Why is combined ratio important?
Another important concept to know about the insurance business is that there are two ways insurers make money. The first is by profitable underwriting, which is covered by the combined ratio.
The second is through investments. In the previous example, the insurer would invest the $100 million in premiums it collected from the time they were received until it needed to be used to pay out claims or cover business expenses. Most insurers keep this money (known as the float) in safe fixed-income investments like Treasury bonds, and investment returns can remain invested to build up the investment portfolio over time.
The combined ratio gives investors a picture of the profitability of an insurer's underwriting. Between the combined ratio and investment income, it's possible to get a great picture of an insurance company's profitability.
What is a good combined ratio?
There's no set definition of what a good combined ratio is, but it's fair to say that most insurers want to keep it less than 100%. In a recent year, the average combined ratio among property and casualty insurance companies was 97.5%. This indicates a 2.5% underwriting margin, plus whatever investment income the insurers make.
Having said that, there's a wide range of profitability in the insurance business, and combined ratios often fluctuate significantly due to various factors. For example, in years where there is a disproportionately high number of natural disasters leading to insured losses, combined ratios tend to be higher throughout the industry.