Some of the most important ratios for quantifying the financial health of an insurance company include expense ratio, loss ratio, combined ratio, and operating ratio. These ratios each offer a different lens for viewing a carrier’s operations, even as they intersect in various ways. They provide a broad set of ratios that fit together to provide insight into the performance of an insurance company and include critical financial and underwriting metrics including losses, expenses, premiums, and investment income.
For most lines of insurance (and especially for publicly held companies like ProAssurance), the combined ratio is often seen as the basic touchstone for performance. As a combination of loss ratio and expense ratio, a combined ratio below 100% represents an underwriting profit, and rating firms such as AM Best see this as a key benchmark when evaluating insurance companies. It’s important to note, however, that investment income tends to be higher for medical professional liability (MPL) companies than for carriers in other property/casualty lines (i.e. auto, property, etc.) because of the long duration between receiving premiums and paying out claims. This “long tail” allows investments more opportunity to grow. Since this potential for higher investment income tends to help offset losses, AM Best will generally accept a higher combined ratio for MPL companies as long as their operating ratios are around or below 100%.
Expense ratios typically don’t vary much year-over-year, but managing expenses is critical as it is the only metric that is 100% within our control. Differentiation in the expense ratio can reflect competitive advantages. A major component of the expense ratio is the commissions paid to agency partners. These commissions account for about one third of the total expense ratio in MPL companies. This addition is much lower for direct writers that do not pay commissions providing them with an expense advantage. The disadvantage of writing directly is that growth is usually very slow.
Our focus, though, is more on our combined ratio (which includes the expense ratio and loss ratio). The loss ratio is driven by the costs to manage claims reported to us and the cost of claims resolution via settlement, verdict, or closure without payment. As the sum of the combined ratio (loss ratio plus expense ratio) minus the net investment income ratio (investment income divided by earned premium), the operating ratio is therefore the most all-encompassing of the ratios used in the industry and often a better tool for assessing an MPL company’s performance than the other ratios. It is certainly the primary metric driving decision-making in mutual MPL companies. Thus, a combined ratio over 100% can yield an operating ratio of less than 100% after consideration of investment income. That would mean that the company has positive net income despite the higher combined ratio. So changes in the loss environment that increase the number of claims reported to us (the frequency) or the cost of those claims (the severity) can negatively impact the combined and operating ratio performance of the company. Uncontrolled expenses or higher commission payments will increase the expense ratio. The level of external interest rates has a direct effect on our investment income changing the magnitude of the investment offset to underwriting performance.
For example, in the last several years investment yields have been very low on average in the conservative (mostly bonds) portfolios of insurance carriers. As interest rates now start to rise, we will experience an increase in investment yields which will improve our operating performance (operating ratio) given a constant combined ratio.