This article forms part of our insurance glossary and how-to series.

Have you ever heard of Reinstatement and Day One Basis of Cover?

1. What is Reinstatement Basis of Cover ?
2. What is Day One Reinstatement Basis of Cover ?
3. Is Day One Reinstatement more expensive ?
4. Why choose a Day One Basis ?
5. Example of calculating a Day One Sum Insured

What is Reinstatement Basis of Cover ?

The most common method of insuring commercial buildings is on a Reinstatement Basis.

Cover is determined by the cost of repair or reconstruction at the time of loss as opposed to at the start of the insurance period.

This will most likely have increased during the policy period as a result of construction cost inflation.

The selected Sum Insured therefore must include an allowance for this inflation, not only during the period of insurance but also during the rebuilding period.

A loss may not occur until very well into the policy period, possibly almost at expiry so it is vital that the selected Sum Insured allows for the potential of an extended period of reinstatement.

What is Day One Reinstatement Basis of Cover ?

Under the Day One Reinstatement Basis the Sum Insured is declared as at the first day of the insurance and an inflation provision is then chosen to reflect the affect of inflation.

The initial Day One Declared Value must be accurately set, sometimes following a professional survey otherwise the base figure may be incorrect.

Is Day One Reinstatement more expensive ?

The premium for the inflation provision is much lower in percentage terms than the actual band itself and therefore offers a very economical method of providing the extra cover.

As an example the rate charged for a 25% inflation provision may be around 5% of the full rate.

Why choose a Day One Basis ?

This is one of the most economical and safe ways to avoid under insurance and the application of Average which may effect a claim settlement.

Example of calculating a Day One Sum Insured

In this example there will be two elements:

a) the declared value – the cost of rebuilding the property including any associated costs such as debris removal, professional fees and VAT on day one of the policy period.

b) the inflation provision – the percentage uplift sufficient to take into account inflated construction costs both during the policy period and beyond to cover the rebuilding period.

Rebuildings costs on day one £38,000
Debris Removal £1,800
Professional Fees £4,500
Public charges £1,700
Declared Value £46,000

Inflation during 12 months £1,500
Inflation during design and planning £2,000
Inflation during construction £4,000

Total Sum Insured £53,500

On the policy schedule you would probably see the Sum Insured first £53,500 with the Declared Value in brackets (£46,000)

Did you find this article useful?

Yes | No

As part of our ongoing insurance how-to we continue to explore the terminology and practices used in the Insurance world.

Today we will be looking at The Average Condition and will explore ;

1. What is an Average Condition ?
2. Example of Average applying to a Claim
3. Special Condition of Average – 75%
4. Why do Insurers apply an Average Condition ?

What is an Average Condition ?

If a Sum Insured on an insurance policy is subject to Average, and the Sum Insured is less than the value at risk at the time of loss, any claim will be reduced in the same proportion as the amount of under insurance that existed at the time of loss.

Example of Average applying to a Claim

In this example we have a scenario where a building is insured for a sum of £1,000,000

At the time of a major fire which causes £250,000 of damage to the property Insurers have calculated that the building was actually valued at £1,100,000

There was therefore an amount of under insurance at the time of the loss, in this case 10%

The Average Condition would therefore apply, so the amount of the claim settlement would be reduced by the same percentage – again 10%

The net amount paid by Insurers would therefore be £225,000

Special Condition of Average – 75%

In some cases it is very difficult to assess an exact Sum Insured as values may fluctuate.

To avoid Average being unfairly applied in these cases some Insurers also offer an amended Average Condition whereby if the Sum Insured is 75% or more than the value at the time of loss no deduction is made for under insurance.

Why do Insurers apply an Average Condition ?

The Average Condition is applied to try and ensure that policyholders insure their property for the correct values.

As most premiums are calculated on a rate applied to a sum insured the Insurers are keen to receive the correct premium for the risk that they are covering, hence this must be applied to the full Sum Insured at risk.

Did you find this article useful?

Yes | No

As part of our ongoing insurance how-to series we continue to explore the terminology and practices used in the Insurance world.

Today we will be looking at Operating Ratio and will explore:

1. What is an Operating Ratio?
2. How do you calculate an Operating Ratio?
3. How can an Operating Ratio help me with my business?

What is an Operating Ratio?

An Operating Ratio is a means of monitoring the efficiency of a business in terms of its operating expenses against net sales.

Operating expenses normally include administrative costs, office expenses and selling and distribution costs.

Financial charges such as interest are normally excluded from operating expenses.

How do you calculate an Operating Ratio?

