Loss Cost: What it Means, How to Calculate

Loss Cost

Investopedia / Ryan Oakley

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 items, is factored in when calculating premiums.

Key Takeaways

  • Loss cost is the total amount of money an insurer must pay to cover claims, including costs to administer and investigate such claims.
  • When determining what insurance premium to charge a policyholder, insurance companies factor in the loss cost.
  • Insurance companies make a profit when collected premiums are greater than loss costs.
  • In calculating the loss cost, insurance underwriters use statistical models and historical data from their business and the entire industry.
  • The loss cost multiplier is an adjustment to the loss cost that takes into consideration business expenses and profit.
  • The loss cost multiplied by the loss cost multiplier equals the desirable premium to charge for coverage.

Understanding 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 of insurance companies. Loss cost also includes administrative expenses associated with investigating and adjusting claims made by policyholders. It is, therefore, the actual total 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, the loss cost, is less than the total amount of collected premiums.

Determining Loss Cost

While an insurer could set the premium 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 that 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 premium to charge for coverage.

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