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Combined Ratio – How to Calculate it With Examples

How do we determine if the insurance companies that we invest in are making money? Is there some secret formula or hidden clues in the financial reports? In a word, yes, there is. It is called the combined ratio, and it can reveal all to us.

Well, 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 will. Keep this in mind as we investigate further the intricacies of the combined ratio. 

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. Thus the reason it will not work

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 then 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 is making a profit on its underwriting operations. 

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

Insurance experts say that the combined ratio is the best way to determine whether or not a company is making a profit. It is the best calculation because it excludes investment income.

It only concentrates on the underwriting operations.

Insurance companies must bring in more revenue from premiums than it is paying out in claims. In simple terms, they must bring in more than the payout. 

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

An insurance company that can make a profit from its underwriting business for a long time thrives. It is also more likely to be around for a long time. 

Which is music to a value investors‘ ears, we want companies we invest in to last a very long time.

Combined Ratio Terms

Now we know what the combined ratio is 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 refers to the value to loss that an insurance company incurs during a given period. The losses represent the profits that the company will not earn. Instead, it represents the money paid back to policyholders.

There are multiple parts to the incurred losses:

Policyholder claims – A policyholder claims compensation when he/she suffers a loss on the insured loss or event. Insurance companies maintain a reserve to settle claims on losses they underwrite. The amount made as compensation for losses incurred is recognized 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 then 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 be forced to pay a higher amount than it had 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 it will make payments of old claims, as well as the new claims anticipated in the next period. The standard level of reserves varies from 8% to 12% of the annual revenues, depending on the state laws.

The loss reserves may also be based 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 because it was not anticipated.

Incurred Expenses: An incurred expense is a cost that a business incurs when it purchases goods or services on credit. The purchase may be made either through 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 at a later date.

An incurred expense becomes a paid expense once the business has paid the cost it owed 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.

Ok, now that we have explored what the combined ratio is, and what the accounting terms mean. Let’s take a look at some examples of how to calculate the combined ratio.

How to Calculate the Combined Ratio

We need to break down the combined ratio into the 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 have not yet been paid by the insurer.

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

When the loss ratio is low, it means that consumers are paying too much for the benefit received.

Because 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 and injury, accident, or some other catastrophic loss.

To calculate the loss ratio, we are going to 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.

claims and claims expense for Allstate (income statement)
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Premiums are also going to be found in the same statement right 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 are going to be similar to the cost of goods sold in a more traditional business. In a traditional business, it 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 is our way of determining profitability by dividing the costs associated with acquiring, underwriting, and servicing premiums by the net premiums earned by the insurance company.

expense ratio Allstate (income statement)
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We can see that we are primarily using the income statement to acquire this data. This 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 very transparent about their combined ratio and will provide the ratios quite freely.

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

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

Combined Ratio Calculations with Examples

Now that we understand what the combined ratio is and where to find the data to determine our profitability let’s put this all to use so you can calculate this for yourself.

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

Looking at the 2018 10-k, we find the income statement and find our numbers to determine the combined ratio.

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

CINF combined ratio calculation (income statement)
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Loss Ratio will be up first:

  • Insurance losses and contract holders benefits – 3490
  • Earned premiums – 5170

Loss Ratio = 3490 / 5170
Loss Ratio = 67.5%

Next up will be the expense ratio:

  • Underwriting, acquisition, and insurance expenses – 1597
  • Other operating expenses – 16
  • Other revenues – 5
  • Earned premiums – 5170

Expense ratio = ( 1597 + 16 + 5 ) / 5170
Expense ratio = ( 1618 ) / 5170
Expense ratio = 31.2%

Now, after calculating the loss ratio and expense ratio, we will add those two numbers together to get our combined ratio.

Combined Ratio = Loss Ratio + Expense Ratio
Combined Ratio = 67.5 + 31.2
Combined Ratio = 98.7%

The combined ratio score of 98.7% indicates that Cincinnati Financial is doing a good job of creating profitability from their underwriting business. Which is great because the majority of the income they derive is through the generation of premiums.

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

Next up, let’s look at The Hartford (HIG), another property-casualty company that has total assets of $62.3 billion and shareholders equity of $13.1 billion.

combined ratio calculation HIG (income statement)
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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 = 11,165 / 15869
Loss Ratio = 70.35%

Next up, the expense ratio.

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

Expense Ratio = ( 1384 + 4281 + 105 ) / 15869
Expense Ratio = 5770 / 15869
Expense Ratio = 36.36%

Combined Ratio = Loss Ratio + Expense Ratio
Combined Ratio = 70.35% + 36.36%
Combined Ratio = 106.71%

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 that also dabbles in life insurance. Chubb has a market cap of $73.39 billion and $174. 5 million.

income statement chubb combined ratio calculation
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There are notes at the bottom that will help us with our combined ratio calculations; please note them.

CB 10-k footnotes
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Combined Ratio = Loss Ratio + Expense Ratio

Data from 10-k:

  • Earned premiums – 27846
  • Losses and Expenses – 18067
  • Losses and expenses attributed to life insurance – 766
  • Policy and acquisition costs – 8798
  • Policy and acquisition costs per life insurance – 867

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

Loss Ratio = ( 18067 – 766 ) / 27846
Loss Ratio = ( 17301 )/ 27846
Loss Ratio = 62.1%

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

Expense Ratio = ( 8798 – 867 ) / 27846
Expense Ratio = 7931 / 27846
Expense Ratio = 28.4%

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

Combined Ratio = 62.1% + 28.4
Combined Ratio = 90.5%

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, the 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 those that 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 utilize to determine profitability.

As we have discovered insurance companies are no different from “regular” companies, it is a matter of determining the different language that they speak. Once you speak the language, we can set about learning 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, and that can help you with your investing journey.

Take care,

Dave