Loss Ratio

Reviewed by Stefan Tirschler

Noun

loss ra·tio | ˈlɔs ˈreɪʃiːˌoʊ /

Definition: The expenses an insurer incurs to adjust and pay claims expressed as a percentage of premiums earned.

The insurance company’s strong loss ratio indicated that they were in a healthy financial position.

What is a loss ratio?

In the insurance world, a loss ratio is one indicator of how financially stable an insurance company is. It’s the ratio of losses paid to premiums earned. That is, a comparison of how much the company spent settling claims and how much it earned from paying customers.

The formula for the loss ratio is:

(Insurance claims paid) + (adjustment expenses) / (total earned premiums)

The result is a percentage, which describes how much of the company’s income it used to settle claims over a set period of time.

Let’s quickly break down the three parts of that equation:

Insurance claims paid: The amount of money the insurance company spent that went directly towards claim settlements. That is, money they used to pay for replacement or repair of damaged property, cash settlements, or legal damages in liability claims.

Adjustment expenses: The money the company spent investigating and adjusting claims. This category includes things like adjusters’ pay and expenses, costs for investigations, and other miscellaneous administrative costs.

Total earned premiums: The sum of all the insurance premiums the company’s customers paid during the period in question.

Knowing what each piece of the puzzle is, here’s an example of a loss ratio calculation:

Example

The GreenTree Insurance company earned $10 million in premiums from its customers in 2019. During that same year, they paid $5 million in claim settlements and spent another $2 million adjusting those claims.

That’s all the information we need to calculate GreenTree’s loss ratio for 2019.

(5,000,000 + 2,000,000) / 10,000,000

That’s their claim payments, plus their adjustment expenses, divided by their total premiums earned. The result is 0.7, or 70%; GreenTree Insurance Company had a loss ratio of 70% in 2019. That means they used 70% of their premium earnings to pay for losses.

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What is a loss ratio used for?

The loss ratio is a simple tool for an insurance company to get one high-level view of how they’re doing financially.

If the company is spending more on claims then they’re earning in premiums, that’s a red flag. It means they either need to charge higher premiums or be more selective about the properties they insure.

The only way an insurance company can function is if they stay profitable. If they lose money to claim settlements year after year, eventually they’ll run out of money to pay claims altogether. They’d go out of business and make their customers rather unhappy in the process.

It’s common for a loss ratio to fluctuate from year to year. In a year with many claims, perhaps due to a natural disaster, their loss ratio may be far above 100%. That’s okay if it’s below 100% other years.

Insurance companies often take a much wider view with the loss ratio. They frequently look at 5-year chunks of time instead of just 1 year.

What is a good loss ratio?

Different companies and different lines of insurance have different definitions of what an acceptable loss ratio is.

Any number from 0-99% means they’re earning more premiums than they’re paying out in losses, but it’s not as simple as that.

Insurance companies also have operating expenses that have nothing to do with claims: agent salaries, rent, utility bills, office coffee, and so on. The expense ratio is much like the loss ratio. Instead of comparing income to loss payments, it compares income to operating expenses.

When you add the loss ratio to the expense ratio, you get the combined ratio, which is a more complete picture of a company’s financial health.

After paying for losses and expenses, it’s common for an insurance company to have less than 5% of it’s earnings left. Out of that small share, they still need to set aside money for their cash reserves. Insurance companies always keep a reserve on hand to pay claims that their actuaries know statistically are coming soon.

With all that in mind, many companies consider a loss ratio around 60-70% to be acceptable. That gives them enough leftover to pay expenses and set aside reserves. The acceptable loss ratio does, however, vary wildly from company to company.

The important points

  • The loss ratio is a simple measurement of how much money an insurance company is paying for claims compared to what they’re earning in premiums.

  • The loss ratio is often combined with the expense ratio to create the combined ratio, which is one measure of an insurance company’s overall profitability.

  • Different companies and different lines of insurance have different acceptable loss ratios, but 60-70% is common.

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