There are hundreds of financial ratios, but when it comes to insurance, there are three ratios that matter most. These are the loss ratio, expense ratio, and combined ratio, which measure how effectively an insurance company prices its risks, manages it losses, and minimizes the amount it pays out to its policyholders.
Join The Motley Fool's Gaby Lapera and Jordan Wathen as they discuss how these ratios measure an insurance company's efficiency in turning revenue into profits.
A transcript follows the video.
This podcast was recorded on April 4, 2016.
Gaby Lapera: When you look at an insurance company's balance sheet, there are a few metrics that you definitely need to look at to understand what's going on. They're different than other companies' metrics because there's some things that you look at for any company that you're going to research, but for insurance companies you need to look at the loss ratio, the expense ratio and the combined ratio.
Jordan Wathen: Right. Let's break those down. The loss ratio is the percentage of premiums earned that are paid out in losses. If I get in a car accident today and do $1,000 of damage to my car that would show up in the loss ratio because that's actually money paid out for losses. Then you have expenses, which are things like advertising or getting a claims adjuster to show up to look at my car. That would go in the expenses. When you add those together you get the combined ratio, which is the percentage of money paid out in claims and expenses to run the insurance company, as a percentage of premiums.
Lapera: As a percentage of premiums, it's the loss ratio plus the expense ratio over premiums. Would you want a higher or a lower combined ratio? Because this tripped me up the first time that I tried to analyze and insurance company.
Wathen: Right, you definitely want a lower combined ratio. A lower combined ratio would mean that you have a fatter underwriting margin, meaning you're making more money on each dollar of premium that comes in.
Lapera: Right. This is actually I think a really interesting topic. I don't know if everyone thinks this is interesting but actuarial tables are fascinating because they have these lists of risk factors and they can run their fingers across the lines and figure out exactly how risky you are for any given thing. Companies that are better at underwriting, are going to have better combined ratios. This is how you check if a company is doing well on that side of their business, just like the actually business of insurance.
Wathen: Right, exactly. The key to running a great insurance company is pricing risk correctly. It's very easy to grow premiums, it's very easy to grow revenue. All you have to do is write bad risks, all you have to do is insurance something that should cost $100 for $50. But ultimately, at the end of the day, there's nothing wrong with being small and being very profitable the premiums you do write, or the policies you write.
Lapera: Again just like banks with loans except in this case it's insurance.