Combined Ratio

The Combined Ratio is the undisputed champion of metrics for sizing up an insurance company. Think of it as the ultimate scorecard for an insurer's core business: taking in money (premiums) and paying it out for accidents and disasters (claims). In a nutshell, this single number tells you whether an insurer is making a profit from its underwriting activities, before factoring in any money it makes from investing. The ratio is calculated by adding two other key ratios together: the Loss Ratio (what it pays in claims) and the Expense Ratio (what it costs to run the business). A result below 100% is cause for celebration, signaling a profit. A result above 100% is a red flag, indicating that the insurer is paying out more in claims and expenses than it's bringing in from premiums. For investors, it's a quick and powerful tool to gauge the health and discipline of an insurance operation.

The beauty of the Combined Ratio lies in its simplicity. It’s just addition: Combined Ratio = Loss Ratio + Expense Ratio Let's break down the ingredients:

• The Loss Ratio: This measures how much the company pays out in claims relative to the premiums it collects. The formula is:
  • (Incurred Losses + Loss Adjustment Expenses) / Earned Premium
  • In plain English, this is the money paid for customers' claims (e.g., car repairs, hospital bills) plus the costs associated with handling those claims (e.g., investigator fees), all divided by the revenue earned from selling policies.
• The Expense Ratio: This measures how efficient the company is. It compares the costs of running the business—like salaries, agent commissions, and marketing—to the premiums it collects. The formula is:
  • Underwriting Expenses / Earned Premium
  • A lower expense ratio suggests a leaner, more efficient operation.

The Combined Ratio is a simple benchmark with a crystal-clear meaning. It's all about the 100% mark.

• Below 100% (e.g., 95%): This is the goal! It means the insurer has an underwriting profit. For every dollar in premiums it collected, it only paid out 95 cents in claims and expenses. The remaining 5 cents is pure profit from the insurance business itself. This is a sign of a disciplined and well-managed company.
• Exactly 100%: The insurer is at breakeven. It's not losing money on its policies, but it's not making any profit from them either. Every dollar that came in as a premium went right back out to cover claims and operating costs.
• Above 100% (e.g., 105%): This signals an underwriting loss. The company is paying out $1.05 for every $1.00 it collects in premiums. This is unsustainable in the long run unless the company can consistently earn massive profits from its investments to cover the shortfall.

For value investors, especially fans of Warren Buffett, the Combined Ratio isn't just a metric; it's the key to understanding one of the most beautiful business models in the world. Buffett built his empire, Berkshire Hathaway, on the back of its insurance operations, and the secret sauce is something called float. Float is the massive pool of cash an insurer holds—premiums that have been collected but not yet paid out as claims. An insurance company gets to invest this float for its own benefit. Now, here's where the Combined Ratio becomes magical:

• The Magic of Sub-100% Ratios: When an insurer consistently maintains a Combined Ratio below 100%, it’s achieving an underwriting profit. This means the float it gets to invest costs less than nothing. The company is literally being paid to hold and invest billions of dollars of other people's money. This is an investor's dream and a powerful tailwind for compounding wealth.
• A Sign of a Moat: A consistently low Combined Ratio is a strong indicator that an insurance company has a durable competitive advantage, or moat. It suggests the company has a unique edge, whether it's superior risk assessment, brand loyalty, or cost efficiency, that allows it to price policies profitably while its competitors struggle.
• Practical Advice: When analyzing an insurer, don't be swayed by a single good year. Look at the Combined Ratio over a 5-to-10-year period. A company that keeps its ratio below 100% through thick and thin (including years with major hurricanes or other catastrophes) is demonstrating remarkable discipline and resilience. It's these kinds of boringly consistent, profitable underwriters that make for fantastic long-term investments.