The loss ratio is a term that comes from the insurance industry. It describes how much money an insurance company plans to lose by providing coverage to its subscribers. A low loss ratio is great for insurance plan investors. If a plan spends less on losses due to covered events, such as auto accidents, that leaves more money for profits.
There's a limit on how low an insurance plan can go with a plan loss ratio. An insurance plan that puts 10 percent of subscribers' premiums toward covering losses and stashing away the rest would most likely be unable to convince the potentially insured that its policy is a great product.
What Is a Loss Ratio?
In the insurance industry, the loss ratio represents the ratio of paid insured claims and adjustment expenses to policyholder premiums, or losses to premiums. It's the losses the insurance company incurs in the form of claims it pays to its insured and its adjustment expenses as a percentage of the premiums the insured pay.
As demonstrated by the following example, the loss ratio formula is the sum of paid insurance claims and adjustment expenses divided by the insurer's total earned premiums. For instance, if a company pays $90 in insured claims for each $180 it receives in auto premiums, the loss ratio equals $180 divided by $90, or 50 percent.
Importance of Loss Ratio
An insurance company with a high loss ratio is likely to experience financial distress. If the company's loss ratio for a certain insured policyholder becomes excessively high in relation to the insurance company's acceptable loss ratio range, the insurance company may raise the insured's policy premium or refuse to renew the policy.
Each insurer defines a target loss ratio, which depends on the company's expense ratio. For instance, a company with a relatively low expense ratio may accept a higher target loss ratio than other companies in the industry.
The Function of a Loss Ratio Formula
The loss ratio is insurance type-specific. For instance, the property and casualty insurance loss ratio will differ from that of auto insurance. In general, the insurance industry considers a loss ratio between 40 and 60 percent of premiums acceptable.
An insurance policy premium is directly related not only to the risk related to each insurance type, but also the insurance company's loss ratio for a certain insurance type.
In turn, the loss ratio is a means to evaluate an insurance company's profitability. The higher the loss ratio – the ratio of paid insured claims and adjustment expenses to policyholder premiums – the lesser the insurance company's profitability.
State and Federal Regulations
State and national regulations affect the operations of an insurance company, so the loss ratio of a certain insurance plan will likely vary from one state to another. For instance, the Affordable Care Act requires all medical plans to spend 80 percent or more of subscriber premiums on medical care and quality of life issues. The remaining 20 percent of subscriber premiums is spent on administrative costs and company investor profits.
Loss Ratio Types
Individual loss ratios correlate to different types of insurance, so the former includes life insurance, property insurance, marine insurance, fire insurance, liability insurance, guarantee insurance and social insurance ratios.
Medical Insurance Loss Ratio
Assume that a health insurance company pays $7 in claims and adjustment expenses for each $11 it collects in premiums. In this case, the insurer's medical cost ratio (MCR) is 64 percent. The Affordable Care Act (ACA) however, requires health insurance companies to allocate at least 80 percent of their collected premiums to the actual provision of clinical services and the improvement in the quality of healthcare. Consequently, this insurer must rebate the difference between 80 percent of its collected premiums and 64 percent that it pays in claims to the consumer.