What Is Loss Adjustment Expense?
Loss Adjustment Expense (LAE) defined: An essential cost incurred by insurance companies during the investigation and settlement of insurance claims, LAE plays a crucial role in the insurance process.
Key Takeaways
- Insurance companies bear the cost of loss adjustment expenses to investigate and settle insurance claims, contributing to the integrity of the insurance system.
- LAEs, although affecting an insurer’s bottom line, serve to prevent fraudulent claims.
- Two main categories of loss adjustment expenses exist—allocated and unallocated, each serving distinct purposes in the claims process.
- Allocated costs accumulate during active claim investigations, while unallocated expenses form part of the investigation overhead.
- Some incurred loss adjustment expenses are recoverable by insurance companies through policyholder reimbursement.
How Loss Adjustment Expense Works
Upon receiving a claim, an insurer initiates an investigation to verify the accuracy of damages claimed, involving a comprehensive assessment of the incident. Failure to conduct this investigation may leave insurers vulnerable to fraudulent claims.
Typical loss adjustment expenses cover costs associated with adjusters, investigators, legal representation, and other relevant professionals.
The extent of LAEs varies depending on the complexity of claims, with insurance companies willing to invest in these expenses to safeguard against fraudulent activities. Investigations serve as a deterrent for potential fraudulent claimants seeking unlawful gains through the insurance system.
Research indicates that fraudulent insurance claims pose significant financial strains on insurers, necessitating a stringent approach to claims processing to mitigate losses passed on to policyholders.
Special Considerations
Certain commercial liability policies may contain clauses requiring policyholders to reimburse insurers for loss adjustment expenses.
It is crucial for policyholders to review the endorsement language, as some clauses may exclude policyholder attorney fees if coverage is denied and litigation ensues.
In instances where no claims adjustment occurs, insurance companies may not leverage their deductibles to cover policyholder expenditures related to defending denied claims.
Using LAE to Calculate the Combined Ratio
The combined ratio, a vital measure in the insurance sector, factors in loss adjustment expenses in its calculation to determine underwriting profitability.
Calculation: Combined Ratio = (Incurred Losses + Loss Adjustment Expense + Other Underwriting Expenses) / Earned Premiums
A combined ratio below 100% signals underwriting profits, while a ratio above 100% indicates underwriting losses. Lower ratios indicate higher profitability in underwriting operations.
Example
Illustratively, a higher loss adjustment expense directly impacts the company’s combined ratio, reflecting the financial dynamics of the insurer’s operations.
Consider insurer ABC, which incurred $5 million in underwriting losses, $3 million in loss adjustment expenses, and $2 million in underwriting expenses in a quarter totaling $10 million, against an $11 million earned premium. This results in ABC’s quarterly combined ratio of 91%, signifying profitability as earned premiums exceed operating costs.
Maintaining a combined ratio between 75%-90% indicates financially sound underwriting practices over the long term.
Types of Loss Adjustment Expense
Loss adjustment expenses categorically fall into allocated loss adjustment expenses (ALAE) for specific claims and unallocated loss adjustment expenses (ULAE) not tied to any specific claim.
Allocated expenses arise from claim-specific investigations, including assessments by third-party professionals to verify claims.
Examples of allocated expenses include fees for obtaining reports, assessing injuries, and similar claim-specific investigations.
Conversely, unallocated expenses cover operational overhead, such as salaries of claims evaluators, vehicle maintenance costs, and other general operational expenses.
Insurance companies without filed claims may still incur unallocated expenses, highlighting the operational costs of maintaining claims evaluation capacities.
How Is a Loss Ratio Different From the Combined Ratio?
The loss ratio differs from the combined ratio by focusing on total incurred losses relative to collected insurance premiums, excluding underwriting and adjustment expenses.
What Does It Mean If a Company’s LAE Increases Each Year?
An annual increase in a company’s LAE may indicate aggressive financial practices, potentially leading to under-reserving for losses and overstated income.
What Is the Difference Between an Incurred Loss and an LAE?
Incurred loss represents money paid out in claims, while loss adjustment expense accounts for the cost of investigating and settling those claims.
The Bottom Line
In summary, loss adjustment expenses are indispensable costs incurred during the claims process, encompassing fees for adjusters, investigators, attorneys, and mediators.
The combined ratio, incorporating loss adjustment expenses, is a pivotal metric for assessing insurers’ underwriting profitability.