What Are Claims Incurred?
Claims incurred represent the total financial obligations that an insurance company has taken on from policyholders due to covered events, regardless of whether these claims have been reported or paid. This metric is a fundamental concept within insurance accounting and plays a crucial role in an insurer's financial statements, particularly in determining its liabilities. It encompasses not only claims that have been reported and for which a payment amount is known (case reserves) but also an estimate for claims that have occurred but have not yet been reported to the insurer, known as incurred but not reported (IBNR) claims. Accurately measuring claims incurred is vital for an insurer to assess its financial health and operational performance.
History and Origin
The concept of accounting for "claims incurred" evolved with the formalization of the insurance industry itself, which traces its roots back centuries, with early forms of risk pooling seen in Babylonian and medieval guilds. As insurance policies became more structured, particularly after major events like the Great Fire of London in 1666, the need for robust financial practices grew. Initially, accounting for insurance was rudimentary, focusing on simple cash flows. However, as the industry matured and the duration and complexity of insurance policies increased, particularly in property/casualty and life insurance, it became evident that simply tracking cash paid out for claims was insufficient.
The development of modern insurance accounting principles, including the recognition of liabilities for future claims, gained significant traction in the 20th century. In the United States, the Financial Accounting Standards Board (FASB) and the National Association of Insurance Commissioners (NAIC) have been instrumental in establishing the frameworks for how insurers record and report their financial positions. For instance, the FASB issued Accounting Standards Update (ASU) No. 2015-09, "Disclosures about Short-Duration Contracts," to improve disclosures about claims development, emphasizing the importance of transparency in incurred and paid claims.6 Meanwhile, the NAIC established Statutory Accounting Principles (SAP), which often differ from Generally Accepted Accounting Principles (GAAP), but similarly mandate rigorous accounting for claims liabilities to ensure insurer solvency.5
Key Takeaways
- Claims incurred represent the total cost of claims arising from covered events during a specific period, regardless of when they are reported or paid.
- This figure includes both reported claims and an estimate for "incurred but not reported" (IBNR) claims.
- Accurate estimation of claims incurred is critical for an insurer's financial statements and the assessment of its financial stability.
- Claims incurred are a key component of an insurer's liabilities on its balance sheet and impact its income statement.
- The estimation process relies heavily on historical data, actuarial judgment, and sophisticated risk management techniques.
Interpreting Claims Incurred
Interpreting claims incurred is crucial for stakeholders to understand an insurer's financial performance and future obligations. A high claims incurred figure relative to premiums earned might indicate an unfavorable claims experience, potentially impacting profitability. Conversely, a lower figure suggests a more favorable claims environment or effective underwriting.
Analysts closely examine the trend of claims incurred over time, alongside claims paid and reserves, to gauge the accuracy of an insurer's estimations and its ability to manage risk. Significant fluctuations or unexpected increases in claims incurred could signal underlying issues, such as changes in claims frequency, severity, or ineffective pricing strategies. Actuaries, who specialize in actuarial science, play a critical role in estimating claims incurred, particularly the IBNR component, using statistical models and historical claims development patterns.
Hypothetical Example
Consider "Horizon Insurance," a hypothetical company providing auto insurance. In a given quarter, Horizon Insurance receives 500 new claims reports, with an estimated total payout of $1,000,000 for these reported claims. However, based on historical data and expert analysis, Horizon Insurance's actuarial science department estimates that an additional $300,000 worth of claims have occurred during the quarter but have not yet been reported (IBNR). These could be minor fender-benders that policyholders haven't gotten around to reporting, or more serious accidents with delayed diagnoses.
To calculate its total claims incurred for the quarter, Horizon Insurance combines these figures:
Reported Claims: $1,000,000
Estimated IBNR Claims: $300,000
Total Claims Incurred = $1,000,000 (Reported Claims) + $300,000 (IBNR Claims) = $1,300,000
This $1,300,000 is the amount Horizon Insurance recognizes as its claims incurred for the quarter. It reflects the total cost of insured events that happened during the period, forming a significant portion of its financial liabilities even though not all of it has been paid out.
Practical Applications
Claims incurred are a cornerstone in several aspects of the insurance industry:
- Financial Reporting: Insurers report claims incurred on their financial statements, often within the income statement as an expense and on the balance sheet as a component of the claims liability. This provides a comprehensive view of the company's obligations.
