DEFINITION of 'Average Severity'

The amount of loss associated with an average insurance claim. Average severity is calculated by dividing the total amount of losses that an insurance company experiences by the number of claims that were made against policies that it underwrites. Average severity is used to show the observed amount of loss for the average claim, or may be an estimate of the amount of loss an insurer should expect from the average claim in the future.

BREAKING DOWN 'Average Severity'

Insurance companies rely on actuaries and the models that actuaries create to predict future claims, as well as the losses that those claims may result in. These models are dependent on a number of factors, including the type of risk being insured against, the demographic and geographic information of the individual or business that bought a policy, and the number of claims that are made. Together, this information forms the past experience of the insurer. Actuaries look at past experience data to determine if any patterns exist, and then compare this data to the industry at large.

Actuaries look at external factors to determine whether these factors influence trends in data. External factors include the environment, government legislation, and the economy. This type of analysis requires the actuary to compare past data to external factors to see if there is any correlation, and then to determine whether these external factors influence the trends that the actuary sees.

Average severity is used by an insurance company to determine the premium that it must charge in order to break even. The insurer will then add a percentage to this premium to take into account any profit that it would like to make. The pure premium, calculated by multiplying frequency by severity, represents the amount of money that the insurer will need to pay in estimated losses over the life of the policy.

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