Operating Ratio is calculated as a percentage figure by applying the following formula:

Operating Ratio = Cost of Goods Sold + Operating Expenses / Net Sales x 100

A typical calculation may be made as follows:

Goods Sold = £360,000

Operating Expenses = £60,000

Net Sales = £600,000

In this example the calculation would be:

£420,000 / £600,000 x 100 = 70%

How can an Operating Ratio help me with my business?

An Operating Ratio is an indicator of the efficiency of a business – a low Operating ratio will indicate high operating profit.

A low Operating Ratio is ideal because it indicates that in the event of a reduction in sales or revenue a company will be able to maintain profitability.

Did you find this article useful?

Yes | No

As part of our ongoing insurance how-to series we continue to explore the terminology and practices used in the Insurance world.

Today we’ll be explaining Lapse Ratio, how it is used and the effects is has, giving examples and calculations. (If you haven’t already, you may also like to see our articles on Claims Loss Ratio and Combined Ratio.)

We will explore the following topics:

1. What is a Lapse Ratio?
2. What do Insurers use a Lapse Ratio for?
3. What factors can effect a Lapse Ratio?

Watch out: not everyone renews their insurance.

What is a Lapse Ratio?

This is the proportion of renewals that an Insurer secures in relation to the number that they invited expressed as a percentage.

So, if an Insurer invited 200 renewals and secured instructions to renew on 150 the Lapse Ratio would be 25% – in other words 25% of the cases did not renew and are therefore deemed to have been Lapsed.

The term Lapsed only applies to policies that have not renewed at expiry and would not include policies that been cancelled during the policy year.

What do Insurers use a Lapse Ratio for?

A Lapse Ratio is a key piece of information to an Insurer as it allows them to see if the renewal terms that they are offering are competitive within the market.

This Ratio will be continually monitored and an acceptable percentage will vary depending on the types of cover involved.

Traditionally Personal Lines type policies (Motor, Household etc) will have a higher Lapse Ratio as policyholders are far more likely to shop around for alternatives than they will on a large Commercial type policy.

What factors can effect a Lapse Ratio?

A Lapse Ratio can be effected by a number of things although it is to a certain extent beyond the control of the Insurer if they cannot offer improved premium terms.

Uncompetitive renewal premiums is the most likely reason for an increase in Lapse Ratio. This may be as the result of premium increases that the Insurer are seeking or if a competitor has entered the market with cheaper rates.

The stage at which an Insurer classes a policy as Lapsed can also have an effect. This would normally be if no instructions are received by expiry and policies are automatically Lapsed.

However, if the Insurer delays this process to send out chasers or makes contact with the policyholders it is possible that they will still be able to retain some of the business and hence the Lapse Ratio will decrease.

Did you find this article useful?

Yes | No

As part of our ongoing insurance how-to series we continue to explore the terminology and practices used in the Insurance world.

Today we’ll be explaining Claims Deductions; we’ll break down the Claims Excesses and Claims Franchises that are applied by Insurers and explain why they use them.

We will explore:

1. What is an Excess and why do Insurers apply them?
2. How does an Excess affect my claim?
3. What is a Franchise and why do Insurers apply them?
4. How does a Franchise affect my claim?

What is an Excess and why do Insurers apply them?

A Claims Excess is the amount that your Insurer will deduct from a Claim that you make under your insurance policy.

Some policies which have a number of sections may have a number of different Excesses applying – these will normally apply to different types of claim that may occur.

They are normally applied to help Insurers avoid the costs incurred in dealing with very minor incidents where the amount being claimed is less than the administration costs involved in dealing with the processing of a Claim.

Increased Excesses are sometimes applied to reflect an increased risk in a certain area of the coverage applied.

For example if the premises being covered are located in a very high risk flood area Insurers may well impose a flood excess which is much greater than their standard one.

How does an Excess affect my Claim?

A Claims Excess will be automatically deducted from any payments that Insurers make to you in settlement of a loss that you have incurred.

If the amount of the Claim is less than the Excess then no payment will be made at all.

If the amount of the Claim is greater than the Excess then you will receive the balance of the amount due.

For example if you have a Theft Excess of £250 on your policy and have a Break In which involves losses and damages of £1,000 you will receive the balance after deduction of the Excess, in this case £750.

What is a Franchise and why do Insurers apply them?

Some Insurers feel that to totally exclude an amount from a claim is a little harsh and adopt a different approach by applying a Franchise.

A Franchise will apply to the policy in the same way and for the same reasons as an Excess but in the event that a Claim exceeds the Franchise the full amount of the loss will be paid.

How does a Franchise affect my Claim?

If you have a very small claim which is below the policy Franchise then there will be no difference in the way that the two systems are applied – in neither case will any amount be paid.

