Interpreting the Loss Ratio

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The loss ratio is a quick and easy way for an insurer to determine the profitability of a workers compensation insurance policy.  It is calculated simply by dividing the incurred losses by the total earned premium.  Therefore, a company with a very low loss ratio would be considered a very profitable policy, and an employer with a very high one would be less profitable or not profitable at all.  The loss ratio can be looked at in two different perspectives.  From the insurer’s side, it represents the percent of earned premium that they need to set aside to pay off incurred claims.  From the insureds perspective, the loss ratio represents the amount of premium paid that will be returned to cover the cost of their claims.  By knowing the loss ratio, the insured can also determine the amount of money that the insurer keeps as payment for expenses and risk.  Take for instance a company with a loss ratio of 95%.  That would mean that for every $1.00 of premium paid, the company is receiving $0.95 of insurance coverage, which would most likely result in loss for the insurer after they pay expenses.  If the company with a 95% loss ratio paid a total of $25,000 in premium, then the insurer would only be left with $1,250 to cover their expenses.  A company with a loss ratio of >100% would be receiving more money for claims than it is paying out for premium, and would cause the insurer to lose even more money.  This gives incentive for insurers to write more policies with employers that have a low loss ratio.  If it writes a company with a 45% loss ratio, it will have 55% of the paid premium to cover its expenses and produce profit.

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You can also use the loss ratio to look at the insurer’s profitability.  For example, an insurance company that has a book of business that pays $100 million in premium has a loss ratio of 40%.  This would mean the company earns $60 million in profit.  If the same company had a loss ratio of 50%, it would only earn $50 million in profit (before expenses).  Another ratio that is very similar to the simple loss ratio is the combined ratio.  The combined ratio is the loss ratio with the various insurance expenses included.  It is calculated by: (Total incurred losses + Total expenses incurred) ÷ (The total premium earned) = Combined ratio.  The NCCI lists that the combined ratio for the entire workers compensation market in 2014 was 100%, and it was 94% in 2015.  The 94% combined ratio of 2015 represents the first underwriting gain of the workers compensation market since 2006, when it was 93%.

 

There are a few reasons why a company may have a high loss ratio.  The most obvious reason is that the company has a bad history of losses.  Therefore a high loss ratio can sometimes indicate that a company is riskier.  However, the frequency and severity of the claims listed on the loss history must be analyzed to understand why the ratio is so high.  If it seems there is a high amount of small claims, the insurer could insist the company does something to change its operations and/or safety procedures to help stop or slow down the amount of claims.  If it is a small amount of high severity claims, perhaps the insurer should help the company mitigate the cost of the claims.  A high loss ratio could also be the indicator that the insured is being charged too low of a premium rate.  This could be due to a misclassification of payrolls or just a soft insurance market (soft meaning premium rates of the market are lower than usual).  In this instance the insurer would be inclined to fix misclassified employees, and perhaps increase the premium rates being charged if they can.

 

There are also a few reasons why a company would have a low loss ratio.  The simplest reason being that the company has suffered little to no losses while they have been insured.  The insurer would see this as a highly profitable policy, whereas the insured may view it as an inefficient use of their resources.  While it would seem like the right thing to do for insurers to seek the lowest possible loss ratios, it is not always beneficial.  Very low loss ratios can also be an indicator that premium rates are too high.  When rates are too high it results in slower growth, and this can cause the company to lose market share.  Depending on the strategy of the firm, maintaining growth and achieving certain market shares may be the goals that management is pressured by.  Also, when premium rates are too high it is likely that profit is not being maximized.  For example, imagine a firm that has a book of business with $100 million in earned premium, and a loss ratio of 40%. It would be earning $60 million in profit.  However, if the firm was to lower their rates it would increase their amount of earned premium to $125 million while also increasing their loss ratio to 50%.  This would cause them to earn $62.5 million in profit, which is a $2.5 million increase in profit.  Even though the company’s loss ratio increases, they earn increased profit and therefore benefit from lowering their premium rates.

 

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