What Are Underwriting Expenses?
Underwriting expenses encompass the costs and expenditures associated with underwriting activities. Unlike fixed definitions, these expenses vary between insurance companies and investment banks. A crucial expense category, minimizing these expenditures as a proportion of underwriting activities boosts an insurer or investment bank’s profitability.
Key Takeaways
- Underwriting expenses embody the costs incurred during underwriting activities.
- For insurance companies, it includes underwriting insurance policies, whereas for investment banks, it covers securities underwriting for initial public offerings (IPO).
- Typical underwriting expenses span actuarial reviews, inspections, due diligence, and legal, as well as accounting fees.
- Companies aim to maintain low underwriting expenses to maximize net income.
- For insurance firms, the expense ratio determines the proportion of premiums spent on underwriting expenses.
Unveiling Underwriting Expenses
Primarily discussed in the context of insurance companies, underwriting expenses represent costs associated with underwriting policies. These expenses include direct costs such as salaries, commissions, and inspections, alongside indirect costs like accounting, legal, and customer service expenses.
In investment banking, underwriting often refers to the underwriting of securities during a company’s IPO. Expenses within this context include costs from due diligence, research, legal, and accounting fees.
Expense Ratio and Its Importance
For insurance firms, calculating the expense ratio is vital. This ratio determines the portion of insurance premiums allocated towards underwriting costs. It is calculated by dividing underwriting expenses by premiums over a specific timeframe. Since an insurer’s profitability inversely correlates with its expense ratio, maintaining a low ratio is essential for centering profitability.
Depending on various factors, underwriting expenses can markedly differ among insurers. For instance, a renowned insurer with a well-established presence might rely less on advertising, while a new entrant may need significant advertising and incurring higher startup expenditures. Consequently, newer entities may offer heightened salaries and commissions to attract premium talent and generate business.
Economies of scale also affect expense ratios; larger insurers with extensive advertising budgets and strong brand names can draw customers more cost-effectively. Some insurers reduce costs by implementing direct-sales techniques, effectively bypassing agents, brokers, and subsequent underwriting expenses connected with them.
Digital transformation has empowered companies like GEICO and Progressive in the auto insurance industry to eliminate middlemen, leveraging direct sales methods akin to Dell’s profit-centric strategy. The shift towards internet-based direct sales has amplified this trend.
It’s crucial to differentiate underwriting expenses from claims paid out on written insurance policies, as the former strictly pertains to business operation costs.
Related Terms: actuarial reviews, initial public offering (IPO), securities underwriting, direct costs, indirect costs, expense ratio.
References
- Insurance Information Institute. “Background On: Buying Insurance. Evolving Distribution Channels”.
