What Is Loss Adjustment Expense?

What Is Loss Adjustment Expense?

Let me explain what a loss adjustment expense (LAE) is—it's a cost that insurance companies like mine incur when we investigate and settle an insurance claim. You need to know this because it directly affects how claims are handled and ultimately impacts premiums.

Key Takeaways on Loss Adjustment Expenses

As an insurance professional, I can tell you that a loss adjustment expense is a burden insurance companies take on to properly investigate and settle claims. Even though these expenses reduce our bottom line, we incur them to prevent fraudulent claims that could cost us dearly. Remember, there are two types: allocated and unallocated. Allocated costs build up during active investigations of specific claims, while unallocated costs cover the general overhead of investigations. In some cases, we recover these expenses by having policyholders pay them back.

How Loss Adjustment Expense Works

When we receive a claim at an insurance company, we don't just pay out right away. We conduct due diligence to verify the damages you claim are accurate. This means investigating the incident and the claim itself. Skipping this could lead to big losses from fraud.

These LAEs can cover costs for adjusters, investigators, attorneys, mediators, and similar roles. The expenses vary a lot based on how tough the claim is to investigate. Even if the LAE is high, we see it as worthwhile to avoid getting scammed by fake claims. Plus, thorough investigations deter people from filing fraudulent ones for quick cash.

Here's something important: fraudulent claims cost insurers billions, and that drives up premiums for everyone else. We have to factor those into our business costs.

Special Considerations for LAEs

In some commercial liability policies, there are endorsements that make policyholders reimburse us for loss adjustment expenses. You should read the endorsement language carefully—it might specify that LAEs don't include your attorney fees and costs if we deny coverage and you successfully sue us.

So, if there's no actual claim adjustment happening, we shouldn't use your deductible to cover expenses you incur defending a claim we dismissed.

Using LAE to Calculate the Combined Ratio

The combined ratio is a key measure of profitability in insurance, focusing on profits from daily underwriting without including investment income. It incorporates LAE in its formula: Combined Ratio = (Incurred Losses + Loss Adjustment Expense (LAE) + Other Underwriting Expenses) / Earned Premiums.

This ratio compares expenses to revenue. If it's below 100%, we're making an underwriting profit; above 100%, it's a loss. Lower is better for us.

Example of LAE in the Combined Ratio

Look at the formula—LAE is a key part. Higher LAE means a higher combined ratio, all else equal, and vice versa.

Suppose insurance company ABC has $5 million in underwriting losses, $3 million in LAEs, and $2 million in other underwriting expenses in Q1, totaling $10 million. They earned $11 million in premiums. The combined ratio is 91% ($10 million / $11 million), meaning they're profitable since premiums exceed costs.

Generally, a combined ratio of 75%-90% long-term is healthy.

Types of Loss Adjustment Expense

We divide LAEs into allocated (ALAE) for specific claims and unallocated (ULAE) for general ones.

Allocated LAEs happen when we pay an investigator for a particular policy's claims or require a driver to get a damaged car assessed at an authorized shop. Costs for police reports or verifying injuries are also allocated.

Unallocated LAEs include salaries for home office staff, vehicle maintenance for investigators, and other operational costs. If we have staff ready but no claims, those are still unallocated LAEs without any allocated ones.

How Is a Loss Ratio Different From the Combined Ratio?

The loss ratio is total incurred losses divided by collected premiums, excluding underwriting and LAEs, unlike the combined ratio.

What Does It Mean If a Company's LAE Increases Each Year?

If LAEs keep rising, it might indicate management is too aggressive in reporting, perhaps under-reserving for losses and inflating income.

What Is the Difference Between an Incurred Loss and an LAE?

Incurred loss is just the money paid out on claims, while LAE is the cost of investigating and settling them.

The Bottom Line

Loss adjustment expenses are what we in insurance spend on investigating and handling claims, covering investigators, adjusters, attorneys, and mediators. The combined ratio uses LAEs to compare expenses to premiums, serving as a profitability metric in our industry.