What Is Net Premium?
Net premium is the expected present value of a policy’s benefits less the expected present value of future premiums. The net premium calculation does not take into account future expenses associated with maintaining the policy.
Net Premium Explained
The net premium value of a policy differs from the policy’s gross premium value, which takes into account future expenses. The calculated difference between net premium and gross premium equals the expected present value of expense loadings, less the expected present value of future expenses. Thus, a policy’s gross value will be less than its net value when the value of future expenses is less than the present value of those expense loadings.
Since the net premium calculation does not take into account expenses, companies must determine the amount of expenses that can be added without causing a loss. Types of expenses that a company must take into account include commissions paid to agents who sell the policies, legal expenses associated with settlements, salaries, taxes, clerical expense, and other general expenses. Commissions typically vary with the policy’s premium, while general and legal expenses may not be tied to the premium.
To estimate allowed expenses, a company can add a fixed amount of expenses to the net premium (called flat loading), add a percentage of the premium, or add a combination of a fixed amount and a percentage of the premium. When comparing policies with different net premiums, adding a fixed amount will lead to the same proportion of expenses to premiums as long as expenses do vary by proportion to the premium. Determining which method to use depends on the general and legal expenses associated with the policy, as they relate to commissions on the premium. Most policy calculations leave a margin for contingencies, such as money made from investing the premiums being less than expected.
Importance of Net Premium
Net premiums and gross premiums are helpful in figuring out how much an insurance company owes in taxes. State insurance departments often tax the income of insurance companies. Tax laws, however, may allow companies to reduce their gross premium by figuring in expenses and unearned premiums. For example, if the state of Ohio imposes a tax on gross premiums written by Ohio insurance companies, but the tax does not apply to amounts deducted for reinsurance, it also won't apply to gross premiums not earned because the insurance company or policyholder canceled a policy before it expired.