Final answer:
The correct formula for a loss ratio is (Incurred losses + loss adjusting expense)/Earned premium. It's used by insurers to measure profitability and underwriting effectiveness, taking into account the total expected claims costs and the costs to manage those claims relative to the premiums earned.
Step-by-step explanation:
The correct formula for computing a loss ratio in the context of insurance is option C: (Incurred losses + loss adjusting expense)/Earned premium. A loss ratio is a financial metric used by insurance companies to determine the relationship between incurred losses plus loss adjusting expenses and the premiums they earn. The loss ratio helps insurers assess their profitability and pricing adequacy.
Here is the calculation broken down:
- Incurred losses are the total amount the insurer expects to pay for claims that have occurred during a defined period, regardless of whether they have been paid yet.
- Loss adjusting expenses (LAE) are the costs associated with investigating and settling insurance claims.
- Earned premium is the portion of premium that has been "earned" by serving as insurance protection for the stipulated period.
Thus, the loss ratio formula looks at the sum of incurred losses and loss adjusting expenses, divided by the earned premium, which provides insight into the company's underwriting effectiveness. A high loss ratio can indicate that an insurance company is paying out more in claims and expenses than it is receiving from premiums, which could be problematic. Conversely, a low loss ratio may suggest profitability, but it could also indicate overpricing if it's too low.