PREMIUM BASIS

Premium Basis – A Key Factor in Calculating Premiums

In plain language: The premium basis is simply the unit or factor that an insurance company uses to help decide how much to charge for insurance. Like measuring ingredients when you bake, it's the "how much" that goes into your insurance cost recipe.

Technical definition: The premium basis is the unit of exposure, such as payroll or gross sales, that an insurer utilizes in determining premiums for certain types of insurance policies. This term typically appears in policy documents and during general liability audits. It's most associated with lines of business like general liability insurance and workers compensation policies. The choice of premium basis can vary, depending largely on the type of risk being insured.

Auditing a recent client’s general liability insurance policy, you uncover an extensive trade breakdown. The client's foreign sales, which were previously overlooked, significantly changed the exposure basis and hence the premium basis.

TL;DR

Premium basis is the amount or type of risk used to determine insurance premiums.

It can make a big difference in the cost of liability coverage.

It's often misunderstood, leading to misquoted premiums or incorrect premium collections.

Regular audits and transparency can help ensure your agency applies premium basis correctly.

What Is Premium Basis in Insurance?

The premium basis is a central, yet often misunderstood, concept in insurance. It's essentially a measure of the risk an insurer takes on when writing a policy. The specific premium basis depends on the type of policy issued. For instance, in general liability insurance or products liability, the premium basis can be auditable gross sales. And for workers compensation, it's usually the payroll.

The premium basis plays a significant role in insurance rating systems. These systems identify units of exposure to calculate the total cost of the policy coverage. In general liability insurance, premium basis often includes total operating expenditures, like employees' salaries, overtime pay, and payments to leased workers. It excludes items like federal and state taxes.

It’s important to note that premium basis can influence the variability of an insurance policy’s premium. With an adjustable rate policy, the insurers might adjust premiums based on changes in exposure (for example, a fleet of vehicles increases from 10 to 15). After policy terms end, the insurer may then perform a premium audit to reconcile estimated premium with actual premium.

Key Related Terms to Know

Exposure Basis: The unit or measure used to assess or determine the potential for loss associated with the insured risk.

Rating Systems: Mechanisms insurers use to determine premium costs, taking into account various factors including risk classification, claims history, and exposure basis.

Experience Rating: A method of pricing insurance which adjusts the premium up or down based on the insured's loss history.

Premium Audit: A review conducted by an insurer to verify the accuracy of information that was used to calculate the insurance premium.

Common Questions About Premium Basis

How is premium basis for general liability insurance determined?

In general liability insurance, the premium basis generally includes auditable gross sales. This involves all receipts from the sale or service of all your products or operations, whether they're retail operations or foreign exchange operations. Exclusions often comprise returns and allowances, cash discounts, bad debts, freight charges not assumed by the insured, and taxes where applicable.

How are workers' compensation premiums calculated?

Workers' compensation premiums often use payroll as the premium basis. This includes not only the salaries and wages employees earn per their employment agencies but also other compensation like bonuses and commissions. Notably, overtime pay is usually partially excluded, while payments for leased workers or executive officers could be included or excluded depending on state-specific workers' compensation laws.

What risks could improper understanding of premium basis pose to my agency?

An incorrect understanding or a misapplication of premium basis during the premium preparation or premium audit process can lead to complications. These include client dissatisfaction, lost business, and even potential E&O risks if an incorrect premium leads to inadequate liability protection for the client.

What are the situations where premium basis might change?

Factors leading to changes in the premium basis can include significant changes in a company's operations, like an expansion into export operations, increased governmental subdivisions, or when a fleet of mobile equipment operators are added to the payroll. These changes can therefore warrant a new premium basis evaluation.

Premium Basis vs. Risk Classification

Risk classification and premium basis are both essential components of the premium calculation process. However, they differ substantially in purpose and effect.

Comparison Area	Premium Basis	Risk Classification
Primary use case	To quantify exposure for premium calculation	To classify risks into groups with similar loss experiences
Coverage / concept type	Financial	Statistical
Typical exclusions	Varies by policy type, may include certain wages or sales using a predefined list	Not applicable
Who is most affected by errors	Insureds, as premium miscalculations affect the cost of insurance	Insurers, insureds
Common mistakes	Accidental over or underreporting of exposure units	Incorrect classification leading to inadequate coverage

Real Claim Examples Involving Premium Basis

Scenario 1: A commercial business sees increased revenues due to a boom in sales of repossessed merchandise. Neglecting to notify their agent, the business receives a higher premium bill at the end of the term after a general liability audit, due to their increased gross sales - the premium basis for their commercial general liability policy.

Scenario 2: A client who exports manufactured goods did not disclose their foreign sales traffic. After an audit, the discovery of this foreign risk factor leads to a change in their premium basis. This involves significant back-paying and an adjustment of future premiums.

Scenario 3: A construction company narrowly avoids a steep increase in premiums after an audit. The insurer had estimated a higher construction value as the premium basis for a specific project. The contractor provides accurate financial documents, proving a lower value and subsequently reducing the premium.

Limitations and Common Mistakes

Overlooking key definitional elements like what constitutes payroll inclusions and payroll exclusions for workers compensation.

Not considering some factors that should be part of the premium basis like trade breakdown, royalty income, and financing charges.

Failing to update changes in business size or operations that could influence the premium basis.

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How to Explain Premium Basis to Clients

Personal Lines client "Just think of premium basis like a pie recipe. The cost of your policy is like the total pie, and the premium basis is the amount of each ingredient going into it. Just like apples are crucial to an apple pie, factors like your income or the value of your property are crucial 'ingredients' in your insurance cost."

Small Business owner "Your insurance premium isn't just a random number. It's based on measuring certain parts of your business - like your payroll or sales - to see how much risk the insurer is taking on. We call these measurements 'premium basis'. And it's important to get them right to ensure you're not overpaying or underinsured."

CFO or Risk Manager "Your premium is calculated by looking at specific exposure mediums within your organization. The exposure basis used becomes the premium basis. These can include factors like gross sales, total workforce payroll, and even the area and frontage of your premises for premises liability. Regular audits help us to keep the premium basis accurate for each policy term."