The definition of short rate cancellation is a penalty method that is applied when an insurance policy is canceled before its expiration date. This penalty method uses a table to determine how much premium was used by the time the policy is canceled. Based on that result, the insurance company can establish the penalties applied for each canceled policy. This financial penalty allows the insurance company to retain a percentage of the unearned premium to cover possible costs.
Short rate cancellation is similar to the pro rata cancellation, but there is one big difference between them. Unlike the pro rata cancellation, the short term cancellation comes with penalties. This cancellation method is often applied when the insured decides to cancel a policy before its expiration date. Short rate cancellation is applied because the insured signed a contract, and they choose to break it early. As in any other circumstances, a penalty is usually applied.
When an insured party cancels an insurance policy that covers a property or disability, the short rate cancellation penalty can be activated. If a short rate cancellation occurs then the unearned premium is returned, but not in full. The insurance company diminishes the refund for administration costs sustained by the insurance company when the policy is placed in its books. The short rate cancellation is also used as a disincentive for insured individuals who canceled a policy early—a way to motivate their policy-holders to respect the signed contract.
In short rate cancellations, there is no set penalty that every insurance company applies. The penalty is calculated on the policy’s length in time and remaining days left on the policy. Through the short rate cancellation, the insured won’t receive all the unearned premium back when the policy is canceled but be penalized by a percentage from it. Through this method of cancellation, the policy-holder doesn’t receive the full refund of the unearned premium.
The amount set as the penalty is determined by the insurance company, either based on the short rate table or on the pro rata value multiplied by an added percentage.
A policy-holder that bought an annual policy with a premium of $1,000 decides to cancel their policy after six months. The pro rata cancellation would return $500 to them, but the short rate cancellation uses the pro rata, and the insurance company adds 20% to it for their incurred cost, which is $100. The policy-holder will receive $400 with a short rate cancellation.