permissible (target) loss ratio

Out of every dollar of premium a customer pays, only part can go toward paying claims; the rest must cover the company's expenses and a fair profit. The permissible loss ratio is the answer to: 'what fraction of premium are we allowed to spend on losses (and claim-handling) if the price is to leave enough for everything else?' It is the loss ratio the rates are designed to produce.

It is computed from the expense and profit provisions, not from claims data. The standard form is: permissible loss ratio = (1 − expense ratio − profit and contingencies provision), often refined to separate fixed expenses and variable expenses. For example, if commissions, taxes, general expenses, and profit together take 35 percent of premium, the permissible loss ratio is 1 − 0.35 = 65 percent. That 65 percent is then the benchmark the loss ratio method of rate indication compares the experience loss ratio against: if actual losses run at 72 percent of premium, the price is too low because it leaves only 28 percent for everything else when 35 percent is needed.

The permissible loss ratio is the bridge between the cost of claims and the cost of running an insurance company. Raising the expense or profit load lowers the permissible loss ratio, which (for the same losses) pushes indicated rates up — so it is closely watched by regulators, who may challenge a profit provision they consider excessive. A subtle point: the permissible loss ratio usually does or does not include loss adjustment expense depending on how the losses are defined, so the two must be kept consistent or the indication is biased.