What Are 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.

Understanding Underwriting Expenses

Underwriting expenses are primarily associated with insurance companies as the cost of doing business, which is underwriting insurance policies. For an insurer, underwriting expenses may include direct costs, such as salaries, commissions, actuarial reviews, and inspections, as well as indirect costs, such as accounting, legal, and customer service expenses.

For an investment bank, underwriting usually relates to the process of underwriting securities for a company's initial public offering (IPO). Underwriting expenses would include such costs as due diligence activities, research, and legal and accounting fees.

Underwriting Expenses and the Expense Ratio

For insurance companies, calculating the expense ratio allows for it to determine the portion of insurance premiums (revenue) that must go towards paying underwriting expenses. The expense ratio for an insurer is obtained by dividing underwriting expenses by premiums 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.

Depending on the insurer, the underwriting expenses can be vastly different. If the entity is a well-known insurer, it might not have to advertise as much. On the other hand, a new insurance company has to advertise significantly, as well as incur expenses in starting a new business and paying stronger salaries and commissions to attract premium talent to generate business.

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 (BRK.A), and Progressive (PGR) have contributed to their own long-term success by eliminating the middleman, similar to how Dell's (DELL) direct sales method gives it a pricing advantage over competitors. Given the presence of the Internet, direct sales methods are more common than they were.

It's important to stress that any claims that insurance companies pay out on insurance policies written are not included as underwriting expenses. The expenses are purely the cost of running a business.