However if the loss is above the Franchise limit the amount will be paid in full.

For example if there is a Theft Franchise on the policy of £250 and a Break In occurs which results in £240 of damage no amount will be paid.

If the loss reaches £260 the full amount of £260 will be paid – there will be no deduction made.

This still means that Insurers do not have to deal with very small losses below the Franchise limit but that if a more significant loss occurs the Insured is not penalised in any way.

This alternative approach can often be highlighted in marketing as a good sales point, although in recent years it is becoming a little less common, particularly outside of commercial insurance; this is perhaps because it can be easily missed by consumers.

Did you find this article useful?

Yes | No

Following on from our glossary series of insurance terms and methods in which we outlined Claims Loss Ratio and Combined Ratio, I would like to take a look at the concept of Earned Premium and give you a few examples as to the usage, importance and pitfalls when working with it.

In this article I investigate Earned Premium in the following ways:

1. What is Earned Premium?
2. Why is Earned Premium important? Why bother?
3. Calculating Earned Premium
4. More advanced calculations.
5. Common mistakes and how to avoid them

What is Earned Premium?

Most insurance policyholders would probably assume that when they pay a premium their Insurers can immediately class this as premium income and incorporate this into their company accounts.

In reality Insurers to do not do this as they only class a premium as being Earned when it is based on the amount of time which has actually elapsed under a contract for an insurance policy.

Why is Earned Premium important? Why bother?

Whilst policyholders pay premiums for their insurance up front, the Insurer must earn the premium by exposing itself to the risk on behalf of the Insured.

Within the accounting systems used by insurers the Earned premium can be counted as part of the profit for a given accounting period while the unearned premium cannot.

For this reason, it is very important for insurance companies and their agents to put software in place to easily calculate Earned Premium.

Earned premium is also often used to calculate Insurers’ loss ratio where total losses for a period are divided by the Earned premium for the corresponding period.

Without determining Earned Premium, the true profitability of any insurance operation cannot be determined, which is why the savvy insurer doesn’t leave home without his Earned Premium report.

Calculating Earned Premium

To determine Earned premium, we need to look at the length of the policy, and determine how much time has already elapsed.

Earned Premium = Total Premium / 365 * Number of Days Elapsed

For example if a 365 day policy with a full premium payment at the commencement of the insurance has been in effect for 180 days, 180/365 of the premium can be considered as being Earned. This will also mean that 185/365 of the premium would have to be considered unearned.

The same rules apply for policies with a term of more than one year, if someone paid a premium for two years of home insurance and 18 months has elapsed the Insurance company has Earned three quarters the premium.

Note that in leap years you will need to use 366 and not 365 in the formula above.

Alternative method:

Instead of using days elapsed it’s also possible to use whole months to calculate Earned Premium.  So for instance, if 3 whole months of a two year (24 month) policy have elapsed, the calculation would be as follows.  Thanks for George for pointing this out in the comments!

Earned Premium = Total Premium / Full Policy Term in Months * Number of Months Elapsed

i.e. Earned Premium = Total Premium / 24 * 3

More advanced calculations

There are two different methods for calculating earned premiums, an accounting method and an exposure method.

The accounting method is highlighted above and is the more commonly used and is frequently used by Insurers in their corporate income statements.

Under the exposure method, Earned premiums are calculated based on the percentage of total premium that was exposed to loss during the period being calculated and does not take when the premium was actually collected into account.

Common mistakes and how to avoid them

It’s easy to calculate Earned Premium providing you have the right tools. Often we’ve seen mistakes made during manual calculation of Earned Premium or through oversights in Excel spreadsheets. We would always recommend using software to avoid mistakes and make Earned Premium a cornerstone of automatic reporting across your entire operation, but maybe we’re biased!

Feedback

As ever we absolutely thrive on your questions and feedback. Leave us a comment below!

1. What is Combined Ratio?
2. What is Combined Ratio used for?
3. Example of how to calculate Combined Ratio…
4. How the experts make Combined Ratio work tor them
5. Common mistakes and how to avoid them

What is Combined Ratio?

Combined Ratio is a measure of performance used by underwriters/insurance companies.

What is Combined Ratio used for?

Combined Ratio is perhaps the most useful way to determine the profitability of an underwriting operation.

Example of how to calculate Combined Ratio…

To calculate Combined Ratio simply add the Loss Ratio to the Expense Ratio.

Combined Ratio = Loss Ratio + Expense Ratio

How the experts make Combined Ratio work for them

A combined ratio of less than 100 percent indicates underwriting profitability, while anything over 100 indicates an underwriting loss. Ensuring easy access to accurate Combined Ratio figures is critical for underwriters; without it or some meaningful equivalent we cannot ever be certain of company position, and therefore cannot expand or make float investments.