- Pricing and Underwriting: Accurate claims incurred data, especially historical trends, are crucial for insurers to set appropriate premiums for insurance policies. By understanding the true cost of claims over time, they can price policies to ensure profitability while remaining competitive.
- Reserving and Capital Management: The incurred claims figure directly informs the calculation of claims reserves, which are crucial liabilities set aside to pay future claims. Regulators, such as those overseeing Statutory Accounting Principles (SAP) in the U.S. through the NAIC, mandate robust reserving practices to ensure insurers maintain adequate policyholders' surplus and capital to meet their obligations.4
- Performance Analysis: Analysts and investors use claims incurred, along with earned premiums, to calculate key performance indicators like the loss ratio, which is a primary measure of an insurer's underwriting profitability.
Limitations and Criticisms
While essential, the concept of claims incurred has limitations, primarily stemming from the inherent uncertainty in estimating the IBNR component. Actuarial estimates, though based on sophisticated models and historical data, are still projections and can be subject to significant judgment.3 Challenges arise from factors such as:
- Data Quality: The accuracy of claims incurred relies heavily on the quality and completeness of historical claims data. Incomplete or inconsistent data can lead to inaccurate projections.2
- Emerging Risks: New types of claims or changes in legal interpretations (e.g., environmental liabilities, long-tail claims like asbestos exposure) can make historical patterns less reliable for predicting future incurred claims.
- Economic and Social Factors: Inflation, changes in medical costs, legal precedents, and even societal attitudes toward litigation can influence the ultimate cost of claims, making long-term estimation challenging.
- Estimation Volatility: For certain lines of business, especially those with long payout patterns (e.g., professional liability, workers' compensation), the IBNR estimates can be volatile and subject to revisions, potentially impacting reported earnings.
- Regulatory Scrutiny: Regulators closely examine claims incurred and the underlying reserve adequacy to prevent insurers from understating liabilities, which could mislead stakeholders about the company's true solvency.
Claims Incurred vs. Claims Paid
The terms "claims incurred" and "claims paid" are frequently confused but represent distinct aspects of an insurer's financial activity.
| Feature | Claims Incurred | Claims Paid |
|---|---|---|
| Definition | The total cost of claims that have occurred during a period, whether reported or not, and whether settled or not. | The actual cash disbursed by the insurer to settle claims during a specific period. |
| Timing | Recognized when the insured event happens. | Recognized when payment is made. |
| Components | Includes reported claims (case reserves) and estimated IBNR claims. | Represents cash outflow for claims, regardless of when they were incurred. |
| Accounting Basis | Primarily an accrual accounting concept, reflecting obligations. | A cash-basis concept, reflecting actual expenditures. |
| Impact | Affects liabilities on the balance sheet and expense on the income statement, reflecting financial obligations. | Affects cash flow statement and reduces the claims liability on the balance sheet as claims are settled. |
Understanding the difference is critical. Claims incurred provide a forward-looking view of the insurer's total obligations arising from current period events, including those that are yet to materialize or be fully processed. Unearned premium, for example, is a liability that will convert to earned premium as coverage is provided, and from which incurred claims will arise. Claims paid, on the other hand, offer a historical cash-outflow perspective, showing how much money has actually left the company to settle past and present claims.1
FAQs
What does "incurred but not reported" (IBNR) mean in the context of claims incurred?
IBNR refers to claims that have occurred but have not yet been formally reported to the insurance company. Since the events leading to these claims have already happened, their estimated cost is included in claims incurred to provide a comprehensive view of the insurer's total obligations. This is a critical component estimated through actuarial science and statistical analysis.
Why are claims incurred important for an insurance company?
Claims incurred are vital because they represent the true cost of the risk assumed by the insurer for a given period. They directly impact the company's profitability, balance sheet liabilities, and capital requirements. Accurate calculation of claims incurred is essential for regulatory compliance and for setting appropriate premiums.
How do auditors verify claims incurred?
Auditors assess claims incurred by examining the insurer's reserving methodologies, actuarial assumptions, and historical claims development data. They often work with external actuaries to evaluate the reasonableness of the claims reserves and the underlying incurred claims estimates.
Can claims incurred estimates change over time?
Yes, claims incurred estimates, particularly the IBNR component, are dynamic and can change. As more information becomes available, claims are reported, and payments are made, the initial estimates are updated. This process is known as "claims development," and it reflects the ongoing refinement of an insurer's financial obligations. Such changes are often disclosed in the insurer's financial statements.