Loss Adjustment Expense (LAE)

Loss adjustment expense (LAE) is the cost an insurer incurs in investigating, defending and settling claims, as distinct from the amount paid to the claimant. It includes the fees and salaries of claims adjusters, legal defence costs, expert and engineering reports, medical reviews, and the overhead of running a claims department.

LAE is traditionally divided into allocated loss adjustment expense (ALAE), which can be tied to a particular claim, and unallocated loss adjustment expense (ULAE), which cannot. Since 1998, US statutory reporting has used a slightly different split: defense and cost containment (DCC) and adjusting and other (A&O). Insurers hold reserves for unpaid LAE alongside their claims reserve, and LAE is counted with losses when measuring underwriting results.

When a pipe bursts in someone's kitchen, the bill for new flooring and cabinets is the loss. But the insurer also has to send someone to look at the damage, take photos, check the policy, get quotes, and perhaps argue with a builder whose price seems too high. If a neighbour sues, the insurer may need a lawyer. All of that effort costs money, even though none of it goes to the homeowner.

That is loss adjustment expense: the cost of working out what is owed and getting the claim settled. A good claims team spends money in a way that saves more than it costs, for example by spotting an inflated invoice. A poor one can spend heavily and still pay too much.

The split matters because the two behave differently. DCC rises and falls with litigation and is closely linked to individual claims, while A&O behaves more like the fixed expenses of a claims operation, with a variable element driven by claim counts.

Insurers and analysts usually combine losses and LAE when measuring how well business is priced:

Adding the underwriting expense ratio gives the combined ratio, the standard measure of underwriting profit:

• Incurred losses and LAE are amounts paid in the period plus the change in their reserves.
• The underwriting expense ratio compares acquisition and administration expenses with premium.
• A combined ratio below 100% means an underwriting profit before investment income.

Suppose an insurer earns $500 million of premium, incurs $310 million of losses and $55 million of LAE, and has a 28% expense ratio. The loss and LAE ratio is 365 ÷ 500, or 73%, and the combined ratio is 101%: a small underwriting loss, which investment income on reserves may offset. Here LAE is 11 points of the ratio, so even modest savings in claims handling change the result on the income statement.

Because LAE on open claims is still to be paid, insurers must reserve for it. DCC is usually projected with the same development triangles used for losses, either on its own or as a ratio to losses. A&O is harder to tie to individual claims, so actuaries often use ratio methods, for example applying the historical ratio of paid A&O to paid losses to the claims still open and to those not yet reported. The NAIC's statutory accounting guidance, SSAP No. 55, treats unpaid LAE together with unpaid losses and requires management's best estimate of both.

Insurers try to control LAE without letting claim payments rise. Common tools include:

• Litigation management. Panel law firms on agreed rates, billing guidelines and early settlement of claims likely to be lost, sometimes through arbitration or mediation instead of trial.
• Outsourcing. Independent adjusters and third-party administrators handle surges, such as after a hurricane, at a variable cost.
• Automation. InsurTech tools for photo-based estimates, straight-through processing of small claims and automated triage reduce handling cost per claim.
• Fraud investigation. Special investigation units add LAE but are justified when they deter or uncover fraud, with fraud detection models flagging suspicious claims for review.
• Recoveries. Pursuing subrogation against third parties costs LAE but can return a large share of the claim.

Reinsurance wordings say how LAE is shared. In excess of loss reinsurance, ALAE may be included in the loss that counts towards the retention and limit, or shared pro rata in addition to it, and the choice can change recoveries considerably on litigated claims. Treaty terms normally exclude the cedent's own salaried staff and office costs. Persistent LAE problems, such as slow claims handling or poor controls over outside vendors, are also an operational risk that supervisors examine and that appears in regulatory reporting.

• National Association of Insurance Commissioners (NAIC)
• Casualty Actuarial Society