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Insurance companies make money by collecting more in premium revenue than they have to pay in losses and overhead expenses. The combined ratio is a measure of insurer profitability, calculated simply by taking the sum of claim-related losses and general business costs and then dividing that sum by the earned premiums over the period.

The metric is typically reported as a percentage, and a combined ratio of less than 100 shows that an insurer is taking in more money from premiums than it's paying on claims and overhead, indicating a profitable enterprise. Conversely, a combined ratio of more than 100 shows that the insurer is paying more in claim losses and expenses than it's collecting in premiums, and that's typically bad news for a company's long-term prospects.

Why the combined ratio is important

Many investors make the mistake of focusing entirely on losses when they look at insurance companies. Headlines will tout the impact of a major hurricane, blizzard, or other catastrophic event on an insurer's profits, making it seem as though that's the only determinant of profitability on a long-term basis. As a result, the loss ratio -- which focuses solely on what an insurer pays out in claims -- often becomes the primary focal point for those looking at an insurance company's stock.

However, just as important to profits is how well an insurer manages to run its operations, and that gauge shows up in the insurer's expense ratio. The expense ratio takes operating expenses and divides them by earned premiums.

The combined ratio essentially takes the loss ratio and the expense ratio and combines them. The metric's name stems from its role in combining those two important measures of insurance company success.

Why high combined ratios aren't always terrible

One thing to remember is that combined ratios are entirely concerned with underwriting activity. In particular, they don't include the investment gains that insurance companies earn on the premiums they collect before the insurer has to pay out those funds in claims and expenses. As a result, a combined ratio that's slightly above 100 doesn't always mean that a company is unprofitable.

For example, say an insurance company earns $1 billion in premiums and invests that money for a year at 5%. At the end of the year, losses were $900 million and expenses amounted to $120 million. The combined ratio will be 102, or $900 million plus $120 million, divided by $1 billion. Yet because of the $50 million in investment income, the net profit for the period will be $30 million.

The combined ratio is an easy indicator of how successful an insurance company is with its underwriting activity. The lower the combined ratio, the healthier an insurer is -- and the more likely that shareholders will benefit in the long run.

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