DEFINITION of ‘Equivalent Flat Rate’
The rate at which a flat rate insurance guarantee scheme and a risk-based insurance guarantee scheme are considered equal. Equivalent flat rates adjust the flat rate used in one type of insurance guarantee scheme (IGS) so that the insurer sees the same guarantee fund premiums as it would under the premium loading approached used in risk-based scheme.
BREAKING DOWN ‘Equivalent Flat Rate’
An insurance guarantee scheme (IGS) is designed to protect policyholders in the case of an insurer’s insolvency. While insurance regulators have a variety of tools at their disposal to protect policyholders in the case of an insurer being insolvent, regulations may not be able to protect against all the possible scenarios that could result in insolvency. Insurance guarantee schemes allow policyholders to pool the risks of multiple insurers, and different financing types are used to insure against insolvency.
The most common IGS financing methods are the flat rate and risk-based methods. The flat rate IGS charge a set percentage of an insurer’s premiums, with the flat rate not accounting for how much risk an insurer has taken on because it is developed irrespective of the insurer’s risk profile. Risk-based charges are based on the amount of risk that an insurer has taken on, meaning that a higher proportion of premium is required for insurers that take on more risk.
The type of financing scheme used in an IGS affects the risk-taking behaviors of the insurer. The insurer’s shareholders and policyholders may want the insurer to act differently, with shareholders wanting the higher premiums associated with taking on more risk and policyholders wanting less risk so that their claims can be covered.
The equivalent flat rate is used by analysts to determine how different risk-shifting behaviors affect the welfare of policyholders relative to shareholders. Small increases in the premium charged in an IGS result in the flat rate and risk-based approaches being similar in terms of policyholders’ welfare, while large premium increases in risk-based approaches is better for policyholders.