When an insurance company cancels a policy what is the method used to determine the premium due?

The General Insurance Code of Practice was introduced in 1994 by the Insurance Council of Australia as a voluntary Code and it has been regularly reviewed and updated.

It sets out the standards that general insurers must meet when providing services to their customers, such as being open, fair and honest. It also sets out timeframes for insurers to respond to claims, complaints and requests for information from customers.

The Code is intended to be a positive influence across all aspects of the general insurance industry including product disclosure, claims handling and investigations, relationships with people who are experiencing vulnerability, and reporting obligations.

Pro-rata and Short-rate are two different ways of determining the refund amount that an insured party will receive if their insurance policy is cancelled before the expiry date.  A policy will state in the Terms and Conditions section which approach applies and in which situation.

Pro-rata cancellation

With pro-rata cancellation, the refund amount is calculated based on the remaining length of the policy. This means the insured only ends up paying for the number of days the insurance contract is actually in effect. Pro-rata cancellation applies when the insurer initiates the cancellation and, in some cases, to an insured initiated cancellation.

Short-rate cancellation

Short-rate cancellation calculation is similar to pro-rata but it includes a penalty as a disincentive for early cancellation. In other words, the insured receives less of a refund with this calculation. From the insurer’s perspective, a short-rate cancellation covers their administration costs. It also better balances the money they collect with their chances of paying for a loss.

Policies have different methods for determining the penalty amount. Some policies charge a percentage of the unearned premium amount.  This means the total refund would be the unearned premium amount less, for example, 10%. The result is that the penalty amount will be higher if the policy is cancelled when the policy is new than if the policy is cancelled shortly before the policy expiry date.

Other policies provide a short rate table that lists out the penalty amount that will be charged and when it applies. For example, they may charge a different percentage or factor depending on the number of days that the policy has been in force. Whichever way it is calculated, typically the longer the policy is in effect, the smaller the short-rate cancellation penalty.

Although an insurance policy can be cancelled at any time, it is important to appreciate the implications for doing so.  Like any legally binding agreement, the documents should be reviewed thoroughly, and the cancellation provisions fully understood before entering the commitment.

If you are considering cancelling your insurance policy, you may be wondering if you are entitled to a refund. When a policy is cancelled, insurance companies use a variety of methods to determine how much of your premium will be refunded to you. The method used is dependent on the reason that the policy is being cancelled in the first place. Outlined below are three of the most common cancellation methods used and the related refund implications.

Pro Rata Cancellation

This method of calculating a refund carries no penalty and the amount is otherwise known as the return premium of a cancelled policy. This method is typically used if the policy is cancelled at the request of the insurance company. The return premium (or refund) is calculated by taking the number of days remaining in the policy period, dividing that by the total days of the policy, and then multiplying this number by the annual policy premium.

For example, if you have a 1-year policy with a premium of $1000 that has been fully paid to the insurance company, and you wish to cancel 200 days into the year, you will have 165 days remaining on your policy. Your refund, or return premium, would be calculated as 165 days divided by 365 days in a year times $1000, resulting in a return premium of $452.05

Short Rate

This method of calculating the return premium or refund carries a penalty, and is often used when the policy is cancelled at your request. The penalty charged to you is approximately 10% of the return premium, as described in the Pro Rata method above.

Using the example above and assuming the penalty is exactly 10%, the amount that would be owed to you is $452.05 less the penalty. The penalty of 10% is applied to the return premium and this amount would be substracted from your refund. Therefore, the amount you could receive will be $452.04 less $45.21 equalling to $406.83

Cancellation Calculations for Recreational Vehicles

The cancellation methods used for snowmobile and motorcycle insurance differ to the ones used for car insurance.

Motorcycles and snowmobiles are known as seasonal use vehicles and have their premiums seasonally adjusted. The insurance companies charge the largest percentage of your premium in the months that the vehicle has the greatest exposure. For example, premiums are typically higher for motorcycles in the months of April through October. As such, if you cancel your motorcycle policy for the winter, you will not be entitled to a premium refund. Similarly, if you cancel your snowmobile policy in the summer, you will again not be entitled to a premium refund.

Be sure to discuss your options with your insurance professional if you are thinking about cancelling your policy. They will be able to give you a better idea of whether or not you will receive a refund and, if so, how much you should expect.

The adjusted premium method is used by insurance companies to calculate the amount owed to a customer who decides to cancel their insurance policy prematurely. Specifically, it is used to calculate the cash surrender value (CSV) of a life insurance policy.

• The adjusted premium method is used by insurance companies to calculate the cash surrender value (CSV) of a life insurance contract.
• It is roughly equivalent to the total premiums paid on the contract, less the expenses incurred in acquiring and servicing that contract.
• However, insurers often assess surrender fees that would reduce this amount, making it generally unprofitable to cancel a life insurance contract prematurely.

When a policyholder pays regular insurance premiums on their life insurance policy, a portion of those premiums is applied toward savings while the remainder is applied toward a reserve fund. This reserve fund is then used to finance the death benefit of the policy, which is the amount paid to the policyholder's beneficiaries upon their death.

Initially, a larger portion of the premiums is directed toward the reserve fund as opposed to the savings portion, meaning that the amount of accumulated savings within the policy will be relatively low within the early years.

The CSV is drawn from the savings portion of that policy, as opposed to the portion that is set aside for payment of death benefits. In general, the surrender value will never approach the death benefit of the policy. For this reason, a policyholder should only consider canceling a policy under extreme financial hardship or when they are confident that they are moving assets to a superior investment. This is especially true considering that insurance companies often incorporate surrender fees, sometimes amounting to as much as 10% of a plan's CSV, which would further reduce the amount of money gained from surrendering the policy.

Broadly speaking, the method calculates the CSV by taking the total premiums paid up to the surrender date and deducting all expenses or fees accumulated up to that point. In doing so, the insurer will reduce the CSV in two different ways. First, it will allocate a portion of the costs incurred in order to acquire and service the contract. Then, it will assess surrender fees which will be larger if the contract was surrendered relatively early in its life.

The adjusted premium method is the most commonly used formula that insurance companies use to calculate the cash surrender value of a life insurance policy. Insurance carriers use this formula to determine the payout due to a policyholder in the event they choose to cancel the policy prior to the end of its term, if applicable.

To calculate this value, the insurance carrier starts by looking at the net-value premium, which is essentially the death benefit of the policy divided by the number of years in which premiums are expected to be paid. Then, the insurer reduces this figure by the policy's expense allowance, which reflects the expenses incurred by the insurer in order to acquire the insurance contract. The carrier then deducts surrender fees, which will be higher if the policyholder cancels in the early years of their contract.

Cash surrender value is the internal value of an insurance policy at any point that is equal to the value of the accumulation account minus a surrender charge. 

Insurance carriers use the method to determine the payout due to a policyholder in the event they choose to cancel the policy prior to the end of its term, if applicable.