What is the difference between the Loss Ratio and Expense Ratio?

30.03.2020
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Introduction

We have already discussed the meaning and relevance of the Expense Ratio in the Insurance sector. However, it is imperative to understand various other ways that an insurance company uses to calculate its efficiency. In order to do that, we must know the importance of the Loss Ratio as part of the combined ratio that provides basic guidelines to the targets and achievements of the company’s underwritten policies.

How is the Loss Ratio calculated?

It is calculated in comparison with the premiums earned (as its percentage). Losses in this ratio include the adjustment expenses and paid claims. In effect, insurance claims paid added with the adjustment expenses that are divided by total earned premiums. For instance, the company paying $60 in claims for every $100 that it earns/collected premium, Ratio of loss would be 50%. A higher Loss Ratio indicates financial distress and can also mean that the company would think about raising its premium costs or refuse to renew the policies at present prices.

This ratio is subjective for different sectors in the insurance industry. Like, the higher Loss Ratio for the health insurance company is seen to be more damaging and worrisome as compared to the higher Loss Ratio for a casualty and property-related insurance company. In simple words, this Ratio indicates financial distress. Whenever a firm has to shell out more money than it earned by selling policies, its Loss Ratio will most likely be more than 100%.

Expense Ratio

However, the Expense Ratio would be a result if we divide the expenses of the insurance company by its Net Premium Earned. It is just another way of saying that the percentage of sales in comparison with the cost of operating business results in the Expense Ratio.

Insurers calculate the combined ratios that include both the Loss and Expense ratio to measure the cash outflows that resulted from the basic operational services. Based on this value, it is determined whether the company is profitable or not.

Combined Ratio and its relevance:

We get the expense ratio after dividing the insurer’s expenses (Marketing, Commission, Operational expenses, etc.) by the total premiums collected in a given year.

For example, an insurance company realizes $5 million in the underwriting losses from its total insurance policies sold. But it also generates $10 million in premiums. The Loss Ratio would then be $5 million divided by $10 million = 50 percent.

However, if the same insurance company spends $2 million in operating the company, its Expense Ratio would be $2 million divided by $10 million = 20 percent.

The Combined Ratio will add both underwritten claims made by its clients and expenses it occurred and dividing it by the total premiums earned during that period. In this case, $5 million and $2 million makes $7 million. Total premiums earned being $10 million, the combined ratio would be 70 percent. In this way, when we divide the total expenses and claims by the total premiums earned, the Combined Ratio is the end result.

When the Combined Ratio and Expense Ratio turn out to be 100 percent, the insurer breaks even the cost making it no profit no loss. However, if the combined ratio itself exceeds 100 percent, the company will portray a loss.

How insurance companies calculate their efficiency?

It is imperative to understand various other ways that an insurance company uses to calculate its efficiency. In order to do that, we must know the importance of the Loss Ratio as part of the combined ratio that provides basic guidelines to the targets and achievements of the company’s underwritten policies.

What does a higher loss ratio indicate?

It indicates financial distress and can also mean that the company would think about raising its premium costs or refuse to renew the policies at present prices.

How is loss ratio subjective for companies?

It is subjective for different sectors in the insurance industry. Like, the higher Loss Ratio for the health insurance company is seen to be more damaging and worrisome as compared to the higher Loss Ratio for a casualty and property-related insurance company.

How do insurers measure cash outflow?

Insurers calculate the combined ratios that include both the Loss and Expense ratio to measure the cash outflows that resulted from the basic operational services. Based on this value, it is determined whether the company is profitable or not.

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