Incurred Losses

Incurred Losses are a cornerstone concept in the insurance company world, representing the total amount of claims an insurer anticipates paying for policies covering a specific period. Think of it as the insurer's “cost of goods sold.” This figure isn't just the cash that has already been paid out to settle claims; it crucially includes an estimate for future payments on events that have already happened. This includes claims that have been reported but are still being processed, and even a sophisticated guess for claims that have occurred but haven't yet been reported to the company (the infamous Incurred but not reported (IBNR)). For investors, especially those looking at P&C (Property and Casualty) insurance firms, understanding incurred losses is non-negotiable. It’s a direct window into the quality and discipline of an insurer's underwriting process and the honesty of its management. Get this number wrong, and a seemingly profitable company can quickly find itself in a world of financial pain.

At first glance, “incurred losses” might seem like an arcane accounting term best left to the actuaries. Big mistake! For a value investor, this number is a treasure trove of insight. It’s the single largest expense for any insurer and is central to figuring out if the company is actually making money from writing insurance policies. Here’s why you should care:

• The Heart of Profitability: Incurred losses are a key ingredient in the loss ratio, which in turn drives the all-important combined ratio. A combined ratio below 100% means the insurer is running an underwriting profit; above 100% means it's losing money on its policies. A small, consistent miscalculation in incurred losses can be the difference between profit and loss.
• A Test of Management Integrity: Estimating future losses is both an art and a science. Aggressive managers might deliberately underestimate losses to make their quarterly earnings look better. This is like a ticking time bomb. A conservative and skilled management team, on the other hand, will set aside adequate reserves, ensuring the company’s long-term health. As Warren Buffett has proven with Berkshire Hathaway, disciplined underwriting is the bedrock of a great insurance operation.
• Impact on the Balance Sheet: The estimated, unpaid portion of incurred losses goes onto the balance sheet as a liability called loss reserves. If these reserves are too low (under-reserved), the company’s book value is overstated. The truth eventually comes out, often leading to nasty surprises and a falling stock price.

While the internal calculations are complex, the basic formula is wonderfully simple. For any given period, the calculation is: Incurred Losses = Losses Paid During the Period + Change in Loss Reserves During the Period Let's break down the components:

• Losses Paid: This is the straightforward part—the actual cash paid out to claimants during the period.
• Change in Loss Reserves: This is the tricky part. Loss reserves are the pool of money an insurer sets aside to pay for claims that have already occurred but have not yet been settled. This reserve pool is made up of two key types.

1. Case Reserves: This is money allocated for specific claims that have been reported. For example, if someone reports a car accident, the adjuster will estimate the eventual cost and set up a case reserve for that specific incident.
2. Incurred But Not Reported (IBNR): This is the “ghost in the machine.” IBNR is an educated guess for losses from events that have already happened but that people haven't called in to report yet. Think of a major hailstorm hitting a city on December 29th. The damage is done in that financial year, but most claims won't be filed until January. The insurer can't just ignore this; it has to estimate those future claims and book them as part of its IBNR reserve. Accurately estimating IBNR is what separates the great insurers from the merely good.

Value investors are drawn to insurance companies because of the magical concept of float—the massive pool of premiums collected upfront that can be invested for the company's benefit before claims are paid. However, this float is only valuable if it doesn't come at a cost. If an insurer's combined ratio is consistently over 100%, it means they are paying for the privilege of holding the float, which destroys value. The key to profitable underwriting lies in disciplined risk assessment and conservative reserving. Incurred losses are the ultimate scorecard for this discipline. When analyzing an insurer, don't just look at the headline number. Dig into the annual report (the 10-K) and find the “Loss Reserve Development” table. This table is a report card showing how the company's initial loss estimates for prior years have changed over time.

• Favorable (or Positive) Development: This means the company's initial estimates were too high, and it is now “releasing” those excess reserves, which boosts current earnings. Consistent favorable development is a sign of a conservative, high-quality management team.
• Adverse (or Negative) Development: This means the company's initial estimates were too low, and it now has to add to its reserves, which hurts current earnings. This is a major red flag, suggesting poor controls or overly optimistic assumptions in the past.

By scrutinizing incurred losses and the history of reserve development, you can peel back the layers of the onion and see the true quality of an insurance business. It’s how you separate the long-term compounders from the businesses destined for a nasty surprise.