Losses Incurred: Meaning, In Practice, Example

What Is Losses Incurred?

Losses incurred refers to benefits paid to policyholders during the current year plus changes to loss reserves from the previous year. Losses incurred represents profit that an insurance company will not make from its underwriting activities since funds are to be paid to policyholders based on the coverage outlined in their insurance contracts. Losses incurred are typically viewed by the calendar year.

Understanding Losses Incurred

The amount of losses incurred may vary from year to year for an insurance company. Insurance companies set aside a reserve to cover liabilities from claims made on policies that they underwrite. The reserves are based on a forecast of the losses an insurer may face over a period of time, meaning that the reserves could be adequate or may fall short of covering the company's liabilities. Estimating the amount of reserves necessary requires actuarial projections based upon the types of policies underwritten.

For example, a flood last year might have resulted in an increased number of homeowner policy claims, which would increase incurred losses. However, if there is no flood this year, incurred losses would be lower.

The Claim Process

In an ideal world for insurers, they would underwrite new insurance policies, collect premiums, and never have to pay out benefits. However, in reality, policyholders make claims when accidents happen, and insurers must investigate and pay for those claims if they are found to be accurate.

An insurance claim is filed when a policyholder files a request for a loss that's covered under the insurance policy. The insurance company incurs a loss as a result of the claim since cash is being paid out to the insured.

Once a claim has been started, insurance companies often reevaluate the claims that are already in process. The insurance company needs to review the claim to make sure it's genuine and not fraudulent. The insurer also needs to determine whether the value of the claim that was initially forecasted is going to be accurate. If after the reevaluation process, it's found that the cost of the claim will be higher than the forecasted amount, the company would incur a loss.

Loss Reserves

Insurance companies want to make a profit from the premiums they receive. But they must also comply with the contract benefits outlined in the policies that they underwrite. So, insurance companies must set aside a percentage of total revenue generated to cover for any potential claims in the period, which can be from 8% to 12%.

The amount of funds in the loss reserves must be enough to meet projected liabilities. If the actual liabilities or total claims exceed the total amount of reserves, the company has a loss on its accounting records. The insurer would have to find funds to satisfy the claims and restore the funds in the loss reserves account. Of course, if the claims are high enough to exhaust the loss reserves, and additional funds can't be obtained, the insurer may become insolvent.

Losses Incurred and Loss Ratio

Losses incurred compared to the amount of money earned through premium payments is known as the loss ratio–a key statistic for assessing the health and profitability of an insurance company. For example, if a company has paid $100,000 in claims for every $400,000 collected in premiums, the loss ratio would be 25% ((100,000/$400,000) x100 to create a percentage).

Monitoring loss ratios over time is important in assessing all aspects of operations (including pricing) and financial stability. To fully understand an insurance company's loss ratio results over time, there are many factors to consider, including, but not limited to: the period of time over which losses are paid, the frequency and severity of the lines of coverage being offered, the adequacy of pricing, the amount of loss control measures, and other metrics.

Real World Example of Losses Incurred

In November 2018, wildfires started on Camp Creek Road in California and spread rapidly, becoming the deadliest wildfire in the state's history. The Camp Fire–as it became to be known–killed dozens of residents and destroyed over 153,000 acres of land and more than 18,000 structures, including homes.

The insurance company Merced Property & Casualty Co. faced $63 million in claims from the fires. However, the company only had $23 million in assets. As a result, the company was forced to sell all of its assets in order to cover the claims, which is called liquidation. The company went insolvent and no longer exists because the insurer didn't have enough loss reserves to cover its claims and losses incurred.