What it means
Insurers collect premiums in advance and then pay claims later, so their biggest expense is the cost of those claims. The "losses" part covers the money paid to policyholders and the change in the reserve for claims not yet settled.
The "loss adjustment expense", often shortened to LAE, covers the cost of dealing with claims, such as adjusters' salaries, legal fees and investigation costs. LAE is often split in two.
Allocated LAE can be tied to a particular claim, for example fees for a lawyer defending a lawsuit or an outside expert report. Unallocated LAE covers general claims department costs that cannot be assigned to any single file.
The combined figure matters because it shows the true cost of delivering the insurance promise. A rising LAE can signal growing litigation or a claims process that is becoming less efficient.
Insurers watch it closely and report it as part of their loss ratio. To judge performance, analysts divide losses and LAE by earned premium (the part of premiums that relates to the period of cover already provided).
The loss and LAE ratio is combined with the expense ratio for underwriting costs, and the total is the combined ratio. A combined ratio below 100% indicates an underwriting profit.
Estimates are central. Because claims take time to settle, the reported figure includes the insurer's best estimate of future payments, and later adjustments to earlier estimates, known as reserve development, can raise or lower profit in later years.
Disclosure rules require insurers to show how the figure was built, including how much came from the current accident year and how much from changes in estimates for earlier years. This split lets readers see whether profit is coming from good underwriting or from releasing old reserves.
A business that relies on reserve releases year after year may be storing up trouble.
In practice
Real-world examples.
Example
A motor insurer reports that losses and LAE rose by 14% because of higher repair costs and more legal disputes. Analysts ask whether the premium rates can be raised quickly enough to restore profit, and how regulators in the relevant markets might respond to requests for higher prices.
Example
A professional indemnity insurer sees its allocated LAE climb as lawyers' fees increase in defended cases. The underwriting team reviews which types of claims are most expensive to defend.
Example
A new insurer's finance team explains to investors that its loss and LAE ratio of 68% is below the market average and shows disciplined underwriting. An analyst replies that a young insurer's reserves have not yet been tested by time, and asks to see the pattern of claims development.
Formula
Calculation
Losses and LAE incurred = Claims paid + Change in loss reserves + LAE paid + Change in LAE reserves
Loss and LAE ratio = Losses and LAE incurred / Earned premium
Suppose an insurer pays $60,000,000 of claims and $8,000,000 of LAE in the year. Loss reserves rise by $10,000,000, and LAE reserves rise by $2,000,000.
Losses and LAE incurred = $60,000,000 + $10,000,000 + $8,000,000 + $2,000,000 = $80,000,000.
With earned premium of $100,000,000, the loss and LAE ratio = $80,000,000 / $100,000,000 = 80%.
If underwriting expenses are 25% of premium, the combined ratio is 80% + 25% = 105%, so the insurer has an underwriting loss of $5,000,000.Case study
Seen in the real world.
Northfield Mutual is an illustrative, fictional insurer of small commercial buildings. In one year its premiums earned were $50,000,000, claims paid $27,000,000 and LAE paid $4,000,000, while reserves for both increased by a combined $5,000,000.
Losses and LAE incurred were therefore $27,000,000 + $4,000,000 + $5,000,000 = $36,000,000, giving a ratio of 72%. The board noticed that LAE alone had grown from 6% to 8% of earned premium as more claims were disputed in court.
Management introduced faster settlement of small claims and negotiated lower rates with its legal panel. In this fictional account, LAE fell back to 6.5% of premium within two years, which added about $750,000 a year to underwriting profit. The claims director was given a target for LAE alongside targets for customer satisfaction, so that savings did not come at the expense of fair treatment.
Watch out
Common mistakes.
- Looking only at claims paid and ignoring changes in reserves, which can hide a deteriorating position.
- Forgetting that LAE is a real cost, even though customers never see it.
- Comparing loss ratios between insurers without checking whether LAE is included or excluded.
Questions
People also ask.
What is the difference between ALAE and ULAE?
Allocated LAE can be linked to a specific claim, such as legal fees, while unallocated LAE is general claims department overhead.
Why do reserves affect the figure?
Because the expense recognises claims that have occurred but not yet been paid, so an increase in reserves raises the cost even if no cash has left.
What is a good loss and LAE ratio?
It depends on the type of insurance and the expense ratio, but the aim is to keep the combined ratio below 100%.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related