want the companies we invest in to last long.

# Combined Ratio Terms

Now we know the combined ratio and how it can impact a company. Let’s dive in and look at some of the terms associated with the combined ratio.

Incurred Losses refer to the value of loss an insurance company incurs during a given period. The losses represent the profits the company will not earn. Instead, incurred losses represent the money paid back to policyholders.

There are multiple parts to the incurred losses:

**Policyholder claims** – A policyholder claims compensation when they suffer a loss on the insured loss or event. Insurance companies maintain a reserve to settle claims on losses they underwrite. We can recognize the amount made as compensation for losses incurred as a loss because the money goes out of the company’s account to the policyholder’s account.

**Re-evaluation of claims**: Involves reviewing all claims currently being processed to help determine if their value is higher or lower than the amount recorded first. Before paying any claims, an insurance company must first investigate the claims to verify if the loss occurred and that it is not a fraudulent process.

Once the company is satisfied that the claim is genuine, it sets to determine the accuracy of the recorded value. If the newly determined value of a claim is higher than the recorded claim, the company will have to pay a higher amount than planned. The excess claim paid is a loss to the insurer since it exceeds the amount recorded in the books.

**Change to Loss Reserves**: The law requires insurance companies to maintain an adequate reserve from which they will make payments of old and new claims anticipated in the next period. The standard level of reserves varies from 8% to 12% of the annual revenues, depending on state laws.

The loss reserves may also base the results on a forecast of losses that the insurer anticipates during a given period, which means that the forecast may be correct, excessive, or fall short of the actual claims during a given period. If the actual losses exceed the reserve, the insurer will be required to get additional funds to top up the reserve. The change in the reserve amount will be a loss to the company.

**Incurred Expenses**: An incurred expense is a cost incurred when a business purchases goods or services on credit. The company may purchase a credit card or a billing arrangement with the seller of the goods. Most companies buy raw materials in bulk from manufacturers and wholesalers on credit, with an agreement to pay later.

An incurred expense becomes a paid expense once the business has paid the cost to the supplier of the goods or services. Most of the time, incurred expenses are paid after incurred, while at other times, they may take several years before being paid.

Okay, now that we have explored the combined ratio and the accounting terms, let’s take a look at some examples of how to calculate the combined ratio.

# How to Calculate the Combined Ratio

Let’s break down the combined ratio into two segments that we need to discover, then we can break down the formula.

Let’s first identify the Loss Ratio and where we can find the corresponding data.

**Loss Ratio:**

The Loss Ratio shows the relationship between incurred losses and earned premiums, expressed as a percentage. Incurred are actual paid claims plus loss reserves. The loss reserves are liabilities due to known losses that the insurer has not yet paid.

Insurance companies with very high loss ratios may need to raise premiums to stay profitable and ensure their ability to pay future claims.

Consumers pay too much for the benefit received when the loss ratio is low.

The loss ratio discusses monies lost, and with an insurance company, this will refer to **claims and expenses related to claims**.

Claims are monies the insurance companies pay back to us when we suffer an injury, accident, or some other catastrophic loss.

To calculate the loss ratio, we will look in the financial documents for the term claims and or claims expenses.

In the case of Allstate (ALL), we can find this info in the Consolidated Statements of Operation or Income Statement.

We can find premiums in the same statement under the Revenues section.

Remember that premiums are a larger part of the revenue of property & casualty insurance companies than they will be of life insurance.

**Expense Ratio**

Expenses in insurance companies will be similar to the cost of goods sold in a more traditional business. A traditional business would include things such as payroll, cost of goods sold, and so on.

In the insurance business, it is going to include line items such as:

- Amortization of deferred acquisition costs
- Operating costs and expenses
- Restructuring and related charges
- Other revenue

The expense ratio in the insurance industry determines profitability by dividing the costs associated with acquiring, underwriting, and servicing premiums by the net premiums earned by the insurance company.

We can see that we primarily use the income statement to acquire this data. It makes it easier to find the data and determine our ratios.

I would be remiss if I didn’t mention that some companies will be transparent about their combined ratio and provide the ratios quite freely, plus the loss and expense ratios; thus, taking the calculations out of our hands and making analysis a little easier.

Others will not list it or make it a little more difficult to calculate by making the terms more obscure or hiding them altogether.

Like any other investigation, use the information to give you an idea of the management and whether or not they are free and open about their operations.

# Combined Ratio Calculations with Examples

Now, we should understand the combined ratio and where to find the data to determine our profitability; let’s put the knowledge to use so you can calculate the ratio for yourself.

