What is the Loss Ratio?

Loss Ratio Formula

The loss ratio is calculated as losses incurred in claims (paid to the insured for damages when the risk event happens) plus adjustment expenses (incurred by the insurance company for investigating and settling an insurance claimAn Insurance ClaimAn insurance claim refers to the demand by the policyholder to the insurance provider for compensating losses incurred due to an event covered by the policy. The company either validates or denies the claim based on their assessment and nature of the incurred losses.read more) divided by the premiums earned during the period.

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Loss Ratio Formula = Losses Incurred in Claims + Adjustment Expenses / Premiums Earned for Period.

For example, if an insurer collects $120,000 in premiums and pays $60,000 in claims and adjustment expenses. The loss ratio for the insurer will be calculated as $60,000/$120,000 = 50%.

Understanding Loss Ratio

Loss Ratio gives a first-hand estimate of the insurance company’s profitability from its core business. It is like calculating gross margins (the difference between revenue and direct costsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more like raw materials and fuel) for other businesses. The gross margin tells you what a manufacturing or service business makes from its core business without factoring in the other operating and administrative overheadsAdministrative OverheadsAdministrative overheads are expenses that are not directly linked to the production & distribution of goods & services but are indirect in nature, such as expenses incurred in the policy formulation, employee cost, legal and audit fees, telephone and electricity expenses.read more.

Insurance companies make money and stay solvent when they pay out (claims) lesser than what they collect (premiums) in a particular period. When an insurance company regularly pays out a higher proportion of premiums in losses, it can run into financial trouble, lose its capital, and default on future claims. Therefore, it is always advisable for insurance companies to maintain adequate loss ratios.

This ratio differs across insurance sectors, and some sectors may have a higher ratio than the other sectors. For example, property and casualty insurance tend to have a lower loss ratio than health insurance.

Types of Loss Ratio in Insurance

The following are two types –

#1 – Medical Loss Ratio

It is generally used in health insurance and is the ratio of healthcare claims paid to premiums received. Health insurers in the United States are mandated to spend 80% of the premiums received towards claims and activities that improve the quality of care. Failing the condition, the insurers have to give the excess funds back to the consumers.

#2 – Commercial Insurance Loss Ratio

It is meant for the insured, wherein the insured must maintain an adequate loss ratio, failing which the business risksBusiness RisksBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more non-renewal of insurance or increased premium for the cover. For example, a furniture store pays $3,000 in premium to ensure the inventory, and a hailstorm causes $4000 damage. The ratio for one year becomes $4000/$3000 or 133%. In this case, the insurer will look at the long-term claim history of the insured and take a call on increasing the premium or not renewing the policy.

Real Life Example of Loss Ratio

Property and casualty insurance companies sometimes have a high loss ratio if the insured properties experience devastating events like floods, cyclones, or hailstorms. In such situations, these ratios surpass the 100% mark, and the companies pay much higher than the premium they collected in that period. According to a report, in 2018, most property and casualty insurersProperty And Casualty InsurersProperty and casualty insurers (P&C insurers) provide umbrella insurance services such as indemnity against large groups of assets such as a car, house, or company land, as well as liability insurance for injuries, damage to other people’s property, and accidents.read more reported such ratios above 100%, one of them posted a ratio of more than 250%.

Farmers insurance posted a loss ratio of 155%, while Allstate corp posted a ratio of 257%.

Why is Loss Ratio Useful?

Below are some of the reasons why loss ratios are useful in the insurance industry –

  • It helps to determine the profitability of the insurance company.Comparison of loss ratios amongst different insurance companies can give us useful insights into the businesses and differences in business models of these companies.This ratio helps determine future policies’ premiums as the companies take regular feedback for issued policies and tweak pricing to stay competitive and profitable.

Important Points

  • Different insurance companies will have different loss ratios depending on their cover losses.This ratio may fluctuate from period to period due to reasons under or beyond the insurer’s control.The insurance companies pay the loss adjustment expenses to ensure they do not pay for fraudulent claims even though it eats into their profits.Fraudulent claims sometimes shore up this ratio for insurance companies, even though they use various checks to dishonor fraudulent claims rightly.The insurance companies can also reimburse loss adjustment expenses in case of some commercial liability policies.Loss ratios are always used in conjunction with combined ratios to measure the overall outflow relative to the inflow.

This has been a guide to a loss ratio, and it’s a definition. Here we discuss calculating the loss ratio and its formula, types, examples, and usefulness. You can learn more about finance from the following articles –

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