Common mistakes and how to avoid them

Combined Ratio is dead simple to calculate providing you have access to accurate Loss Ratio and Expense Ratio figures. To ensure you get this right, first read our respective articles on Loss Ratios and Expense Ratios.

Feedback

As ever. we absolutely thrive on your questions and feedback. Leave us a comment below!

Time and again I encounter insurance firms that fail to capitalise on claims loss ratio data. They:

1. Do not have the tools to view reliable Loss Ratios automatically or quickly across all of their accounts.
2. Are not taking the time to put those tools in place.
3. Are not able to automatically tweak rates and fees at policy renewal based on Loss Ratios, without manual intervention.
4. Don’t analyse Loss Ratios for individual policy sections or risk areas.
5. Don’t educate junior staff to ensure they understand the importance of loss ratios and how to manage and compare them.

Not having instant access to loss ratios at a specific level (e.g. per risk area per policy per policy-year) and a general level (e.g. for a new scheme as it grows by the hour) is damaging to businesses since they often cannot spot the poorly performing areas or new behaviour patterns of their best sub-brokers until it is too late.

In this article I will investigate Loss Ratios (or CLRs: “Claims Loss Ratios”), in the following ways:

1. What are Loss Ratios?
2. Why are Loss Ratios so important?
3. Calculating Loss Ratios
4. How the experts make CLRs work tor them
5. Common mistakes and how to avoid them

I hope this article will serve as a refresfer for the more savvy readers out there and a way to share techniques, but also as a learning tool for anyone just starting out. Leave your comments and let me know what you think!

What are Loss Ratios?

Loss Ratios are a means for insurers, underwriting agents and brokers alike to assess the profitability of their businesses, an insurance policy or even a relationship with a partner company. A Loss Ratio is a single number that can be used to identify performance: the lower the number, the better the performance.

Why are Loss Ratios so important?

Without a quick and simple way of comparing the profitability of different accounts, no insurance operation has much hope of success. Critically we must determine the ratio between income and outgoings, which in insurance terms means Premiums vs Claims.

Calculating Loss Ratios

Loss Ratio is the ratio of total losses paid out in claims plus adjustment expenses divided by the total earned premiums.^[1]

So for example, if for one of your insurance products you pay out £70 in claims for every £100 you collect in premiums, then the loss ratio for your product is 70%.

Remember: the total losses+adjustment expenses and total earned premiums can be tied down to a specific area, you can generate a Loss Ratio for just about anything. To make advanced Loss Ratios work however, you will need to make that process quick and easy by having access to accurate data at all times, the tools to help manage that data and something to automate the calculations.

How the experts make CLRs work tor them

The key to making loss ratios work for you lies in having the agility to react to them in very specific ways and according to rules outlined by your best underwriters, without having to involve your most senior staff on every single case.

For instance, it might be prudent on a scheme with buildings cover to up significantly the rate charged for all types of cover if there has ever been a fire claim but instead only to tweak a specific rate if the claim were for roofing damage.

Or perhaps you might up the commission offered to sub-brokers whose Loss Ratio continues not to exceed 50% on all accounts, and adjust that commission proportionate to the average Loss Ratio.

The number of ways in which insurance firms can, should and do react to Loss Ratios at a general and a specific level are extremely numerous, since at the heart of good insurance business is the mitigation of risk at all times.

Common mistakes and how to avoid them

a. Don’t calculate loss ratios manually

You can’t calculate loss ratios for specific areas of cover or policy sections manually without significant human resource, which will not only make mistakes, but in costs will quickly outweight the value of loss ratio analysis in the first place.

b. Don’t imagine that specific Loss Ratios don’t matter

If you work in insurance, Loss Ratios are everything. If you don’t react to them as well as possible, not only will they continue to rise(!) but someone else responding swiftly will dominate the market.

c. Don’t leave junior staff in the dark about loss ratios

All of your staff should understand what makes one account a great performer for you and another one poor, and how and why rates, fees or commissions are tweaked. Often the junior staff are your front line troops, and will be the first to spot trends and suggest new ways to mitigate risk.

Conclusion

This has been a very brief look at Loss Ratios and how they are often neglected and misused (for no good reason), despite being perhaps the single most important statistic facing any single area within an insurance organisation.

Would you like your insurance software to calculate claims loss ratios for you automatically?

Take a look at the latest and greatest insurance software.

References

1. Harvey Rubin, Dictionary of Insurance Terms, 4th Ed. Baron’s Educational Series, 2000