DEFINITION of ‘Converted Losses’
The total amount of claims incurred multiplied by a loss conversion factor. Converted losses allow an insurance company to account for loss adjustment expenses, and are used in the calculation of a Retrospective, or Retro, premium.
INVESTOPEDIA EXPLAINS ‘Converted Losses’
Converted losses are used to calculate the retrospective rating insurance premium, which is calculated by adding together the basic premium, loss premium, and converted losses, and then multiplying this sum by a tax multiplier. The amount of the tax multiplier varies from state to state, as different states tax policies at different rates. An increase in the loss conversion factor, which adjusts the incurred losses, reduces the premium by increasing the amount of risk that the company is assuming.
For example, a policy generated $200,000 in premiums during the latest policy period. This is a standard premium. Losses for that time period amounted to $50,000. The insurer has a basic factor of 28%, a loss conversion factor of 1.12, and a tax multiplier of 1.025. In order to calculate the Retro premium, the insurer will have to make adjustments. The basic premium is calculated as $56,000 (calculated from $200,000 x 0.28), and the converted losses are $56,000 (calculated from $50,000 x 1.12). The sum of the basic premium and converted losses is $112,000, which is then multiplied by the tax factor of 1.025. The Retro premium is $112,000 x 1.025, or $114,800. The Retro plan would result in a premium that is less than the standard premium.
Over time converted losses may adjust as the costs of settling claims increases for a particular policy. This happens in cases in which claims take a long period of time to be completed. The converted loss is based off of incurred losses, which includes both the actual losses associated with a policy as well as estimates that the company set aside as reserves. These reserves take into account what the insurer thinks that losses on the policy will ultimately end up at.