What Is a Loss Ratio?
Loss ratio is used in the insurance industry, representing the ratio of losses to premiums earned. Losses in loss ratios include paid insurance claims and adjustment expenses. The loss ratio formula is insurance claims paid plus adjustment expenses divided by total earned premiums. For example, if a company pays $80 in claims for every $160 in collected premiums, the loss ratio would be 50%.
Key Takeaways
- Loss ratio is the losses an insurer incurs due to paid claims as a percentage of premiums earned.
- A high loss ratio can be an indicator of financial distress, especially for a property or casualty insurance company.
- Insurers will calculate their combined ratios, which include the loss ratio and their expense ratio, to measure total cash outflows associated with their operating activities.
- If loss ratios associated with your policy become excessive, an insurance provider may raise premiums or choose not to renew a policy.
- If health insurers fail to divert 80% of premiums to claims or healthcare improving activities, they will have to issue a rebate to their policyholders.
How a Loss Ratio Works
Loss ratios vary depending on the type of insurance. For example, the loss ratio for health insurance tends to be higher than the loss ratio for property and casualty insurance. Loss ratios help assess the health and profitability of an insurance company. A business collects premiums higher than amounts paid in claims, and so high loss ratios may indicate that a business is in financial distress.
Unlike auto and homeowners insurance, under the ACA, health insurers do not retain the ability to adjust your insurance premiums based on submitted claims or your medical history.
Types of Loss Ratios
Medical Loss Ratio
A health insurance carrier that pays $8 in claims for every $10 in premiums collected has a medical cost ratio (MCR) of 80%. Under the Affordable Care Act (ACA), health insurance carriers were mandated to allocate a significant share of the premium to clinical services and the improvement of healthcare quality.
Health insurance providers are required to divert 80% of premiums to claims and activities that improve the quality of care and offer more value to the plan's participants. If an insurer fails to spend the required 80% on health care costs, it will have to rebate excess funds back to the consumer.
Commercial Insurance Loss Ratio
Businesses with commercial property and liability policies are expected to maintain adequate loss ratios. Otherwise, they may face premium increases and cancellations. Consider a small used car dealer who pays $20,000 in annual premiums to insure their inventory. A hailstorm causes $25,000 in damages, for which the business owner submits a claim. The insured's one-year loss ratio becomes $25,000 / $20,000, or 125%.
To determine if and for what amount a premium increase is warranted, carriers may review claims history and loss ratios for the past five years. If the insured has a very brief tenure with the insurer, the company may decide that the auto dealer presents an unacceptable future risk. At that juncture, the carrier may choose not to renew the policy.
Loss Ratio vs. Benefits-Expense Ratio
Related to loss ratios are benefit-expense ratios, which compares an insurer's expenses for acquiring, underwriting, and servicing a policy by the net premium charged. Expenses can include employee wages, agent and broker commissions, dividends, advertising, legal fees, and other general and administrative expenses (G&A).
An insurer will combine the benefit-expense ratio with their loss ratio to arrive at a combined ratio. While the benefit ratio looks at company expenses, the loss-to-gain ratio looks at paid claims, including adjustments, compared to the net premium.
Also, due to the higher number of probable claims per period, losses for healthcare providers will be higher than those for property or casualty insurance. The combined ratio measures the flow of money out of a company through the payment of expenses and the total losses as they relate to the income from premiums.
