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BUSINESS INSURANCE CORPORATE INSURANCE

Loss Cost: What it Means, How to

Calculate
By JULIA KAGAN Updated August 07, 2023

Reviewed by ERIC ESTEVEZ

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. Ad
 Insurance companies make a profit when collected premiums are
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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.
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Despite the sophistication of these models, the results are only estimates.
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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.

Related Terms
Rate on Line: Meaning in Reinsurance, Profitability
Rate on line is the ratio of premium paid to loss recoverable in a reinsurance contract.
Rate on line represents how much an insurer has to pay to obtain reinsurance coverage,
with a higher ROL indicating that the insurer has to pay more for coverage. more

Coinsurance: Definition, How It Works, and Example

Coinsurance is the claim amount an insured must pay after meeting deductibles and is
also the level at which an owner must protect property. more

Probable Maximum Loss: Definition and How to Calculate It

Probable Maximum Loss (PML) is the maximum loss that an insurer would be expected to
incur on a policy. It's a standard calculation in underwriting. more

Life Insurance: What It Is, How It Works, and How To Buy a

Policy
Life insurance is a contract in which an insurer, in exchange for a premium, guarantees
payment to an insured’s beneficiaries when the insured dies. more

Ground-Up Loss: What it is, How it Works

Ground-up loss is the total amount of loss covered by an insurance policy. It is an
important number to know when choosing plans. more

Loss Adjustment Expense (LAE): Definition, How It Works,

and Types
A loss adjustment expense (LAE) is an expense associated with investigating an insurance
claim. Learn how LAE helps measure a company’s profitability. more

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