Equivalent Flat Rate

What Is an Equivalent Flat Rate?

The term “equivalent flat rate” is used in the context of the insurance industry within the European Union (EU). Specifically, it relates to the methods used by the EU to regulate the insurance industry in order to ensure that insurance policyholders will have their claims honored even if their insurers become insolvent and are unable to meet their obligations.

How Equivalent Flat Rates Work

When purchasing insurance, the two main priorities that all consumers share is to pay as little as possible for their coverage and to be sure that, if they do need to file a claim, their insurance company will be able to honor its commitments. To help ensure this, governments throughout the world create regulatory systems designed to protect consumers from the risk that insurers might become insolvent and be unable to honor their customers’ claims.

To that end, countries in the EU have created insurance guarantee schemes (IGS) to act as government-backed “insurers of last resort” to protect consumers. The two main approaches to funding these organizations are through a flat-rate method, in which insurers are charged a set percentage of their premiums regardless of how much risk is assumed by the insurer; and a risk-based method, in which the insurer is charged an amount that varies depending on the risk of their policies. An equivalent flat rate, therefore, is a flat rate that is intended to average the amount that would be charged to the insurer under a risk-based method.

To achieve an equivalent flat rate, the IGS adjusts the flat rate it charges an insurer to reflect an amount equal to what it would charge that insurer under a risk-based scheme. This adjustment allows the insurer to pay what they perceive to be a flat rate, while the IGS remains protected by charging a rate based on the actual risk assumed by the insurer. If an IGS uses a flat-rate scheme, an insurer that takes on greater risk does not have to pay increasing rates. Therefore, the insurer will not be required to raise the premiums they charge to their policyholders.

Real World Example of an Equivalent Flat Rate

Safe Choice Insurance is a hypothetical insurance company operating in the EU. Under their country’s IGS program, Safe Choice is required to pay a set percentage of their insurance premiums to their insurance regulator. The regulator then holds these funds in a contingency fund to cover any potential future claims that Safe Choice is unable to pay for due to insolvency. For Safe Choice’s customers, this provides an added level of assurance that they will be able to count on the protections they purchase.

Although Safe Choice pays the same percentage rate from one month to the next, the actual percentage chosen by the IGS was based on an equivalent flat rate methodology. What this means is that, in selecting the rate, the regulator considered the risk level of Safe Choice’s policies and chose a flat rate that they felt would approximate, on an average basis, the level of premiums that the regulator would collect if they assessed premiums on a risk-based basis for each of Safe Choice’s individual policies.