Pro Rata Cancellation

What Does Pro Rata Cancellation Mean?

A pro rata cancellation refers to the termination of an insurance policy in which the policyholder receives a full refund for any premiums paid in advance. This is in contrast to a short-rate cancellation, where the refund is subject to a penalty. Policyholders have the right to cancel their policies at any time and for any reason. For instance, if you have sold your car, you would no longer need insurance for it.

Typically, when purchasing an insurance policy, you pay the premiums for the entire term (usually one year) upfront at the policy’s inception. Although a lump sum payment is made at the start of the policy, the broker and insurance company have not technically earned the full amount. Instead, brokers and insurers earn the premium pro-rata, or proportionally, throughout the policy term.

For example, if the policy covers one year, but only six months have passed, the broker and insurer have earned only half of the premium. The remaining amount is considered an “unearned premium” and must be held in trust, ready to be refunded if the client decides to cancel.

Insuranceopedia Explains Pro Rata Cancellation

To further illustrate this, suppose a policyholder purchases a one-year policy for $1,000 but cancels it after six months. In a pro-rata cancellation, they would receive a refund of $500, which reflects the six months of coverage they forfeited. Essentially, a pro-rata cancellation provides a proportional refund for the unused portion of the insurance.

On the other hand, short-rate cancellations work similarly to pro rata in that the premium is calculated proportionally. However, with short-rate cancellations, an administrative fee is deducted from the refund amount. Compared to short-rate cancellations, pro rata cancellations are more favorable for policyholders because they offer better refund terms. The type of cancellation allowed depends on the insurer and the specific policy terms.

In most cases, whether you receive a short-rate or pro-rata refund depends on who initiates the policy cancellation. If the insurance company decides to cancel the policy due to a material change in risk, they may refund the prepaid premiums on a pro-rata basis.

If the insurer cancels the policy, it will typically be on a pro-rata basis, meaning the refund is proportional to the unused portion of the coverage. However, if the policyholder cancels the policy voluntarily—such as after selling the insured asset or switching to another insurer offering a better deal—the insurer will typically apply a short-rate cancellation. This means the policyholder will face a penalty on their refund.

The refund penalty in short-rate cancellations is usually a percentage of the unearned premium. This fee covers the administrative costs of processing the cancellation and discourages policyholders from switching insurers to save small amounts.

In some cases, policies are considered fully earned. No refund is provided for these policies if they are canceled. This often applies to short-term policies, such as vacancy permits, temporary vehicle insurance, or insurance covering a building during renovations.