Underwriting Expenses

Underwriting expenses are costs and expenditures associated with underwriting activity. Underwriting expenses include a wide range of expenditures, and the exact definition differs for insurers and investment banks. As a major expense category, the lower these expenditures are as a proportion of underwriting activity, the higher the profitability of the insurer or investment bank.

For an insurer, underwriting expenses may include direct costs such as business acquisition, actuarial reviews and inspections, as well as indirect costs such as commissions paid and accounting, legal and customer service expenses. For an investment bank, underwriting expenses would include such costs as due diligence activities and research, legal and accounting fees.

The expense ratio for an insurer is obtained by computing underwriting expenses as a percentage of premiums earned for a given period. Since the profitability of an insurer has an inverse correlation with the expense ratio, insurers strive to keep this ratio in check in order to remain profitable.

However, underwriting expenses can be quite significant for an insurer. To attract customers, they have to advertise. They also must pay commissions to insurance agents and brokers, give their employees a salary and pay taxes and other operational expenses. Every dollar paid in underwriting expense is a dollar that doesn't flow to the insurer's bottom line, so investors naturally should look for insurers that run a tight ship.

Some insurers have low expense ratios because of economies of scale – most notably with large national advertising budgets and well-known brand names that help attract customers. Other insurers employ direct-sales techniques to cut out the insurance agents and brokers and the underwriting expenses that come with them. In the auto-insurance industry, for example, GEICO, a unit of Berkshire Hathaway and Progressive (NYSE:PGR), has contributed to its own long-term success by eliminating the middleman -- similar to how Dell's direct sales method gives it a pricing advantage over competitors.

The price of an insurance policy is largely the function of supply and demand. When times are good, insurers make underwriting profits, and underwriting expenses and loss ratios decrease. As a result of the fewer operational expenses and favorable pricing conditions, some insurers, driven by short-term greed, increase capacity by writing more policies. This increase in supply results in decreasing prices. Eventually, the cycle turns, losses increase, and insurers who wrote a lot of policies at low prices are left in a potentially bad situation. These types of swings are extremely similar to the boom-bust cycles of the stock market.