Property and Casualty Insurance Practice Exam

How is the loss ratio typically calculated?

1. By dividing total incurred losses by total premiums received.

2. By dividing incurred losses by earned premium.

3. By dividing total claims filed by policyholder fees.

4. By calculating the average claims cost per risk category.

The correct answer is: By dividing incurred losses by earned premium.

The loss ratio is a key performance indicator in the insurance industry that measures the relationship between the losses an insurer experiences and the premiums it earns. The correct method of calculating the loss ratio involves dividing incurred losses by earned premiums. Incurred losses represent the total amount of claims that the insurance company is obligated to pay during a specific period, regardless of whether those claims have been paid out yet or not. Earned premium, on the other hand, refers to the portion of premiums that has been recognized as income for the insurer during the same period. This calculation provides a clearer picture of the insurer's profitability, allowing them to evaluate how well they are pricing their policies relative to the risk they are covering. This contrasts with the other methodologies mentioned. While total incurred losses divided by total premiums received may appear similar, it does not account for the timing of the income recognition regarding earned premiums, which can skew the understanding of profitability. Another option, which discusses claims filed and policyholder fees, does not connect directly to the standard loss ratio calculation, as the focus should strictly be on incurred losses and earned premiums. Lastly, calculating average claims costs per risk category is useful for analyzing claims but does not reflect the loss ratio itself.