# Understanding Loss Adjustment Expense: Definition, Types & Profit Impact

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*— Investopedia / Theresa Chiechi*

> **Definition**
>
> A loss adjustment expense (LAE) is a cost incurred by insurance companies to investigate and settle insurance claims.

## What Is Loss Adjustment Expense?

The term loss adjustment expense (LAE) refers to the costs insurers spend to investigate and settle claims. LAEs help prevent fraud and support a company’s profitability. There are two types of LAEs: allocated, which are tied to specific claims, and unallocated, which cover general claim-handling costs. LAEs play a role in calculating the combined ratio, which is a key measure of an insurer’s financial health.

### Key Takeaways

*   Loss adjustment expenses (LAE) are costs for investigating and settling insurance claims, including expenses for adjusters and investigators.  
    
*   Insurance companies incur LAE to prevent fraudulent claims, which can significantly impact their profitability.  
    
*   LAE is divided into allocated expenses for specific claims and unallocated expenses as part of general overhead.  
    
*   The combined ratio measures profitability by comparing total expenses, including LAE, to earned premiums.  
    
*   A combined ratio below 100% indicates an insurance company is making an underwriting profit.

## The Mechanics of Loss Adjustment Expenses

When an insurer gets a claim, it doesn't pay right away. It first does its [due diligence](https://www.investopedia.com/terms/d/duediligence.asp) to ensure that the damages claimed by a policyholder are accurate. This means investigating the incident and the claim. The absence of an investigation could lead to losses from fraudulent claims. 

Loss adjustment expenses include costs for adjusters, investigators, attorneys, mediators, and others.

LAEs will vary widely depending upon how difficult a claim is to investigate. Even in cases where the LAE is high, insurance companies deem the expense worth it to avoid being bilked by fraudulent claims. The investigation of claims can be a deterrent to those who might file fraudulent claims for an easy payday.

> **Important**
>
> Fraudulent insurance claims are believed to cost insurers billions of dollars. These claims drive up insurance premiums for the rest of the customers as insurance companies must count fraudulent claims in their cost of doing business.

## Key Considerations for Policyholders

Some commercial liability policies require policyholders to repay the insurer for loss adjustment expenses.

Carefully read the endorsement language; it may state that loss adjustment expenses exclude the policyholder's attorney fees if the insurer denies coverage and the policyholder sues successfully.

If there's no claim adjustment, the insurer shouldn't use the deductible to cover policyholder expenses when defending a dismissed claim.

## Calculating the Insurance Combined Ratio Using LAE

The combined ratio is a key measure of profitability in the insurance industry. It measures profits earned through daily underwriting activities and excludes investment-related income. The calculation includes the LAE, as shown below.

**Combined Ratio** = (Incurred Losses + Loss Adjustment Expense (LAE) + Other Underwriting Expenses)/Earned Premiums

The combined ratio compares expenses to revenue. A ratio below 100% means that the company is making an underwriting profit. A ratio over 100% shows an underwriting loss. So when it comes to the combined ratio, the lower the result, the better.

### Example

As you can see from the above formula, loss adjustment expense is one of the components used in the combined ratio formula. Generally, as loss adjustment expenses rise, the company's combined ratio also increases, and vice-versa.

For example, insurance company ABC had Q1 underwriting losses of $5 million, loss adjustment expenses of $3 million, and $2 million in underwriting expenses, totaling $10 million. In the same period, the company earned $11 million in premiums. Thus, ABC's combined ratio for the quarter is .91, or 91% ($10 million/$11 million). It's making a profit, as the $11 million in earned premiums outpaced the underwriting costs.

> **Fast Fact**
>
> Generally speaking, a combined ratio in the range of 75%-90% over the long run is considered healthy.

## Different Types of Loss Adjustment Expenses Explained

Loss-adjusted expenses that are allocated to a specific claim are called [allocated loss adjustment expenses (ALAE)](https://www.investopedia.com/terms/a/allocated-loss-adjustment-expenses-alae.asp), while expenses not allocated to a specific claim are called unallocated loss adjustment expenses (ULAE).

Allocated loss adjustment expenses occur when the insurance company pays for an investigator to survey claims made on a specific policy. Or, a driver with an automobile insurance policy may be required to take a damaged vehicle to an authorized third-party shop so that a mechanic can assess the damage. 

For a third-party review, hiring costs are allocated loss adjustment expenses.  
REASONING: Simplified sentence structure for better clarity. Other allocated expenses include the cost of obtaining police reports, and the cost required to evaluate whether an injured driver is really injured.

Insurance companies can also incur unallocated loss adjustment expenses. Unallocated expenses could be related to the salaries of the [home office](https://www.investopedia.com/terms/h/home-office.asp) personnel, maintenance costs of the fleet of vehicles used by in-house investigators, and other expenses incurred in the regular course of operations.

An insurer with staff to evaluate claims, though claims are never filed, will have salary and overhead as unallocated expenses but no allocated expenses.

## How Is a Loss Ratio Different From the Combined Ratio?

[The loss ratio](https://www.investopedia.com/ask/answers/042315/what-difference-between-loss-ratio-and-combined-ratio.asp) is calculated by dividing the total incurred losses by the total collected insurance premiums. It does not include underwriting and loss adjustment expenses, as is the case with the combined ratio.

## What Does It Mean If a Company's LAE Increases Each Year?

If a company's LAE increases each year, it could mean that management is overly aggressive in its financial reporting. Specifically, it might be habitually under-reserving for losses and overstating income.

## What Is the Difference Between an Incurred Loss and an LAE?

Incurred loss is simply the amount of money an insurance company paid out in claims. Loss adjusted expense, meanwhile, is the expense associated with investigating and settling those claims.

## The Bottom Line

LAE are the costs insurance companies spend to handle and settle claims. Allocated LAE are linked to specific claims, while unallocated LAE covers general claim-handling costs. LAEs help prevent fraud by making it harder to submit false claims. They are also included in the combined ratio, a measure that shows the profitability and efficiency of an insurer. Rising LAE can hurt a company’s financial health, so careful reporting and planning are important.

> **Article Sources**
>
> 1.  Insuranceopedia. "[Loss Adjustment Expenses](https://www.insuranceopedia.com/definition/118/loss-adjustment-expenses-lae#insuranceopedia-explains-loss-adjustment-expenses-lae)."
>     
> 2.  National Association of Insurance Commissioners. "[Insurance Fraud](https://content.naic.org/cipr-topics/insurance-fraud#:~:text=The%20Coalition%20Against%20Insurance%20Fraud,%24700%20a%20year%20in%20premiums.)."
>     
> 3.  Barnes & Thornburg, LLP. "[Insurance Company Favorite: The 'Loss Adjustment Expense'](https://btlaw.com/insights/blogs/policyholder-protection/2015/insurance-company-favorite-the-loss-adjustment-expense)."