What Does Pro Rata Cancellation Mean?
A pro rata cancellation is a cancellation on an insurance policy in which the policyholder is fully refunded for premiums that have been paid in advance. It is an alternative to a short rate cancellation in which the refund incurs a penalty. Clients have the ability to cancel their policies at any time and for any reason. For example, if you’ve sold your car, you would not need insurance on it anymore.
In most cases, when you are purchasing an insurance policy, you pay your insurance premiums for the entire policy term (usually 1 year) upfront at policy inception date. Although you’ve made a lump sum payment at the start of the policy term, the broker and insurance company technically hasn’t earned all of that money yet. Brokers and insurers earn the premium pro rata or proportionally throughout the policy term.
For example, if the policy is for one year, but only six months have passed, the broker and insurer have earned half of the premium paid. The rest is considered “unearned premiums” and must be held in trust ready to be returned at any time should the client choose to cancel.
Insuranceopedia Explains Pro Rata Cancellation
To further the above example, a policyholder purchases a one-year policy for $1,000 but cancels it after six months. In a pro rate cancellation, they would receive a refund of $500, which is equivalent to the remaining six months of coverage they forfeited. In essence, you receive a proportional refund for the insurance that you did not use.
On the other side are short rate cancellations. With short rate cancellations, your premium is calculated proportionally like pro rata but there is an administration fee applied to the amount of refund. In comparison with short rate cancellations, pro rata cancellations are the more desirable option for policyholders as they offer better refund terms. What types of cancellation a policy allows depends on the insurer and the specific policy.
In most cases, whether you get a short rate or pro rata refund upon cancellation of the policy depends on who requests that the policy be cancelled. In cases where there is a material change in risk reported to the insurance company, they may choose to get off the risk and refund you your prepaid premiums.
If the insurer chooses to cancel the policy, it will usually be a proportional refund - a pro rata cancellation. However, if the insured chooses to cancel the policy because they have sold the asset being insured or want to switch to another insurer that is offering them a better deal, the insurer will require a short rate cancellation. This means when an insured voluntarily cancels a policy, there will be a penalty applied to the premium refund.
This refund penalty for short rate cancellations is usually a percentage of the unearned premium and meant to cover the cost of administration and processing the voluntary refund request. It is also meant to discourage insureds from switching insurers to marginal savings.
There are also cases in which policies are considered full earned. For these policies, there is no refund available when the policy is cancelled. This is usually used for short-term policies like vacancy permits, temporary vehicle insurance, or policies insuring a building during renovations.