Introduction to Expense Ratio

Providing financial security to its consumers is the ultimate aim of an insurance company. However, sustaining its own capability to finance its customers becomes its priority. To measure the financial sustainability, insurance companies use various different methods and techniques. Among them, the Expense Ratio serves as the ideal measure providing clarity on the logistics. Signifying the efficiency of an insurance company and measuring its profitability, the expense ratio gives a clearer picture of the financial aspects of the company.

Calculating Expense Ratio

There are generally two ways by which companies calculate the expense ratio. However, the insurance companies in particular focus on getting conservative ratios. In order to do that, they use Statutory Accounting as opposed to generally accepted accounting principles (GAAP). The only difference is that the statutory accounting method uses Net Premium Written instead of Net Premium Earned. Net Premium Written is the new business brought in by the company in a given financial year. The latter (Net Premium Earned) consists of both new business and revenue earned from existing policies. It is used while calculating it through GAAP.

In layman’s terms, the formula to get the Expense Ratio is dividing the expenses of the insurance company by Net Premium Earned. In other words, the cost of operating an insurance company shown in comparison to the percentage of sales is known as the Expense Ratio.

Defining Expenses

The term expenses can be subjectively used to include various things. Hence, it is required that we define what expenses mean for an insurance company. Here is the list of few of the expenses that contribute towards a major portion of expenditure:

• Underwriting and Servicing the premiums:
  The cost of servicing required in processing the claims made by the clients is technically called servicing the premiums. It is an integral part of any insurance company, hence including this as part of the expenditure is significantly important.
• Advertising:
  Like any other business, insurance companies have to compete in the market where other players offer attractive premium rates. As a result, insurance companies indulge in creative marketing campaigns by advertising their services and getting it endorsed by public figures as their ambassadors. Hence, advertising costs turn out to be a major chunk in the logistics of an insurance company.
• Commissions for Salesforce:
  Apart from hiring the insurance agents on a salary basis, companies give a fixed percentage of any new client. This is done to incentivize the sales and motivate the insurance agents. In this way, a part of the revenue earned that goes into the agent’s account comes under the list of expenses for the insurance company.
• Reinsurance:
  Every insurance company seeks to buy a reinsurance policy that saves itself from the unavoidable risks. In return, it has to pay a percentage of the premium earned from the client. Hence, buying a reinsurance policy becomes quite important for an insurance company and comes in the expense list.

Significance of the Expense Ratio

Simply put, the lower the Expense Ratio of an insurance company, the more profitable its business will be. The expense ratio can be used to compare a company’s performance over a period of time. A ratio below 100% will mean that an insurance company is earning more revenue from writing premiums than it is shelling out in the form of expenses and vice versa.

FAQ

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