Monday, December 9, 2013

Loss Cost Management in Claims

Originally posted on 

Years ago I joined a large, troubled insurance company and the CEO asked me to do just one thing—fix the Claims department. He wasn’t sure what was wrong with it, but he knew it needed work.
I called the claims management team to a meeting and asked one question:  How does Claims contribute to profitability here? I wrote their answers on a flip chart, dozens of them. After about 15 minutes, I told them they were describing important things that Claims did, but they hadn’t mentioned the most important contribution Claims makes to profitability: loss cost management.  Claims organizations exist to manage loss costs. The puzzled faces looking back at me told me what needed to be done to fix that Claims department.
Loss Cost Management is nothing more than the ability to consistently generate superior claims results and outcomes while nurturing stakeholder relationships and complying with applicable laws and regulations
Loss costs have three components:
  • ULAE–unallocated expenses (salaries, rent, etc.)
  • ALAE–allocated expenses (outside attorneys, independent adjusters, TPAs, appraisers, etc.)
  • Loss–loss dollars paid to insureds or third parties.
At most companies, graphically stacking these three components by dollars spent yields a triangle with ULAE at the top, ALAE in the middle and Loss at the base. This is often called the loss cost triangle.
Managing loss costs means managing all three components of the loss cost triangle.  The costs are interrelated, so fewer dollars spent on ULAE may translate into more dollars in ALAE or Loss, while fewer dollars spent on legal expense may increase Loss dollars paid to third parties, and so on.
The challenge for Claims managers is straightforward: understand how the loss cost components interact, then deploy and incur the most effective combination of allocated and unallocated expenses to produce the most appropriate level of loss payments.
Although as a concept it is often misunderstood, the best gauge of loss cost management effectiveness is the level of loss cost leakage (loss dollars paid in error due to breakdowns in claim handling) identified through closed file reviews. World class claims operations operate with leakage of less than 5% (percentage of loss dollars paid that shouldn’t have been paid.)  As it turned out, the troubled insurance company I mentioned earlier was operating with a leakage rate above 20%.
Here’s a quick primer on loss cost leakage:
  • What is loss cost leakage?
    • Leakage is the amount paid on a claim above and beyond what should have been paid. 
    • Leakage is reported as a % of the total amount paid on a claim (or sample of claims), so if $10,000 was paid on a claim that should have been resolved for $9,000, the leakage % is the amount overpaid ($1,000) divided by the total paid ($10,000) or 10%. 
  •  How is leakage measured?
    • Usually a calibrated team of claims experts reviews a sample of closed files periodically.  They analyze claim handling decisions and track compliance with best practices, ultimately estimating the amount of loss cost leakage on each claim.
  • What causes leakage?
    • There are dozens of root causes, but some of the most common involve failure to apply best practices in investigation, evaluation and resolution.  
    • Coverage errors, inadequate subrogation investigations, evaluation based upon unverified damages—these are examples of breakdowns that can inflate claims payments.
  • How can leakage be reduced?
    • Since the closed file review process reveals, by line of business, where in the claims handling process leakage is happening and the root cause analysis reveals why it is happening,  it is actually fairly easy to identify what needs to be done to eliminate causes of leakage. 
    • Training, decision support and process improvement aimed at the root causes of leakage usually produce rapid improvement.
  • Do leakage reductions improve loss ratios?
    • Since leakage reductions imply that overpayments on claims are being reduced, they certainly have a favorable impact on the numerator of the loss ratio (losses.) The denominator of the loss ratio (earned premium) is influenced by other factors, however, including rates charged and policy terms, so there may not always be a direct cause-and-effect relationship between leakage and loss ratios.  The leakage number is a useful indicator of the loss cost management effectiveness of the claims operation since it reveals the extent to which claims are being overpaid.
Dean K. Harring, CPCU, CIC is a retired Chief Claims Officer and an expert and advisor on Property Casualty insurance claims and operations. He can be reached at or through

1 comment:

  1. Hey,
    Thanks for sharing such an amazing and informative post. Really enjoyed reading it :)



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