What is Loss Cost
Loss cost, also known as pure premium or pure cost, is the amount of money an insurer must pay to cover claims, including the costs to administer and investigate such claims. Loss cost, along with other factors, is used to calculate premiums.
BREAKING DOWN Loss Cost
Rate making, or determining the amount of premium to charge, is one of the most critical tasks an insurer faces. It requires insurers to examine historical settlement costs, known as the insurer’s loss cost. The loss cost represents payments to cover claims made on the underwritten policies. Loss cost also includes administrative expenses associated with investigating and adjusting claims. It is, therefore, the actual cost required to cover a claim.
When underwriting a new policy, the insurer agrees to indemnify the policyholder from losses resulting from a specific risk. In exchange for coverage, the insurer receives a premium payment from the policyholder. An insurer realizes a profit when the costs associated with paying and administering a claim is less than the total amount of collected premiums and the return on investments (ROI).
While an insurer could set the rate at no less than the maximum amount it could be liable for, plus administrative costs, such a strategy would result in very high premiums unattractive to potential customers. Regulators also limit the rates an insurer may charge. The insurance underwriter uses statistical models to estimate the number of losses it expects to incur from claims made against its policies. These models factor in the frequency and severity of claims settled in the past. The models also include the frequency and severity experienced by other insurance companies covering the same types of risk. For underwriting use, the National Council on Compensation Insurance (NCCI) and other rating organizations compile and publish claim information.
Despite the sophistication of these models, the results are only estimates. Actual loss associated with a policy can only be known with complete certainty after the policy period expires. Additionally, because the loss cost only includes claims and administrative expenses related to investigating and adjusting claims, it must be modified to take into account profit and other business expenses, such as salaries and overhead. These company-specific adjustments are called the loss cost multiplier (LCM). The loss cost multiplied by the loss cost multiplier equals the desirable rate to charge for coverage.