What it means
Insurance premiums are normally calculated as a rate applied to a measure of exposure, such as payroll or sales. That works well for covering claims, but it does not recover costs that are the same for every policy.
Setting up an account, producing documents and handling a renewal cost roughly the same whether the policy covers a tiny shop or a large factory. The expense constant solves this by adding a fixed charge, usually shown as a separate line on the premium calculation.
It is often a modest figure, such as a few hundred dollars, and it is set in the insurer's filed rating rules or by the regulator, depending on the state or country. Because it does not change with the size of the business, its impact is felt most by small customers.
For a finance manager, the practical point is that an expense constant is part of the cost of insurance and should be included when comparing quotes. Two insurers may quote similar rates but different flat charges, and on a small policy that difference can change the ranking.
It should also be budgeted for each renewal, since it is charged again. The charge is usually treated as part of the premium for accounting purposes, so it is recorded as insurance expense and spread over the period of cover.
It is also commonly included in the premium that is used for calculating audit adjustments, although rules vary, so the policy documents should be read carefully. A useful comparison is with a minimum premium.
A minimum premium sets the least amount a customer can be charged, while an expense constant is added on top of the calculated premium no matter how large it is. Both are tools for covering fixed costs, but they work in different ways.
In practice
Real-world examples.
Example
A landscaping business with a payroll of $60,000 receives a workers' compensation quote. The base premium is $1,800, and a $250 expense constant is added, so the final premium is $2,050. The owner notices that the flat charge is about 12% of the total and compares it against other insurers.
Example
A manufacturing company with 400 employees is charged the same $250 expense constant as the landscaping business. On its $480,000 premium the flat charge is a negligible part of the bill. Finance simply records it within total insurance cost.
Example
A broker is shopping a policy for a family restaurant. One insurer quotes a base premium of $5,000 plus a constant of $400, while another quotes a base premium of $5,100 plus a constant of $150. The totals are $5,400 and $5,250, so the second quote is cheaper despite the higher rate.
Formula
Calculation
Total premium = (Exposure / 100 x Rate per $100) + Expense constant
A building firm has an annual payroll of $2,000,000, and the rate for its classification is $2.50 per $100 of payroll. The base premium is 2,000,000 / 100 x 2.50 = 20,000 x 2.50 = $50,000. The insurer adds an expense constant of $250. Total premium = 50,000 + 250 = $50,250.Case study
Seen in the real world.
Copperfield Print Works is an illustrative, fictional company with three small print shops, each insured under its own workers' compensation policy. Each policy carried a $300 expense constant, so the company paid $900 a year in flat charges alone.
Its finance manager noticed that the three policies had separate renewal dates and separate paperwork. She worked with a broker to combine them under one policy covering all three locations, which meant paying the constant only once.
The saving was 900 - 300 = $600 a year, and administration time fell as well. The illustrative lesson is that flat charges reward consolidation, so it is worth counting the number of policies as well as the rate on each.
Watch out
Common mistakes.
- Comparing insurance quotes on rate alone and overlooking flat charges such as the expense constant.
- Assuming the charge scales with the size of the business, when it is a fixed amount for each policy.
- Forgetting that the constant is charged again at every renewal, so it recurs year after year.
Questions
People also ask.
What is an expense constant used for?
It helps the insurer to cover fixed costs of issuing and administering a policy, which do not vary with the size of the premium.
Is the expense constant the same as a policy fee?
They are similar in purpose, but the expense constant is usually part of the filed rating rules, while a policy fee may be set by the insurer or broker.
Can an expense constant be negotiated?
Often not, because it is set in the rating rules, but you can reduce its effect by combining policies or changing insurers.
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