The first company I would like to look at is Cincinnati Financial Corp (CINF). Cincinnati Financial is an insurance company that provides property-casualty coverage and operates out of Fairfield, Ohio. They are a Dividend King, meaning they have paid a rising dividend for over 50 years.

Looking at the 2021 10-K, we find the income statement and our numbers to determine the combined ratio.

All numbers listed in any financial statements we use will be in the millions unless otherwise stated.

The loss Ratio will be up first:

- Insurance losses and contract holder’s benefits – $3,936 million
- Earned premiums – $6,482 million

Loss Ratio = 3,936 / 6,482

Loss Ratio = 60.7%

Next up will be the expense ratio:

- Underwriting, acquisition, and insurance expenses – $1,951 million
- Other operating expenses – $20 million
- Other revenues – $10 million
- Earned premiums – $6,482 million

Expense ratio = ( 1,951 + 20 + 10 ) / $6,482

Expense ratio = 1,981 / 6,482

Expense ratio = 30.5%

After calculating the loss and expense ratios, we will add those two numbers to get our combined ratio.

Combined Ratio = Loss Ratio + Expense Ratio

Combined Ratio = 60.7% + 30.5%

Combined Ratio = 91.2%

The combined ratio score of 91.2% indicates Cincinnati Financial continues doing a good job of creating profitability from its underwriting business. The combined ratio remains great because most of the income they derive comes through the generation of premiums.

Remember that our goal is to find a company generating a combined ratio of under 100%, indicating a profitable company.

Next, look at The Hartford (HIG), another property-casualty company with total assets of $62.3 billion and shareholders equity of $13.1 billion.

Now that we have the info from the income statement, let’s get to work.

Loss Ratio = Benefits, losses, and loss adjustment expenses / Earned premiums

Loss Ratio = $12,729 / $17,999

Loss Ratio = 70.7%

Next up the expense ratio.

Expense Ratio = ( Amortization of DAC + Insurance operating costs + Other revenues ) / Earned premiums

Expense Ratio = ( $1,680 + $12,729 + $4,779 ) / $17,999

Expense Ratio = $19,188 / $17,999

Expense Ratio = 106.6%

Combined Ratio = Loss Ratio + Expense Ratio

Combined Ratio = 70.7% + 106.6%

Combined Ratio = 177.3%

Ouch, that indicates that Hartford is operating at an underwriting loss.

Discovering the combined ratio is fun; why don’t we take a look at one more company?

The last one is Chubb (CB), another property-casualty company dabbling in life insurance. Chubb has a market cap of $73.39 billion.

Combined Ratio = Loss Ratio + Expense Ratio

Data from 10-K:

- Earned premiums – $37,868 million
- Losses and Expenses – $21,980 million
- Losses and expenses attributed to life insurance – 766
- Policy and acquisition costs – $6,918 million
- Policy and acquisition costs per life insurance – 867

Loss Ratio = ( Loss and expenses – losses and expense life insurance ) / Earned premiums

Loss Ratio = ( $21,980 – $766 ) / $37,868

Loss Ratio = $21,214 / $37,868

Loss Ratio = 56%

Expense Ratio = ( Policy and acquisition costs – Policy and acquisition costs life insurance ) / Earned premiums

Expense Ratio = ( $6,918 – $867 ) / $37,868

Expense Ratio = $6,051 / $37,868

Expense Ratio = 15.97%

Putting the loss ratio and expense ratio together, we get:

Combined Ratio = 56% + 15.97%

Combined Ratio = 71.97%

Our newly calculated combined ratio tells us that Chubb is quite profitable from an underwriting aspect.

Chubb is another great example of a company being completely transparent on the financial reports to help us, shareholders, determine the right numbers and thoughts on our possible investments.

# Final Thoughts

As you can see, calculating the combined ratio is simple once we know where to find our numbers.

The biggest trick is knowing the terminology and discovering where to find the numbers in the financial reports. It can be tricky if you don’t know what and where to look.

We have seen how the combined ratio can help us determine which insurance companies are profitable and which might struggle.

Remember that this is a ratio that only applies to primarily property-casualty insurance companies. In regards to life insurance companies, this ratio doesn’t apply.

For life insurance companies, we will have other ratios and numbers to determine profitability.

As we have discovered, insurance companies are no different from “regular” companies; it is a matter of determining the language they speak. Once you speak the language, we can learn which insurance companies are profitable and would be fantastic investments.

As always, thank you for taking the time to read this article. I hope you found something valuable to help you with your investing journey.

Take care,

Dave

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