Losses and Loss Adjustment Expenses (LAE) - Quick Reference

Overview

• Losses and loss adjustment expenses (LAE) are the largest financial obligations for property and casualty (P&C) insurers.
• Aim: maintain a combined ratio < 100%.
• Combined ratio = Loss ratio + Expense ratio, where:
  • loss ratio = \frac{\text{Losses + LAE incurred}}{\text{Premiums earned}}
  • expense ratio = \frac{\text{Other underwriting expenses}}{\text{Premiums written}}
• Industry context: NAIC statistics (2016–2020) illustrate industry loss experience and provide benchmarks for planning and pricing.

Key Concepts

• Claims data drive profitability analysis, pricing, reinsurance needs, and risk management.
• High-risk exposures are monitored (volatile lines, catastrophes, environmental/technological hazards).

Loss Characteristics

• Losses are categorized by: known vs unknown, reported vs unreported, short-tail vs long-tail.
• These categories influence reserving and timing of income/expense recognition.
• Important reserves concepts:
  • IBNR: incurred but not reported
  • IBNE: incurred but not evaluated (for claims-made policies)
  • Reinsurance can affect reported IBNR as reinsurers may adjust estimates.

Known vs Unknown

• At period end, claims are either known or unknown. Unknown claims are estimated and included in IBNR.
• Delays in reporting can occur due to agent knowledge gaps or pipeline processing.

Reported vs Unreported

• A claim is reported when the insurer/agent receives notice. The record date is when the claim is recorded in the statistical system.
• A claim starts a series of events and reserves (case reserves) are established.

Short-Tail vs Long-Tail

• Short-tail: claims generally settle quickly (e.g., many property claims in 18–24 months).
• Long-tail: claims develop over many years (e.g., auto liability, medical malpractice, workers’ comp).
• Development patterns affect IBNR estimation and reserve planning.

Loss Categories and Reserves

• Four main loss categories:
  • Losses incurred
  • Losses paid
  • Losses reserved for future payment
  • Loss offsets (salvage, subrogation, refunds)
• Five components of loss and LAE liabilities used for reserving:
  1) Case reserves; 2) IBNR reserves; 3) Supplemental/bulk reserves; 4) Reopened claims reserves; 5) Claims-in-transit (CIT) reserves
• Case reserves: established for reported claims, can be per-claim or per-line average; vary by company policy and claims system.
• IBNR: estimate for incurred losses not yet reported; essential for accurate timing of income/expense matching.
• Supplemental/bulk reserves: used when initial reserves are expected to understate ultimate development.
• Reopened claims: claims reopened after close to refine reserves.
• CIT: claims-in-transit—claims not yet fully processed but budgeted for.

Losses Incurred, Paid, and Reserves

• Losses incurred (example formula from text):
  $\text{Losses Incurred} = \text{Paid} - \text{Reserve} + \text{Reserve to date (prior period, current period)}$
• Losses paid: actual payments to claimants (cash, checks, drafts, wire transfers).
• Losses reserved for future payment: estimate of future payments for known losses.
• The goal is to match current period income (premiums earned) with the corresponding expenses and losses.

Loss Adjustment Expenses (LAE)

• LAE = defense and cost containment (DCC) + adjusting and other (AO) expenses.
• DCC includes: surveillance, medical cost containment, litigation management, defense-related staffing, experts, etc.
• AO includes: adjuster fees, litigation-related costs not included in DCC, and other related expenses.
• Five expense groups for reporting purposes:
  1) Loss adjustment expenses (LAE); 2) Acquisition, field supervision, and collection; 3) General expenses; 4) Taxes, licenses, fees; 5) Investment expenses
• DCC and AO reserves must be established for both outstanding case reserves and IBNR reserves.
• Allocation of AO/DCC to lines of business should reflect claim activity (e.g., incurred loss counts, new claims, and time involved).

