What it means
In insurance pricing, an actuary (a specialist who calculates risk using statistics) first works out what claims are expected to cost. That expected claims cost, spread across all policyholders, is the net premium.
It is called net because it is stripped of everything else the insurer needs to cover. The customer does not pay the net premium alone.
The insurer adds a loading for sales commissions, administration, premium taxes, a safety margin and profit, which produces the gross premium actually charged. The difference between gross and net is therefore the price of running the insurance business.
A second common use is in reporting. An insurer buys reinsurance, which is insurance for insurers, to pass on part of its risk.
The net premiums written figure is the premiums it has written less the amount paid away to reinsurers, and this shows how much risk it keeps on its own balance sheet. In options trading, net premium means the total amount paid or received when several contracts are combined.
For example, buying one option and selling another produces a net debit if the purchase costs more, or a net credit if the sale brings in more. Traders use this to know the true up-front cost of a strategy.
The nuance is that none of these figures are the full story on their own. A low net premium does not mean the insurance is cheap if the loading is large.
Likewise, a high amount ceded to reinsurers is not automatically bad, since it may reflect a sensible decision to limit exposure.
In practice
Real-world examples.
Example
A home insurer's actuaries estimate $540 of expected claims per policy. They add $160 for costs and a profit margin, and the customer is quoted $700. The net premium is the $540 element that is expected to go straight back out in claims.
Example
A commercial insurer writes $80,000,000 of policies for factories and warehouses. It buys reinsurance for $20,000,000 to protect against a major fire or storm. Its net premium is $60,000,000, and that is the amount whose risk it keeps.
Example
An options trader buys a call for $6.50 and sells another call at a higher strike for $2.50, paying a net premium of $4.00 per share. For 100 shares, the trade costs $400. This is the most she can lose on the position.
Formula
Calculation
Net premium = expected claims cost per policy (in a simple model with no interest adjustment)
Gross premium = net premium + loading for expenses, commission and profit
Reinsurance version: net premiums written = gross premiums written - premiums ceded to reinsurers
An insurer expects claims of $720 per year on each household policy, so the net premium is $720. It adds a loading of $180 for expenses, commissions and profit, giving a gross premium of $720 + $180 = $900. The loading is $180 / $900 = 20% of the gross premium. If the insurer writes $50,000,000 of such premiums and passes $12,000,000 to reinsurers, net premiums written are $50,000,000 - $12,000,000 = $38,000,000.Case study
Seen in the real world.
Brightwater Mutual is a fictional insurer that sells small business policies. In this illustrative story, a new product manager was surprised to learn that customers paid $1,000 per policy while expected claims were only $650. The actuary explained that the $650 was the net premium and the remaining $350 covered distribution, claims handling, regulatory capital costs and a profit margin.
The manager used this breakdown to design a direct online channel with lower commission, cutting the loading from $350 to $290. Brightwater was able to reduce the gross premium to $940 while keeping the same expected profit per policy. Sales grew because the price was now more competitive, and the net premium stayed unchanged at $650 because the underlying risk had not changed.
Watch out
Common mistakes.
- Thinking the net premium is what the customer pays. The customer pays the gross premium, which includes the insurer's loading.
- Mixing up the insurance, reinsurance and options meanings. Always confirm which definition a report or colleague is using.
- Assuming a low net premium means a good deal. The cost of expenses and commissions can make the gross price much higher than the net.
Questions
People also ask.
Who calculates the net premium?
In insurance, actuaries do this using claims data, probabilities and sometimes an allowance for investment income.
Is net premium the same as net premiums written?
Not exactly, since net premiums written is a reporting measure showing premiums after reinsurance, while the pricing meaning is the claims-only portion of a premium.
Can the net premium change after a policy is sold?
In pricing terms the figure is fixed for that policy, but the insurer will review its assumptions for new policies as claims experience develops.
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