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A loss ratio is a term that is important for insurance companies. It enables insurance companies to determine the overall profitability of the policies that they are issuing. The loss ratio compares the amount of money that an insurance company spends on insurance claims to the amount of money that the insurance company takes in through premium payments.
To calculate a loss ratio, a company first determines how much it is paying out as a result of insurance claims and adjustment expenses. It then calculates the total money that the company earns through its customers' premium payments. The company then divides the amount that it pays in claims by the total amount of premiums and converts the resulting number into a percentage. This percentage represents the loss ratio. For example, if an insurance company earns $100,000 US Dollars in premiums while paying out $75,000 US Dollars in claims, then the loss ratio would be 75 percent.
It is important that an insurance company know its loss ratio, because it relates directly to the success of the company's business model. If the loss ratio is too high, then the company will not earn enough in profit to be successful. Problems also can arise, though, if it is too low, because a low loss ratio might indicate to customers that the insurance company is charging excessive premiums or not adequately paying customers' claims.
The ideal balance point, which is also called the permissible, target or expected loss ratio, for an insurance company will depend on a number of variables and is largely dependent on the insurance company's industry. Loss ratios among health insurance companies, for instance, can be between 60 percent and 110 percent. Loss ratios for property insurance, such as automobile or home insurance, are more likely to be between 40 percent and 60 percent.
In addition to providing insurance companies with an accurate measure of the relationship between their premiums and claims, loss ratios also enable insurance companies to make very simple calculations when considering a change in premiums. To calculate this change, a company can simply divide the actual experienced loss ratio (AER) by the target ratio to arrive at another percentage that will indicate the appropriate rate change. For instance, if customer's AER is 40 percent and the balance point is 50 percent, then the customer's premium should be 80 percent of its current amount, which means it should decrease by 20 percent. However, if the AER were 60 percent, then the premium should increase by 20 percent.