Claims Handling and Processing

• Roles in claims handling:
  • Independent adjusters (not employees)
  • Company adjusters (employees)
  • Agents (may handle simple claims within authority limits)
• Claims processing steps: loss notification → claim file → coverage triggers → loss adjusting → data maintenance/accuracy → loss settlement → audit/control
• Claims processing may be manual or automated; data must feed the GL with appropriate coding.

Triggers and Policy Types

• Occurrence-based triggers: coverage triggered by the event (BI/PD) or the offense for certain coverages; continuous triggers possible for ongoing harm (asbestos, environmental).
• Claims-made triggers: coverage triggered by the claim first made/notice within policy period; retroactive dates and tail coverage considerations apply.
• Extended reporting periods may be purchased to cover late claims.
• Determining coverage involves matching loss notices to policy files, whether manually or automatically.

Recording Loss Transactions in the General Ledger (GL)

• Two common GL recording methods exist (not detailed here): used to track incurred losses and LAE, paid losses/LAE, and reserves.
• Salvage and subrogation: reduce incurred losses; recorded with the related claim data; require proper statistical matching.
• Refunds: reduce the claim and require same statistical data as the original payment for proper netting.
• Structured settlements (annuity-funded) have specific accounting treatments depending on whether the company or claimant owns the annuity.
• Drafts, checks, and positive pay: controls over payments, with emphasis on proper authorization and reconciliation.

Salvage, Subrogation, and Offsets

• Salvage: sale of damaged property after indemnity; reduces losses via recoveries.
• Subrogation: insurer recovers from third parties after paying a claim; crucial for preventing double recovery.
• Loss offsets affect both the loss and the related reserves; requires accurate tracking in Schedule P data.

Reinsurance

• Reinsurance recoveries from treaties/facultative reinsurance are a major loss offset for insurers.
• Reinsurance accounting is covered in Chapter 14 and interacts with IBNR/IBNE and other reserves.

Bases for Reporting Financial Information

• Financial statement/calendar year basis: used for annual profitability; common default for statutory reporting.
• Underwriting/policy year basis: used to analyze profitability by policy year and line of business.
• Accident year basis: used to analyze losses by when the accident occurred; ignores policy term for simplicity in some analyses.

Basic and Other Loss Reports

• Five basic reports:
  1) Paid loss and LAE; 2) Outstanding loss and LAE; 3) Incurred loss and LAE; 4) Summary of loss and LAE; 5) DCC and AO expense analysis
• Other loss reports include:
  • Individual risk experience; reinsurance recoverables; accident year vs policy year analyses; large loss reports; adjusters’ workload
• Schedule P provides a high-level view; internal reports can be more detailed by line of business or product.

Occurrence-Based Case Study (High-Level)

• Demonstrates end-to-end accounting entries from initial reserves to claim closure over two years.
• Illustrates effects on Losses, LAE, Salvage, and final settlements; shows interaction of case reserves, IBNR, and AO/DCC expenses.

Audit and Controls

• Emphasis on data integrity, controls over transactions, and regular audits.
• Claims audits may involve reinsurers and external auditors to verify proper payment and allocations.
• Data maintenance and accuracy are critical for reliable loss reserve estimation and regulatory reporting.

Quick Reference Formulas and Concepts

• Combined ratio:
  $\text{Combined ratio} = \text{Loss ratio} + \text{Expense ratio}$
  where $\text{Loss ratio} = \frac{\text{Losses + LAE incurred}}{\text{Premiums earned}}, \quad \text{Expense ratio} = \frac{\text{Other underwriting expenses}}{\text{Premiums written}}.$
• Losses incurred example: $\text{Losses Incurred} = \text{Paid} - \text{Reserve} + \text{Reserve to date (prior period, current period)}$
• Key components to track for solvency and pricing: paid losses, outstanding losses, incurred losses, LAE, DCC, AO, salvage, subrogation, and reinsurance recoverables.