Different Ways to Interpret a Businesses Loss Ratio

For Small Businesses throughout the United States, the loss ratio is one of the single most influential aspects of the business that is controllable in relation to commercial insurance.  The loss ratio is a quick and easy way for an insurance company to determine the profitability of a workers compensation insurance policy. If your business has a lot of claims or a few large claims, the policy is not very profitable to the insurer. If the business keeps the claims low and not severe, it will have a positive impact on the Loss Ratio of the business.  The Loss Ratio is calculated by dividing the incurred losses by the total earned premium. A company with an extremely low loss ratio is considered a profitable policy and is a business insurance underwriters want to do business with. Conversely, an employer with a high loss ratio is less profitable. They will more than likely pay more for coverage and be less likely to get significant credits or discounts.

Loss Ratio

What is the Loss Ratio?

The loss ratio can be looked at two different ways.  From the side of the insurance carrier, the loss ratio represents what percent of earned premium they need to anticipate in order to cover the potential incurred claims.  When the underwriter at the insurance carrier knows the loss ratio of a business they are considering offering coverage to, this is the main aspect they use to determine how much to charge for premium and if they are going to offer the business coverage at all.  For example, Imagine a business that has a loss ratio of 95%.  That would mean that for every $1.00 of premium paid, the company is receiving $0.95 of insurance coverage. This is a large number and more than likely results in a loss for the insurer. If the underwriter offers coverage to too many of these businesses they may find themselves updating their resume before too long.  If the company with a 95% loss ratio paid a total of $25,000 in premium, then the insurer would only be left with $1,250 to cover their expenses. If an underwriter decide to write a company with a 45% loss ratio, it will have 55% of the paid premium to cover its expenses and produce profit. A company with a loss ratio of >100% would be receiving more money for claims than it is paying out for premium, and would cause the insurer to lose even more money. Businesses with this type of loss ratio are going to have a hard time finding carriers willing to offer coverage and are more than likely going to end up having to purchase workers compensation coverage from the state provider.

40 % Loss Ratio

How can a Small Business Owner use the Loos Ratio?

A small business owner can also use the loss ratio of an insurance company to determine the health and profitable of an insurer. If the insurer is healthy than they are making wise decisions about who to insure and they are less likely to squeeze your business when you do have to make a claim or several claims within one year. A good example of this would be a company abc insurance company.

This is an insurance company that has a book of business of $100 million in premium. This means they take in $100 million a year in premium. If this company insures businesses with an average loss ratio of 40% the insurance company brings in $60 million more than it pays out in claims.  If a similar company has a loss ratio of 60% they bring in $40 million more in premium than it pays out in claims.  This is not what the insurance company profits. This is what it brings in before additional expenses.

Why Might a Company Have a High Loss Ratio?

There are a number of reasons why a company might have a high loss ratio.  The first and foremost reason is the company is not extremely safe. A lack of emphasis on safety typically leads to a bad history of losses. In most cases a high loss ratio indicates a company is riskier than a comparable company with a lower loss ratio.  However, the frequency and severity of the claims listed on the loss history must be analyzed to understand why the ratio is so high.  If the ratio is higher because of a large amount of small claims, the insurer could insist the company takes certain steps to lower the amount of claims. Lots of claims typically indicate a pattern and a pattern is easier to predict and prevent than one large claim.  On the contrary, if the reason for the high loss ratio is a small amount of high severity claims, there are steps the insurer can take to mitigate the cost of the claims. Implementing an effective return to work program is high on the list of things a company can do to limit claims getting out of control. The faster you get a worker back on the job in any capacity, the more likely they are to return to full-time permanent work.

Why Might a Company have a Low Loss Ratio?

There are multiple reasons why a company might have a low loss ratio. A primary reason is that the business has had very few or no claims in the past few years. This makes the policy highly profitable to the insurer. In many cases, this is a situation where the business owner feels the insurance policy is an inefficient use of the businesses resources, but if one claim occurs and they are sued, it could save them from facing hundreds of thousands of dollars if not millions if the business is found liable in a court of law. even if the business is not found guilty it can incur an enormous cost in court and lawyers fees.

From the side of the insurer, a very low loss ratio can be an indicator that premium rates are too high.  When rates are too high it results in slower growth, and this can cause the company to lose market share. Depending on the strategy of the firm, maintaining growth and achieving certain market shares may be the goals that management is pressured by.  Also, when premium rates are too high it is likely that profit is not being maximized.  For example, imagine a firm that has a book of business with $100 million in earned premium, and a loss ratio of 40%. It would be earning $60 million in profit.  However, if the firm was to lower their rates it would increase their amount of earned premium to $125 million while also increasing their loss ratio to 50%.  This would cause them to earn $62.5 million in profit, which is a $2.5 million increase in profit.  Even though the company’s loss ratio increases, they earn increased profit and therefore benefit from lowering their premium rates.

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