Question 7.3: Interpreting a Financial Ratio A US insurance company report......
Interpreting a Financial Ratio
A US insurance company reports that its “combined ratio” is determined by dividing losses and expenses incurred by net premiums earned. It reports the following combined ratios: (Table 1)
Explain what this ratio is measuring and compare the results reported for each of the years shown in the chart. What other information might an analyst want to review before making any conclusions on this information?
| Fiscal Year | 5 | 4 | 3 | 2 | 1 |
| Combined ratio | 90.1% | 104.0% | 98.5% | 104.1% | 101.1% |
| (Table 1) | |||||
The combined ratio is a profitability measure. The ratio is explaining how much costs (losses and expenses) were incurred for every dollar of revenue (net premiums earned). The underlying formula indicates that a lower ratio is better. The Year 5 ratio of 90.1 percent means that for every dollar of net premiums earned, the costs were $0.901, yielding a gross profit of $0.099. Ratios greater than 100 percent indicate an overall loss. A review of the data indicates that there does not seem to be a consistent trend in this ratio. Profits were achieved in Years 5 and 3. The results for Years 4 and 2 show the most significant costs at approximately 104 percent.
The analyst would want to discuss this data further with management and understand the characteristics of the underlying business. He or she would want to understand why the results are so volatile. The analyst would also want to determine what should be used as a benchmark for this ratio.