What it means
An insurer cannot wait until every claim has been paid to report its results. A fire in December may not be settled until the following year, yet it belongs to the period in which it happened.
Losses incurred therefore combines payments made with the reserve the insurer sets aside for claims not yet paid. The usual way to compute it is to start with claims paid in the period and then adjust for the change in reserves.
If the reserve at the end of the period is higher than at the start, the increase is added, because it represents claims recognised but not yet paid. If it is lower, the reduction is subtracted.
The number is important to everyone who reads an insurer's accounts. Investors use it to judge profitability, regulators use it to test solvency and managers use it to set premium rates.
A steady rise in losses incurred relative to premiums warns that pricing may be too low. Estimates drive the figure, so it can be revised.
If claims eventually cost more than reserved, the insurer records adverse development in a later period, which reduces that period's profit. Favourable development has the opposite effect.
Losses incurred should be distinguished from losses paid. A business could see low payments for a year because several large claims are still being negotiated, yet its incurred losses may be high.
Looking at incurred figures gives a truer view of the year's claims experience. The figure also feeds into tax and capital calculations.
Many regulators require insurers to hold capital against reserve uncertainty, and tax authorities may limit how much of a reserve can be deducted before claims are paid. Finance teams therefore keep a clear reconciliation from paid losses to incurred losses each quarter.
In practice
Real-world examples.
Example
A home insurer has a severe storm season in the last month of the year. Many claims are not paid until the next year, but the reserves set aside raise its losses incurred for the storm year. The following year's payments then reduce the reserve without adding to incurred losses again.
Example
A reinsurer reviewing a client's accounts compares losses incurred over five years to see whether claims costs are drifting upward relative to premium. It notes that two years show unusually good results and asks whether reserves were set too cautiously.
Example
An insurance start-up's finance lead explains to a board member that a quiet payment year does not mean a profitable one, because reserves for open claims are still growing. He recommends that the board look at incurred figures and not at cash paid.
Formula
Calculation
Losses incurred = Losses paid + Ending loss reserves - Beginning loss reserves
Loss ratio = Losses incurred / Earned premium
Suppose an insurer paid $40,000,000 of claims during the year. Its loss reserve at the start of the year was $30,000,000, and at the end of the year it was $35,000,000.
Losses incurred = $40,000,000 + $35,000,000 - $30,000,000 = $45,000,000.
With earned premium of $60,000,000, the loss ratio = $45,000,000 / $60,000,000 = 75%.
If the insurer had looked only at payments, it would have computed $40,000,000 / $60,000,000 = 66.7%, and underestimated its claims cost by about 8 percentage points.Case study
Seen in the real world.
Cobalt Coast Insurance is an illustrative, fictional insurer of fishing boats. In its first year it paid only $3,000,000 in claims against $10,000,000 of earned premium, and a young manager celebrated a 30% loss ratio.
The finance director pointed out that several large claims were still open. After adding $5,000,000 of reserves for these claims, losses incurred were $8,000,000, and the real loss ratio was 80%.
The board revised its profit expectations and kept pricing steady rather than cutting rates. In this illustrative story the following year confirmed that the early claims had been slow to arrive rather than absent, and the cautious approach avoided a pricing mistake.
Watch out
Common mistakes.
- Equating losses incurred with cash paid, when it also includes the change in reserves.
- Forgetting to subtract the opening reserve, which double counts claims already recognised in earlier periods.
- Treating the reserve as certain, when it is an estimate that can be revised up or down later.
Questions
People also ask.
What is the difference between losses paid and losses incurred?
Paid losses are cash settlements, whereas incurred losses add the movement in reserves for unpaid claims.
Do incurred losses include claims not yet reported?
Usually yes, through a reserve called incurred but not reported, or IBNR, which estimates claims that have happened but not yet been notified.
Why do insurers use incurred and not paid losses?
Because it matches the cost of claims to the period of cover, giving a fairer view of profit.
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