How to Calculate a Short Rate

Insurers discourage policy cancellations by charging short rates.
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Unlike the prorated cancellation that's triggered by the insurance company itself, a short-rate cancellation is initiated by the insurance policyholder. Policyholder-induced cancellations of some policies before their expiration dates may trigger the deduction of cash penalties from the returned prepaid premiums that the insured parties receive.

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A short-rate cancellation means that a policyholder may not receive a refund that is proportional to the coverage period that remains under the policy's terms. Consequently, the short-rate cancellation serves as a disincentive to the early cancellation of a policy by its insured.

The Short-Rate Cancellation

When a policyholder cancels an insurance policy, the exposure to loss of the insurance company that issued the policy decreases. The company's fixed costs related to that policy, however, remain the same. Consequently, insurance companies are permitted to recover a portion of these costs by deducting a penalty from the insured's returned premium. This penalty is termed a short-rate cancellation.

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Short-Rate Cancellation Penalty Amount

The dollar amount of the early cancellation penalty, which is termed a short-rate cancellation fee, and the refund triggered by the early cancellation are determined in part by the time during which insurance coverage was in effect. The short-rate cancellation is pro-rated across the difference between a policy's full term and its actual duration.

In this way, the calculation of an insured's returned premium is not always based on an equal distribution of a premium over a certain policy term. In this case, the insurance company retains more than a pro-rata share of the prepaid premium.

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The additional share is intended to cover the cost of issuing the policy in question. These administration fees are costs the insurance company incurs when it generates and maintains the policy regardless of whether the policyholder keeps the policy for its entire term or not.

Typical Short-Rate Cancellation

If you cancel an insurance policy, it's typical that the insurer will return only 90 percent of the pro-rata portion of the policy's unearned premium. Consequently, the typical penalty for early cancellation is 10 percent of the policy's unearned premium.

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Policy-Specific Cancellation Fees

An insurance company's application of the short-rate cancellation penalty varies with the type of insurance policy. For instance, the applicable pro-rata cancellation fee may be stated in the policy. Alternatively, the short-rate penalty might be calculated by multiplying a certain pro-rata cancellation factor by the unearned premium amount.

Example of Short-Rate Cancellation

Assume that an insured cancels a three-year policy at the end of month 12 of the first year. In this case, the insurance company earned the prepaid premium for the entire first year of the policy's three-year term. So, the insurance company's expenses for the year have been recovered. Consequently, the insurance company will return the entire amount of the prepaid premiums for years two and three, namely, for the two-year unexpired term.

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Insurance Policy Selection

If the calculation for a returned premium for a customer-cancelled insurance policy includes the deduction of this early cancellation fee, it's termed a short-rate cancellation. Before you purchase any policy, take the time to read the terms carefully and look for this policy provision. If you identify the penalty in the policy, you may want to consider asking the insurer to remove the penalty from your policy or searching for a different policy and provider. You may also try negotiating with the insurance company.

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