In a different blog, How do Insurance Companies make money?, we discussed that Premiums and Return on Investment contribute a major chunk in the profits. In the same way, claims made by the insurers against any accident would be considered as a loss for the insurance company. These claims combined with the loss preserves from previous years together are known as Incurred Losses. However, this becomes a complex issue since various other things are considered while calculating the total Incurred Losses in a calendar year.
Definition of Loss in the Insurance sector
Loss is simply calculated by subtracting the expenditure from revenue. However, the terminology used in the insurance sector, the loss is the money claimed by the insurer. It means that if the clients of the company who pay the premium in exchange for the policy, get involved in an accident, will demand money from the company. The reason that the claim money is considered as a loss, is because of the fact that it was a lost opportunity for the insurance company to earn money from the premiums collected. Instead, it had to pay for the claim made by the insurer. Hence, in the accounting books of every insurance firm, all the claims made by policyholders is considered as a “loss”.
What can cause Incurred Losses?
When it comes to the casualties of the incurred losses, it can be both- natural as well as man-made. The amount of loss incurred can vary drastically depending on the natural or man-made disasters resulting in insurers taking benefits of the insurance policy. Let us discuss the various causes of incurred losses in detail.
- Natural Disasters:
Nature, as we know, is unpredictable. Even after building sophisticated machines to understand nature so as to predict it has helped a little bit. Nevertheless, no one can really predict when the next earthquake will strike which part of the world.
The insurance companies play this probability that no earthquake will strike in the given year and the amount of revenue they will earn from that will be their profits. But what if there is one? What if the whole city is affected by a major earthquake? In that scenario, the insurance company is liable to pay for all the rightful claims. In this way, nature’s fury can very well become a reason to Incurred Loss for the insurance company. Hence, this is simple math for the insurance company, more earthquakes will result in more incurred losses and vice versa.
- Man-made Disasters:
Post industrialization world has seen many man-made disasters. For example, World War 2, Nuclear explosion at Chernobyl, and 9/11 attack in the United States. These unfortunate incidents were all human-induced and have the capacity to affect many people’s lives. However, all of these were equally unpredictable when compared to natural disasters.
Nonetheless, all these reasons ended up becoming the incurred loss for an insurance firm. For example, those people who died in the nuclear accident in Chernobyl or the type of property damage done in World War 2 or the 9/11 attacks resulted in life or property insurance being claimed by those who got affected and were insured by an insurance policy.
Losses Incurred and Loss Ratio:
When losses incurred are compared to the premium earned, we come to what is known as the Loss Ratio. Many analysts treat the loss ratio as the basic thing to understand the financial health of the insurance company. Apart from that, the frequency with which the claims are processed and severity of coverage being offered to the clients, serve as other elements to understand the stability of the respective firm.
As a result, insurance companies are also keen to keep this data at the optimum level so as to attract new businesses and investors. In this way, Losses Incurred as raw data becomes crucial for any insurance company and keeping it in a healthy state becomes the company’s responsibility towards a growth-oriented future.