DEFINITION
Loss ratio reflects the amount of money an insurer earns in premium receipts minus the amount spent in claims payments and claims administrative costs.
Loss ratio reflects the amount of money an insurer earns in premium receipts minus the amount spent in claims payments and claims administrative costs. Along with expense ratios, loss ratios can determine an insurance company’s financial stability.
Definition and Example of a Loss Ratio
In the insurance industry, loss ratio is the amount of money an insurer pays in claims and claims-handling costs as a proportion to the amount it receives in premiums. It’s expressed as a percentage.
Understanding Loss Ratio
Loss ratio margins vary among insurance products. Federal law regulates loss ratios for health care, and state insurance codes regulate loss margins for other types of insurance products.
Loss Ratio vs. Expense Ratio
Although loss ratios and expense ratios both involve losses to earned premiums, they are not the same. A loss ratio reflects the proportionate relationship between all losses, including paid claims and the administrative cost of paying claims.
On the other hand, an insurer’s expense ratio reflects the percentage of the premium used to pay costs such as acquiring, servicing, and writing an insurance policy. Costs may include agent salaries or commissions, underwriting costs, and policy management expenses. Insurance companies apply their expense ratios when rating policy premiums
Acceptable Loss Ratio
If an insurance company’s loss ratio exceeds 100%, that means a company is paying out more than it’s taking in, which could impact its ability to cover losses, including claims. An acceptable loss ratio, which varies by the type of insurance, enables an insurer to earn a profit.
For example, in the health care industry, insurers must maintain a loss ratio of 80% or above as a way to ensure they are using most of their premium funds on health care and improving the quality of services. In other industries, insurers aim to be more profitable.
Several factors can increase an insurer’s loss ratio, including:
- Underestimating risk: An insurer may underestimate the risks of insuring certain drivers, or the risks of insuring property in areas prone to catastrophic losses. Underestimating risk can lead to a high loss ratio at the policyholder level or a broader level, such as a geographic area.
- Natural disasters: Natural occurrences such as hurricanes and wildfires can dramatically increase claims and insurers’ loss ratios.
- Operations issues: Problems such as needless overhead costs or poor insurance-adjuster protocols can lead to increased loss ratios.
The Bottom Line
An insurance company’s loss ratio is a measure of its earnings performance. While loss ratio reflects the cost of paying claims and expenses, a carrier’s expense ratio focuses on the cost of offering, writing, and maintaining policies as a proportion of its premiums. To maximize earnings, providers strive to operate with lower loss ratios.
Federal law sets limits on health insurance loss ratios, while some state insurance codes regulate the loss ratios of other insurance products. Loss ratio regulations help moderate the cost of insurance and urge the industry to provide high-quality products.