What Is Loss Adjustment Expense (LAE)?
A loss adjustment expense (LAE) is a cost insurance companies incur when investigating and settling an insurance claim.
- A loss adjustment expense is a cost insurance companies shoulder to investigate and settle insurance claims.
- Although loss adjustment expenses cut into an insurance company’s bottom line, they pay them so they can avoid paying out for fraudulent claims.
- There are two types of loss adjustment expenses—allocated and unallocated.
- Allocated costs are those accumulated during the active investigation of a claim. Unallocated costs are those created by the overhead of having to do investigations.
- Some loss adjustment expenses can be recouped by insurance companies by requiring the policyholder to pay them.
How Loss Adjustment Expense (LAE) Works
When insurers receive a claim, they don't open their checkbooks immediately. They do their due diligence to ensure the number of damages claimed by the policyholder is accurate. They send out investigators to ensure what was claimed actually did happen. Not conducting an investigation could lead to losses from fraudulent claims.
The LAE will vary widely depending upon how difficult a claim is to investigate. Even in cases where the LAE is quite high, insurance companies still deem the expense worth it because knowing claims are being investigated acts as a deterrent to those who might file fraudulent claims for an easy payday.
The knowledge that companies are investigating claims will stop many people from filing false claims. To that end, paying the LAE is worth it to the companies that otherwise might be bilked by fraudulent claims.
Fraudulent insurance claims are believed to cost insurers billions of dollars. These claims drive up insurance premiums for the rest of the customers as insurance companies must count fraudulent claims in their cost of doing business.
Some commercial liability policies contain endorsements that require policyholders to reimburse their insurance company for loss adjustment expenses. These expenses can include fees charged by attorneys, investigators, experts, arbitrators, mediators, and other fees or expenses incidental to adjusting a claim.
It is important to carefully read the endorsement language, which may indicate that a loss adjustment expense is not intended to include the policyholder’s attorney fees and costs if an insurer denies coverage and a policyholder successfully sues the insurer.
In this situation, where the insurance company has done no actual “adjusting” of the claim, it should not be entitled to apply its deductible to expenses incurred by the policyholder in defending the claim abandoned by the insurance company.
Using LAE to Calculate Combined Ratios
The combined ratio, or "the combined ratio after policyholder dividends ratio," is one of the key profitability measures in the insurance industry. It only measures profits earned through daily underwriting activities and excludes investment-related income.
The combined ratio is calculated by dividing the total of incurred losses and expenses by the earned premium:
Combined Ratio = (Incurred Losses + Loss Adjustment Expense (LAE) + Other Underwriting Expenses)/Earned Premiums
A ratio below 100 means that the company is making an underwriting profit, while a ratio above 100 says that it is underwriting at a loss. So when it comes to combined ratio, the lower the better.
As you can see from the above formula, loss adjustment expense is one of the key components used in the combined ratio formula. All things equal, the higher (lower) the loss adjustment expense, the higher (lower) the company's combined ratio.
Let's say, for example, insurance company ABC incurred underwriting losses of $5 million, loss adjustment expenses of $3 million, and $2 million in underwriting expenses in Q1 (for a total of $10 million dollars). In Q1, company ABC also earned $11 million in premiums. Thus, company ABC's combined ratio for the quarter is 91% ($10 million / $11 million).
Generally speaking, a combined ratio that averages in the range of 75%-90% over the long run is considered healthy.
Types of Loss Adjustment Expense (LAE)
Loss-adjusted expenses that are allocated to a specific claim are called allocated loss adjustment expenses (ALAE), while expenses not allocated to a specific claim are called unallocated loss adjustment expenses (ULAE).
Allocated loss adjustment expenses occur when the insurance company pays for an investigator to survey claims made on a specific policy. For example, a driver with an automobile insurance policy may be required to take a damaged vehicle to an authorized third-party shop so that a mechanic can assess the damage.
In the case of a third-party review of the vehicle, the cost associated with hiring that professional is an allocated loss adjustment expense. Other allocated expenses include the cost of obtaining police reports, or the cost required to evaluate whether an injured driver is really injured.
Insurance companies can also incur unallocated loss adjustment expenses. Unallocated expenses could be related to the salaries of the home office personnel, maintenance costs of the fleet of vehicles used by in-house investigators, and other expenses incurred in the regular course of operations.
An insurance company that maintains a staff to evaluate claims, but is fortunate enough to never have a claim filed, will have salary and overhead as unallocated loss adjustment expenses, but will not have any allocated loss adjustment expenses.
How Do You Calculate a Loss Ratio?
The loss ratio is calculated by dividing the total incurred losses by the total collected insurance premiums. It does not include underwriting and loss adjustment expenses, as is the case with the combined ratio.
What Does It Mean If a Company's LAE Increases Each Year?
If a company's LAE increases each year, it could mean that management is overly aggressive in its financial reporting. Specifically, they might be habitually under-reserving for losses and overstating income.
What Is the Difference Between an Incurred Loss and an LAE?
Incurred loss is simply the amount of money an insurance company paid out in claims. Loss-adjusted expense, meanwhile, is the expense associated with investigating and settling those claims.