What Is Experience Refund?

Experience refund is the portion of an insurance company’s premiums or profits that is returned to the policyholder if the insurer’s loss experience is better than expected. An experience refund is provided to a policyholder by the insurer, or to a ceding insurer by a reinsurer.

Experience Refund Explained

When an insurer sells an insurance policy, and the insured costs the insurer less than expected, they might offer an experience refund, which is the return part of the profits they made from the policy. When an insurance company underwrites a new policy, it makes a series of estimations in order to determine how much to charge for coverage. It examines the type of peril being insured against, the risk profile of the policyholder, and the potential severity and frequency of claims. An insurer’s profitability is directly linked to the difference between the amount of premiums charged for coverage and the amount of losses resulting from claims against a policy, and the insurer has an incentive to both maximize premiums and minimize losses.

Insurers charge higher premiums to policyholders who pose a bigger insurance risk as a way of preventing financial loss. Conversely, they also provide incentives to policyholders who haven't cost them much in terms of claims. Insurers can also limit the losses they experience by improving the speed and efficiency of their claims departments, but those marginal gains from spending fewer resources on internal processes will eventually reach a limit. In order to create further improvements, an insurer has to reduce the likelihood of a claim being made in the first place, which requires working with policyholders to reduce behaviors that may result in a claim. The insurer may provide guidelines and best practices that policyholders can follow, but they can also align the goals of the insurer with that of the insured. One way to accomplish this is through financial incentives. The experience refund is one of those incentives. 

Experience refunds are included as a provision in an insurance policy. This provision entitles the policyholder to a percentage of the insurer’s premiums or profits if the severity of claims made against an insurance policy falls short of what was anticipated. For example, a policy may indicate that a policyholder who pays a premium above a certain threshold is entitled to a refund of up to 15% of net profits. If the policyholder is able to reduce the number of claims filed, it will receive a financial reward.