Loss RatioA ratio of claims paid to premiums earned

Dealing with the business of selling insurance can be a little tricky.

On one hand, you have the policyholders that want to get the most bang for their buck.

They don’t want to pay insurance premiums for nothing after all, is what I’m saying.

On the other hand, you have insurance companies that want to generate as much profit as possible.

This can be usually done by collecting as many insurance premiums as possible while paying the least amount of insurance claims.

However, insurance companies have the responsibility to answer valid insurance claims.

Balancing these two sides is essential to running a successful insurance business.

You don’t want to be too greedy to the point that your customers would rather deal with another insurance provider.

On the other hand, you don’t want to disregard your profit generation as it will lead to the eventual closure of your insurance business.

So, what are you to do as someone who wants to delve into the business of providing/selling insurance policies?

Well, aside from learning the basics of dealing with insurance, you may want to familiarize yourself with a metric we refer to as “loss ratio”.

The loss ratio is basically a metric that measures the amount of losses incurred against the premiums earned by an insurance business.

In this context, losses refer to the total paid insurance claims plus any incurred adjustment expenses.

In this article, we will be discussing what a loss ratio is.

We will define it as well as explain its importance to businesses that deal in the sale of insurance policies.

We will also discuss the formulation for the calculation of a loss ratio.

By the end of this article, we should be more familiar with what a loss ratio is.

What is a Loss Ratio?

The loss ratio is a metric mainly used in the insurance industry. It’s the ratio of losses paid by the insurance provider to the premiums it earned.

In this context, losses refer to the total amount of paid insurance claims and adjustment expenses.

In other words, the loss ratio compares the amount that the insurance provider spent settling insurance claims to the amount that it has earned from collecting insurance premiums.

One of the benefits of doing so is that the insurance provider can gauge whether or not it’s charging enough for its insurance policies.

The loss ratio is just one of the indicators that can gauge the financial stability of an insurance company.

To better understand the loss ratio, let’s take a look at the formula that we use for its calculation:

Loss Ratio = (Insurance Claims Paid + Loss Adjustment Expense) ÷ Total Insurance Premiums Earned x 100%

Where:

Insurance Claims Paid – refers to the amount of money spent by the insurance provider to settle insurance claims

Loss Adjustment Expense – refers to the expenses incurred by the insurance provider to investigate and verify insurance claims; this is so that the insurance provider doesn’t pay for bogus claims

Total Insurance Premiums Earned – refers to the amount of insurance premiums collected by the insurance provider

We usually express the loss ratio in terms of percentage.

For example, let’s say that an insurance provider pays $40 for every $100 insurance premiums that it collects.

This results in a loss ratio of 40%.

While the loss ratio can be computed using the respective total of losses paid and premiums earned, it can also be computed using a specific insurance policy.

This is useful if an insurance provider wants to determine if a certain insurance policy needs a premium increase.

Purpose of the Loss Ratio

The loss ratio is an important ratio for insurance providers.

It provides them with information regarding their financial performance.

By comparing the cost paid in settling claims to the total premiums collected, the insurance provider can have an overview of how it’s performing financially.

Depending on the level of the loss ratio, we can gauge if the insurance is performing well or not.

A loss ratio of less than 100% means that the insurance provider is retaining a portion of its premiums even after disbursing cash to settle claims.

The lower the ratio, the more likely that the insurance provider generates a profit. In general, a loss ratio of 40%-60% is an acceptable level.

A loss ratio of exactly 100% means that the insurance provider is only breaking even on its settlements and collections.

This means that the insurance provider wasn’t able to retain any amount of money from its premium collections.

This isn’t a favorable result for the insurance provider as even if it breaks evens on its settlements and collections, it still has operating expenses to worry about.

A loss ratio of exactly 100% usually leads to a loss.

A loss ratio that’s greater than 100% means that the insurance provider is losing money on its settlements.

This may also mean that the total premium collections aren’t enough to settle all claims.

A loss ratio of 100% is unfavorable for the insurance provider. It will always lead to a loss.

And the higher the loss ratio is, the greater the loss will be.

Do note that a loss ratio of less than 100% doesn’t automatically indicate a profitable company.

There are still operating expenses to consider (e.g. salaries, commissions, rent). As such, the loss ratio is often paired with the benefits-expense ratio to assess an insurance company’s profitability.

Loss Ratio vs Benefits-Expense Ratio

The benefits-expense ratio (or expense ratio) is a ratio that compares the insurance provider’s operating expenses to its total (net) premium collections.

Expenses could include the salaries and wages of employees, agent commissions and allowances, legal fees, etc.

The expense ratio looks at the relationship between operating expenses and the total premium collections.

This is in contrast with the loss ratio which instead looks at the relationship between the cost of settling claims and the total premium collections (similar to the “cost of sales” and “revenue”).

The loss ratio goes hand in hand with the expense ratio.

An insurance provider usually sets its target loss ratio relative to its expense ratio.

A low expense ratio can allow a higher target loss ratio.

In general, a loss ratio of 40%-60% should be acceptable, but it will still ultimately depend on the expense ratio.

Adding the loss ratio and expense ratio together will result in another ratio that we refer to as the “combined ratio”.

This ratio measures the total outflow of money due to operations. It also helps in measuring the insurance provider’s profitability.

Medical Loss Ratio

Under the Affordable Care Act (ACA), health insurance companies have to spend at least 80% of premiums on medical care.

This includes paying for insurance claims as well as spending on activities and programs that improve the quality of medical care.

If an insurance provider is not able to spend the required 80% on medical care, it will have to rebate the excess back to its customers.

Health insurance providers generally do not have the option to adjust a plan’s insurance premium according to the policyholder’s claims and medical history.

The ACA has strict rules regarding the increase in the insurance premium of health insurance.