Definition
 

Incurred losses refer to financial losses that have already been experienced or accrued by an individual or organisation due to various factors such as operational inefficiencies, market fluctuations, or unexpected events.

Description

For startups, incurred losses represent the financial setbacks and expenses they have encountered during their operations. These losses can arise from various sources, such as initial investments, operating costs, marketing expenditures, product development expenses, and unforeseen challenges or setbacks. 

Incurred losses are an inevitable part of the startup journey as companies strive to establish themselves, innovate, and grow in competitive markets. Understanding and managing these losses is crucial for startups to adapt, pivot if necessary, and ultimately achieve long-term success.

Importance to know incurred losses in an insurance company.
 

For an insurance company, understanding incurred losses is critical for several reasons:

1. At the heart of risk assessment in insurance lies the understanding of incurred losses. These losses provide invaluable data for assessing and evaluating risks associated with different insurance policies. By analysing past loss trends, insurers can better anticipate and price future risks and collect adequate premiums to cover potential payouts.
2. Underwriting Decisions: Knowledge of incurred losses helps insurance companies make informed underwriting decisions. By understanding the frequency and severity of past losses, insurers can determine which risks to accept, modify, or decline and set appropriate premiums and deductibles.
3. Reserving: Incurred losses influence the setting of reserves to ensure the company has sufficient funds to cover future claim payments. Accurate reserving is essential for maintaining financial stability and meeting regulatory requirements.
4. Financial Planning: Incurred losses impact an insurance company's financial performance and profitability. By tracking and analyzing incurred losses over time, insurers can assess their financial health, set realistic growth targets, and develop effective strategies for managing risk and improving profitability.
5. Claims Management: Understanding incurred losses helps insurance companies streamline claims management processes. By identifying patterns and trends in claims data, insurers can implement proactive measures to mitigate risks, detect fraudulent activities, and improve customer satisfaction by expediting claim settlements.

How to calculate incurred losses?

Calculating incurred losses involves several steps:

1. Data Collection: Gather comprehensive data on all incurred losses within a specified period. This includes information on the date of each loss event, the type of loss (e.g., property damage, liability claim), the amount paid out for each claim, and any outstanding reserves for open claims.
2. Categorization: Classify the incurred losses into relevant categories based on the nature of the loss (e.g., property, liability, workers' compensation) and any other applicable criteria (e.g., geographical location, severity).
3. Loss Development: Analyze the historical data to account for loss development factors. Losses may develop over time due to delayed reporting, settlement negotiations, or changes in claim estimates. Adjust the reported losses to reflect the expected ultimate loss amounts based on historical patterns.
4. Reserve Estimation: Estimate the reserves needed to cover outstanding liabilities for open claims. This involves assessing the potential future payments required to settle these claims, considering factors such as legal expenses, medical costs, and possible litigation.
5. Calculation: Calculate the total incurred losses by summing up the actual paid losses and the estimated reserves for open claims. This provides an overall picture of the financial impact of past loss events on the insurance company's balance sheet.
6. Analysis: Analyze the calculated incurred losses to identify trends, patterns, and areas of concern. Look for factors contributing to high losses, such as frequency of claims, severity of losses, or changes in underwriting practices. This analysis can inform strategic decisions to mitigate future losses and improve profitability.
7. Reporting: Present the calculated incurred losses clearly and transparently, along with supporting documentation and analysis. This information is crucial for internal decision-making, regulatory compliance, and communicating with stakeholders such as investors, regulators, and rating agencies.

Effective trends that can impact incurred losses

Here are three concise trends that can impact incurred losses for insurance companies:

1. Technological Advances: IoT, AI, and automation offer opportunities for better risk assessment and introduce new risks like cybersecurity vulnerabilities.
2. Climate Change: Increasing frequency and severity of natural disasters lead to higher property damage claims, necessitating proactive risk management.
3. Social and Economic Changes: Demographic shifts, economic fluctuations, and regulatory reforms influence insurance demand and claims experience, requiring insurers to adapt strategies accordingly.

Example

Let's consider a leading Indian insurance company facing higher incurred losses due to a surge in motor vehicle accidents. With the increase in traffic congestion and reckless driving behaviours, the insurer experiences a rise in claims related to vehicle damages, injuries, and third-party liabilities. 

Despite efforts to adjust premiums and enhance risk management measures, the frequency and severity of accidents continue to impact the company's bottom line, leading to significant incurred losses in the motor insurance segment. To address this challenge, the insurer may need to leverage data analytics, telematics, and partnerships with road safety initiatives to promote safer driving practices and mitigate future losses.

FAQ

Does insurance compensate for the losses directly? 

Insurance compensates for losses indirectly through financial mechanisms like premiums and claims. Policyholders pay premiums to the insurer, which pools funds to compensate for losses suffered by policyholders. When a covered loss occurs, policyholders file claims, and the insurer evaluates and settles these claims based on policy terms and conditions. Therefore, while insurance doesn't compensate for losses directly, it provides financial protection against unforeseen events.

What are loss reserves, and how do they relate to the loss ratio? 

Loss reserves are funds set aside by insurance companies to cover future claim payments for incurred but not yet settled claims. These reserves represent the estimated future liabilities associated with open claims. 

The loss ratio is a key performance metric that measures the ratio of incurred losses (including paid losses and changes in reserves) to earned premiums. Loss reserves directly impact the loss ratio because changes in reserves affect the amount of incurred losses reported, thereby influencing the ratio's calculation and reflecting the insurer's claims-paying ability and underwriting profitability.