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In the insurance industry, the term “incurred but not reported” refers to losses the insurance company is preparing to pay out on, although it has not yet done so. The company has incurred expenses, but it has not yet reported them because claims haven't officially been filed and the payouts haven't occurred yet. This can be a significant liability for an insurance company and becomes a particularly important issue in reinsurance, where there is a risk of being misled about an insurance company's financial situation.
In a classic example of how this works, a major earthquake might strike a city. An insurance company with policies in that city can send out inspectors to begin estimating the extent of the damage so the company can create a reserve fund to pay expected claims. The insurance company does not know precisely how much money is needed, but it can anticipate large payouts as a result of the natural disaster. When it creates a reserve fund, it has an incurred but not reported expense.
Reserve funds are usually established before the company even begins receiving and processing claims in the case of natural disasters. The company wants to make sure funds are available to cover all outstanding claims and usually also wants to facilitate rapid payments, as customers may be experiencing economic and personal hardships as a result of the disaster. Once the company has received, processed, and paid out claims, the incurred but not reported expense can be recorded in the company's ledgers and converted to a reported expense.
In reinsurance, essentially a form of insurance for the insurance industry, a company attempts to mitigate risks by insuring all or some of its policies. When a company has incurred but not reported expenses, this can create a false picture for the company offering the reinsurance policy. The company's finances may look strong, with ample funds available to manage policy claims, but in actuality, some of that money has already been spoken for in the form of incurred but not reported expenses like a fund to cover anticipated claims.
Insurance companies have to balance their financial records and needs carefully. They do not want to encounter a situation where they cannot afford to provide coverage to all the people involved in a natural disaster or similar event, which is one reason companies attempt to distribute their risks. An insurance company only offering earthquake insurance in San Francisco, for example, is taking a significant risk, while a company offering coverage across a large geographic area reduces the chances of experiencing a bankrupting number of claims in the wake of a disaster.
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