The loss ratio and combined ratio are two ratios used to measure the profitability of an insurance company. The loss ratio measures the total incurred losses in relation to the total collected insurance premiums, while the combined ratio measures the incurred losses and expenses in relation to the total collected premiums.
The loss ratio is calculated by dividing the total incurred losses by the total collected insurance premiums. The lower the ratio, the more profitable the insurance company and vice versa. If the loss ratio is above 1, or 100%, the insurance company is unprofitable and may be in poor financial health because it is paying out more in claims than it is receiving in premiums. For example, say the incurred losses, or paid-out claims, of insurance company ABC are $5 million and the collected premiums are $3 million. The loss ratio is 1.67, or 167%; therefore, the company is in poor financial health and unprofitable because it is paying more in claims than it receives in revenues.
Conversely, the combined ratio is calculated by summing the incurred losses and expenses and dividing the sum by the total earned premiums. For example, suppose insurance company XYZ pays out $7 million in claims, has $5 million in expenses, and its total revenue from collected premiums is $60 million. The combined ratio of company XYZ is 0.20, or 20%. Therefore, the company is considered profitable and in good financial health.
The two ratios are different because the combined ratio takes expenses into account, unlike the loss ratio. Thus, the two ratios should not be compared to each other when evaluating the profitability of an insurance company.
(For related reading, see: How to Value an Insurance Company.)