May the Combined Ratio R.I.P. (for Measuring Profit)

When Mr. Best of AM Best created the combined ratio, he did the industry and arguably the world a great favor. After all, what business would only measure part of their cost and ignore the other 30% when determining profitability? Insurance financial acumen (i.e., leaving out expenses) has not developed much more than this except at the highest levels.

I am always stunned when I hear an insurance company executive, including some CFOs, refer to the combined ratio and say something silly like, “We lost so much money last year because our combined ratio was 103!” Then, when I ask them how they made $100 million last year if they lost so much money, they are stumped. I haven’t met one yet who could immediately answer that question. I know some can, I just haven’t met them.

The combined ratio measures the “combined” loss ratio and expense ratio. Another way to put it is that the numerator is the sum of losses and expenses while the denominator is earned premium (or is supposed to be). If the numerator is larger than the denominator, the insurance company has lost money–but they’ve only lost underwriting money.

The combined ratio is an important metric, but it does not measure profitability very well.

For example, in 2023, the industry’s combined ratio exceeded 100 but carriers as a whole made record profits. If the combined ratio is so important, how in the world did carriers make record profits in a year where their combined ratio exceeded 100? It’s because they made a fortune in investments.

This industry should be a case study for making the public angry and trial attorneys wealthy. One way in which the industry shoots itself in the foot and causes public frustration is that, intuitively, it makes zero sense to tell the public you need more money when you’ve made record profits. To tell the public that because the combined ratio is 102, you are not making a reasonable profit while recording record profits is a ridiculous point to sell. Moreover, why do you need a 20% rate increase if the deficit is only 2% (102 – 100) to break even on a combined ratio?

The public and trial attorneys may not understand insurance company financials, but intuitively, they know this story has Swiss cheese holes. Many in the public, plaintiffs’ bar, and politicians think industry people and carrier spokespeople are lying, cheating, and at least fibbing when saying the carriers are not making money because the combined ratio exceeds 100.

Underwriting Profit

Over the last 25 years, the average combined ratio is just about 100. This industry would not exist if it never made a profit. Profit is required for more than attracting capital. In this industry, profit is required to generate surplus, and if surplus does not grow, the industry cannot increase what it insures. This industry could not have grown 85%, and carriers would not have averaged about $55 billion of net income annually during the last 18 years, without profit.

The right approach is to first understand how insurance companies make money. This should begin with CFOs, but I’ll aim for a wider audience. Warren Buffett said it best, “Insurance companies are nothing more than poorly run mutual funds.”

Why did he say this? Because insurance companies typically make 100% of their profit from their investments, not their underwriting. (If the combined ratio is 100, carriers normally never make money underwriting.) But because their combined ratios often exceed 100, carriers would make even more money by not writing insurance and focusing entirely on managing their investment portfolios.

From a societal perspective, talking about the need to make an underwriting profit is not only untrue, but it sounds greedy–and it kind of is.

Instead, the pitch should be that insurance companies are subsidizing rates with their investment income so that Americans do not have to pay even higher rates. That is a 100% true statement, although it is still somewhat on shaky ground because the subsidy is due to carriers not evaluating their risks correctly so the combined ratio exceeds 100. The public then benefits from a certain level of incompetence–which, frankly, is easier to sell than dishonesty.

Operating Ratio

The correct measure is the operating ratio because it includes all income, not just most of the income. Just as it made little sense to exclude expenses at one time, it makes little sense to exclude a material revenue source when calculating total revenue and profits. I have known some insurance company CEOs who did not even know what their operating ratio was, which may be why those are not the most robust companies today.

I advise insurance carriers and distributors on these facts and have been doing so for decades. I can guarantee to every reader that carriers led by people with a deep understanding of their financials–preferably including the entire C-suite and maybe the next level down–are achieving far more success. And I can guarantee my distributor clients engaged with me to delve deeply into these matters are also achieving far more success.

The fact that so many carriers are led by people who do not really understand their own financials is simply an artifact of momentum and, truly, how sloppy the industry is. Tighter management would likely reduce premiums or at least minimize the rate of increase. Competition, though, would decrease because there would be fewer companies. Given this is the hardest market in 100 years and it is likely to remain hard for longer than any previous hard market, competition is likely to decrease anyway. Hard markets eliminate more carriers than soft markets.

Knowledge is power. The combined ratio is an important metric, but it does not measure true profitability in any sense or manner. The question exists, though, as to why so many people in this industry think the combined ratio is the ultimate measure of profitability. When myth beats reality, print the myth. That is the best explanation I have.

But if you want to beat the competition and improve your reputation, focus on reality!

Topics Profit Loss